‘Let’s Be Careful Out There’
By Anthony Basile, Robert Katz, Neil D. Katz,
and Harold Finkelstein
JULY 2008 -
Tax practitioners have been guided and influenced in the preparation
of income tax returns by various statutory, regulatory, and administrative
provisions, as well as by professional rules. Such provisions and
rules can be found in the Internal Revenue Code (IRC), Treasury
Department Regulations, IRS administrative guidance, Treasury Department
Circular 230, and the AICPA’s Statements on Standards for
preparing a tax return, accountants must be aware of two areas
of the IRC: section 6662, Accuracy-Related Penalties; and section
6694, Return-Preparer Penalties. The Small Business Tax Act of
2007 made major changes to the provisions of section 6694, placing
additional burdens on accountants who prepare tax returns.
how the Small Business Tax Act of 2007 affects IRC section 6694
requires a working knowledge of section 6662 and the rules that
preparers were subject to under section 6694 prior to the enactment
of the Small Business Tax Act of 2007.
Section 6662: Accuracy-Related Penalties
to IRC section 6662(b), an accuracy-related penalty can be asserted
when an understatement of tax results from:
1) negligence or disregard of rules and regulations; 2) substantial
understatement of income tax; 3) substantial valuation misstatement;
4) substantial overstatement of pension liabilities; or 5) any
substantial valuation understatement of estate or gift tax.
to IRC section 6662(c), the factors under Treasury Regulations
section 1.6662-3(1)(i)–(iv) used to determine whether a
tax return has been negligently prepared include the following:
to include income shown on an information return;
to reasonably attempt to ascertain the correctness of an item
that to a reasonably prudent person would appear “too
good to be true” under the circumstances; and
of a partner or an S corporation shareholder to treat partnership
or subchapter S items on an individual return consistent with
the treatment of such items on the partnership or S corporation
to Treasury Regulations section 1.6662-3(b)(2), the term “disregard”
means to carelessly, recklessly, or intentionally avoid conforming
to Treasury regulations or IRS rulings and notices.
include the following:
to exercise reasonable diligence to determine the correctness
of a return position contrary to a rule or regulation;
to determine whether a rule or regulation exists in a situation
where a reasonable person would inquire; and
to comply with a known rule or regulation, unless the contrary
position has a realistic possibility of being sustained.
Regulations section 1.6662-2(a)(3) stipulates that the accuracy-related
penalty is applicable only if a return is filed. IRC section 6020(b)
provides that it is not applicable if the IRS prepares a substitute
return for the taxpayer.
is 20% of the portion of the underpayment of tax resulting from
the actions of the taxpayer that created the penalty under IRC
section 6662, regardless of the frequency with which such actions
are demonstrated. If a return is filed late, however, the delinquency
penalty may be imposed on the same portion of an underpayment
as the accuracy-related penalty. The penalty does not apply to
the failure-to-collect and pay-over tax penalties provided by
IRC section 6672. As provided by Treasury Regulations section
1.6662(d)(2), the penalty is increased to 40% if any part of the
underpayment is attributable to a gross valuation misstatement.
to IRC section 6662(d), a substantial understatement of income
tax for individuals generally exists if the understatement amount
exceeds either 10% of the tax required to be shown on the return
for that year or $5,000, whichever is greater. For corporations,
a substantial understatement exists if the amount exceeds the
lesser of 10% of the tax required to be shown on the return for
that year (or $10,000, if greater) or $10 million. The amount
of the understatement will be reduced to the extent to which it
is attributable to the treatment of an item (other than one attributable
to a tax shelter) for which substantial authority exists for such
treatment. The amount may also be reduced if there is adequate
disclosure in the return (or in a statement attached thereto)
of the relevant facts, and if a reasonable basis for the tax treatment
Section 6694: Return-Preparer Penalties
6694 establishes the standards to which tax return preparers must
adhere in order to avoid incurring a preparer penalty. On May
25, 2007, President Bush signed into law the Small Business Tax
Act of 2007, which made substantial changes to the standards that
apply, and significantly increased the penalty imposed for failure
to comply with those standards.
the Act, IRC section 6694(a) imposed a $250 penalty on an “income”
tax return preparer for filing a return or a refund claim that
resulted in an understatement of tax based upon an “unrealistic
position” on the filed tax return. This included the preparation
of information returns filed by partnerships and S corporations,
as well as amended returns.
