Fall 2008
By Edward R. Jenkins Jr., CPA
In June 2008, the IRS published proposed regulation changes regarding Internal Revenue Code (IRC) Section 6694. The proposed changes are expected to enhance the IRS’s ability to hold unscrupulous and unethical tax return preparers accountable for their actions. Under the revisions, however, intent is irrelevant. In other words, a tax return preparer cannot claim ignorance as an excuse, as the law will still apply to someone who unintentionally causes an understatement of tax return liability.
The burden of these regulations will need to be considered within the context of the profession’s other ongoing challenges, including finding and retaining employees, transitioning to International Financial Reporting Standards, and the head-spinning rate of new and revised rules with which all practitioners must deal. If there is any good news in this, it is that much of the voluminous IRC changes are aimed at conforming current regulations to a changed definition of the tax return preparer.
Changes
The changes to IRC Section 6694 are significant. The statute was changed to cover preparers of all tax returns - defined in IRC Section 7701(a)(36) - instead of just income tax return preparers. That means IRC Section 6694 now applies to preparers of income tax, estate and gift, excise, exempt organization, and employment tax returns.
-- The definition includes any person who prepares a substantial portion of a return, not just the nominal signer.
-- Employees of taxpayers are carved out of the definition of "return preparer."
-- Fiduciaries who prepare returns are also carved out of the definition of tax return preparer.
The revised statute instituted a new standard for the level of confidence a preparer must have with respect to the likelihood that any tax return position will be upheld on examination: a reasonable belief that the tax return position would "more likely than not" (more than 50 percent) be sustained on its merits. That standard should be familiar to CPAs as a result of FIN 48.
-- This confidence level is higher than the "substantial authority" standard for taxpayers, which in general terms means there is at least a 40 percent chance the tax return position will survive on examination.
-- Therefore, if a taxpayer self-prepares a return, they are held to a lower standard of care than a tax return preparer.
IRC Section 6694 increases penalties as well. The first-tier penalty of $250 went to the greater of $1,000 or 50 percent of the compensation derived from the preparation of the return. The willful or reckless conduct penalty went from $1,000 to the greater of $5,000 or 50 percent of the compensation derived from the preparation of the return. Preparation of a faulty return will be fined on all income derived by the preparer, which may include the fee for preparation plus any fees charged for related research, letters, communications, and opinions. Circular 230 was also recently changed to reflect penalties arising from the American Jobs Creation Act of 2004 (AJCA), which provides for penalties up to 100 percent of the income derived from the representation activity.
The revisions to the statute also change the standard of conduct for practitioners in two ways. Practitioners cannot sign a return without disclosure of a tax position, unless the return position meets the more-likely-than-not standard. The proposed regulations permit the substantial-authority standard if penalty provisions are discussed with the taxpayer. The old standard was "realistic possibility," which was consistent with the AICPA Statements on Standards for Tax Services. Also, practitioners cannot sign a return with disclosure of a tax position unless the position has a reasonable basis - at least 15 percent likelihood - in law. The old standard was "not frivolous" or "patently incorrect." Disclosure is generally made on Form 8275 or 8275R and is required to be attached to a return. The proposed regulations provide four additional ways of meeting the adequate disclosure requirement.
Difficulties
The IRS is aware of practitioner concerns regarding the application of the IRC Section 6694 penalties in addition to potential Circular 230 penalties. The IRS intends to provide revenue agents with balanced guidance on when tax return preparers should be referred to the IRS Office of Professional Responsibility (OPR) for sanctions under Circular 230 and the 100 percent monetary penalty imposed by the AJCA. The IRS is clear in the preamble to the proposed regulations that an IRC Section 6694 penalty would not automatically generate an OPR referral for practitioners to then become subject to Circular 230. Note, IRC Section 6694 applies to all tax return preparers, and Circular 230 applies only to those who practice before the IRS.
IRS policy prior to what was expressed in the proposed regulations was a mandatory referral of Circular 230 practitioners to OPR when the following penalties had been asserted:
-- IRC Section 6695(f) (negotiation of a check), Section 6700 (promoting shelters), or Section 6701 (aiding/abetting an understatement)
-- IRC Sections 6694(a) and (b) when closed and agreed, sustained in appeals, or closed unagreed
-- Enjoining actions under IRC Section 7407 and Section 7408
-- IRC Section 6701(a) with respect to appraisers
Reliance on information provided by others is a significant issue. Current regulations allow a tax return preparer to rely in good faith upon information provided by a taxpayer or other advisers, without verification. The proposed regulations include the caveat that a tax return preparer cannot rely on taxpayers’ interpretation/application of federal tax law to their facts and circumstances. A tax return preparer can rely on other advisers’ advice, so long as it does not conflict with information the tax return preparer knows or should know. The proposed regulations create the expectation that a tax return preparer will make an inquiry if information is incomplete or the information appears to be incorrect or inconsistent with other information available.
The basis of the new IRC Section 6694 penalty calculation is "income derived, or expected to be derived, from services rendered to prepare a return or claim for refund or from providing advice with respect to positions taken on the return or claim that give rise to the understatement." Consider a preparer in a firm who earns roughly $45 per hour, but the firm charges $450 per hour for his time. What is the "income derived" from the preparation or advice of the tax return preparer?
