PDF DownloadTax Return Preparer Penalties: The New Rules of Code § 6694, Part 2
By Brian C. Bernhardt

Probate & Property Magazine: September/October 2009, Volume 23, Number 5

Real Property|Trust & Estate

Brian C. Bernhardt practices with the law firm of Bernhardt & Strawser, P.A., in Charlotte, North Carolina. An abridged version of this article recently appeared in the February/March 2009 issue of Wealth Management Business magazine.

This is Part 2 of a two-part article. Part 1 appeared in the July/August 2009 issue of Probate & Property.

The Final Regulations and Related Guidance (continued)

Definition of Tax Return Preparer

The Final Regulations define a tax return preparer broadly as any person who prepares for compensation, or who employs one or more persons to prepare for compensation, all or a substantial portion of any tax return. Note that compensation is a key part of the definition: if the return is prepared at no cost, then the preparer does not meet the definition. Also, the Final Regulations exclude any person who prepares a return for the employer by whom they are regularly and continuously employed. This is a beneficial rule for in-house accounting personnel.

The Final Regulations continue the prior classification of preparers into two types: (1) signing preparers and (2) nonsigning preparers.

A signing preparer is the preparer who has the primary responsibility for the overall substantive accuracy of the return. This definition does not necessarily include, or exclude, the preparer who actually signs the return, but instead focuses on the person who has responsibility for its accuracy.

A nonsigning preparer is any preparer who is not a signing preparer but who prepares all or a substantial portion of a return for events that occurred before the advice is rendered. When determining whether a tax advisor is a nonsigning preparer, the IRS does not take into account time spent providing advice that is given about past events, which represents less than 5% of the advisor's aggregate time spent providing advice on the position that caused the understatement. The IRS believes that this exception will encourage advisors who principally give advice before transactions also to give follow-up advice without becoming nonsigning preparers.

The IRS, however, is also concerned that nonsigning preparers may abuse this exception, so the Final Regulations incorporate an anti-abuse rule. Time spent providing advice before the events occurred will be taken into account to determine whether a tax advisor is a nonsigning preparer if the facts and circumstances show that (1) the position giving rise to the understatement is primarily attributable to the advice, (2) the advice was substantially given before events occurred primarily to avoid treating the person giving the advice as a preparer, and (3) the advice given before events occurred was confirmed after events had occurred for purposes of preparing a tax return.

The definition of a nonsigning preparer requires a determination whether a tax advisor has prepared a portion of a return and whether that portion is a substantial portion of the return. A tax advisor who renders advice on a position directly relevant to the determination of the existence, characterization, or amount of an entry on a return has prepared that entry and therefore prepared a portion of the tax return to which the entry relates. A schedule, entry, or other portion of a return is a substantial portion of the return if the advisor knows or reasonably should know that the tax attributable to the schedule, entry, or other portion of a return is a substantial portion of the tax required to be shown on the return.

In making its determination whether a portion of a return is a substantial portion, the IRS has identified two nonexclusive factors: first, the size and complexity of the item relative to the taxpayer's gross income; and second, the size of the understatement attributable to the item compared to the taxpayer's reported tax liability. This clarifies that determining whether a person has prepared a substantial portion of a return depends on the relative size of the deficiency attributable to the schedule, entry, or other portion of the return. Thus, a single tax entry can constitute a substantial portion of the tax required to be shown on a return.

There are two de minimis exceptions under which some portions of a return are automatically not a substantial portion of the return: first, when the gross income, deductions, or amounts on which credits are determined are less than $10,000; and second, when the gross income, deductions, or amounts on which credits are determined are less than $400,000 and less than 20% of the gross income shown on the return. Notably, a tax advisor must aggregate all schedules, entries, or other portions he or she prepared to determine whether either of the de minimis exceptions apply.

