The following article is from the BNA Tax Management Weekly Report. To see the full report and take a trial to the BNA Tax and Accounting Center, visit this site.
By Mitchell M. Gans and Jonathan G. Blattmachr
Mitchell M. Gans is a professor of law at Hofstra University School of Law in Hempstead, N.Y. Jonathan G. Blattmachr is a partner at Milbank, Tweed, Hadley & McCloy LLP in New York.
Copyright Mitchell M. Gans and Jonathan G. Blattmachr 2008. All rights reserved.
The Small Business and Work Opportunity Tax Act of 2007 (the “Act”), which was contained in the Iraq Appropriations Act and was signed by the president May 25, 2007, made substantial changes in the standards applicable under § 6694(a).1
1 References to the “Code” are references to the Internal Revenue Code of 1986.
The section imposes a penalty on return preparers who fail to comply with the standards it sets forth. In general, the Act heightened the standards, making it more difficult for preparers to avoid the penalties that the section imposes.
Prior to the Act, in the event that the amount of income tax on a tax return or a claim for refund was understated,2 the preparer could be subject to penalty under § 6694 if the preparer failed to comply with the standards contained in that section. For this purpose, a person was deemed to be a preparer if he or she, for compensation:
- prepared and signed the return or claim for refund, or3
- gave advice about a return-related or claim-related position.4
2 If it ultimately is determined that no underpayment of tax occurred, no penalty is imposed. See § 6694(d).
3 In Notice 2008-13, such a person is referred to as a “signing preparer.” Throughout this article, such a person is usually referred to simply as a “preparer.”
4 In Notice 2008-13, such a person is referred to as a “non-signing preparer” rather than a “non-signing adviser.” Throughout this article, such a person is usually referred to simply as an “adviser.”
In addition, preparers and non-signing advisers could be sanctioned for failing to meet the requisite standard under Circular 230.5
5 Where a practitioner gave tax advice prior to the consummation of the transaction, § 6694 was inapplicable. See Regs. § 301.7701-15(a)(2)(i). In contrast, Section 10.34 of the circular does not have an explicit exception for such pre-transaction advice. It applies where the practitioner signs the return (or prepares a portion of it) or advises the client to take a position on the return. In the case of pre-transaction advice, it was not clear (and remains unclear) whether Section 10.34 applies. Nonetheless, if the pre-transaction advice was in writing, Section 10.37 would apply since its scope is much broader—it applies to written advice “concerning one or more Federal tax issues”(and Section 10.35 could apply, as well, if the advice was in writing and constituted a “covered opinion” within the meaning of that section).
Section 6694(a), before it was amended, imposed its penalty if a position taken on a return or claim for refund did not have a realistic possibility of success (at least a one-in-three possibility of being sustained on the merits6).
6 See Regs. § 1.6694-2(b) (“A position is considered to have a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits.”).
If, however, in the case of a signing preparer, adequate disclosure concerning the position was made on the return, the standard was lower—no penalty was imposed if the position was not frivolous (i.e., not patently improper). In the case of a non-signing adviser, the lower standard was applicable if the adviser had advised the client about any opportunity to avoid penalties through disclosure.7
7 See Regs. § 1.6694-2(c)(3)(ii).
In any case, a preparer would not be subject to the penalty with respect to any position if the preparer did not know of the position (and reasonably should not have known).8
8 It seems clear that, under Section 6694, more one than person may be the preparer of the same return. For example, a person who prepares an appraisal that becomes part of an estate tax return would not be a preparer with respect to some other position taken on the return (e.g., a deduction for interest incurred during the administration of the estate) and, therefore, would not be subject to the penalty if it turns out that the interest should not have been deducted, even if the appraiser is treated as a preparer of the return for other purposes.
While § 6694 only applied in the income tax setting, Section 10.34 of Circular 230 imposed a parallel obligation—using the same two standards—on all practitioners preparing returns or giving advice about return-related or refund-related positions. Thus, for example, a practitioner signing an estate tax return or giving advice about a position taken on the return had been required to comply with these standards by virtue of Section 10.34 of the circular (even though § 6694 was inapplicable).
Act Changes
Under the Act, § 6694 is amended in three ways. First, the standards are elevated. As amended, the section makes the penalty inapplicable if the preparer or adviser reasonably believed that the position was more likely than not correct (thus importing the more-likely-than-not standard from the covered opinion rules in Section 10.35 of the circular).
If, however, disclosure is in fact made on the return (or, in the case of a non-signing adviser, advice about disclosure is given), the penalty is not imposed if there is a reasonable basis for the position (a standard that appears to be less rigorous than the one-in-three formulation applicable under pre-Act law).9 There is a pending amendment to Section 10.34 that would make it consistent with these new standards in § 6694(a).10
9 See, generally, Gould, Giving Tax Advice—Some Ethical, Professional and Legal Considerations, 97 Tax Notes 523 (Oct. 28, 2002) (discussing American Bar Association Ethics Opinions 314 and 85-352 and, in this context, explaining how the realistic-possibility standard requires a higher degree of certainty than the reasonable-basis standard);see also Cummings, The Range of Legal Tax Opinions, With Emphasis on the Should Opinion, 98 Tax Notes 1125 (Feb. 17, 2003) (canvassing other articles in which the author took the view that the reasonable-basis standard required less certainty of success than the realistic-possibility standard).