Proposed regulation 1.6694-1(f) attempts to define "income derived, or expected to be derived," from preparation of a return or claim. The IRS must determine if the firm is responsible for the behavior giving rise to the penalty, or if the individual is responsible. If the firm is responsible, then the base is the fees derived from the return preparation. If the individual is responsible, the base is the compensation received from the firm for the preparation of the return, advice, or claim.
Interim guidance and the proposed regulations harmonize the standard for both preparer and taxpayer at "substantial authority," as defined in IRC Section 6662. Treasury Reg. 1.6662-4(d) explains the "substantial authority" basis and that regulation includes explanations of the protocol by which authority for tax return positions is evaluated. That regulation establishes IRS expectations for preparers’ documentation and research of tax return positions. The proposed IRC regulations permit the lower "substantial authority" standard for preparers, as long as the preparer advises the taxpayer about understatement penalties that could apply to the return. That advice must be documented contemporaneously for penalty relief to apply for the tax return preparer.
The IRS has asked for practitioner guidance on the proposed regulations. One area is the one preparer per firm or tax return rule. The IRS believes increasing tax and accounting complexity has created the need for greater specialization within firms. Therefore, the IRS is developing a theory of "One Preparer per Tax Return Position." Thus, a nonsigning preparer in a firm that provides advice to the signing preparer for a particular return issue would be primarily responsible for that issue, rather than the signing preparer.
While the "One Preparer per Tax Return Position" theory may make sense, the administrative challenges and changes to the process of tax return preparation and quality control could be significant in order to implement the desired change. The IRS believes facts and circumstances in each case will determine whether an IRC Section 6694 penalty will be assessed against the signing preparer or a nonsigning specialist on a particular tax return position. The documentation levels needed within a firm to identify who is to blame when a return position is questioned are frightening.
Another problem arises when a return is prepared that has an issue that would create an understatement and generate an IRC Section 6694 penalty, except for the existence of other audit issues that offset the understatement. The statute specifically looks to the net liability in IRC Section 6694(e) and provides for abatement of penalty if there is no understatement. Note that the standard in IRC Section 6694(e) is any understatement, as distinguished from "substantial understatement" in IRC Section 6662(d). It should also be noted that the understatement is determined without regard to any administrative or judicial action by the taxpayer. Thus, if a taxpayer decides not to litigate because of the hazards of litigation, and you think the understatement would be reversed if litigated, you still are subject to the penalty. That disconnect in interests of the parties could create a conflict in some circumstances.
The unavoidable answer seems to be a more time-consuming and expensive tax return preparation process with greater financial burden placed on taxpayers. Theoretically, taxpayers are presented with a higher quality product. It is likely, however, that clients assume they are already getting a top-quality tax return product, and they will not see the added value despite the higher invoice they must pay.
Possible Solutions
Practitioners may want to consider making the following changes to the return and claim preparation process and the process of rendering advice.
Even though SSTS No. 9 was never finalized, consider each practitioner’s system of quality control. Much of the documentation required by the changes to IRC Sections 6694, 6695, and 7701 is to be prepared contemporaneously. The return/claim preparation process should contemplate a means by which the following are accomplished:
-- Tax return positions are identified.
-- Research and documentation effort is assessed.
-- Research is used to assess confidence levels.
-- Documentation is prepared that conforms to Treasury Regulation 1.6662-4(d)(3), and a standard memorandum methodology, such as IRAC, is used.
-- The additional tax returns now covered by the statute should be brought into the system of quality control.
-- The processes should identify who was responsible for the conclusion on each tax return position.
Firms should consider providing additional training in tax research and writing to promote effective and efficient documentation processes. Of particular import is training that captures best practices in research and writing methods and that harnesses the power of the office technology that is available.
Practitioners should look to FAS 109/FIN 48 working papers to leverage the documentation that is included therein as much as possible.
Firms should establish reasonable frameworks to guide staff in determining levels of confidence of tax return positions being sustained on examination. There are differences between FIN 48 and the documentation standards under IRC Sections 6694 and 6662. Contemporaneous documentation is vital, particularly when you consider time gaps, likely employee turnover, and advancement.
Intra-firm resolution processes should be established to resolve differences of opinion among staff assigned to engagements regarding confidence levels and documentation expectations.
Standard language that describes the penalty regime applicable to taxpayers should be developed and incorporated into the firm’s engagement letters and other appropriate communications. Clients need to know the standard for return preparers is "substantial authority" rather than "more likely than not" under the proposed regulations’ interpretation of the statute.
Conclusion
The changes wrought by the IRS’s proposed regulations will be critically important to CPAs. The potential penalties under IRC Section 6694 are much more significant, and they are in addition to the potential 100 percent of fees derived penalty under the AJCA. Therefore, substantial changes will be necessary for each preparer’s system of quality control.
Edward R. Jenkins Jr., CPA, is managing member of Jenkins & Co. LLC in Spring Grove, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at edwardj@wemanagetaxes.com.
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