One question that arises is whether interrelated returns will implicate preparers. For instance, if a tax advisor prepares a partnership tax return but not the returns of the individual partners, the issue is whether the tax advisor is still a nonsigning preparer of the individual returns because the entries on the partnership return are reflected on the individual returns. The Final Regulations resolve this issue consistently with the "substantial portion" analysis. Thus, although a preparer for one return is not automatically considered a preparer of a second return simply because one or more entries on the first affect an entry on the second, if any entries reported on the first are directly reflected on, and constitute a substantial portion of, the second, then the preparer of the first return will be treated as a preparer of the second return. Recall, however, that the analysis for determining whether an entry on a return is a substantial portion of the return includes a knowledge requirement. As a result, unless (1) the entry on the partnership return is reflected on a partner's individual return and (2) the preparer for the partnership return knows or should know that the tax attributable to the entry on the individual return is a substantial portion of the tax required to be shown on the individual return, then the preparer has not prepared a substantial portion of the individual tax return and is therefore not a preparer for the individual tax return.

Determining Which Preparer Is the Preparer Subject to Code § 6694

Under the regulations previously in effect, there was only one preparer in each firm, the so-called "one preparer per firm" rule. Thus, if a signing preparer was associated with a firm, that individual, and no other individual in the firm, was treated as a preparer for the return for purposes of Code § 6694. If two or more individuals associated with a firm were preparers for a return and neither was a signing preparer, only one of them could be a nonsigning preparer for that return for purposes of Code § 6694. Typically, the individual who was the preparer for purposes of Code § 6694 was the individual with overall supervisory responsibility for the advice given by the firm about the return.

The IRS now believes it appropriate to reconsider the "one preparer per firm" rule. Because of specialization and the increased complexity of federal tax law, the IRS wants to focus on each position within a return, rather than the return as a whole. As a result of this change in focus, the "one preparer per firm" rule no longer applies. Instead, the IRS has created a "one preparer per position per firm" rule.

Accordingly, under the Final Regulations, an individual is a preparer if the individual is primarily responsible for the position on the return giving rise to the understatement. Only one person within a firm is considered primarily responsible for each position. In the course of identifying the individual who is primarily responsible for the position, the IRS may advise multiple individuals within the firm that it is considering whether one of them is the individual within the firm primarily responsible for the position.

Note that, in some circumstances, there may be more than one preparer who is primarily responsible for a position giving rise to an understatement if multiple preparers are with different firms. The preamble to the Final Regulations, however, makes it clear that only one person within a firm will be considered primarily responsible for each position giving rise to an understatement.

If there is a signing preparer, the IRS will generally consider the signing preparer to be the person primarily responsible for all of the positions on the return giving rise to an understatement. If there is no signing preparer, then the IRS will generally treat the nonsigning preparer in the firm with overall supervisory responsibility for the position on the return giving rise to the understatement as the preparer primarily responsible for the position for purposes of Code § 6694.

In both cases, however, if another person is the person primarily responsible for a position giving rise to the understatement, then the IRS may treat that person, rather than the signing preparer or nonsigning preparer, as the case may be, as the preparer for purposes of the position. This caveat will prevent the IRS from assessing a penalty against a person who may have overall responsibility for a return but who may lack detailed knowledge of, or responsibility for, a return position and who reasonably relied on another advisor at the same firm. This rule allows the IRS to implement its policy objective of focusing on positions in a return rather than the return as a whole. To the extent that specialization has resulted in delegation, this rule will allow the IRS to penalize the individual who has specialized knowledge of, and responsibility for, a specific return position, rather than penalizing the individual who, while primarily responsible for the return as a whole, was not primarily responsible for the specific return position.

In addition, if the IRS obtains information that would support a finding that either the signing preparer or a nonsigning preparer is primarily responsible for a position on the return giving rise to the understatement, then the IRS may assess the penalty against either, but not both.

In certain circumstances, the IRS will hold a preparer's firm responsible for the penalty, instead of or in addition to the preparer. This may occur if one or more members of the principal management of the firm or a branch office participated in or knew of the conduct; the firm failed to provide reasonable and appropriate procedures for review of the position for which the penalty is imposed; or the review procedures were disregarded through willfulness, recklessness, or gross indifference.

Substantial Authority for Position

Other than positions with respect to a tax shelter or a reportable transaction, a preparer must disclose a position if the preparer does not have substantial authority for the position. In Notice 2009-5, the IRS announced that the term "substantial authority" will have the same meaning for purposes of Code § 6694 as it does in a variety of regulations promulgated under Code § 6662.