Notice 2008-13 provides that whether or not the reasonable-basis standard is satisfied is controlled by Regs. § 1.6662-3(b)(3). As the cited regulation indicates, the reasonable-basis standard is significantly higher than the pre-Act not-frivolous standard but not as high as the substantial-authority standard. In order to satisfy the reasonable-basis standard, the return position must be based on one or more of the authorities listed in Regs. § 1.6662-4(d)(iii) (after taking into account the persuasiveness and relevance of the authorities and subsequent developments). (Note that this may not suggest that the preparer must research the issue to establish the reasonable-basis standard; rather, it seems to suggest that the reasonable-basis standard is an objective determination just as the substantial-authority standard seems to be. But cf. Example 10 in Notice 2008-13, discussed elsewhere herein.)
Like the pre-Act version of § 6694, Section 10.34 of the circular had imposed a realistic-possibility standard, under which a one-in-three likelihood of success had to be present. See Section 10.34(e). But with Congress's adoption of the reasonable-basis standard in § 6694, the Treasury Department has proposed an amendment to Section 10.34 of the circular that would eliminate the one-in-three standard and thereby make it consistent with § 6694. See 72 Fed. Reg. 54621-01, 2007-45 I.R.B. 977 (Sept. 26, 2007). Whether the adoption of the reasonable-basis standard will ultimately be viewed as substantively different from the pre-Act realistic-possibility-of-success standard remains to be seen.
10 See 72 Fed. Reg. 54621-01, 2007-45 I.R.B. 977 (Sept. 26, 2007).
Second, § 6694 will now apply to preparers and advisers outside of the income tax setting. Unlike the change in standards, this aspect of the Act should not affect day-to-day practice for any practitioner covered by Circular 230 inasmuch as he or she presumably has been complying with the parallel obligation under Section 10.34 (which, as indicated, has not been limited to the income tax setting).11
11 Note, however, that there is an important difference between the scope of Section 10.34 of the circular and § 6694. A practitioner who does not sign the return but merely gives advice about a transaction before it is consummated is not subject to § 6694. See Regs. § 301.7701-15; see also Notice 2008-13 (indicating that this provision continues to apply under the amended version of § 6694). In contrast, there appears to be no similar exception for pre-transaction advice in Section 10.34.
Third, the amount of the penalty has been increased from $250 to the greater of $1,000 or one-half of the preparer's fee with respect to the return (or claim for refund). In the case of a willful or reckless understatement, the subsection b penalty is increased from $1,000 to the greater of $5,000 or one-half of the preparer's fee.
Expansion of Those Treated As Return Preparers
Under § 7701(a)(36) of the Code, as amended by the Act, a “tax return preparer” includes any person who prepares for compensation a tax return or claim for refund or a substantial portion of a tax return or claim for refund. Thus, for example, as amended, § 6694 can apply in the case of an estate tax return.
In contrast, prior to the Act, as indicated, the section did not apply outside of the income tax setting. As under pre-Act law, the section applies to persons who do not actually sign or prepare the return but merely give advice about a position to be taken on the return. It might, for example, cover a divorce lawyer who advises a client that certain payments made to the client's spouse constitute alimony deductible under § 215, even though that attorney never prepares returns and knows that the client's income tax return will be prepared by another professional.
New Penalty for Erroneous Claims for Refund
The Act also imposes a new penalty on taxpayers, as opposed to the preparer or adviser, for filing an erroneous claim for income tax refund or credit. Under new § 6676, if the taxpayer files a claim for refund or credit of income tax that is determined to be excessive, it will no longer simply be denied, but a penalty equal to 20% of the “excessive amount” will be imposed. Note that, unlike § 6694, this section only applies in the income tax context.
A claim is excessive to the extent it seeks more than the amount properly refundable except for a credit under § 32 (i.e., the earned income credit). The provision is designed to deter taxpayers from taking aggressive positions on a risk-free basis—no penalty could be imposed under pre-Act law if the refund claim was denied, thus permitting taxpayers to take an aggressive position without concern about any downside risk. In contrast, a taxpayer taking an aggressive position on a return would have to weigh the risk of the accuracy-related penalty in § 6662 and the fraud penalty in § 6663.
This new provision eliminates the disparity between taxpayers taking aggressive positions in a refund claim and taxpayers taking such a position on a return. And, as suggested, it eliminates the opportunity taxpayers previously enjoyed to take aggressive positions on a risk-free basis via a refund claim.
As the IRS has indicated, it will impose the penalty if the claim is excessive and is denied.12 In other words, the claim is deemed excessive and the penalty is automatically imposed in any case where the claim is not allowed unless there was a “reasonable basis” for the claim.13 Thus, to the extent the IRS denies the claim and determines that it lacked a reasonable basis, it will impose the penalty even if the taxpayer chooses not to commence litigation on the claim.14
12 See, e.g., CCA 200747020.
13 See id. Note that, again, the determination of whether there was a reasonable basis for the claim seems to be an objective one.
14 Note that the penalty is reduced for any penalty imposed by § 6662 (an accuracy-related penalty) or by § 6663 (civil fraud penalty). Note also that it does not apply in the case of the earned income credit.
In terms of reasonable basis, it would seem that the taxpayer's subjective belief about the merit of the claim is irrelevant, as the section does not cross-reference § 6664 (which may permit a taxpayer to defeat penalties under § 6662 based, in part, on such a subjective belief) or otherwise provide for such a defense.
Thus, even if a preparer advises the taxpayer that the position taken in the refund claim has a reasonable basis, the taxpayer may still be liable for the penalty if the IRS and the courts conclude otherwise, although perhaps the taxpayer might be able to sue the preparer or adviser for malpractice if he or she did not fully inform the taxpayer about the risk of the penalty and the underlying weaknesses in the position taken in the claim.