Regulations section 1.6694-2(b)(1), Circular 230, defines an “unrealistic
position” as one for which the preparer knew or should have
known that: 1) a realistic possibility—a 33 Qd % or better
chance—of being upheld on the merits did not exist, and
2) that the position was either frivolous or not appropriately
disclosed in accordance with IRC section 6662(d). In this case,
a realistic possibility implied that a reasonable and well-informed
analysis by a person knowledgeable in tax law would lead to a
conclusion that the position had an approximate one-in-three chance
of being sustained.
unrealistic position would not necessarily result in the imposition
of a penalty if the preparer showed a “reasonable basis”
for the understatement and acted in good faith. [The reasonable-basis
standard, while less than the realistic-possibility standard,
is higher than a patently improper (plausible-basis) or frivolous
(nonarguable-basis) position.] According to Treasury Regulations
section 1.6662-3(b)(3), if a return position was reasonable based
on one or more authorities set forth in Treasury Regulations section
1.6662-4(d)(3)(iii), then the reasonable-basis standard would
have been satisfied, even though it did not fulfill the substantial
Even if a
position contrary to a rule or regulation was taken on a return,
an understatement penalty would not have been imposed if the position
was adequately disclosed on a properly completed and filed Form
8275 or 8275-R. [Taxpayers use Form 8275 to disclose positions
on a return. If, however, the position being taken is contrary
to a regulation, then the taxpayer must use Form 8275-R to disclose
such a position. See Treasury Regulations section 1.6662-3(c)(2).]
Treasury Regulations section 1.6662-3(c)(1) provides that this
exception for adequate disclosure would not apply if a reasonable
basis for the position did not exist.
to Treasury Regulations section 1.6662-4(d), however, disclosure
was not required and an understatement penalty would not have
been imposed if substantial authority existed for the tax treatment
of a return item. Substantial authority would exist if the authority
supporting the treatment was substantial and weighed heavily in
relation to the weight of contrary authority. This was an objective
standard that involved an analysis of the law and its application
to the relevant facts. It was also more strictly construed than
the reasonable-basis standard.
to IRC section 6694(b), the penalty was increased to $1,000 if
the preparer made a willful attempt to understate a client’s
tax liability or intentionally disregarded rules and regulations
without adequate disclosure.
Made by the Small Business Tax Act of 2007
mentioned, the Small Business Tax Act of 2007 made significant
changes to the reporting standards of tax return preparers and
increased the penalties under IRC sections 6694(a) and 6694(b).
Pursuant to the Act, the changes are effective for returns prepared
after May 25, 2007 (see transitional rules discussed herein).
the 2007 Act provisions, IRC section 6694 applied only to “income
tax return preparers.” An income tax return preparer was
anyone who prepared all or a substantial portion of an income
tax return or income tax refund claim. The word “income”
was removed. As a result of this change, all tax return preparers
are now liable for any applicable section 6694 penalties. This
includes income tax returns, estate and gift tax returns, employment
tax returns, excise tax returns, and information returns.
A tax return
preparer can also include an employee who is not the signatory
on the tax return. For a signing preparer, the relevant date is
the date the preparer signs and dates the tax return or refund
claim. If the preparer did not enter the date, then the relevant
date is the date of the taxpayer’s signature or the filing
date, if the taxpayer did not also date the return or claim. For
a nonsigning preparer, the relevant date is the date the preparer
provides the advice.
the Act, IRC section 6694 adopted the “realistic possibility”
standard for the nondisclosure of a position taken on a tax return.
It generally meant that the position taken on a return had an
approximate one-in-three likelihood of being sustained on its
section 6694 adopts a “more-likely-than-not” standard
and now provides that a penalty for the nondisclosure of a position
taken on a tax return will be imposed, unless the return preparer
has a reasonable belief that the position would have a greater-than-50%
likelihood of being sustained on its merits.
2007 Act, taking a position that does not meet the more-likely-than-not
standard on a tax return will now result in the imposition of
a penalty on the tax return preparer. A position is deemed unreasonable
if the following conditions are met:
- The preparer
knew (or reasonably should have known) of the position;
was no reasonable belief that the position would more likely
than not be sustained on its merits; and
- The position
was not disclosed or there was no reasonable basis for the position.
will not be imposed for an understatement due to an unreasonable
position, even without a reasonable belief, if this position is
adequately disclosed and there is a reasonable basis (a higher
standard than nonfrivolous) for the tax treatment.
A taxpayer claims that various items are business expenses, but,
upon review, the tax return preparer determined that some of these
expenses could be deemed personal and nondeductible.
pre-Act law, if the return preparer believed the likelihood of
sustaining these deductions exceeded 33 Qd %, the tax return could
be signed without disclosure, because the realistic-possibility
standard would have been met.
