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Brian C. Bernhardt is a partner in the Taxation and Employee Benefits Department of the Richmond, Virginia, office of McGuireWoods LLP. An abridged version of this article appeared in the February/March 2009 issue of Wealth Management Business magazine.
Until May 2007, Internal Revenue Code § 6694, which imposes monetary penalties on certain tax advisors, was largely ignored. On May 25, 2007, however, Congress substantially revised Code § 6694, and the changes caused a great gnashing of teeth and wringing of hands among tax advisors for more than a year. Under the new rules, even if a tax advisor never signs a client's tax return, never looks at a client's tax return, and never answers a specific tax return-related question, the IRS may subject the tax advisor to these rules.
The IRS quickly provided interim guidance and Proposed Regulations, at first, to delay implementation of the new rules and then to provide initial rules for compliance.
On October 31, 2008, Congress further revised Code § 6694 to mitigate the most objectionable aspect of the 2007 revisions. On December 15, 2008, the IRS issued Final Regulations, a revenue procedure, and administrative guidance explaining the application and operation of revised Code § 6694.
This article provides a summary and overview of the new rules, their application, and some practical concerns that remain. Please note that the rules described in this article apply to both returns and claims for refund. For ease of nomenclature, however, the article will refer only to returns. All references to returns include claims for refund.
Before May 25, 2007, Code § 6694 imposed a monetary penalty on income tax return preparers in certain circumstances. The penalty, however, was minimal, so it rarely received attention from practitioners or the IRS.
The section imposed a penalty if four events took place. First, an income tax return had an understatement of income tax liability. Second, the income tax return was prepared by an income tax return preparer. Third, the understatement of income tax was because of a position that did not have a "realistic possibility of being sustained on the merits"—in other words, a position that did not have at least a 33% chance of being sustained on the merits. Fourth, either the income tax return preparer did not disclose the position causing the understatement or the income tax return preparer did disclose the position causing the understatement but the position was frivolous, meaning that it had less than a 10% chance of being sustained on the merits.
The penalty was typically only $250. Moreover, the IRS waived the penalty if the income tax return preparer had reasonable cause for the understatement and acted in good faith. Even if the income tax return preparer acted willfully or recklessly in preparing the income tax return, the penalty only increased to $1,000.
Congress significantly revised Code § 6694 by enacting section 8246 of the Small Business and Work Opportunity Tax Act of 2007, Pub. L. No. 110-28 (formerly H.R. 2206). This law became effective on May 25, 2007. It was one of the methods by which Congress raised revenue to pay for the 2007 Iraq war-funding bill.
Generally speaking, the new law (1) extended the application of Code § 6694 to all taxes, (2) extended the application of Code § 6694 to all tax return preparers, (3) altered the standards of conduct required of tax return preparers, and (4) increased the penalties for violations of Code § 6694. As a result, revised Code § 6694 imposed a penalty if four events took place. First, the tax return understated the tax liability. Second, the tax return was prepared by a tax return preparer. Third, the tax return preparer did not have a reasonable belief that the position would more likely than not be sustained on the merits, a standard that required more than a 50% chance of success. Recall that under "old" Code § 6694 the preparer needed to have only a reasonable belief that the position had a realistic possibility of success, meaning a 33% chance. Fourth, either the tax return preparer did not disclose the position or did disclose the position but did not have a reasonable basis for it, a standard requiring more than about a 20% chance of success. Recall that under "old" Code § 6694, disclosure by the preparer only required the preparer to believe the position was not frivolous, requiring a 10% chance of success. The penalty for violating Code § 6694 also increased to the greater of (1) $1,000 or (2) 50% of the income derived, or to be derived, by the preparer from the tax return. This penalty was substantially stronger than the penalty under the old law. There was, however, no penalty if the tax return preparer had reasonable cause for the understatement and acted in good faith. If the preparer acted willfully or recklessly, the revised Code § 6694 penalty increased to the greater of (1) $5,000 or (2) 50% of the income derived, or to be derived, by the preparer from the return.
This version of Code § 6694 left a number of questions unanswered. For instance, do the rules apply only to tax returns or also to information returns? How does a tax advisor become a nonsigning tax return preparer? What information could a preparer rely on when preparing an actual return or providing tax advice? How thorough an investigation must the preparer conduct before concluding that there is a reasonable belief that a return position will more likely than not succeed on the merits? What happens if multiple people qualify as preparers?