This penalty will likely strengthen the IRS's hand in terms of refund claims. As it has already suggested, it will seek to impose the penalty in all cases where it denies the claim (unless it determines that there was a reasonable basis for the claim). Perhaps it will use the penalty to deter taxpayers from commencing litigation on the refund claim by offering an abatement of the penalty if the taxpayer agrees not to sue. To the extent the penalty has the effect of closing the courthouse door on taxpayers, it will be unfortunate.
On the other hand, taxpayers should not be able to abuse the system with meritless claims on a risk-free basis. But ultimately one is left to wonder why judicial sanctions would not sufficiently deter frivolous litigation of refund claims.15 Perhaps these concerns could be ameliorated if the Code were amended to provide that the penalty would be negated if the claim satisfied the lower, not-frivolous standard.
15 See Rule 11 of the Federal Rules of Civil Procedure.
Notice 2007-54 ‘Suspended’ Act Changes for 2007
As indicated, the Act was signed May 25, 2007, and the amendment to § 6694 became effective immediately. However, in Notice 2007-54,16 the IRS provided transitional relief. The IRS essentially suspended the application of the new provisions with respect to income tax returns due on or before December 31, 2007. That is, pre-Act law continued to apply during this time frame.
16 2007-27 I.R.B. 12.
Oddly, Notice 2007-54 treated preparers and advisers of other returns (such as estate and gift tax returns) more harshly. Although the notice suspended the application of the amendments for income tax return preparers and advisers in their entirety, it required preparers and advisers with respect to non-income tax returns to use the “reasonable basis” standard during the transition period.
Thus, during this period, in order for a non-income tax preparer or adviser to avoid the penalty, he or she had to establish that there was a reasonable basis for the return position. And even if disclosure was made, the reasonable-basis standard remained applicable. In this regard, the 2007 notice was “out of sync” with Section 10.34 of the circular, which provided that a practitioner could take a position on a return if it was not frivolous as long as disclosure was made (or, in the case of a non-signing adviser, advice about disclosure was given).17
17 While there is a pending amendment to Section 10.34 that would make it consistent with § 6694, see 72 Fed. Reg. 54621-01, 2007-45 I.R.B. 977 (Sept. 26, 2007), it was not effective during the transition period.
Hence, it seems that, in the case of a return not involving income tax, a preparer or adviser, who was a practitioner, could face a penalty under § 6694 during the transition period even though he or she was in compliance with the circular.
Notice 2008-13
The IRS December 31, 2007, issued Notice 2008-1318 (the “Notice”). In the Notice, the IRS clarified its intentions regarding the enforcement of § 6694 pending further guidance (which, it indicates, will be issued during 2008).
18 2008-3 I.R.B. 282. As a general matter, the notice is effective January 1, 2008 (i.e., it is effective with respect to returns filed and advice provided after January 1). There is an exception for 2007 employment and excise tax returns.
In the case of someone who for compensation signs a return or gives advice with respect to a return where there is an understatement of tax liability, the Notice provides, as does the statute itself, that the penalty is not imposed if the person had a reasonable belief that the position would more likely than not be sustained on the merits. In order to meet this standard, the preparer or adviser must analyze the appropriate authorities19 and, as a result, in good faith, reasonably hold the belief that the likelihood of the taxpayer succeeding is greater than 50%.20
19 Practitioners and other preparers may well wish to record in writing what authorities they considered in reaching their conclusions. Among other things, this may show that the preparer acted in good faith, which, along with reasonable cause for the understatement, will vitiate the penalty otherwise imposed by § 6694(a).
20 See Notice 2008-13, Paragraph D. In analyzing the merit of the position, the preparer may rely in good faith on the facts and schedules prepared by the taxpayer or another adviser. See id. Thus, there is no duty independently to verify the accuracy of the information supplied. If, however, the information supplied appears to be incorrect or incomplete, the preparer must make further inquiry. Also, the preparer may not ignore information in his or her possession or any implications suggested by such information.
Reasonable Basis Exceptions.
The absence of such a belief is not, however, necessarily fatal. The Notice makes a distinction between preparers and advisers. For preparers, no penalty is imposed if there is a reasonable basis for the position,21 even if the preparer does not reasonably conclude that the position is more likely than not to be sustained, if, as discussed in part in more detail below:
- the required disclosure form disclosing the position is in fact filed with the return;
- there is no substantial authority for the position but the preparer provides the taxpayer with a return that includes the disclosure form (even if, apparently, the taxpayer removes it before filing the return);
- there is substantial authority for the position and the preparer advises the taxpayer of the difference between the penalty standards applicable to the taxpayer under § 666222 and those applicable to the preparer under § 6694 and contemporaneously documents that this advice was given, even though apparently no disclosure form was prepared or filed; or
- the position relates to a tax shelter23 and the preparer advises the taxpayer of the penalty standards applicable to the taxpayer under § 6662(d)(2)(C)24 and the difference, if any, between those standards and the standards under § 6694 and contemporaneously documents that this advice was given, even though apparently no disclosure form was prepared or filed.
21 Notice 2008-13, Paragraph F, indicates that the term “reasonable basis” has, for purposes of the Notice, the same meaning as in Regs. § 1.6662-3(b)(3). See Footnote 9, supra, for a discussion of this regulation. Paragraph F goes on to provide that, in assessing the facts, the preparer may rely on information supplied by the taxpayer or another adviser. There is no duty independently to investigate. However, a duty does arise if the information is incomplete or inaccurate. And a preparer may not ignore information or the implication of such information.
