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Probate & Property Magazine: November/December 2008, Vol. 22, No. 5

Real Property

WARNING: Tax Preparer Penalties May Now Apply to You

By Tina R. Green

Tina R. Green is a partner in the Texarkana, Texas, firm of Patton Roberts PLLC

Section 6694 of the Internal Revenue Code was implemented with the passage of the Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1520. It authorized the imposition of penalties on those who prepare income tax returns for compensation regardless of their educational background or profession—lawyers or accountants—under certain circumstances. In the event the amount of income tax on a tax return or claim for refund (collectively referred to herein as “a return”) was understated, the preparer may be subject to penalty under Code § 6694 if the preparer failed to comply with the applicable standards of conduct. Former Code § 7701(a)(36) defined a person to be an “income tax return preparer” if he or she prepares (or employs one or more persons to prepare) all or a substantial portion of a return under Subtitle A (income taxes) for compensation.

A penalty could be imposed under Code § 6694(a) if a position taken on a return did not have “a realistic possibility of success,” defined in Treas. Reg. § 1.6694-2(b) to mean at least a one-in-three possibility of being sustained on the merits. Treas. Reg. § 1.6694-2(c), however, provided that no penalty would be imposed for adequately disclosed positions if the position taken was “not frivolous,” meaning not patently improper. If a signing preparer took a position that did not satisfy the realistic possibility standard, disclosure of the position was adequate only if it was made on a properly completed and filed IRS Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, as appropriate, or on the return. For a nonsigning preparer, disclosure of a position that did not satisfy the realistic possibility standard was adequate if the preparer had advised the client about the opportunity to avoid penalties through disclosure. Again, disclosure of the position could be made on IRS Form 8275 or 8275-R, whichever was appropriate, or on the return.

The rules for Code § 6694 changed in 2007, greatly expanding those who fall under its umbrella and, thereby, subject to penalty. This article will review those changes, the subsequent guidance provided by the IRS, and provide recommendations to tax practitioners. Although tax return preparers also should be cognizant of Circular 230, which provides sanctions for preparers who fail to meet the requisite standard set forth therein, a discussion of it is beyond the scope of this article.

Unless otherwise indicated, references to sections (§) are to the Internal Revenue Code of 1986, as amended. References to Regulations (Treas. Reg.) are to U.S. Treasury Regulations issued by the Treasury Department (the “Treasury”).

Small Business and Work OpportunityTax Act of 2007

The passage of the Small Business and Work Opportunity Tax Act of 2007 (the “Act”), Pub. L. No. 110-28, 121 Stat. 190, enacted into law on May 25, 2007, substantially broadened the applicability of Code § 6694. Section 8246 of the Act amends several provisions of the Code relating to tax return preparers. Specifically, the Act (1) extends the income tax return preparer penalties to all tax return preparers, (2) alters the standards of conduct that must be met to avoid imposition of the penalties for preparing a return that reflects an understatement of liability, and (3) increases the penalties. The amendments to Code § 6694 are effective for tax returns prepared after the date of enactment, May 25, 2007.

The Act amended Code § 6694(a) to provide that the unreasonable position penalty (formerly referred to as the “negligent penalty”) would apply if (1) the tax return preparer knew (or reasonably should have known) of the position; (2) there was no reasonable belief that the position would more likely than not be sustained on its merits; and (3)(a) the position was not disclosed as provided in Code § 6662(d)(2)(B)(ii) or (b) the position had no reasonable basis. The Act amends the standards of conduct under Code § 6694(a) in two ways. First, for undisclosed positions, the Act replaces the “realistic possibility” standard with a requirement that there be a “reasonable belief” that the tax treatment of the position would more likely than not be sustained on its merits. Second, for disclosed positions, the Act replaces the “not-frivolous” standard with the requirement that there be a “reasonable basis” for the tax treatment of the position.

