Section 6694 of the Internal Revenue Code sets the standards that tax return preparers must follow to avoid preparer penalties. The Small Business and Work Opportunity Tax Act of 2007 (the Act), which became effective May 25, 2007, included major changes to the applicable standards, and substantially increased the penalty for failure to comply with those standards. This summer the Internal Revenue Service (IRS) issued new proposed regulations providing further guidance on these standards.
The Act expanded the preparer penalty in three significant ways:
- It extended application of the penalty to all types of federal tax returns, not just income tax returns.
- It raised the standard of certainty that practitioners must reach to avoid preparer penalties.
- It increased the monetary penalties on practitioners who fail to meet the standard.
Extension of the Penalty Provision
The penalty now applies to the preparation of all returns or refund claims with respect to which a taxpayer could understate a liability, including estate and gift tax returns, employment tax returns, and excise tax returns.
Higher Standard to Avoid Penalties
The preparer penalty under section 6694 will apply if the return position causing the tax liability is an “unreasonable position.” A position is unreasonable if three factors exist:
- The preparer knew or reasonably should have known of the position;
- There was not a reasonable belief that the position would more likely than not be sustained on the merits; and
- The preparer either failed to adequately disclose the position or had no reasonable basis for the position.
Prior to the Act, the penalty would not apply if the position had a “reasonable possibility of success on the merits,” which was generally interpreted to mean at least a 33.3 percent chance of success, or if the preparer acted in good faith with reasonable cause. The new standard means that a preparer must reasonably conclude in good faith that a position has a greater than 50 percent likelihood of being sustained. Facts and circumstances, including the advisor’s diligence and the complexity of the matter, will determine whether an advisor has satisfied this standard. Regulations require that the preparer have a reasonable belief that the position meets the standard. At a minimum, advisors must be able to support the position with a well-reasoned construction of the governing statute. Preparers may rely on information or advice provided by the taxpayer, advisor, or another return preparer in meeting this standard, but may not make unreasonable assumptions in this reliance.
If the preparer cannot meet the more likely than not standard, the preparer must properly and adequately disclose the position on the return itself or in an attachment to the return to avoid penalty exposure, and the preparer must have a reasonable basis for such disclosed position. The proposed regulations identify several ways to make proper disclosure of a return position in order to avoid preparer penalties.
Increased Monetary Penalties
Prior to the Act, the preparer penalty was only $250, and would not apply at all if the practitioner met a certain standard in preparation of the return. Because of the small penalty amount, most practitioners were unconcerned about the risk of the penalty’s application. The Act increased the penalty to 50 percent of the income derived or to be derived by the preparer from preparation of the return or claim. The minimum penalty is now $1,000 ($5,000 in the case of reckless or willful conduct). The 50 percent calculation applies only to the part of the preparation allocable to the position that gave rise to the understatement of liability.
Who is a Preparer?
The proposed regulations provide rules for two types of preparers who could be subject to the preparer penalty: signing and nonsigning preparers. A signing preparer is the preparer who signs or is required to sign the return. A nonsigning preparer is any preparer who prepares all or a substantial portion of a claim or return with respect to events that have already occurred at the time the advice is rendered. An advisor can be a nonsigning preparer by providing written or oral advice to a taxpayer or another preparer if the advice is a substantial portion of a return. A single entry on the return can constitute a substantial portion of a return, but for nonsigning preparers only, there is a safe harbor. The item is not a substantial portion of the return if the relevant income or deduction item is (1) less than $10,000 or (2) less than $400,000 and less than 20 percent of gross income shown on the return. The advice must be directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund. There also must be some explicit or implicit agreement for compensation for a preparer to be subject to the penalty.
Advisors can remember the important elements for determining if one is a nonsigning preparer with the mnemonic “CARS”:
- After the events have occurred
- Relevant directly to the position on the return
- Substantial portion of the return
For instance, an attorney who provides advice to a corporate client concerning the tax consequences of a completed corporate transaction may be a nonsigning preparer if her advice is directly relevant to an item on the return, even if she was not otherwise involved in the preparation or signing of the return. Importantly, these rules apply only to advice provided after the relevant events have occurred. If, in the example above, the attorney had advised the client only before the corporate transaction occurred and gave the client no additional advice after the transaction, the attorney will not be treated as a nonsigning preparer.
Exceptions to the preparer penalty apply for certain classes of preparers. As noted above, returns prepared pro bono will not expose an advisor to a preparer penalty. Inhouse tax counsel are generally exempt from the preparer penalty, as are individual officers, general partners, members, shareholders and employees who prepare a return on behalf of an entity if the individual is regularly and continuously employed or compensated.