22 Perhaps, in order to provide the taxpayer with a full explanation of § 6662, the preparer must explore with the taxpayer the penalty for disregarding a rule or regulation and the taxpayer's ability to defeat it by making disclosure (provided there is a reasonable basis for the position). See Regs. § 1.6662-3(c). Thus, cautious practitioners will include a discussion of this penalty and the opportunity to defeat it by disclosure in their explanation of the penalties.
23 A tax shelter for this purpose is defined as a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance of federal income tax. See § 6662(d)(2)(C)(ii).
24 Section 6662(d)(2)(C) in effect provides that, in the case of a tax shelter, neither substantial authority nor disclosure enables the taxpayer to avoid the substantial-understatement penalty under § 6662.
In the case of an adviser, on the other hand, if there is a reasonable basis, the penalty can be avoided by explaining the opportunities for the taxpayer to avoid penalties through disclosure.
Significantly, the Notice, in Example 10, appears to undercut the statute, making it easier for preparers to escape the penalty in close cases. The example suggests that the penalty can be avoided where the preparer researches an issue, concludes that there is a reasonable basis for the position but cannot “handicap” whether the position is more likely than not correct. In the example, no penalty is imposed in these circumstances,25 even though no disclosure of the position was made on the return.
25 The example does not specify whether the preparer concluded it was impossible to quantify or whether, in fact, it was impossible to quantify. This difference, obviously, could be important. Perhaps, it will be clarified in regulations.
The example does not provide any explanation for its conclusion. Nor does it indicate how extensively the preparer had researched the issue(though prudent preparers seeking to rely on the example will presumably research the issue thoroughly and contemporaneously record their efforts). One might reasonably read the example as implying that, in any case where the issue is researched and it is impossible to precisely quantify the likelihood that the taxpayer will succeed, the benefit of the doubt goes to the preparer (i.e., no penalty is imposed).
Even though this example in effect rewrites the statute—the statute contemplates that the penalty is to be imposed if there is no disclosure and the preparer did not reasonably believe that the position would more likely than not be sustained—it is a welcome development from the practitioner's perspective. After all, preparers will often have a difficult time quantifying the likelihood of success with precision. Perhaps this example will be clarified when final regulations are issued.
Another aspect of the example requires clarification. The example posits that the preparer had concluded, after doing legal research, that the position had a reasonable basis. It goes on to assume, based on this posited fact, that the position was in fact supported by a reasonable basis. If, however, the reasonable-basis standard is an objective one, as seems to be indicated in Regs. § 1.6662-3(b)(3), the preparer's belief as to the merits of the position should be irrelevant.
One is left to wonder if the example was intended to incorporate a subjective element of analysis into the reasonable-basis inquiry. It must be conceded, however, that a subjective reading is a difficult one to reach given that paragraph E of the Notice indicates that the term “reasonable basis” is to be defined with reference to Regs. § 1.6662-3(b)(3) (which, in defining the term, does not make the taxpayer's subjective belief a relevant factor).
In any event, as suggested, Example 10 will likely prove to have enormous practical value. To illustrate, consider a preparer who is required to determine what portion of an investment adviser's fee incurred by a trustee is subject to the 2% “haircut” rule under § 67. In Knight v. Comr.,26 the Supreme Court held that, as a general matter, such fees are subject to the rule.
26 __ U.S. __, 2008 WL 140749 (2008).
The Court acknowledged, however, that in some cases a trustee might be able to establish that the trust has an “unusual investment objective” or a need to invest in a manner that will balance the interests of the beneficiaries. If the trustee is able to show such need, the resulting incremental fees are not subject to the rule.
It would seem that, given the amorphous nature of the inquiry the court contemplates, preparers will find it impossible to precisely quantify the likelihood of success when claiming deductions for the portion of the fee attributable to an unusual investment objective or a need to balance the beneficiaries' interests. Example 10 offers a helpful defense to preparers facing this difficult task.
Inconsistency Between the Code and the Notice.
The Notice is somewhat inconsistent with the statute in another important respect. As indicated, if it is determined that the position was supported by substantial authority, the penalty is not imposed if the preparer had explained to the client the differences between the penalty standards applicable to preparers and advisers under § 6694 and the penalty standards applicable to the client under § 6662 (with the preparer or adviser required to record contemporaneously in the file the fact that the explanation was provided).
This aspect of the Notice is rather surprising given that the statute clearly contemplates a contrary result—unlike the Notice, the statute does not contain a substantial-authority exception to the general rule requiring disclosure where the preparer or adviser does not reasonably believe that the more-likely-than-not standard has been satisfied.
This deviation from the statute was presumably driven by concern about the conflict of interest issue inherent in the statute—if there is substantial authority, the client has no exposure to the Section 6662(d) penalty and therefore has no need to disclose in order to avoid the penalty, whereas the preparer would nonetheless have an incentive to make disclosure on the return in order to qualify for the lower, reasonable-basis standard under Section 6694. Under the Notice, this conflict is avoided because it eliminates the preparer's incentive to insist that the return contain the disclosure.
This aspect of the Notice will likely prove to be of great practical significance, for in those cases where the taxpayer is unwilling to disclose, the preparer nonetheless will be able to sign the return even though the more-likely-than-not-belief standard is not satisfied. Under the Notice, no penalty will be imposed as long as it is ultimately determined (apparently, on an objective basis and not based upon the belief of the preparer or adviser) that there was substantial authority supporting the position, the preparer explained the differences in the penalty standards, and the preparer contemporaneously documented the fact that the explanation had been given.