Act, however, a preparer penalty would be imposed if the preparer
signed the return without disclosure, unless the likelihood of
sustaining these deductions exceeded 50%, which is the more-likely-than-not
standard introduced by the 2007 Act. The preparer can avoid the
penalty by attaching the appropriate disclosure form to the return.
Regulations section 1.6694-(2)(d) continues the exception to the
penalty if reasonable cause for the understatement existed and
the tax return preparer acted in good faith. Several factors must
nature of the error causing the understatement. Was the
applicable provision so complex, uncommon, or highly technical
that a competent preparer of such returns could reasonably make
the same error? (This exception does not apply to an error that
would be apparent from a general review of the return or refund
of errors. Did the understatement result from a single,
isolated error, unless that error itself is so obvious or flagrant
that it should have been discovered upon review? (This exception
is inapplicable where there is a pattern of errors.)
of errors. Was the understatement material, with respect
to the correct tax amount? (This exception will not apply, even
to an immaterial understatement, if the error was sufficiently
normal office practice. Would the error have occurred if
normal office practice for ensuring accuracy and consistency—including
checklists, a review of the prior year’s return, and current
review procedures—were followed? (This exception is inapplicable
if the error is flagrant, if a pattern of errors exists, or
if the same error is repeated on numerous returns.)
on advice of another preparer. Did the preparer rely on
advice or schedules prepared by other individuals in good faith,
and did the preparer have reason to believe that the other preparer
was competent? (This exception is inapplicable if the advice
is unreasonable on its face, if the preparer knew that the other
preparer was unaware of all relevant facts, or if the preparer
knew or should have known that the advice was no longer reliable
due to recent legal developments.)
Act has increased the prior $250 penalty. The penalty is now the
greater of $1,000 or 50% of the income that the tax return preparer
has derived or will derive from the preparation of a tax return
or refund claim.
An accountant prepares and signs, as preparer, an income tax return
for a client and receives a fee of $1,200 for these services.
Upon examination of the return by the IRS, items are disallowed
that are determined not to have met the 50% more-likely-than-not
standard, thereby subjecting the accountant to a section 6694(a)
of the fee received for the preparation of the return would be
only $600, the penalty would be $1,000. If the fee were $4,000,
the penalty amount would be $2,000 (50% of the fee).
2007 Act, IRC section 6694(b) stated that the willful or reckless
conduct of the income tax preparer resulted in the imposition
of a $1,000-per-return penalty. Section 6694(b) describes willful
or reckless conduct as a willful attempt, in any manner, to understate
the liability for tax on the return or claim, or a reckless or
intentional disregard of rules and regulations.
The new section
6694(b) increases this penalty to the greater of $5,000 or 50%
of the income that the preparer (of any type of tax return) has
derived or will derive from the preparation of such return or
refund claim. In many instances, a penalty of $5,000 will be greater
than 50% of the fee.
2007-54. On June 11, 2007, the IRS issued Notice
2007-54 (2007-27 IRB 1) to assist tax return preparers in familiarizing
themselves with and adjusting to the new rules. This notice provides
guidance and transitional relief from the return preparer penalty
rules. However, the transitional relief applies only to those
penalties imposed under IRC section 6694(a). This notice provides
no transitional relief for willful or reckless conduct.
tax returns (including amended returns) and refund claims, standards
previously in effect for determining if the IRS would impose a
penalty under section 6694(a) will apply during the transitional
relief period. Thus, disclosure will be deemed adequate if made
on Form 8275 or Form 8275-R.
For all other
types of tax returns, the reasonable-basis standard established
in the regulations under section 6662 (without regard to the disclosure
requirements contained therein) will be applied in determining
if the IRS will impose a preparer penalty.
in Notice 2007-54, the period of transitional relief covers:
- All returns,
amended returns, and refund claims due on or before December
31, 2007, determined with regard to any extension of time for
estimated tax returns due on or before January 15, 2008; and
employment and excise tax returns due on or before January 15,
2008-11. On December 31, 2007, the U.S. Department
of the Treasury and the IRS issued Notice 2008-11 (2008-3 IRB,
effective May 25, 2007), which clarifies that the transition relief
described in Notice 2007-54 applies to the following:
amended returns or claims for refund filed on or before December
31, 2007 (for amended employment and excise tax returns, the
rules apply to returns filed on or before January 31, 2008);
returns filed on or before December 31, 2007 (as to employment
and excise tax returns, the rules apply to returns filed on
or before January 31, 2008); and
provided on or before December 31, 2007 (for nonsigning preparers).
2008-13. On December 31, 2007, the Treasury Department
and IRS issued guidance and provided interim rules implementing
and interpreting the new provisions of IRC section 6694 (Notice
2008-13, IRB 2008-3). In this notice, the IRS stated its intention
to revise the regulations governing preparer penalties in 2008.
