Taxing changes: what's different about tax preparer penalties?

Time will tell if recent amendments to tax preparer penalties will significantly impact how tax services are provided or if things will remain business as usual.

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On the one hand, increases in penalty amounts may provide IRS agents with the incentive to pursue additional fines. On the other hand, the apparent intent of the law is to punish abusers of the tax system. As such, the IRS may choose to broadly define "reasonable belief" to limit application of the new standard to those originally designed to be penalized. In any case, it is important for preparers to be aware of the changes and any potential consequences.

OVERVIEW

The Small Business and Work Opportunity Act of 2007 amended IRC Sec. 6694 for all returns prepared after May 25, 2007. Overall, changes to the Act apply to tax preparers and taxpayers, as well as the IRS. Highlights of the amendments include:

* The preparer standard for undisclosed positions was raised from the "realistic possibility of success" (RPOS) standard to a "reasonable belief that the position would more likely than not be sustained on its merits" (MLTN).

* The preparer standard for disclosed positions was raised from "not frivolous" to "reasonable basis."

* The preparer penalty and related standards now apply to a number of additional forms including estate, gift, excise and payroll tax returns. Previously these penalties only applied to income tax returns. (At press time, it was not established whether the IRS will publish a list of affected forms.)

While these changes are generally effective for returns prepared after May 25, 2007, the U.S. Treasury issued Notice 2007-54 deferring the implementation of the new penalty structure and easing the difficulties of implementation. The Treasury also issued proposed regulations to change Circular 230 Sec. 10.34 to conform to the changes to IRC Sec. 6694.

Preparers must understand the importance of these amendments because they affect the way tax returns are prepared and the communications between the preparer, taxpayer, other preparers and the IRS.

CONFLICTS OF INTEREST

In short, the amended Act presents a greater potential for conflicts of interest between preparers and their clients. For many preparers, it may prove difficult to determine the correct treatment of routine items with the degree of certainty required by the MLTN standard.

In response to the severe potential penalties for failing to disclose items on the tax return, preparers may urge their clients to disclose virtually every uncertain item on the return, which would defeat the true purpose of the disclosure system.

The preparer can only be protected from the Sec. 6694 penalty if a less than MLTN position is disclosed. In contrast, the taxpayer is not required to disclose a position on a return unless it is less than Substantial Authority.

Sec. 10.29 of Circular 230 states "a practitioner shall not represent a client ... before the IRS if the representation involves a conflict of interest." A "conflict of interest" includes situations where there is "a significant risk that the representation of one or more clients will be materially limited by ... a personal interest of the practitioner."

The reality is that a preparer does not control the taxpayer's tax return and cannot force the taxpayer to disclose a position on a return. If the taxpayer does not agree to disclose the position, then the preparer may not want to sign the return. It's likely that, under this scenario, the preparer is still subject to applicable penalties (including the $25 fine for not signing the return) in addition to the conflict of interest issues that will be created with their client.

MLTN COMPLIANCE

Under the revised Act, preparers may have greater difficulty determining the right treatment of routine items. MLTN requires a higher degree of certainty than the previous RPOS standard. For many items, the preparer may have little guidance. For others, unusual circumstances may exist that were not addressed by regulations.

Uncertainty may also be generated from the client's information. The penalty provisions include the phrase "or reasonably should have known." While the preparer is clearly allowed to rely on information provided by the taxpayer, there is a responsibility to determine the reasonableness with a high degree of certainty.

There are a few common items on tax returns where preparers may now find it difficult to determine whether or not the position meets the MLTN standard. These include capitalization of expenses, independent contractor status (the penalties now include payroll tax returns), valuations, reasonable compensation and substantiation of expenses.

To deal with potential issues that may arise, one recommendation is to document the information provided by clients and the basis for determining its reasonableness.

DISCLOSURES

Preparers should be familiar with Rev. Proc. 2006-48 and subsequent annual releases. This document identifies circumstances under which the disclosure on a taxpayer's return will be deemed adequate. It states in the introduction "Additional disclosure of facts relevant to, or positions taken with respect to, issues involving certain specified items is unnecessary, provided that the applicable tax return forms and attachments are completed in a clear manner and in accordance with their instructions. The money amounts entered on the forms must be verifiable, and information on the return must be properly disclosed."

Sec. 4.01(3) states "The disclosure of an amount as provided in Sec. 4.02 below is not adequate when the understatement arises from a transaction between related parties. If an entry may present a legal issue or controversy because of a related party transaction, then that transaction must be disclosed on a Form 8275."

Because the penalties are so high, preparers may feel compelled to have their clients disclose virtually every related party transaction for which there is some uncertainty. The fines under Sec. 6694 and Circular 230 could total as much as 150 percent of fees derived from the return. Adding insult to injury, the preparer may also be subject to sanction by the Office of Professional Responsibility.

Non-signing preparers present another disclosure issue under the new amendments. It's not clear how penalties will be imposed on non-signing preparers, but it appears that the preparer should be treated as having satisfied their responsibility to disclose if the position is adequately disclosed by the taxpayer, or the non-signing preparer informs the taxpayer or another preparer of any opportunities to avoid penalties through disclosure.

A final disclosure issue exists for all of the new forms including estate/gift tax and payroll forms. For these forms, the preparer will have to determine what constitutes sufficient disclosure for penalty purposes because there is no clear guidance. CPAs remain hopeful that the IRS will rapidly address this deficiency before these returns must be filed.

TRANSITION ISSUES

Notice 2007-54 provided transitional relief to offset the difficulties of mid-year compliance and implementation. The Notice deferred compliance with the new standard to income tax returns due by Dec. 31, 2007; estimated tax returns due before Jan. 15, 2008; and employment and excise taxes due by Jan. 31, 2008.

It's important to note this applies to returns due by those dates not necessarily returns filed by those dates. For example, a June 30, 2007, year-end corporation on extension with a due date of March 15, 2008, the relief may not apply, even if the return is filed before Dec. 31, 2007.

TREAD CAREFULLY

Recent changes to IRC Sec. 6694 are significant--and often confusing. For the preparer, changes to the Act will fundamentally impact how information is gathered and uncertain positions documented and reported. It will also affect how the preparer establishes the reasonableness of reliance on information provided by the taxpayer and other preparers.

The revisions should focus preparers on being more detail-oriented than ever--clearly documenting how information was gathered and the reasonableness for reliance on sources--including the client, other preparers and previously filed returns. For all of you Hill Street Blues fans, Sgt. Phil Esterhaus would say, "Hey, let's be careful out there."

Conrad Davis, CPA is a partner at Ueltzen & Company LLC in Sacramento. You can reach him at cdavis@ueltzen.com.

BY CONRAD DAVIS, CPA