For penalties, the Act increased the Code § 6694(a) unreasonable position penalty for understatements from $250 to the greater of (1) $1,000 and (2) 50% of the income derived (or to be derived) by the tax return preparer from the preparation of a return on which the penalty was imposed. The Act increased the Code § 6694(b) penalty for willful or reckless conduct from $1,000 to the greater of (1) $5,000 and (2) 50% of the income derived (or to be derived) by the tax return preparer.

Under both prior and current law, disclosure under Code § 6694(a) is adequate if made on an IRS Form 8275 or 8275-R, as appropriate, attached to the return or amended return or under the annual revenue procedure authorized in Treas. Reg. §§ 1.6694-2(c)(3) and 1.6662-4(f)(2).

Notice 2007-54

The IRS issued Notice 2007-54, 2007-27 I.R.B. 12, on July 2, 2007, effective as of May 25, 2007, to provide guidance and transitional relief for the return preparer penalty provision under Code § 6694 as amended by the Act. It provides that for income tax returns and amended returns the standard set forth under the previous law and current Regulations under Code § 6694 would be applied in determining whether the IRS would impose a penalty under Code § 6694(a). For all other returns and amended returns, the reasonable basis standard set forth in the Regulations issued under Code § 6662, without regard to disclosure requirements contained therein, would be applied in determining whether the IRS would impose a penalty under Code § 6694(a). This transitional relief would apply for all returns and amended returns due on or before December 31, 2007; to 2007 estimated tax returns due on or before January 15, 2008; and to 2007 employment and excise tax returns due on or before January 31, 2008.

Notice 2008-11

On January 22, 2008, the IRS published three Notices—Notice 2008-11, 2008-3 I.R.B. 279; Notice 2008-12, 2008-3 I.R.B. 280; and Notice 2008-13, 2008-3 I.R.B. 282. Notice 2008-11 addresses additional questions that had arisen about the transitional relief provided in Notice 2007-54. Notice 2008-11, effective as of May 25, 2007, clarifies that there is no set due date for amended returns or refund claims other than before the expiration of the period proscribed by the applicable statute of limitations. Accordingly, the transitional relief described in Notice 2007-54 applies to timely amended returns (other than 2007 employment and excise tax returns) filed on or before December 31, 2007, and to timely amended employment and excise tax returns or claims for refund filed on or before January 31, 2008.

The extent to which original tax returns due on extension after December 31, 2007, but filed before December 31, 2007, qualify for transitional relief, the transitional relief described in Notice 2007-54 applies to original returns (other than 2007 employment and excise tax returns) filed on or before December 31, 2007, and to original employment and excise tax returns filed on or before January 31, 2008.

For advice rendered by nonsigning preparers, it qualifies for transitional relief under Notice 2007-54 for advice provided on or before December 31, 2007.

Notice 2008-12

Code § 6695 imposes other assessable penalties for the preparation of tax returns including failure of the preparer to sign a return. The Act amended Code § 6695(b) to impose a penalty on a tax return preparer of a return who fails to sign the return when required by regulations unless it is shown that the failure is due to reasonable cause and not due to willful neglect. The penalty under Code § 6695(b) is $50 for each failure to sign, with a maximum of $25,000 per person imposed per year. The amendments to Code § 6695(b) made by the Act are effective for tax returns prepared after May 25, 2007.

Notice 2008-12 was written to provide guidance to (1) identify the returns required to be signed by a tax return preparer to avoid a Code § 6695(b) penalty under current Regulations and (2) identify the returns that would be required to be signed by a tax return preparer to avoid a Code § 6695(b) penalty under future Regulations. The interim guidance provided in Notice 2008-12 will apply until further guidance is issued, and tax return preparers may rely on the interim guidance in Notice 2008-12.

Signing Tax Return Preparer

An individual who is a tax return preparer for a return of tax listed in Notice 2008-12 shall sign the return after it is completed and before it is presented to the taxpayer (or nontaxable entity) for signature. If the tax return preparer is unavailable for signature, another tax return preparer shall review the entire preparation of the return and claim for refund and then shall sign the return.