Preparers can use this notice as interim guidance regarding definitions
and standards of conduct they must adhere to in order to avoid
penalties under section 6694. The notice cautions preparers that
when the regulations are finalized they may be substantially different
from the rules in the notice “and in some cases more stringent.”
guidance focuses on the following issues:
- Tax returns
or claims for refund covered by IRC section 6694;
- The definition
of a “tax return preparer”;
of conduct for disclosed and undisclosed positions; and
penalty compliance obligations.
or claims for refunds covered by IRC section 6694. Notice
2008-13 includes a number of exhibits. Exhibit 1 of the notice
sets forth the returns that are covered by the new preparer penalty
under the interim guidance, divided into the following categories:
tax returns, including Forms 1040, 1041, and 1120;
and gift tax returns, including Forms 706, 709, and 843;
tax returns, including Forms 940, 941, and 1040SE
excise tax returns, including Forms 720, 990PF, and 8849; and
tobacco, and certain other excise tax returns, including Forms
8725 and 8876.
the notice includes Exhibit 2, which sets forth information returns
that report information reported on another return. The new IRC
section 6694 will apply to the preparer of these information returns
if the information contained therein is a “substantial portion”
of the other return. Forms in this category included—
the notice contains Exhibit 3, which sets forth a schedule of
the tax forms that will not create a penalty under IRC section
6694, unless the return is prepared willfully in any manner that
will understate the tax liability or that demonstrates a reckless
or intentional disregard of rules or regulations. This category
includes the following:
1099 series of returns;
W-2 series of returns;
SS-8, Determination of Worker Status for Purposes of Federal
Employment Taxes and Income Tax Withholding;
990, Return of Organization Exempt from Income Tax;
1040ES, Estimated Income Tax Payment;
1120W, Estimated Tax for Corporations;
4868, Application for Automatic Extension of Time to File U.S.
Individual Income Tax Return;
8027, Employer’s Annual Information Return of Tip Income
and Allocated Tips; and
8919, Uncollected Social Security and Medicare Tax on Wages.
of a tax return preparer. IRC section 7701(a)(36)(A)
defines a tax return preparer as someone who, for compensation,
prepares all or a substantial portion of a tax return or claim
for refund with respect to such return. In interpreting the term
“substantial portion,” the notice includes a schedule,
entry, or other position that, if adjusted or disallowed, could
result in a deficiency (or disallowance of a claim for refund)
that the preparer knows or should have known is a significant
portion of the tax liability reported on the return. Whether someone
is a tax preparer is a question of fact and will depend upon the
relative size of the deficiency attributable to the schedule,
entry, or other position prepared or taken by the preparer.
Smith, an accountant, prepares a partnership return, including
Schedules K-1, allocating losses to each partner in proportion
to his or her original investment. Smith does not prepare the
individual return of Partner A, but knows that A’s share
of the partnership loss is the most significant portion of A’s
individual income tax computation. Smith is a preparer of Partner
A’s individual income tax return, pursuant to IRC section
of conduct for disclosed and undisclosed positions. For
undisclosed positions, Notice 2008-13 requires the preparer to
analyze the pertinent facts and authorities in the manner described
in Treasury Regulations section 1.6662-4(d)(3)(ii) and to reasonably
conclude in good faith that there is a greater than 50% likelihood
that the position will be upheld if challenged. This determination
must be made without taking into account the possibility that
the return will not be audited.
preparer may rely in good faith, without verification, upon information
furnished by the taxpayer. In addition, the preparer may rely
in good faith and without verification upon information furnished
by another advisor, tax return preparer, or other third party.
The preparer may not, however, ignore the implications of information
furnished to him or actually known by him. In addition, the preparer
must make reasonable inquiries if the information furnished by
another tax return preparer or third party appears to be incomplete
Returning to the facts in the previous example, Jones is
the preparer of Partner A’s individual income tax return.
She can rely, without verification, on the Form K-1 prepared by
Smith. Unless she has reason to know that it is incorrect or incomplete,
she will not be subject to the IRC section 6694 penalty with regard
to the information contained on the Form K-1. She is responsible
for determining if Partner A has sufficient basis to claim all
or a portion of the loss from the partnership.
reiterates the reasonable cause and good faith exceptions contained
in both the old section 6694 provisions and the new section 6694
rules. Regarding reliance on the advice of a third party, the
notice provides that the third party may not be a member of the
same firm as the tax return preparer. In addition, the third party
must be a person that the preparer has reason to believe is competent
to render the advice. The advice can be either oral or written,
but, in either event, the burden of establishing that the advice
was received is on the preparer.