The biggest issue revolved around the increased standard to which tax return preparers were subject. Even aside from the practical difficulties of reaching a more likely than not comfort level on any particular issue, the increased standard raised the question of its integration with the application of Code § 6662 penalties to taxpayers. Under Code § 6662, a taxpayer with substantial authority for a position, requiring a 40% chance of success, can avoid a substantial understatement penalty without disclosing the position. Under the 2007 version of Code § 6694, however, a preparer with substantial authority for a position still had to disclose the position unless the preparer also had a reasonable belief that the position would more likely than not be sustained on its merits, requiring more than a 50% chance of success. Thus, if the preparer had substantial authority for a position but lacked a reasonable belief that the position would more likely than not be sustained on its merits, then the preparer, but not the taxpayer, had an obligation to disclose the position. How could the preparer make the disclosure if the taxpayer refused to allow the disclosure without creating a conflict of interest under Circular 230? This issue exposed a fundamental shifting in policy by the IRS: from a system of voluntary disclosure by the taxpayer, the IRS embarked on a policy of requiring taxpayer advisors to report to the IRS on their clients.
The IRS was well aware of these issues yet not at all prepared to deal with them immediately following the revision of Code § 6694. Delay was necessary.
To give the IRS sufficient time to address the many issues pertaining to the implementation of revised Code § 6694, the IRS issued Notice 2007-54, effective on May 25, 2007, that essentially applied the prior rules to all returns due and advice given before January 1, 2008. On December 31, 2007, the IRS issued Notices 2008-11, 2008-12, and 2008-13, providing preliminary guidance on the application of Code § 6694. Then, on June 17, 2008, the IRS issued Proposed Regulations.
During the second half of 2007 and into 2008, practitioners continued to express their displeasure at a disclosure standard putting them in conflict with the best interests of their clients. Although the Proposed Regulations provided practitioners with some guidance on dealing with this issue, a legislative remedy remained a priority.
On October 3, 2008, Congress revised Code § 6694 by enacting section 506 of the Emergency Economic Stabilization Act of 2008, H.R. 1424, Pub. L. No. 110-343. This law was one of the provisions in the original financial services bailout/rescue bill. This revision was retroactively effective to May 25, 2007, the date of the earlier revision.
This revision to Code § 6694 reduced the "more likely than not" standard to a "substantial authority" standard. Assuming the other required events occur, the IRS can only impose the Code § 6694 penalty if an understatement is because of a position for which the tax return preparer does not have "substantial authority" and fails to make an appropriate disclosure. A position has "substantial authority" if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead that person to conclude that the position has at least a 40% chance of being sustained on the merits.
This standard coordinates the standards for preparers under Code § 6694 and the standard for taxpayers under Code § 6662. In addition, although this standard is higher than the pre-2007 requirement that the preparer have a reasonable belief that the position had a realistic possibility of success (33%), it is lower than the 2007 approach, requiring the preparer to have a reasonable belief that the position would more likely than not be sustained (more than 50%).
Notably, the standard did not change in all cases. For tax shelters and reportable transactions to which Code § 6662A applies, a tax return preparer is still required to have a reasonable belief that the position is more likely than not to be sustained on the merits.
On December 15, 2008, the IRS issued Final Regulations, interim guidance relating to tax shelters and reportable transactions, and a revenue procedure identifying the returns to which the Code § 6694 penalty applies. The Final Regulations became effective December 22, 2008, and apply to returns filed and advice provided after December 31, 2008.
Returns Subject to Code § 6694
The Final Regulations do not specify which returns are subject to Code § 6694. But Rev. Proc. 2009-11, issued contemporaneously with the Final Regulations, does identify these returns.
Section 3.02 of the revenue procedure provides a list of tax returns subject to Code § 6694. This list includes various income tax returns, estate and gift tax returns, employment tax returns, alcohol, tobacco, and certain other excise tax returns, and a procedural and administrative return.
Section 3.03(1) and (2) provide a list of information returns subject to Code § 6694, if the information reported on the information return constitutes a "substantial portion" of the taxpayer's tax return. The most notable returns identified are Form 1065 and Form 1120S.
Sections 3.03(1) and (3) provide for the treatment of certain other documents as returns subject to Code § 6694. Other documents that include information that is or may be reported on a taxpayer's tax return are subject to Code § 6694 if the information reported on the document constitutes a "substantial portion" of the taxpayer's tax return. The revenue procedure identifies, as examples, depreciation schedules, as well as cost, expense, or income allocation studies that, although they do not report a tax liability, will affect one or more entries on a tax return that does report a tax liability.
Section 3.04 provides a list of information returns that include information that is or may be reported on a taxpayer's tax return that are not subject to Code § 6694 unless (1) the information reported on the information return constitutes a "substantial portion" of the taxpayer's tax return and (2) the tax return preparer (a) willfully prepares the information return in any manner to understate the liability on the taxpayer's tax return or (b) prepares the information return recklessly or with intentional disregard of rules or regulations. The list includes, but is not limited to, Forms SS-8, 990, 990-EZ, 990-N, W-2, and 1099.
The second part of this article will appear in the September/October 2009 issue.Return To Issue Index