There have been many new developments surrounding penalties the IRS can impose on tax return preparers. Given the current tax season, it is worthwhile to briefly review these new developments. Section 6694 of the Internal Revenue Code provides that a tax return preparer can be penalized if they prepares a tax return which contains an understatement of tax due to certain positions taken on the return. The penalty is the greater of $1,000 or 50 percent of the income the return preparer received for preparing the tax return (and the penalty is higher for willful or reckless conduct by the return preparer).
Previously, only income tax return preparers were subject to this penalty. Under that old law, the penalty was imposed on an income tax return preparer for taking a position on an income tax return for which there was not a realistic possibility of being sustained on the merits. However, as a result of the Small Business and Work Opportunity Tax Act of 2007 (“2007 Act”) which was passed on May 25, 2007, this penalty was expanded to impose the penalty on preparers of any Federal tax return, including estate and gift tax returns. In addition, the standard of conduct a preparer must meet to avoid imposition of the penalty was increased. Under the 2007 Act, a return preparer could be liable for the penalty if the preparer knew (or reasonably should have known) of the position and there was not a reasonable belief that the position would be “more likely than not” sustained on its merits. Or, if the position was disclosed on the return, then the return preparer could be penalized if she knew there was no reasonable basis for the position taken.
The problem with the new standard imposed by the 2007 Act was that the change in the standard to avoid the preparer penalty (“more likely than not”) was at a higher level than the standard a taxpayer had to meet to avoid the negligence penalty (“substantial authority for the position taken.”) There was much debate in the tax return preparer community over this new standard and the sense of unfairness that went along with this disparate treatment of the taxpayer and the return preparer.
As a result, in large part, of this debate, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (“2008 Act”), passed on Oct. 3, 2008, included a provision that lowered the standards for imposition of preparer penalties in most cases. The 2008 Act reduced the standard for preparer penalties from the “more likely than not” standard to “substantial authority” standard (except for tax shelters and reportable transactions where the “more likely than not” standard is retained) and the 2008 Act makes this new standard retroactive to May 25, 2007, the date the 2007 Act was effective. The IRS issued interim advice in Notice 2009-5 (published on Jan. 21, 2009). As the IRS explained in that notice, the 2008 Act provides that a position on a tax return will be treated as unreasonable (and therefore subject to the penalty) unless (a) there is or was substantial authority for the position taken on the return or (b) the position was properly disclosed and had a reasonable basis. The notice also acknowledges that the “more likely than not” standard is retained for tax shelters and reportable transactions. Further, the notice explains that the term “substantial authority” has the same meaning as used for imposition of the negligence penalty imposed on taxpayers. Substantial authority includes, among other things, the Internal Revenue Code, Treasury Regulations (temporary and final), court cases, revenue rulings, revenue procedures, other published guidance by the IRS, and legislative history.
The lesson to be taken from these developments is that any return preparer, including those professionals that prepare estate and gift tax returns, and even employment tax returns, must be careful to ensure that positions taken on a tax return are based on substantial authority (that is, based on statutes, regulations, court cases, and rulings by the IRS). If a preparer has any doubt about the position, the preparer should disclose the position being taken and that the basis for the position is reasonable, not frivolous. Otherwise, the preparer could be subject to a penalty of at least $1,000 or more if the fee received for the preparation exceeds $2,000.