An analysis of the new preparer penalty proposed regulations.

• Author: Tillinger, Janet W.

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EXECUTIVE SUMMARY

* The Small Business and Work Opportunity Tax Act of 2007 amended the preparer penalty provisions in Sec. 6694. In January 2008, the IRS issued Notice 2008-13, which provides guidance on the application of the new preparer penalty rules. Building on the guidance provided in Notice 2008-13, in June 2008 the IRS issued proposed regulations under Sec. 6694.

* Under the proposed regulations, the Sec. 6694 preparer penalties potentially apply to both signing and nonsigning return preparers of a tax return. The proposed regulations contain two de minimis rules that except certain persons who have provided advice with respect to a return position from being considered nonsigning preparers.

* The proposed regulations set out methods of disclosure for both signing and nonsigning preparers that will allow preparers to avoid preparer penalty liability. In addition, the proposed regulations provide guidance on the calculation of the amount of the penalty under the new standards in Sec. 6694.

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This article analyzes the recently issued proposed regulations (1) on the new Sec. 6694 preparer penalty provisions that were enacted as part of the Small Business and Work Opportunity Tax Act of 2007 (SBWOTA). (2) The amended Sec. 6694 exposes CPA practitioners to significantly higher penalty amounts and increases the risk to their practices and CPA licenses. Final regulations are expected to be issued before the end of the year and made effective after December 31, 2008.

Practitioners and firms should respond immediately to Treasury's positions in these proposed regulations by putting into place business practices and due diligence processes that will support a defense against the imposition of preparer penalties under the new Sec. 6694 regime.

To provide insight into the proposed regulations' practical significance, the following analysis is written in the context of comments submitted by the American Institute of Certified Public Accountants (AICPA) (3) and the American Bar Association (ABA) (4) to Treasury and the IRS subsequent to the issuance of Notice 2008-13. (5) Following a brief statement of background, the analysis of the proposed regulations in this article focuses on five key questions of interest to practitioners:

1. Who is subject to the Sec. 6694 preparer penalty provisions?

2. How is the particular tax return preparer for a particular position on a return identified?

3. What standard of conduct is required of the tax return preparer?

4. How can the tax return preparer avoid the application of the penalty? and 5. How is the penalty calculated and allocated among tax return preparers?

Background

Effective May 25, 2007, Congress passed into law new preparer penalty rules under Sec. 6694 that require tax return preparers to have a reasonable belief that an undisclosed tax position taken on a return would more likely than not (MLTN) be sustained on its merits. Disclosed positions must meet a reasonable basis minimum authoritative standard. Failing to meet these new standards will expose the preparer to the Sec. 6694 penalty for "unreasonable positions," now increased to the greater of $1,000 or 50% of the preparer's income derived (or to be derived) by the tax return preparer with respect to the return or claim. The taxpayer accuracy-related penalty requiring substantial authority to support undisclosed tax positions was not changed.

SBWOTA also removed the word "income" from the definition of "income tax return preparer" in Sec. 7701(a)(36), thereby expanding the preparer penalty to encompass preparers of any federal tax return, including income tax returns, estate and gift tax returns, generation-skipping transfer tax returns, employment tax returns, excise tax returns, and not-for-profit tax returns.

The legislation took Treasury, the Service, and the tax practice community by surprise and generated criticism and requests for guidance from the practice community. The change in the law was so dramatic that it would have been virtually impossible for many practitioners to immediately comply. (6) Treasury and the IRS feared that the preparation of tax returns would simply stop. (7) They quickly issued transitional relief in Notice 2007-54 (8) to effectively delay until 2008 the implementation of the provisions for tax returns and claims for refund, and promised additional guidance by the end of 2007.

If the uncertainty for practitioners was not already great enough, in September 2007, Treasury issued proposed regulations under Circular 230 (9) intended to conform the regulations to the new requirements in the law. These proposed regulations state that a tax return preparer may not sign a return unless each position on the return either meets the reasonable belief/MLTN standard or has a reasonable basis and is disclosed in the manner required by the Service. Fearing the possibility of a career-ending ethics violation under Circular 230 and of possible referral to the IRS Office of Professional Responsibility for failures to meet the new standards of conduct, tax preparers' concerns rose to a new level. These concerns were compounded by the realization that preparers must have a higher level of certainty for tax return positions than their taxpayer/clients, thereby creating a potential conflict of interest between the preparer and the client.

On December 31, 2007, the Service issued guidance in Notice 2008-13, on which tax preparers can rely until final regulations are released. This interim guidance relieved some major practitioner concerns and generally was praised by practitioner groups as striking an appropriate balance between the roles of tax preparers and the needs of effective tax administration.

The proposed regulations build upon the framework in Notice 2008-13 with few deviations. However, the analysis below reveals a number of areas where additional clarification will be needed.

Who Is Subject to the Penalty Provisions?

Sec. 6694, as amended by SBWOTA, now applies to the universe of paid tax advisers and preparers with respect to all federal tax issues. Any person who receives compensation in a federal tax matter that will or may eventually be reported on a return or claim for refund is potentially a "tax return preparer" and as such may be subject to the Sec. 6694 preparer penalty. Thus, the applicability of the preparer penalty to a particular practitioner depends on defining who is treated as being a tax return preparer under the new proposed regulations and what now constitutes a return or a claim for refund within the expanded scope of amended Sec. 6694.

Tax Return Preparer Defined

Sec. 7701(a)(36)(A) defines the term "tax return preparer" to mean any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any federal tax return or claim for refund of tax under the Internal Revenue Code. The section further provides that the preparation of a substantial portion of a return or claim for refund constitutes the preparation of such return or claim for refund. Thus, the Sec. 7701(a)(36) designation of a tax return preparer hinges on determining what constitutes a "substantial portion" for purposes of return preparation.

Consistent with the above definition, the new Prop. Regs. Sec. 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."

Prop. Regs. Sec. 301.7701-15(f) lists persons who are not tax return preparers. The list includes:

* Employees of the IRS;

* Individuals working for various volunteer assistance organizations;

* Employees preparing returns or claims of their employers;

* Fiduciaries, or officers, partners, or employees of a fiduciary preparing returns or claims of a trust, estate, or other similar entity; and

* Individuals providing only typing, reproduction, or other mechanical assistance in the preparation of a return or claim.

Signing and Nonsigning Tax Return Preparers

Signing tax return preparer: Prop. Regs. Sec. 301.7701-15(b)(1) defines a signing tax return preparer as any tax return preparer who signs or is required to sign a return or claim for refund under Prop. Regs. Sec. 1.6695-1(b). Prop. Regs. Sec. 1.6695-1(b)(1) provides that returns that are not electronically filed must be signed by the individual who is a "tax return preparer" with respect to the return or claim as described in Prop. Regs. Sec. 301.7701-15. As will be seen in the discussion below, under Prop. Regs. Sec. 301.7701-15, more than one person within a firm may be treated as being a tax return preparer with respect to one or more positions on the return or claim. In such a case, Prop. Regs. Sec. 1.6695 1(b)(3) provides that the individual tax return preparer who has the primary responsibility for the overall substantive accuracy of the preparation of the return or claim is the signing preparer.

Nonsigning tax return preparer: A nonsigning tax return preparer is any tax return preparer who is not a signing tax return preparer but who prepares all or a substantial portion of a return or claim for refund with respect to events that have occurred at the time the advice is rendered. Thus, advice given by a tax practitioner with respect to events that have not yet occurred is considered tax planning rather than tax preparation.

The proposed regulations do not provide a definition of the term "advice," thus leaving the definition of nonsigning preparer vague. As the ABA recommended in its...