It should be noted that the requirement that the preparer explain the difference in penalty standards under Sections 6662 and 6694 seems rather odd. Given the premise that there is substantial authority, disclosure on the taxpayer's return is not required under the Notice in order for the preparer to avoid the § 6694 penalty (i.e., as indicated, under the Notice, if there is substantial authority, the preparer can avoid the penalty even if the taxpayer does not make disclosure) or for the taxpayer to avoid the substantial-understatement penalty under § 6662(d) (i.e., if there is substantial authority, the substantial-understatement penalty will not apply).27
27 See Notice 2008-13, Paragraph G. Disclosure must be made in accordance with Regs. § 1.6662-4(f)(2) (requiring that a Form 8275 or Form 8275R (where there is a contrary regulation)be attached to the return unless the IRS has indicated in its annual revenue procedure that a particular form of disclosure on the return itself obviates the need to attach the form).
If disclosure were required to avoid the preparer penalty, it might be appropriate for him or her to explain that there could be a conflict of interest between the preparer and the client—the preparer would want disclosure to avoid the penalty but the client may wish not to disclose. But, as stated, there does not seem to be such a conflict in this case. So the reason for the requirement of the explanation to the client does not seem apparent.
If the preparer cannot reasonably reach a more-likely-than-not conclusion and there is no substantial authority, he or she may still avoid the § 6694(a)penalty if it is determined that the position had a reasonable basis and either of the following occurs:
- the return is in fact filed with the necessary disclosure28;
- the preparer presents the taxpayer with a signed return that contains the necessary disclosure (in which case the preparer is apparently not subject to penalty even if the taxpayer removes the disclosure before filing the return).
28 Notice 2008-13, Paragraph G, provides that the preparer's obligations under § 6694 are satisfied in these circumstances if the “preparer provides the taxpayer with the prepared tax return that includes the disclosure.”In addition, Notice 2008-12, 2008-3 I.R.B. 280, provides that preparers must sign the return before presenting it to the taxpayer in order to avoid a penalty under § 6695 (relating to duties of return preparers to sign returns, provide copies to taxpayers, and maintain copies and list). Thus, in order to avoid penalties in the circumstances posited in the text, the preparer must include the requisite disclosure and sign the return before providing it to the taxpayer.
In Rev. Proc. 2008-14, the IRS, updating earlier guidance, indicates that taxpayers can satisfy the disclosure requirement in certain contexts by providing the necessary information on the return without filing a separate disclosure form. But, as the revenue procedure provides, the abridged version of disclosure that it contemplates does not apply for purposes of defeating the disregard penalty. Nor does it apply for purposes of § 6694 in the case of a non-income tax return. Thus, taxpayers who are concerned about the possible imposition of the disregard penalty should use Form 8275, rather than relying on the revenue procedure. Similarly, preparers of non-income tax returns should, if they conclude that disclosure is necessary, make it on the separate form.
In this context, the Notice fails to eliminate a possible conflict of interest. Assume, for example, that an issue arises in the course of preparing an estate tax return. Assume further that, while the preparer believes that there is reasonable basis for the position, the preparer concludes that it is not supported by substantial authority and that it cannot satisfy the more-likely-than-not standard.
Because this is an estate tax issue, not an income tax issue, the substantial-understatement penalty under § 6662(d) cannot apply. Thus, if the position is not sustained, the IRS could not assert the substantial-understatement penalty. It could, however, assert the negligence penalty.
Under the Notice, the preparer would be subject to the § 6694 penalty if the return is prepared and filed without disclosure. Yet the taxpayer has no incentive to make the disclosure because, unlike the substantial-understatement penalty, the negligence penalty cannot be defeated through disclosure.Thus, in this case, the preparer's and the taxpayer's incentives are not aligned, creating the potential for a conflict that the Notice fails to avert.29
29 Note, however, that if the preparer implicitly or explicitly advises the taxpayer that there is a reasonable basis, in the preparer's view, for the position, this should be sufficient to preclude IRS from imposing the negligence penalty on the estate. See Melnik v. Comr., T.C. Memo 2006-25 (indicating that a reasonable-basis opinion can be a predicate for defeating the negligence penalty by reason of § 6664).
Reasonable Basis Exception for Advisers.
In the case of a non-signing adviser, until further guidance is issued, the penalty can be avoided even if he or she could not reasonably conclude it was more like than not the position would be sustained on the merits as long as there is a reasonable basis for the position and the adviser informed the taxpayer of any opportunity to avoid penalties under § 6662 through disclosure (and the requirements for any such disclosure).
However, if the advice is given to another preparer, instead of advising about avoiding penalties under § 6662, the non-signing adviser must simply advise that a disclosure under § 6694(a) may be required. Contemporaneously prepared documentation by the adviser of the advice is sufficient to establish the advice was given.
Finally, as the statute itself provides, the § 6694(a) penalty is not imposed if it is shown that there is reasonable cause for the understatement and that the preparer/adviser had acted in good faith.30
30 The factors relevant to determining whether the preparer acted in good faith are set forth in Regs. § 1.6694-2(d). Notice 2008-13, in Paragraph F, provides that those factors will continue to apply except that a preparer will be treated as having acted if good faith if the preparer relied on the advice of a third party who is not in the same firm as the preparer and whom the preparer had reason to believe was competent to render the advice. The burden of proof that the advice was received is on the preparer.
Some Lessons From the Examples
The several examples contained in Notice 2008-13 provide illustrations of when a preparer or adviser will or will not be subject to the penalty under § 6694(a).
As indicated above, Example 10 suggests that if the preparer researches the issue and it is impossible to reach a precise “quantification”of whether the position is more likely than not correct, no penalty is imposed even if no disclosure is made. It seems, although it is not certain, that the lack of precise quantification is an objective question, not based upon the preparer's belief that there is not a precise quantification to determine if the position is more likely than not correct.