If more than one tax return preparer is involved in the preparation of the return, the individual tax return preparer who has the primary responsibility as between or among the preparers for the overall substantive accuracy of the preparation of the return shall be considered to be the tax return preparer for purposes of Code § 6695(b).

Forms Requiring Signature of the Tax Return Preparer

A signing tax return preparer described in the previous paragraph must provide a signature on any income tax returns that are filed after December 31, 2007, including, but not limited to, the following: Form 990-T, Exempt Organization Business Income Tax Return; Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation; Form 1040, U.S. Individual Income Tax Return; Form 1041, U.S. Income Tax Return for Estates and Trusts; Form 1065, U.S. Return of Partnership Income; and Form 1120, U.S. Corporation Income Tax Return.

Notice 2008-13

The IRS issued Notice 2008-13 on December 31, 2007. The Notice provides guidance regarding implementation of the tax return preparer provisions under Code § 6694 and the related definitional provisions under Code § 7701(a)(36), as amended by the Act. In the Notice, the IRS states its intent along with that of the Treasury to revise the regulatory scheme governing tax return preparer penalties by the end of 2008. The Notice provides interim guidance to tax return preparers regarding the definitions and standards of conduct that must be met by a tax return preparer to avoid a penalty under Code § 6694(a). The Notice provides interim guidance on the following issues: (1) relevant categories of tax returns or claims for refund for purposes of Code § 6694, (2) the definition of tax return preparer under Code §§ 6694 and 7701(a)(36), (3) standards of conduct applicable to tax return preparers for disclosed and undisclosed positions taken on tax returns, and (4) interim penalty compliance obligations applicable to tax return preparers. The guidance provided in Notice 2008-13 is applicable only until further guidance is issued.

Categories of Tax Returns

For purposes of Code § 6694, a return includes the tax return’s reporting tax liability listed on Exhibit 1 to the Notice. These returns include, but are not limited to, Form 1040, U.S. Individual Income Tax Return; Form 706, U.S. Estate Tax Return; Form 709, U.S. Gift (and Generation-Skipping Transfer) Tax Return; Form 843, Claim for Refund and Request for Abatement; and Form 941, Employer’s Quarterly Federal Tax Return. Therefore, if a person prepares all or a substantial portion of a tax return listed in Exhibit 1 for compensation, or a claim for refund for any such tax return, he or she is a tax return preparer subject to Code § 6694.

For purposes of Code § 6694, an information return listed on Exhibit 2 to the Noticethat includes information that is or may be reported on a taxpayer’s tax return is a return to which Code § 6694 could apply if the information reported constitutes a substantial portion of that taxpayer’s tax return. These returns include, but are not limited to, Form 1065, U.S. Return of Partnership Income; Form 1120S, U.S. Income Tax Return for an S Corporation; and Form 8038, Information Return for Tax-Exempt Private Activity Bond Issues. A person who, for compensation, prepares any of the forms listed in Exhibit 2, which form does not report a tax liability but affects one or more entries on a tax return and constitutes a substantial portion of the tax return that does report a tax liability, is a tax return preparer subject to Code § 6694. In addition, a document that includes information that is or may be reported on a taxpayer’s tax return is treated as a return to which Code § 6694 could apply if the information reported constitutes a substantial portion of that taxpayer’s tax return. For example, a person who for compensation prepares a document that does not report a tax liability but which will affect one or more entries on a tax return that does report a tax liability and that constitutes a substantial portion of such tax return is a tax return preparer subject to Code § 6694.

The Notice, however, also provides that documents listed in Exhibit 3will not subject the preparer to a penalty under Code § 6694(a). Examples of some of the forms listed in Exhibit 3 include Form 1099 series of returns, Form W-2 series of returns, and Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes. Even though the documents listed in Exhibit 3 may not subject the preparer to a penalty for an unreasonable position under Code § 6694(a), they may subject the preparer to a willful or reckless conduct penalty under Code § 6694(b). A person who for compensation prepares all or a substantial portion of any of the forms or other documents listed in Exhibit 3 is not a tax return preparer subject to Code § 6694(a) unless the form or document was prepared willfully in a manner to understate the liability of tax on a tax return or in reckless or intentional disregard of rules or regulations that then may subject the preparer to penalties under Code § 6694(b).

