Prop. regs. heighten the "reasonable basis" standard for return positions.

• Author: Hill, Lawrence M.

Income tax return preparers have long had to navigate a compliance minefield in determining whether positions taken on their client's returns could subject them to Sec. 6694 return preparer penalties or their clients to Sec. 6662 accuracy-related penalties.(1) Interpretations of such nebulous compliance standards as "not frivolous," "reasonable basis," "realistic possibility of being sustained" and "substantial authority" have assumed great importance as a means of avoiding potentially stiff monetary penalties and professional sanctions. Before the Revenue Reconciliation Act of 1993 (RRA '93), Section 13251 (a), enacted stricter rules for disclosed return positions, return preparers confronted with the murky compliance standards and concerned with the prospect of harsh penalties could seek refuge in the disclosure safe harbor under Sec. 6662(d)(2)(B)(ii); penalties could be avoided by adequate disclosure of "nonfrivolous" return positions.(2) The relatively low and easily interpreted standard for disclosed return positions made disclosure a palatable fallback position, particularly for aggressive return positions.

RRA '93 undermined (at least in part) the relative certainty of the disclosure mechanism by adding the requirement that there be a "reasonable basis" for the tax treatment of the disclosed item, a standard intended to be "significantly higher" than the nonfrivolous standard.(3) Congress may have overlooked the potential for the new standard to discourage disclosure; the rules required taxpayers who intended to disclose return positions to wade through the same morass of compliance standards as nondisclosing taxpayers.

New Rules

Proposed regulations issued in November 1996 further raised the threshold for disclosed return positions.(4) Prop. Regs. Sec. 1.6662-3(b)(3) defines reasonable basis as follows:

Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in [sections] 1.66624(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in [sections] 1.66624(d)(2) ....

Consistent with the RRA '93's legislative history, Prop. Regs. Sec. 1.6662-3(b)(3) provides that the reasonable basis standard is not satisfied by a position that is merely arguable or colorable; further, the disclosed return position must now be "reasonably based on one or more of the authorities" set forth in Regs. Sec. 1.6662-4(d)(3)(iii) (e.g., the Code, regulations, revenue rulings and procedures, tax treaties, court cases, committee reports, etc.). This new definition of "reasonable basis" is more rigorous than under prior law and will bring the compliance standard for disclosed positions closer to the "substantial authority" standard for undisclosed positions.(5) As a result, disclosure will become a less attractive option in many cases.

Because disclosure substantially raises the audit potential of the position and the entire return, the new reasonable basis rules will require careful consideration to determine whether disclosure is appropriate in close cases. Because of the stakes and the complexities involved in interpreting the new rules, conflicts will undoubtedly arise between return preparers and their clients. Practitioners will need to take affirmative steps to protect themselves, their clients and their client relationships.

Accuracy-Related and Preparer Penalties

The basic penalty framework must be understood to evaluate appropriately the pros and cons of disclosure. Currently, the Sec. 6662 accuracy-related penalty is assessed for the following transgressions:

* Negligence or disregard of the rules or regulations (Sec. 6662(b) (1)).

* A substantial understatement of income tax liability (Sec. 6662(b)(2)).

* A substantial valuation misstatement under Chapter 1 (Sec. 6662(b)(3)).

* A substantial overstatement of pension liabilities (Sec. 6662(b)(4)).

* A substantial understatement of an estate or gift tax valuation (Sec. 6662(b)(5)).

In each case, the penalty is 20% of the underpayment attributable to the penalized conduct (e.g., in the case of negligence, the penalty is assessed on the amount of any underpayment attributable to...