It may be that a precise quantification cannot be made based upon evenly “conflicting” authority (e.g., one federal court of appeals has sustained the position and another has ruled to the contrary and that is the only authority dealing with the issue) or simply that there is a lack of developed authority—that is, it is simply uncertain.
Preparers may rely, in good faith, on the information, schedules or documents supplied by the taxpayer or another adviser.31 Thus, a preparer/adviser may rely on such third-party material in order to satisfy the reasonable-basis and more-likely-than-not standards. If, however, the information appears to be incomplete or inaccurate or the preparer/adviser knows of contrary information or there are problematic implications in the supplied material, the penalty can be imposed.
31 See Notice 2008-13, Paragraphs D and E.
Consider this case. The executor of a decedent's will has engaged an appraiser to determine the estate tax value of an asset included in the decedent's gross estate for estate tax purposes. The appraised value is used to determine the amount of estate tax due. The preparer, who is someone other than the appraiser, does not have the expertise to determine if the appraised value is more likely than not correct but concludes in good faith, after reviewing the appraisal, that it seems reasonable.
The penalty will not be imposed in this case as long as the preparer had no knowledge of any contradictory information, the appraisal did not imply that there were problematic issues, and it did not appear to be inaccurate or incomplete. Nevertheless, it would seem, the appraiser could well be subject to the section, as it applies to a person who prepares a “substantial portion” of the return, which includes “a schedule, entry, or other portion of a tax return or claim for refund that, if adjusted or disallowed, could result in a deficiency (or disallowance of refund claim).”32
32 Someone who does not sign the return may nonetheless be viewed as a preparer. A person is a preparer if he or she, for compensation, prepares “a schedule, entry, or other portion of a tax return or claim for refund that, if adjusted or disallowed, could result in a deficiency determination (or disallowance of refund claim) that the preparer knows or reasonably should know is a significant portion of the tax liability reported on the tax return (or, in the case of a claim for refund, a significant portion of the tax originally reported or previously adjusted).” See Notice 2008-13, Paragraph B.
In certain cases, the preparer may have a duty to make affirmative inquiry. In Example 8, a preparer is advised by the taxpayer that he made a charitable contribution of real estate worth $50,000. In fact, the contribution had not been made, although nothing in the example suggests that the preparer was aware of that. However, the preparer did not inquire about the existence of a qualified appraisal(a requirement under § 170(f)(11) to take a charitable deduction for income tax purposes) or prepare the Form 8283 (a form necessary to substantiate the contribution).
The example concludes that the preparer is subject to penalty under § 6694(a). Hence, it seems that whenever a special form or information is required for a return position, a preparer who neglects to inquire of the client or who fails to prepare the form will be subject to the penalty if there is a resulting understatement in tax.
Treatment of Tax Shelters
Finally, in the case of a tax shelter,33 provided that there is a reasonable basis for the position, the Notice provides that the preparer is not subject to the § 6694 penalty if the client is given an explanation of the differences between the 6694 and 6662 penalties (with the preparer again being required to contemporaneously document the fact that the explanation was given).
33 Tax shelter is defined in § 6662(d)(2)(C).
Thus, even though there is no substantial authority and the preparer did not reasonably conclude the position was more likely than not correct, the penalty can be avoided by explaining the differences in the penalties. While such solicitous treatment of tax shelters may, at first, seem odd, it begins to make sense when one considers the potential conflict of interest that the Notice apparently seeks to avert.
By way of background, as a general matter, if there is a substantial understatement of income tax attributable to any position that does not constitute a tax shelter, the taxpayer may avoid the substantial-understatement penalty if:
- there is a reasonable basis for the position and disclosure is made, or
- there is substantial authority for the position.
But, in the case of a tax shelter, neither of these safe harbors is available. In other words, in the case of a tax shelter, neither the presence of substantial authority nor the taxpayer's disclosure will enable the taxpayer to avoid the penalty.
Because disclosure will not protect the taxpayer in the case of a tax shelter, it is apparent that the Notice was drafted to avoid situations in which the preparer has an incentive to insist that disclosure be made while the client has no penalty-protection incentive to make the disclosure. This is similar to another aspect of the Notice already discussed and also presumably driven by a conflict of interest concern—the provision allowing the preparer to avoid the § 6694 penalty if there is substantial authority even if disclosure is not in fact made by the taxpayer.
To illustrate the different treatment under the Notice of tax shelters and non-tax shelter cases, compare two situations where the position taken on the return has a reasonable basis but there is no substantial authority or a more-likely-than-not belief. If one is a tax shelter and the other is not, the conclusions that the Notice produces might, at first blush, appear surprising.
In the case of the tax shelter, no penalty is imposed on the preparer if an explanation about penalties is provided even though the preparer prepares and signs the return without disclosure and the taxpayer does not in fact make disclosure. In sharp contrast, in the non-tax shelter case, if the taxpayer decides not to include the disclosure on the return and the preparer provides the taxpayer with a signed return that does not contain the disclosure, the preparer will be subject to the § 6694 penalty.
The more favorable treatment of tax shelters, while seemingly aberrational, is understandable given the conflict of interest between the preparer and the taxpayer that might otherwise result. As indicated, in the case of a tax shelter, the taxpayer gains nothing by making disclosure and may therefore choose not to make it. On the other hand, under the statute as written, the preparer has an incentive to insist on taxpayer disclosure in order to qualify for the lower, reasonable-basis standard.