Definition of Tax Return Preparer

The term “tax return preparer” in Code § 7701(a)(36) is defined by using the definitions in Treas. Reg. §§ 1.6694-1 (penalties applicable to income tax return preparers), 1.6694-3 (penalty for understatement due to willful, reckless, or intentional conduct), and 301.7701-15 (income tax return preparer), with the following modifications. First, it eliminates the word “income” as a modifier to “tax return preparer” throughout Treas. Reg. §§ 1.6694-1, 1.6694-3, and 301.7701-15. Second, it expands the definition of returns and claims for refund from returns of tax under Subtitle A (income taxes), or similar language, to include returns of tax and claims for refund under Subtitles A through E of the Code (income taxes, estate and gift taxes, employment taxes, excise taxes, and exempt organization returns) throughout Treas. Reg. §§ 1.6694-1, 1.6694-3, and 301.7701-15. Finally, for purposes of interpreting the term “substantial portion” in Treas. Reg. § 301.7701-15(b)(1), it means a schedule, entry, or other portion of a tax return that, if adjusted or disallowed, could result in a deficiency determination (or disallowance of a refund claim) that the preparer knows or reasonably should know is a significant portion of the tax liability reported on the tax return (or, in the case of a claim for refund, a significant portion of the tax originally reported or previously adjusted). Therefore, the determination of whether a person is a tax return preparer by meeting the requirement that he or she prepared a substantial portion of a tax return will depend on the relative size of the deficiency (or disallowance of a refund claim) attributable to the schedule, entry, or other portion of a tax return prepared by the advisor.

Standards of Conduct

The Notice provides that the penalty is not imposed if the person had a “reasonable belief that the position would more likely than not” be sustained on the merits. To meet this standard, the preparer must analyze the appropriate authorities and, in good faith, reasonably hold the belief that the likelihood of the taxpayer succeeding is greater than 50%. Treas. Reg. § 1.6662-4(d)(3)(iii) provides that only the following are authority for purposes of determining whether there is substantial authority for the tax treatment of an item: the Code and other statutory provisions; Proposed, Temporary, and Final Regulations construing such statutes; revenue rulings and revenue procedures; tax treaties and regulations thereunder and Treasury and other official explanations of such treaties; court cases; congressional intent as reflected in committee reports and floor statements made before enactment by one of a bill’s managers; General Explanations of Tax Legislation prepared by the Joint Committee on Taxation; private letter rulings and technical advice memoranda issued after October 31, 1972; actions on decisions and general counsel memoranda issued after March 12, 1981; IRS information or press releases; and notices, announcements, and other administrative pronouncements published by the IRS. Equally important are those items listed that are not authority, such as conclusions reached in treatises, legal periodicals, legal opinions, or opinions rendered by tax professionals.

A tax return preparer is considered reasonably to believe that the tax treatment of an item is more likely than not the proper tax treatment (without taking into account the possibility that the tax return will not be audited, that an issue will not be raised on audit, or that an issue will be settled) if the tax return preparer analyzes the pertinent facts and authorities in the manner described in Treas. Reg. § 1.6662-4(d)(3)(ii) and, in reliance on that analysis, reasonably concludes in good faith that there is a greater than 50% likelihood that the tax treatment of the item will be upheld if challenged by the IRS. This standard will apply instead of that in Treas. Reg.
§ 1.6694-2(b) (realistic possibility standard) until further guidance.