The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. The substantial authority standard is less stringent than the more likely than not standard (more than a 50% chance of success) but more stringent than the reasonable basis standard (about a 20% chance of success). It is generally considered to require about a 40% chance of success. A preparer may not take into account the possibility that the IRS may not audit the return or that the IRS may not raise the issue on audit. A position must satisfy the substantial authority standard on the last day of the taxable year to which the return relates.

There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. The preparer must take all authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, into account in determining whether substantial authority exists. The weight of authorities is determined in light of the pertinent facts and circumstances. There may be substantial authority for more than one position on the same item.

The weight accorded an authority depends on its relevance, persuasiveness, and the type of document providing the authority. An authority having some facts in common with the position at issue is not particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the position at issue. An authority that merely states a conclusion is ordinarily less persuasive than one that reaches its conclusion by cogently relating the applicable law to pertinent facts.

The type of document also must be considered. For example, a revenue ruling is accorded greater weight than a private letter ruling addressing the same issue. An older authority generally must be accorded less weight than a more recent one. Any private letter ruling, technical advice memorandum, general counsel memorandum, or action on decision that is more than 10 years old generally is accorded very little weight. But the persuasiveness and relevance of a document, viewed in light of subsequent developments, should be taken into account along with the age of the document. There also may be substantial authority for the tax treatment of an item despite the absence of certain types of authority. Thus, a taxpayer may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision. A preparer has substantial authority for a position if the position is the subject of a written determination (such as a private letter ruling, revenue ruling, and so on).

The Treasury Regulations describe the type of authorities a preparer may rely on when determining whether substantial authority exists. The preparer must use authorities such as the Code, Final and Temporary Regulations, revenue rulings and revenue procedures, treaties, cases, legislative history (including the Joint Committee on Taxation Blue Book), private letter rulings, technical advice memoranda, actions on decisions and general counsel memoranda issued after March 12, 1981, IRS information and press releases, and IRS notices, announcements, and administrative pronouncements.

An authority, however, does not continue to be an authority to the extent it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify the earlier authority. In the case of court decisions, for example, a district court opinion on an issue is not an authority if overruled or reversed by the U.S. court of appeals. A Tax Court opinion, however, is not considered to be overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling, or other administrative pronouncement published in the Internal Revenue Bulletin.

Furthermore, conclusions reached in treatises, legal periodicals, legal opinions, or opinions rendered by tax professionals are not authority. But the authorities underlying such expressions of opinion, when applicable to the facts of a particular case, can give rise to substantial authority for the tax treatment of an item.

When determining whether it is reasonable to believe that a position satisfies the "substantial authority" standard, the preparer may not take into account the applicability of court cases to the taxpayer based on the taxpayer's residence in a particular jurisdiction (that is, district court cases). The tax return preparer, however, can rely on controlling precedent of a U.S. court of appeals to which the taxpayer has a right of appeal. The rule does not address the applicability of cases in the Tax Court or Court of Federal Claims—but because those cases are not based on the taxpayer's residence in a particular jurisdiction, the regulation would not seem to apply.

For the purpose of determining whether a preparer has substantial authority, the IRS allows preparers to rely on third-party information. Thus, a preparer may rely in good faith and without verification on three different types of information. First, the preparer may rely on information furnished by the taxpayer. Second, the preparer may rely on information furnished by another advisor, another preparer, or another party within or without the same firm, and is not required to audit, examine, or review books and records, business operations, or documents or other evidence to independently verify information provided by the taxpayer, advisor, other preparer, or other party. Third, the preparer may rely on a return previously prepared by a taxpayer or another preparer and filed with the IRS, although the preparer must confirm that the position relied on has not been adjusted.

At the same time, there are limitations on the lengths to which a preparer may rely on information provided by third parties. First, a preparer may not ignore the implications of information furnished to or actually known by the preparer and must make reasonable inquiries if the information furnished appears to be incorrect or incomplete. Second, a preparer may not rely on unreasonable legal or factual assumptions (including assumptions related to future events), such as an assumption or representation the preparer knows is not true, and cannot unreasonably rely on third-party statements or representations.

