The Small Business Tax Act amended Code Sec. 6694 to increase tax return preparer penalties, the types of returns to which the penalties apply, and the support required for the position taken on the return. The provision was to be effective for tax returns prepared after May 25, 2007.However, based on requests from the return preparation community, the Internal Revenue Service has provided transitional relief that generally applies the prior standards to returns and refund claims due before Jan. 1, 2008, estimated tax returns due on or before Jan. 15, 2008, and employment and excise tax returns due on or before Jan. 31, 2008. The transitional relief does not apply to willful or reckless conduct.
Tax practitioners have also pointed out that the support standard required for tax return preparers is now higher than the support standard required for taxpayers, creating an obvious conflict situation. While Congress may well act to create a uniform standard, most commentators feel that Congress would raise the taxpayer standard, rather than lower the return preparer standard.
What issues do these return preparer penalties raise for the coming tax filing season?
REVISED CODE SEC. 6694
The penalties for unreasonable positions have been raised from $250 to the greater of $1,000 or 50 percent of the income derived from preparing the return or claim for refund. The penalties for willful or reckless conduct have been raised from $1,000 to the greater of $5,000 or 50 percent of the income derived from the return or claim. These increases are designed to attract more attention from preparers, and they have achieved that goal. The addition of the percentage-of-income calculation will also put attention on billing practices.
The definition of a tax return preparer under Code Sec. 7701(a)(36) has been changed to apply not only to returns and claims for refunds with respect to income tax, but also other types of returns, such as estate and gift tax returns and employment and excise tax returns. Many probate attorneys still get involved in estate tax returns, even though they have never been engaged to do income tax returns. A whole new class of individuals may now have to worry about the return preparer penalties for the first time.
The standard for undisclosed positions has been raised from a realistic possibility of success to avoid disclosure to a more-likely-than-not standard. This is generally interpreted as raising the standard from a one-third chance of being sustained on the merits to a greater-than-50-percent chance of being sustained on the merits. Given the uncertainties often associated with the tax law, from ambiguous language, lack of guidance or conflicting guidance, this increase in standards is likely to create many more disclosure issues than in the past.
The standard for disclosed positions has also been raised, from a not-frivolous standard to a reasonable-basis standard.
THE PENALTY CALCULATION
One clear response to the change in the penalty amounts will be for preparers to clearly segregate their work on return preparation from their other work on behalf of the client in their billing statements. Return preparers will want to minimize the risk that the percentage calculation of the penalties will be applied to the entire work done by the preparer on behalf of the client due to inability to differentiate what work related to return preparation.
The Code Section 6694 penalties are not the only penalties that may apply. There is also the possibility of penalties under Circular 230. The combined penalties could easily exceed the total fees derived from the engagement.
THE SCOPE OF THE PENALTIES
It is possible that estate and probate attorneys will turn away from estate and gift return preparation, just as tax attorneys over the years have given up income tax return preparation.
The penalties can still apply, however, to a non-signing preparer who was involved with the preparation of a substantial portion of the return. Advice given following the completion of a transaction and before the tax return is prepared can put one into the category of a non-signing preparer.
THE SUPPORT STANDARD
Perhaps the most critical issue under the new return preparer penalties is the increase in the support standard. Some commentators have suggested that the new standard changes the role of the return preparer from one of an advocate to one of an advisor.
Rather than the preparer saying to a client that a position is aggressive but has a reasonable chance and the preparer will work to defend the position, the preparer will increasingly say that there is insufficient support for the position and, if taken, it must be disclosed on the return. Disclosure on the return is generally viewed by the client as an invitation for IRS scrutiny.
If the standard remains different for the taxpayer and the preparer, clear conflict problems emerge. The return preparer will insist on disclosure that the taxpayer will resist, since it is not necessary to avoid taxpayer penalties (unless the strategy constitutes a shelter). The conflicts could well end in the termination of engagements.
Assuming that the standards eventually merge into the same more-likely-than-not standard, the volume of disclosures is likely to dramatically increase. This will increase the cost of return preparation, may well inundate the IRS staff with more disclosures than they can handle, and may even hinder the move to e-filing due to the inability to handle disclosures electronically.
Most tax return preparers will not be in a position to walk away from business just because the risks have significantly increased. As long as the standards for the taxpayer and preparer are different, there may be engagements that a return preparer will have to walk away from if agreement on disclosure cannot be reached with the client.
Even when the standards merge, assuming that they merge at the more-likely-than-not level, return preparers will have to adjust their clients to either much more conservative positions taken on returns or to significant increases in disclosure. The clients will not like either the disclosure or the additional fees necessitated by the preparation of the disclosure documents.
One hope is that the IRS will not like the influx of the disclosure documents very much either, and work with Congress on modification of the requirements. Barring any further extensions by the IRS, return preparers will generally have to start grappling with these issues for tax returns due after Dec. 31, 2007.
The IRS stated in granting transitional relief that it would give it time to provide additional guidance. It may well be, therefore, that before tax filing season arrives, the IRS will either provide a further extension or additional guidance with respect to these issues.
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