For purposes of determining whether the tax return preparer has a reasonable belief that the position would more likely than not be sustained on the merits, a tax return preparer may rely in good faith without verification on information provided by the taxpayer. In addition, the tax return preparer may rely in good faith and without verification on information furnished by another advisor, tax return preparer, or other third party. Thus, a tax return preparer is not required to independently verify or review the items reported on tax returns, schedules, or other third-party documents to determine if the items meet the standard requiring a reasonable belief that the position would more likely than not be sustained on the merits. The tax return preparer, however, may not ignore the implications of information furnished or actually known to the tax return preparer. In addition, the tax return preparer must make reasonable inquiries if the information furnished by another tax return preparer or a t hird party appears to be incorrect or incomplete. For purposes of Code § 6694, re asonable basis will be interpreted in accordance with Treas. Reg. § 1.6662-3(b)(3). The reasonable basis standard will apply instead of Treas. Reg. § 1.6694-2(c) (not-frivolous standard). The reasonable basis standard will also apply for purposes of Treas. Reg. § 1.6694-3(c)(2) (reckless or intentional disregard of a rule or regulation).

A tax return preparer will be found to have acted in good faith when the tax return preparer relied on the advice of a third party who is not in the same firm as the tax return preparer and whom the tax return preparer had reason to believe was competent to render the advice. The advice may be written or oral, but, in either case, the burden of establishing that the advice was received is on the tax return preparer. A tax return preparer is not considered to have relied in good faith if (1) the advice is unreasonable on its face, (2) the tax return preparer knew or should have known that the third-party advisor was not aware of all relevant facts, or (3) the tax return preparer knew or should have known at the time the tax return was prepared that the advice was no longer reliable because of developments in the law since the time the advice was given.

Signing Tax Return Preparer

A signing tax return preparer shall be deemed to meet the requirements of Code § 6694 for which there is a reasonable basis but for which the tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on its merits, if the tax return preparer meets any of the following requirements: (1) the position is disclosed on a properly completed and filed Form 8275 or 8275-R or on the tax return; (2) the tax return preparer provides the taxpayer with the prepared tax return that includes the disclosure if the position would not meet the standard for the taxpayer to avoid a penalty under Code § 6662(d)(2)(B); (3) the tax return preparer advises the taxpayer of the difference between the penalty standards applicable to the taxpayer under Code § 6662 and the penalty standards applicable to the tax return preparer under Code § 6694, and contemporaneously documents in the tax return preparer’s files that this advice was provided, if the position would otherwise meet the requirement for nondisclosure under Code § 6662(d)(2)(B)(i) (substantial aut hority for the treatment); or (4) the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer under Code § 6662(d)(2)(C) (tax shel ters) and the difference, if any, between these standards and the standards under Code § 6694, and contemporaneously documents in the tax return preparer’s files that this advice was provided, if Code § 6662(d)(2)(B) does not apply because the position may be described in Code § 6662(d)(2)(C).

Nonsigning Tax Return Preparer

There are circumstances under which a nonsigning tax return preparer shall be deemed to meet the requirements of Code § 6694 for a position for which there is a reasonable basis but for which the nonsigning tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits. If the tax return preparer’s advice to the taxpayer includes a statement informing the taxpayer of the opportunity to avoid penalties under Code § 6662 that could apply to the position as a result of disclosure, if relevant, and of the requirements for disclosure, then the requirements of Code § 6694 are deemed to have been met. If the advice about the position is in writing, the statement must be in writing. If the advice about the position is oral, the statement also may be oral. Contemporaneously prepared documentation in the nonsigning tax return preparer’s files is sufficient to establish that the statement was given to the taxpayer or other tax return preparer.

Examples Provided in the Notice

The Notice provides a number of different examples about the application of Code § 6694 that provide insight into the application of the penalty compliance rules set forth in the Notice.

Effective Date

The Notice is effective as of (1) January 1, 2008, for all tax returns, amended tax returns, and claims for refund (other than 2007 employment and excise tax returns) filed on or after that date for advice provided on or after that date; and (2) February 1, 2008, for all 2007 employment and excise tax returns filed on or after that date for advice provided on or after that date. The Notice provides only interim guidance and warns that final guidance may not be as generous.

Notice 2008-46

The IRS issued Notice 2008-46, 2008-18 I.R.B. 868, on May 5, 2008, effective as of April 16, 2008, to add certain returns and documents supplementing the Exhibits 1, 2, and 3 of Notice 2008-13.