In addition, unlike the Proposed Regulations, the Final Regulations do not prohibit reliance on legal conclusions furnished by taxpayers. The reason for this change is that many taxpayers—such as large corporate or other business entities—employ sophisticated tax staffs as employees, and the entity, through those staffers, routinely provides its tax advisors with legal conclusions. This, however, is not always the case and often more unsophisticated taxpayers (such as individuals without any tax background) may attempt to provide their advisors with legal conclusions. To guard against that problem, however, the limitations described above (including good faith) still apply to advisors' reliance on legal conclusions furnished by taxpayers.

Reason to Believe That Tax Treatment Would More Likely Than Not Be Sustained on the Merits

If a preparer prepares a position on a tax shelter or a reportable transaction, then the higher "more likely than not" standard still applies: the preparer must disclose the position if it is not reasonable for the preparer to believe that the tax treatment of the position would more likely than not be sustained on the merits. A position must satisfy the more likely than not standard on the date the return was prepared.

The term "tax shelter" means a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of federal income tax. Reportable transactions are transactions subject to certain disclosure rules because the IRS has determined that they have the potential for tax avoidance or evasion. Currently, six types of transactions are reportable: (1) listed transactions, (2) confidential transactions, (3) transactions with contractual protection, (4) loss transactions, (5) transactions of interest, and (6) patented transactions.

It is reasonable for a preparer to believe that the tax treatment of an item is more likely than not the proper tax treatment if the preparer analyzes the relevant facts and authorities and, relying on that analysis, reasonably concludes in good faith that the tax treatment of the item would more likely than not be sustained on the merits. A preparer may not take into account the possibility that the IRS may not audit the return or that the IRS may not raise the issue on audit. Whether it is reasonable for a preparer to have a belief is determined based on all facts and circumstances, including the preparer's due diligence. When examining the level of diligence in a particular case, the IRS will take into account the preparer's experience with the area of tax law and familiarity with the taxpayer's affairs, as well as the complexity of the issues and facts in the case.

When determining whether it is reasonable for a preparer to believe that a position will more likely than not be sustained on the merits, the preparer must use the authorities, methodology, and analysis described above about the substantial authority standard.

Notice 2009-5, however, alleviates this rule for tax shelters pending further guidance. Under Notice 2009-5, if there is substantial authority for the position and the preparer makes the appropriate disclosure, then the preparer will not be subject to a penalty under Code § 6694. In addition, if a nonsigning preparer provides advice to another preparer regarding a position on a tax shelter, there is substantial authority for the position, and the one preparer makes the appropriate disclosure to the other, then the nonsigning preparer will not be subject to a penalty under Code § 6694.

Notably, the Notice 2009-5 rules applicable to tax shelters do not apply to reportable transactions.

Reasonable Basis for Position

A preparer must have a reasonable basis for a position. If a preparer does not have a reasonable basis for a position, then disclosure of the position does not protect the preparer from the potential application of the Code § 6694 penalty.

A reasonable basis for a position is about a 20% confidence level in the position. It is not satisfied by a return position that is merely arguable. When determining whether a reasonable basis for a position exists, a preparer may rely on certain information provided by third parties. The applicable rules are the same as when the preparer may rely on third-party information to establish substantial authority for a position, which is discussed above.

Methods of Disclosure

A preparer can (generally) avoid the Code § 6694 penalty when there is a reasonable basis for a position but there is not substantial authority for the position by making appropriate disclosures. There are different rules for signing and nonsigning preparers. In addition, there are separate rules for tax shelter and reportable transactions.

A signing preparer meets disclosure in any one of the following three ways:

  1. Actually disclosing the position on a properly completed and filed Form 8275 (Disclosure Statement), a properly completed and filed Form 8275-R (Regulation Disclosure Statement), or on the tax return.
  2. Providing the taxpayer with a tax return that includes a disclosure of the position.
  3. For returns subject to accuracy-related penalties under Code § 6662 other than the substantial understatement penalty, the signing preparer can advise the taxpayer of all the Code § 6662 penalty standards to which the taxpayer may be subject. The signing preparer must contemporaneously document this advice in his own files.