Thus, had the Notice simply enforced the statute, as written, preparers would have been motivated to insist on disclosure even though it would not enhance the taxpayer's interest. In order to eliminate this conflict, the Notice understandably allows the preparer to qualify for the lower standard—even though the taxpayer chooses not to disclose—by explaining to the client that disclosure will not be effective as a penalty defense and that the preparer will be able to avoid penalties under § 6694 by reason of giving this explanation.
As indicated, those who give tax advice for compensation about a return position but who do not sign the return or otherwise prepare it may be subject to § 6694. This was the case prior to the 2007 amendment, and it remains the case.
Notice 2008-13 provides that, in the case of such a non-signing adviser, the penalty will not apply if:
- the adviser had a reasonable belief that the position would more likely than not be sustained on the merits, or
- it is ultimately determined that there was a reasonable basis for the position and the adviser informed the taxpayer of any opportunity to avoid penalties under § 6662 through disclosure (and of the requirements for disclosure).34
34 If the preparer is a practitioner subject to Circular 230, it may be better to do a separate memorandum that the oral advice was given rather than enter it into so-called “time sheets” in which the practitioner records time spent on matters. Not infrequently, clients will ask for such time sheets in connection with receiving a bill from the practitioner. If the time sheets delivered contain information about advice given, it may be that the time sheets themselves could be a covered opinion subject to the requirements of Section 10.35 of Circular 230.
If the advice is in writing, the information about disclosure must also be in writing. If not in writing, the disclosure-related advice can be given orally (but the practitioner must make a contemporaneous record, apparently in writing, that the information was given).
If a non-signing adviser gives the advice to a preparer, rather than directly to the taxpayer, similar rules apply. No penalty will be imposed if:
- the adviser had reasonably believed that the more-likely-than-not standard would be satisfied; or
- the adviser indicated to the preparer that disclosure under § 6694 could be required (again, it can be given orally or in writing, depending on whether the substantive advice was in writing, and a contemporaneous record must also be made).
Guidance on Identifying Preparers
Finally, Notice 2008-13 provides guidance in terms of who constitutes a return preparer, an important issue given that § 6694 only applies to preparers. As suggested, the Notice provides, as did prior law,35 that a non-signing adviser is subject to the section.36
35 See Notice 2008-13, Paragraph B (incorporating Regs. § 301.7701-15(b)(1)).
36 See Regs. § 301.7701-15(b)(1).
Echoing, however, a pre-existing regulation,37 the Notice also provides that someone who gives advice about tax issues prior to the consummation of the transaction is not a preparer and, therefore, is not subject to the section.
37 See Regs. § 301.7701-15(a)(2)(ii).
The Notice illustrates the pre-transaction advice concept in two examples, Example 3 and Example 5. When considered together, these examples make it quite certain that any post-transaction advice renders the person a preparer and, as a result, subject to the section. Indeed, as Example 5 suggests, a person who gives pre-transaction advice and then merely gives post-transaction advice about how much to report on the return is a preparer.
Thus, those seeking to avoid the section via the pre-transaction advice concept may need to be careful about giving post-transaction assistance to the client.
Returns Covered and Not Covered
The Notice contains three exhibits. The first (Exhibit 1) lists those income, estate and gift, employment, and miscellaneous returns that cause someone who prepares or provides advice with respect to the return for compensation to be subject to the provisions of § 6694(a). These include Forms 1040 (U.S. Individual Income Tax Return), 706(U.S. Estate (and Generation-Skipping Transfer) Tax Return), 709 (U.S. Gift (and Generation-Skipping Transfer) Tax Return), and 990-PF (Return of a Private Foundation), among many others.
The second (Exhibit 2) lists those information returns that cause someone who prepares the return for compensation to be subject to the provisions of § 6694(a) if it affects an entry or entries on a tax return and constitutes a substantial portion of the tax return or claim for refund. These include, among several others, Forms 1065(U.S. Return of Partnership Income), including Schedules K-1, and 1120S (U.S. Income Tax Return for an S Corporation), including Schedules K-1.
As mentioned above, the Notice interprets the term “substantial portion” to mean a schedule, entry, or other portion of a tax return or claim for refund that, if adjusted or disallowed, could result in a deficiency determination (or disallowance of refund claim)that the preparer knows or reasonably should know is a significant portion of the tax liability report on the return (or, in the case of a claim for refund, a significant portion of the tax originally reported or previously adjusted).
The Notice states that this interpretation “clarifies that any determination as to whether a person who prepared a substantial portion of a tax return and thus is considered a tax return preparer will depend on the relative size of the deficiency attributable to the schedule, entry or other portion.” It appears that whether the entry is substantial or not is an objective one, not based upon the belief or knowledge of the preparer of such information return that it is substantial.
The third (Exhibit 3) lists forms that would not subject someone who prepares such a form for compensation to the provisions of § 6694 unless it was prepared willfully in a manner to understate tax liability on a refund or claim for refund or in a reckless or intentional disregard of rules or regulations—which would trigger a violation of § 6694(b). These forms include, but are not limited to, Forms 1099 and W-2.
Written Advice to Taxpayers About Penalty Standards
As discussed, the Notice in some cases requires a preparer or adviser to advise a taxpayer about certain penalties. Some preparers and advisers may wish to set forth the basic rule relating to these penalties in an engagement letter. If this is done, a detailed description of the penalties (as interpreted by the Notice) will have been delivered in writing to the client.