Proposed Regulations

On June 17, 2008, in keeping with the intent expressed in Notice 2008-13, the Treasury issued Proposed Regulations on the tax preparer penalties under Code §§ 6694 and 6695: REG-129243-07, 73 Fed. Reg. 34,560-97 (June 17, 2008). The Proposed Regulations are generally in line with the interim guidance issued in Notice 2008-13. The Treasury and the IRS intend to finalize these Proposed Regulations by the end of 2008, with the expectation that the Final Regulations will be applicable to returns (and advice given) after the date that Final Regulations are published in the Federal Register, but in no event sooner than December 31, 2008. Comments on the Proposed Regulations were requested with a deadline of August 18, 2008, on which date a public hearing was scheduled to be held in the Internal Revenue Building in Washington, D.C.

In the preamble to the Proposed Regulations, the Treasury and the IRS recognize that tax return preparers are critical to ensuring compliance with the federal tax laws and are an important component in the IRS’s administration of those laws. The Proposed Regulations are intended to balance the interests of the IRS in curtailing the activities of noncompliant tax return preparers against the burden imposed on all tax return preparers in complying with the requirements imposed by the Act and these Proposed Regulations. They also provide that the IRS will assess penalties when appropriate; however, there will not be an automatic referral to the IRS Office of Professional Responsibility (OPR) every time a tax return preparer penalty is assessed. Generally, the IRS looks for a pattern of failing to meet the required penalty standards in matters involving nonwillful conduct under Code § 6694(a) before making a referral to OPR, although any egregious conduct by a preparer also may form a basis for referral.

The Proposed Regulations provide guidance on the tax return preparer penalties in a number of areas, three of which will be discussed here. These three are (1) a change in the “one preparer per firm” rule, (2) additions to the definition of tax return preparer, and (3) de minimis exceptions to the penalty.

Currently, Treas. Reg. § 1.6694-1(b)(1) provides a “one preparer per firm” rule. Specifically, if a signing tax return preparer is associated with a firm, that individual, and no other individual in the firm, is treated as a tax return preparer for the return for purposes of Code § 6694. The Proposed Regulations do away with this limitation and adopt a framework that centers on the return on a position-by-position basis with the focus of any penalty on the position(s) giving rise to the understatement on the return and any responsible parties for such position(s). The new rule can be referred to as a “preparer-per-position within a firm” rule. Prop. Treas. Reg. § 1.6694-1(b)(1) provides that only one person within a firm will be considered primarily responsible for each position giving rise to an understatement and subject to the penalty. More than one tax return preparer may be primarily responsible for the position giving rise to the understatement if multiple tax return preparers are employed by different firms. Under the Proposed Regulations, the IRS may assess the penalty against either the signing tax return preparer or the nonsigning tax return preparer with overall supervisory responsibility for the position(s) giving rise to an understatement depending on the specific facts and circumstances.

For the definition of a “tax return preparer,” the Proposed Regulations provide two new definitions—“signing tax return preparer” and “nonsigning tax return preparer.” Prop. Treas. Reg. § 301.7701-15(b)(1) defines a signing tax return preparer as any tax return preparer who signs or who is required to sign a return as a tax return preparer. Prop. Treas. Reg. § 301.7701-15(b)(2) defines a nonsigning tax return preparer as any tax return preparer who is not a signing tax return preparer but who prepares all or a substantial portion of a return for events that have occurred at the time the advice is rendered.

Finally, the Proposed Regulations also provide some de minimis safe harbors and increase others. Specifically, Prop. Treas. Reg. § 301.7701-15 (b)(2) provides that any time spent on advice that is given about events that have occurred, which is less than 5% of the aggregate time incurred by the person for the position(s) giving rise to the understatement, will not be taken into account in determining whether an individual is a nonsigning tax return preparer. In addition, Prop. Treas. Reg. § 301.7701-15(b)(3)(ii) increases the de minimis exception in determining whether a nonsigning tax return preparer meets the requirement of preparing a substantial portion of a return. The de minimis exception applies if the item giving rise to the understatement is (1) less than $10,000 or (2) less than $400,000 if the item is also less than 20% of the taxpayer’s gross income (or, for an individual, the individual’s adjusted gross income). This exception does not apply to signing tax return preparers.