A nonsigning preparer meets disclosure in any one of the following three ways:

  1. Actually disclosing the position on a properly completed and filed Form 8275 (Disclosure Statement), a properly completed and filed Form 8275-R (Regulation Disclosure Statement), or on the tax return.
  2. Advising the taxpayer of any opportunity to avoid the Code § 6662 penalties to which the taxpayer may be subject and the standards for such disclosures. The nonsigning preparer must contemporaneously document this advice in his own files. The contemporaneous documentation should reflect that the affected taxpayer has been advised by a preparer in the firm of the potential penalties and the opportunity to avoid penalty through disclosure.
  3. Advising another preparer on the position that disclosure under Code § 6694 may be required. The nonsigning preparer must contemporaneously document this advice in his own files. The contemporaneous documentation should reflect that a preparer outside the firm has been advised that disclosure may be required. If the advice is to another nonsigning preparer within the same firm, contemporaneous documentation is satisfied if there is a single instance of contemporaneous documentation within the firm.

Notice 2009-5 provides two types of allowable disclosures for tax shelter positions for which there is substantial authority:

  1. A signing preparer must advise the taxpayer of the penalty standards applicable to the taxpayer in the event that the transaction is deemed to have a significant purpose of federal tax avoidance or evasion. The advice must explain to the taxpayer that, if the position has a significant purpose of tax avoidance or evasion, then the position must have substantial authority, the taxpayer must possess a reasonable belief that the tax treatment is more likely than not the proper treatment to avoid a penalty under Code § 6662(d), and disclosure will not protect the taxpayer from assessment of an accuracy-related penalty if Code § 6662(d)(2)(C) applies to the position. The preparer must contemporaneously document the advice in the tax return preparer's files.
  2. A nonsigning preparer must provide a statement to the other preparer about the penalty standards applicable under Code § 6694. Contemporaneously prepared documentation in the nonsigning preparer's files will establish that the statement was given. If a nonsigning preparer and other preparers are employed by the same firm, then contemporaneous documentation of advice provided by any preparer in that firm to the taxpayer regarding applicable penalty standards, as described above, is also sufficient to establish that the statement was given by a nonsigning preparer to the other tax return preparers within the firm.

Notably, Notice 2009-5 does not provide similar rules for reportable transactions. As a result, not only does the "more likely than not" standard remain the applicable standard for reportable transactions, but it also appears that actual disclosure to the IRS is the only allowable method of disclosure.

Manner of Disclosure

To satisfy these disclosure rules, the Final Regulations provide that a preparer must satisfy the rules on a position-by-position basis. It is not enough to disclose that the return itself does not meet the substantial authority standard. The preparer must examine each individual position on the return and make the appropriate disclosure, as needed, for each position for which a disclosure is required.

As a result, the disclosure advice to the taxpayer must be particular to the taxpayer, the return, and the position in question, and must be specifically tailored to the taxpayer's facts and circumstances. Although there is no pro forma language or special format required for compliance with these rules, a boilerplate disclosure (such as the type of Circular 230 disclosures that have become so commonplace at the bottom of attorney e-mails) will not satisfy the requirement. Preparers, however, can rely on established forms or templates when advising clients regarding the penalty provisions of the Internal Revenue Code. Preparers can choose to comply with the documentation requirement in one document addressing each position or in multiple documents addressing all of the provisions.

A special rule applies for making disclosures about pass-through entities. When the positions at issue are attributable to a pass-through entity, the preparer can make the disclosure at the entity level on a properly completed and filed Form 8275, Form 8275-R, on the tax return, or by other means available.