Sample language for inclusion in the engagement letter is set forth below:
In connection with our representation, we may be providing you advice about one or more positions with respect to a tax return you may file or we may prepare or may participate in the preparation of such a return. In certain circumstances, Circular 230 will require that we advise you about certain penalties that may apply with respect to such a return and circumstances under which you may be able to avoid one or more tax penalties. Also, Section 6694 of the Internal Revenue Code of 1986, as amended, imposes penalties on preparers of certain federal tax returns and on those who provide advice with respect to such returns. We intend, in representing you, to comply fully with Circular 230 and to render any advice with respect to any tax return you may file and to prepare or participate in the preparation of any such return in a manner so that no penalty is imposed upon us by Section 6694.
In some situations, we will be required to advise you about certain tax penalties and how disclosure of a return position may avoid the imposition of penalties. Many penalties are imposed by Section 6662. The penalties under Section 6662 are imposed on any portion of an underpayment of tax required to be shown on a return if the underpayment is attributable to one of more of (1) negligence or disregard of rules or regulations,(2) any substantial underpayment of income tax, (3) any substantial valuation misstatement for income tax purposes, (4) any substantial overstatement of pension liabilities, or (5) any substantial estate or gift tax valuation understatement. The penalty for negligence does not apply if the taxpayer's position has a reasonable basis or the position has substantial authority. The penalty for disregard of rules or regulations does not apply if the position is disclosed on the return and there is a reasonable basis for the position. Similarly, the penalty for substantial understatement of income tax will not be imposed if the position is disclosed and it is determined that the position has a reasonable basis. The substantial-understatement penalty can also be avoided if there is substantial authority for the position. However, neither the substantial-authority nor the disclosure exception will apply if the transaction constitutes a tax shelter within the meaning of Section 6662(d)(2)(C). It is important to note, however, that under Section 6664(c), no penalty under Section 6662 is imposed if there was a reasonable cause and the taxpayer acted in good faith. There are many other penalties that may be imposed on a taxpayer under the Internal Revenue Code. For example, a penalty on taxpayers (not preparers or advisers) under Section 6676 is imposed for filing an erroneous claim for income tax refund or credit.
As indicated above, Section 6694 imposes penalties on return preparers and advisers when the return understates the tax actually due where the preparer or adviser was aware (or should have been aware) that the position in question was taken on the return. The penalty is not imposed, however, if the preparer or adviser had a reasonable belief that the position would more likely than not be sustained on the merits or there was a reasonable basis for the position and it was adequately disclosed on the return. There may be cases in which a preparer or adviser can avoid the Section 6694 penalty even though the more-likely-than-not standard is not satisfied and disclosure is not made by the client provided that the preparer/adviser provides the client with information about the opportunities to avoid taxpayer penalties by making disclosure. For example, the preparer/adviser will not be subject to penalty under 6694 if there is substantial authority for the position and the preparer advises the taxpayer of the difference between the penalty standards applicable to the taxpayer under Section 6662 and those applicable to the preparer under Section 6694 and contemporaneously documents that this advice was given. If the position relates to a tax shelter, the preparer will not be subject to the section provided that the preparer advises the taxpayer of the penalty standards applicable to the taxpayer under Section 6662(d)(2)(C) and the difference, if any, between those standards and the standards under Section 6694 and contemporaneously documents that this advice was given. In the case of an adviser, if there is a reasonable basis for the tax position, the Section 6693 penalty can be avoided by explaining the opportunities for the taxpayer to avoid penalties through disclosure. We anticipate that the IRS will change the standards for avoiding penalties in the future. As a general rule, the defenses for both taxpayers and preparers/advisers that require disclosure mean that a properly completed IRS Form 8275 or 8275R must be attached to the return. We specifically note to you that, in some cases, it will be in the best interests of the preparer or adviser for the disclosure form to be attached to the return so he or she may avoid the penalty imposed by Section 6694 but the taxpayer may not be required to have the disclosure form attached to avoid a penalty under Section 6662 or will not wish to do so even if it would avoid a penalty under that section.
We appreciate that these rules are complex. Nevertheless, to avoid penalties it is necessary in some cases for us to have advised you about them. Accordingly, we may refer you to this discussion from time to time during our representation of you. Needless to say, if you have any question about penalties or any related matter, please contact us.
Summary and Conclusions
Notice 2008-13 creates greater safe harbors from the penalty under § 6694(a) for preparers of tax returns and advisers on return-related matters that are more generous than the section itself.
For preparers, who can be anyone who prepares schedules or reports that are part of the return, the penalty can be avoided not just by reasonably concluding that the position is more-likely-than-not correct but, if there is at least a reasonable basis for it:
- by having a disclosure form attached to the return;
- by giving the taxpayer a return with the disclosure form attached (even if the client removes it) even if there is no substantial authority for the position;
- by explaining the difference to the taxpayer of the differences in penalties under § § 6662 and 6664 if there is substantial authority for the position and contemporaneously documenting that this advice was given; or
- in the case of a tax shelter, by advising the taxpayer of the penalty standards applicable to the taxpayer under § 6662(d)(2)(C) and the difference, if any, between those standards and contemporaneously documenting that this advice was given.
A non-signing adviser can avoid the penalty as long as there is a reasonable basis for the position and the adviser informs the taxpayer of any opportunity to avoid penalties under § 6662 through disclosure and the requirements of such disclosure.
The upshot is that, as a practical matter, preparers will in many cases insist on disclosure—and advisers will give disclosure-related information—in order to reduce the likelihood that they will trigger § 6694. At the same time, taxpayers may often conclude that disclosure is in their interest, as well, in that it will reduce the likelihood of penalties under § 6662.
The following article is from the BNA Tax Management Weekly Report. To see the full report and take a trial to the BNA Tax and Accounting Center, visit this site. |
