On May 25, with lightning speed, Congress passed and President Bush signed PL 110-28, which makes substantial changes to the tax return preparer penalties, effective for “returns prepared” after May 25, 2007. This is no tweak. Prior Law

The prior version of section 6694 imposed a maximum $250 penalty (unless willful or reckless, then it is $1,000) on an income tax return preparer if there was not a “realistic possibility” of the position being sustained on the merits, except in the case of a disclosed non-frivolous position. New Rule

The new rule imposes a maximum penalty of the greater of $1,000 or half of the preparer’s income derived from the return if there was not a “reasonable belief” of a more-likely-than-not chance of success, except in the case of a disclosed “reasonable basis” position or unless the preparer had a “reasonable cause” and acted in good faith.

Existing regulations define “realistic possibility” as one-in-three and incorporate the requirement of “substantial authority” appearing in other regulations, which limits the type of authorities the preparer can depend on. Now all of that regulatory guidance is out the window and we have three new terms: “reasonable basis …. and belief ….. and cause.” At least we know it must be reasonable.

A “reasonable basis” is also the negligence standard and has been viewed as lower than the “realistic possibility” standard. “Reasonable cause” is a subjective test that heretofore has been applied only to taxpayers and asks if it was reasonable for them to rely on their tax advisors. Applying the concept to the tax advisor himself raises different issues and presumably asks whether the preparer could reasonably have convinced himself that he had a case when he really didn’t.

Arguably, a preparer can have a “reasonable cause” if there is in fact a “reasonable basis” and the preparer is not a “bad guy,” i.e., acted in “good faith.” We will find out when the IRS issues the promised speedy guidance. Evidently it was caught off guard by this change, indicating that the change emanated from Congress rather than the Treasury. Bottom Line

Given the broad scope of the definition of return preparer, this change substantially raises the stakes for return preparers by (1) vastly increasing the possible penalty, (2) requiring them to consider disclosure in more cases, and (3) requiring them to take very special care in all not-more-likely-than-not cases. Look for downward pressure on the more-likely-than-not opinion.