Who Is a Tax Return Preparer in Light of the Proposed Regs?

The Prop. Treas. Reg. § 301.7701-15(a) defines a tax return preparer 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 return of tax or any claim for refund of tax under the Internal Revenue Code (Code).” Previously, Code § 7701(a)(36) was limited to the income tax setting. Based on the amended definition above, five distinct elements must all be present for a person to meet the definition of a “tax return preparer.”

The first element is “any person.” Code § 7701(a) defines a person to include an individual, a trust, estate, partnership, association, company, or corporation. Basically, this term envelops everyone and all entities.

The second element is “who prepares .   .   . or employs one or more persons to prepare.” Obviously, a person who prepares a tax return for another person satisfies the second element of the definition of a preparer. This element, however, covers more than just the person who completes the return for a client as evidenced by the definition of the nonsigning tax return preparer added by Prop. Treas. Reg. § 301.7701-15(b)(2)(ii) discussed above. In addition, Rev. Rul. 84-3, 1984-1 C.B. 264, states that a person who reviews a return for substantive correctness is considered a preparer, regardless of whether the review results in any changes. It is possible for a person to be a preparer without ever seeing the taxpayer’s return. Example 1 under Prop. Treas. Reg. § 301.7701-15(b)(2)(ii) gives an example whereby Attorney A provides legal advice to a large corporate taxpayer regarding a completed corporate transaction. The advice provided by Attorney A is relevant directly to the determination of an entry on the taxpayer’s return, and this advice constitutes a substantial portion of the return. Attorney A does not prepare any other portion of the taxpayer’s return and is not the signing tax return preparer of this return, yet Attorney A is a tax return preparer.

There are, however, those who are not covered under the definition but have a connection to the return. Prop. Treas. Reg. § 301.7701-15(f)(1) provides a list of those persons who are not tax return preparers including any individual who provides tax assistance under a Volunteer Income Tax Assistance (VITA) program; an individual providing only typing, reproduction, or other mechanical assistance in the preparation of a return; an individual who prepares a tax return for his or her employer by whom he or she is regularly and continuously employed; and a person who prepares a return for a trust, estate, or other entity of which the person either is a fiduciary or an officer, general partner, or employee of the fiduciary.

The third element is “compensation.” Only a person who prepares a return for compensation can be a preparer for purposes of Code § 6694. Compensation can be payment either in cash or other property. Specifically listed under Prop. Treas. Reg. § 301.7701-15(f)(1)(xii) as a person who is not a tax return preparer is a person who prepares a return for a taxpayer with no explicit or implicit agreement for compensation, even if the person receives an insubstantial gift, return service, or favor.

The fourth element in the definition of a tax return preparer is the “all or a substantial portion” of the return. The term “all” is self-explanatory, but what determines if an entry on a return rises to the level of a “substantial portion”? This is answered in Prop. Treas. Reg. § 301.7701-15(b)(3), which provides that a person who renders tax advice on a position that is directly relevant to the determination of the existence, characterization, or amount of an entry on a return will be regarded as having prepared that entry. Whether the entry is a substantial portion is determined based on whether the person knows or reasonably should know that the tax attributable to the entry is a substantial portion of the tax required to be shown on the return. It is possible for a single entry to constitute a substantial portion of the tax required to be shown on the return. Factors to consider in determining whether an entry is a substantial portion include the size and complexity of the item relative to the taxpayer’s gross income and the size of the understatement attributable to the item compared to the taxpayer’s reported tax liability. Therefore, whether a person is considered a tax return preparer requires a comparative analysis of the relative size of the deficiency attributable to the schedule, entry, or other portion prepared compared with the tax liability or refund claim as a whole. As previously discussed, there are de minimis exceptions as well (less than $10,000 or less than $400,000 and also less than 20% of the gross income).