It is important to note that the disclosure rules have specific attorney-client privilege implications. In every case in which a preparer provides advice to a taxpayer to satisfy the disclosure requirement, the preparer must contemporaneously document the fact that he provided the advice. Therefore, for the preparer to prove to the IRS that he fully complied with the disclosure requirements, he will have to confirm the contemporaneous documentation. If the IRS requires disclosure of the contemporaneous documentation to satisfy this requirement, then the preparer is faced with a privilege issue. On the one hand, the documentation is privileged and the preparer can only disclose it with the taxpayer's consent, consent the taxpayer has no incentive to grant because the documentation might well negatively implicate the tax position. This situation can create a conflict of interest with the client. On the other hand, the IRS may argue the documentation is not privileged because it was not created with an expectation of privacy, because the only purpose for its creation was to satisfy the disclosure requirement, and that can only occur by disclosing the documentation to the IRS, which might well negatively implicate the tax position. This situation creates a disincentive for the client to allow the preparer to create the documentation in the first place, once again creating the potential for a conflict of interest with the client.

Reasonable Cause and Good Faith

Just like the pre-2007 version of Code § 6694, the 2008 version of Code § 6694 includes an exception to the Code § 6694 penalty if the preparer acted with reasonable cause and in good faith. The Final Regulations describe six factors the IRS considers when determining whether reasonable cause and good faith exist.

First, the IRS considers the nature of the error causing the understatement. If the error causing the understatement results from a provision of law that was so complex, uncommon, or highly technical that a competent preparer reasonably could have made the error, there may be reasonable cause and good faith. Reasonable cause and good faith, however, do not exist if the error causing the understatement is apparent from a general review of the return.

Second, the IRS considers the frequency of the errors. If the error causing the understatement is an isolated error (such as an inadvertent mathematical or clerical error) rather than a number of errors, there may be reasonable cause and good faith. Even if the error is an isolated error, however, reasonable cause and good faith do not exist if the error is so obvious, flagrant, or material that it should have been discovered during a review of the return. In addition, reasonable cause and good faith do not exist if there is a pattern of errors on the return, even if any one of the errors, in isolation, would have constituted reasonable cause and good faith.

Third, the IRS considers the materiality of the errors. If the error is of a relatively immaterial amount, there may be reasonable cause and good faith. Even if the error is of a relatively immaterial amount, however, reasonable cause and good faith do not exist if the error or errors creating the understatement are obvious or numerous.

Fourth, the IRS considers the preparer's normal office practice. Reasonable cause and good faith may exist if the preparer's normal office practice, when considered together with other facts and circumstances, such as the preparer's knowledge, indicates that the error resulting in the understatement would rarely occur and the normal office practice was followed in preparing the return or claim in question. Normal office practice means a system for promoting accuracy and consistency in the preparation of returns or claims. It must generally include, in the case of a signing preparer, checklists, methods for obtaining necessary information from the taxpayer, a review of the prior year's return, and review procedures. Reasonable cause and good faith, however, do not exist if there is a flagrant error on the return, a pattern of errors on the return, or a repetition of the same or similar errors on numerous returns or claims.

Fifth, the IRS considers whether the preparer relied on third-party information. A preparer can establish reasonable cause and good faith by relying, without verification, on the advice and information furnished by the taxpayer or other parties if the preparer has reason to believe the third party was competent to render the advice or other information. The advice or information can be written or oral, but in either case the burden of establishing that the advice or information was received is on the preparer. A preparer has not relied on third-party information in good faith, however, if the advice or information is unreasonable on its face or the preparer knew or should have known that the third party providing the advice or information was not aware of all relevant facts; or the preparer knew or should have known, at the time the return was prepared, that the advice or information was no longer reliable because of developments in the law since the time the advice was given.

Sixth, the IRS considers industry practice, which is based on all facts and circumstances. Reasonable cause and good faith may exist if the error is the result of reasonable reliance on generally accepted administrative or industry practice in taking the position that resulted in the understatement. Good faith reliance does not exist if the preparer knew or should have known, at the time the return was prepared, that the administrative or industry practice was no longer reliable because of developments in the law or IRS administrative practice since the time the practice was developed. An accepted administrative or industry practice is based on all facts and circumstances.

Date Return Is Prepared

The Final Regulations provide two rules clarifying when the IRS deems a return prepared. Signing preparers are deemed to have prepared a return on the date they sign the return. If the signing preparer does not actually sign the return, the return is deemed prepared on the date filed. Nonsigning preparers are deemed to have prepared a return on the date they gave the advice on the position at issue. That date is determined based on the facts and circumstances.