For a position
that was disclosed, new rules replace the nonfrivolous standard
with the requirement that there be a reasonable basis for the
tax treatment of the position taken.
penalty compliance obligations. If a signing preparer
believes that a reasonable basis exists for the position taken
but does not have a reasonable belief that the position would
more likely than not be sustained on audit, the preparer will
not be subject to the penalty under section 6694 if any of the
following requirements are met:
- The position
is disclosed on a properly completed and filed Form 8275 or
- If the
position would not meet the standard to avoid the section 6662
penalty without disclosure, then the preparer provides the taxpayer
with the prepared return that includes the disclosure.
- If the
position would otherwise meet the section 6662 requirement for
nondisclosure, then the preparer advises the taxpayer of the
difference between the requirements of section 6662 and section
6694 and contemporaneously documents that this advice was given.
If a taxpayer
is advised by a nonsigning preparer that a position does have
a more-than-50% chance of being sustained on audit, then the nonsigning
preparer will not be subject to the section 6694 penalty, if the
advice to the taxpayer includes a statement informing the taxpayer
of the penalties under section 6662 and the disclosure requirements.
If such advice is given to another preparer, the penalty will
be avoided if the advice includes a statement that disclosure
under section 6694 may be required. In either case, the nonsigning
preparer should contemporaneously document to establish the fact
that the statement was given to the taxpayer or other preparer.
Procedure 2008-14. On January 25, 2008, the IRS
issued an advance copy of Revenue Procedure 2008-14 (2008-7 IRB),
which updates Revenue Procedure 2006-48 (2006-47 IRB 934). Revenue
Procedure 2008-14 discusses when disclosure of an item on a taxpayer’s
return is adequate for the purpose of avoiding either the accuracy-related
penalties under IRC section 6662 or the return preparer penalties
under section 6694(a). Revenue Procedure 2008-14 applies to any
return filed on 2007 tax forms for taxable years beginning in
2007 and to any return filed on 2007 tax forms in 2008 for short,
taxable years beginning in 2008.
planning on disclosing positions taken on a return should be certain
to familiarize themselves with Revenue Procedure 2008-14 and all
future guidance, to ensure that the disclosure is adequate to
avoid the imposition of penalties. The procedure contains detailed
rules as to the requirements for completing forms and attachments
“in a clear manner and in accordance with their instructions”
to satisfy an “adequate disclosure” test.
230. Following the issuance of Notice 2007-54 (IRB
2007-27), the IRS announced on September 26, 2007 (IRB 2007-45,
TD 9359), that it will incorporate the new tax return preparer
reporting requirements [i.e., the more-likely-than-not standard
found in the revised language of IRC section 6694(a)] in the provisions
of Circular 230. Circular 230 addresses only the right to practice
before the IRS, however; it does not address the imposition of
tax preparer has a reasonable belief that the tax treatment of
an item on a tax return has a better-than-50% chance of being
sustained on its merits, or unless a reasonable (not frivolous)
basis exists for such a position that is adequately disclosed,
the preparer may not sign the tax return.
a tax preparer may not advise a taxpayer to take a position on
a tax return unless the preparer has a reasonable belief that
the more-likely-than-not standard (i.e., more than 50% chance
of being sustained on its merits) will be met, or a reasonable
basis exists for such position and is adequately disclosed.
A tax preparer
must inform a taxpayer of any penalties that will more than likely
be applicable with respect to a position taken on a tax return
for which the preparer either advised the individual or prepared
and signed the tax return. The practitioner must also notify a
taxpayer of the opportunity to avoid such penalties by making
adequate disclosure, following the requirements for making the
disclosure, and also contemporaneously documenting such advice.
be noted that the House of Representatives recently passed a bill
that would reduce the preparer penalty standards to the penalty
standards that apply to taxpayers under IRC section 6662. As of
this writing, no similar action has been taken by the Senate.
Katz, Esq., is the Chaykin Distinguished Teaching Professor
of Taxation at the Zarb School of Business, Hofstra University,
Hempstead, N.Y., and the director of its graduate tax program.
Anthony Basile, PhD, MS (Tax), CPA, is an assistant
professor of accounting, taxation, and legal studies in business,
also at Hofstra University.
Neil D. Katz, Esq., is managing partner of the
law firm Katz, Bernstein & Katz, LLP, Syosset, N.Y., and an
adjunct professor of taxation at Hofstra University.
Harold Finkelstein, Esq., is of counsel to Katz,
Bernstein & Katz, LLP, and is the former lead appeals team manager
of the Long Island appeals office of the IRS.