Tax Preparers Face Broader IRC 6694 Penalties

By Robert L. Goldstein, CPA, and William R. Lalli, CPA, NYSSCPA Tax Policy Manager

NEW YORK—With new tax legislation may come unwelcome surprises for tax practitioners. One such case is with the Small Business and Work Opportunities Tax Act of 2007. Signed into law on May 25, the law amends IRS Tax Code Section 6694, which sets the standards under which tax-return preparers must operate, and sets the penalties for violating those new standards.

The changes have affected some basic tenets of tax-return preparation, such as what constitutes preparation of a tax return, who is a return preparer and when one must sign tax returns.

The new law applies to all returns, amended returns and refund claims due on or before Dec. 31, 2007; 2007 estimated tax returns due on or before Jan. 15, 2007; and 2007 employment and excise tax returns due on or before Jan. 31, 2008.

Because the law extends the types of returns subject to the new provisions, changes are also required to other relevant IRS forms and publications. The IRS must also alter existing procedures in order to process disclosures with certain forms in electronic formats. The IRS has determined that the amended provisions of Code Section 6694 should be incorporated into IRS Circular 230.

Unresolved Practice Problems

Under the new law, all tax preparers will be subject to the “more likely than not” (MLTN) standard. The MLTN means that a tax-return preparer has a reasonable belief that there is a better than 50 percent chance that the position taken in the tax return is correct. Taxpayers are held to the “substantial authority standard,” which requires the taxpayer to have a reasonable belief that there is a better than a 33.3 percent chance the position is correct. A “disconnect” would exist in a situation in which there was a tax position between the two standards. The taxpayer may believe that a disclosure of the tax position is necessary based on the amended Section 6694 standard.

Tax preparers and advisers are also concerned about advice given to clients in connection with gray areas of the law. For example, in situations in which the courts in different jurisdictions have ruled differently on an issue, the practitioner is in a predicament. Under the old standard (“substantial authority”), no disclosure would be required. But under the “more likely than not” standard, in order to be correct, the practitioner would be required to disclose the same tax position.

The reconciliation of this disconnect may result in the practitioner being required to perform additional work or to do additional research into complex tax positions to reach the new standard. This would result, at a minimum, in higher fees for taxpayers.

At the extreme, one can see that every understatement could result in a penalty because an understatement only occurs when the position taken on the tax return is not “more likely than not” correct.

Section 6694 Penalties’ Scope Widened, Amounts Increased

The scope of the income tax return preparer penalties has been extended to preparers of all tax returns, amended returns and claims for refund. This includes estate and gift tax returns, generation-skipping transfer tax returns, employment tax returns and excise tax returns.

Section 6694(a) was changed so that the penalty would apply if:

Although the law did not alter the standard of conduct under section 6694(b), it increased the amount of the penalty and made it apply to all tax-return preparers.

Two changes to conduct under section 6694(a) were made:

The “first-tier” section 6694(a) penalty for understatements was increased from $250 to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax-return preparer from the preparation of a return or claim with respect to which the penalty was imposed.

The law increased the “second-tier” section 6694(b) penalty (for willful or reckless conduct) from $1,000 to the greater of $5,000 or 50 percent of the income derived (or to be derived) by the tax-return preparer.

Under both the prior and current law, disclosure under section 6694(a) is adequate if made on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, attached to the return, amended return or refund claim, or pursuant to the annual revenue procedure authorized in Treasury regulation sections 1.6694-2(c)(3) and 1.6662-4(f)(2).

In addition, under both the prior and current law, the penalty under section 6694(a) would not be imposed if it is shown that there is reasonable cause for the understatement and the tax-return preparer acted in good faith.

Transitional Relief

In order to provide sufficient time to address issues pertaining to the implementation of the law, the IRS provided the following transitional relief:

No transitional relief is available under section 6694(b) as it was deemed inappropriate for return preparers who exhibit willful or reckless conduct, regardless of the type of return prepared.

Apply the Law as It Is Written—Expect Ambiguities

The persistent problem is that the MLTN standard is not consistent with everyday tax-return advice and preparation. Practitioners should give advice that they believe is based on the applicable law and facts, and never take frivolous positions on a return.

As a consequence of these changes, practitioners may become unnecessarily cautious with regard to this change in the law and may conclude that it is in their best interest and in the interest of their clients to disclose every position that is not certain.

Because of the uncertainty as to whether a position is “more likely than not” correct, there will be situations in which a practitioner will be faced with the choice between a penalty and disclosure. Monitor the issues, and, perhaps, subsequent events will cause changes to further improve practice.

Robert L. Goldstein, CPA, a member of the NYSSCPA’s Tax Division Oversight Committee, can be reached at
rgoldstein@markspaneth.com. William R. Lalli, CPA, NYSSCPA Tax Policy Manager, can be reached at wlalli@nysscpa.org.