The fifth and final element is “any return of tax or any claim for refund of tax under the Internal Revenue Code (Code).” Prop. Treas. Reg. § 301.7701-15(b)(4)(i) defines a return for purposes of the tax return preparer penalties as a return (including an amended or adjusted return) filed by or on behalf of a taxpayer reporting the liability of the taxpayer for tax under the Code (that is, income taxes, estate and gift taxes, employment taxes, excise taxes, and exempt organization returns) if the type of return is identified in published guidance in the Internal Revenue Bulletin (IRB). A return also includes any information return or other document identified in published guidance in the IRB and that reports information that is or may be reported on another taxpayer’s return under the Code if it constitutes a substantial portion of the taxpayer’s return. A “claim for refund” is defined in Prop. Treas. Reg. § 301.7701-15(b)(4)(ii) as a claim for credit against any tax that is included in published guidance in the IRB as well as a claim for payment under Code §§ 6420 (gasoline used on farms), 6421 (gasoline used for certain nonhighway purposes), or 6427 (fuels not used for taxable purposes).

Caution to Preparers—Different Standards for Preparers and Taxpayers

Preparers need to be aware that the Code now imposes different standards of conduct for the tax return preparer and the taxpayer to avoid penalties. As previously stated, preparers can avoid the Code § 6694 penalty if they meet the “more likely than not” standard or otherwise they disclose a position that does not meet this standard. Compare this standard with that of taxpayers. Under Code § 6662(d), taxpayers may be able to avoid penalties with a mere “reasonable basis” for their positions. In the case of the substantial understatement penalty under Code § 6662(d), substantial authority is sufficient for a taxpayer to avoid the penalty so long as the item in question is not a tax shelter item. Treas. Reg. § 1.6662-4(d)(2) provides that the substantial authority standard is less stringent than the more likely than not standard. This means that the amendments to Code § 6694 impose a higher standard of conduct on return preparers than on taxpayers for nontax shelter items.

Conclusion

After revisions to Code § 6694, the issuance of Notices 2008-11, 12, and 13, and the Proposed Regulations, tax return preparers should consider several steps at the beginning of representation. First, the broadening of the definition of a tax return preparer for purposes of Code § 6694 will cause more transactions to qualify a person as a “tax return preparer” and thereby subject the preparer to possible penalties being imposed by the IRS. It is important for the practitioner to realize that while previous advice and/or preparation of certain entries, schedules, or other portions of a tax return were not covered under Code § 6694, they are now. Therefore, the preparer needs to take steps at the onset of the representation to prevent application of preparer penalties that previously did not apply. Second, a tax return preparer needs to carefully document the transaction—the information given to the preparer and from whom it was received, the authorities reviewed including not only those positions supporting his or her conclusions but those positions that go against the position taken by the preparer, his or her analysis, and the conclusions reached by the preparer. This research should be performed and documented at the time the work for the taxpayer is being done. Recall that in Notice 2008-13 and in the Proposed Regulations, contemporaneously prepared documentation in the taxpayer’s file will be sufficient to establish that a certain action was taken by the tax return preparer and/or documents were provided to the taxpayer and reflect the due diligence of the preparer. Third, the tax return preparer should prepare the appropriate disclosure form(s) and give it to the taxpayer with the tax return (or other entry, schedule, and so on) when the preparer has a “reasonable basis” for the position taken but for which the tax return preparer does not have a “reasonable belief that the position would more likely than not be sustained on its merits.” Note that a separate disclosure statement is required for each position. No form of a general boilerplate disclaimer will satisfy these standards. Again, to establish that the tax return preparer’s disclosure obligation was satisfied, the preparer must document contemporaneously in the preparer’s files that the information or advice required by the Proposed Regulations was provided. Finally, the tax return preparer should stay tuned for further developments in this area as Final Regulations are expected this year. Return To Issue Index

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