Existence of Understatement of Tax

Under the Final Regulations, an understatement of tax exists if, viewing the return as a whole, there is an understatement of the net amount of tax payable (or an overstatement of the net amount creditable or refundable). For purposes of Code § 6694, the net amount payable is not reduced by any carryback.

Determining whether an understatement of tax exists can be made in a proceeding involving the preparer that is separate and apart from any proceeding involving the taxpayer. But, if the IRS or a court later determines that no understatement of tax existed (for instance, the Office of Appeals or Tax Court decides in favor of the taxpayer to whom the return relates), the IRS must abate the Code § 6694 assessment and refund any portion of the penalty paid, without regard for the statute of limitations.

Calculating the Amount of the Penalty

The penalty for violating Code § 6694 is based on the income derived, or to be derived, by the preparer with respect to the tax return. The term " income derived" (or "to be derived") means all compensation the preparer receives or expects to receive from the engagement of preparing the return or providing tax advice for the position taken on the return that gave rise to the understatement.

A variety of rules explicate this requirement. The rules generally require allocation of income to determine what, and how much, income earned by the preparer relates to the position at issue. Five specific rules are most relevant, and their application can often be interconnected.

First, preparers who are compensated by a firm must allocate their income between (1) the income they personally receive that relates to the engagement of preparing the return or providing tax advice about the position taken on the return that gave rise to the understatement and (2) their other income.

Second, preparers with multiple engagements related to the same return must allocate their income between (1) those engagements relating to the position taken on the return that gave rise to the understatement causing the penalty and (2) other income.

Third, the IRS will take into account only compensation for tax advice given on transactions that have already occurred at the time the advice is rendered and that relate to the position giving rise to the understatement for purposes of calculating the penalty. Thus, if a lump-sum fee includes amounts that should not be taken into account (because, for instance, some part of the fee relates to pre-transaction advice), then the amount of income derived is based on a reasonable allocation of the lump-sum fee between the advice giving rise to the penalty and advice that does not give rise to the penalty.

Fourth, when a preparer issues a refund to the taxpayer for all or part of the amount paid (because, for instance, the fee arrangement is a contingent fee arrangement), the refund will not reduce the amount of "income derived" and therefore the amount of the Code § 6694 penalty. But a fee refund does not include a discounted fee or alternative billing arrangement, which will reduce the amount of "income derived" and therefore the amount of the Code § 6694 penalty.

Fifth, if a preparer provides information to the IRS establishing that the compensation attributable to the position(s) giving rise to the understatement on the return is less than the total amount of compensation associated with the engagement, then the IRS will calculate the amount of the penalty based on the compensation attributable to the position(s) giving rise to the understatement. This might occur, for example, if the number of hours of the engagement spent on the position(s) giving rise to the understatement is less than the total hours associated with the engagement. Otherwise, the total amount of compensation from the engagement will be the amount of income derived for purposes of calculating the penalty under Code § 6694.

In addition, if both an individual and the firm that employs the individual are subject to a penalty under Code § 6694, then the amount of penalties assessed against each may not each exceed 50% of the income derived (or to be derived).

Conclusion

For the past two years, Code § 6694 has undergone an evolutionary process. The IRS did not engage in much activity during this transitional period. Now the transitional period has ended. Practitioners must focus on these rules, anticipating and expecting that the IRS will look closely at how preparers, both signing and nonsigning, prepare returns.

Firms and their tax departments should establish and communicate appropriate policies and procedures. They must provide internal training and communication on these policies and procedures. They must be aware that disregarding the policies and procedures can be damaging. Firms and their tax departments must monitor and test compliance with their policies and procedures. Most crucially, they must rely on their professional judgment, understanding and anticipating that the IRS will test them on the effectiveness and application of their policies and procedures.

It is doubtful that, after two years of constant attention, Code § 6694 will return to its former place of vague relevance. Given the IRS's recent focus on eliminating abusive transactions and its penchant for rounding up innocent bystanders in the rush to find the bad actors, practitioners should be wary.

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