The realistic possibility standard - final regulations.

• Author: Ward, David R.

Regulations finalized in late December 1991 explain the so-called "realistic possibility standard," included in the 1989 penalty reform legislation, for measuring the conduct of tax return preparers.

Under Sec. 669(a), a tax return preparer can be assessed a $250 penalty if the return contains an understatement of tax resulting from a tax treatment that does not have a "realistic possibility of being sustained on its merits." The penalty applies only if the preparer knew (or should have known) of the treatment when the return was signed. In the case of a nonsigning preparer who gives advice relating to a return position, the relevant time is the date advice was given (rather than when the return was signed).

Regs. Sec. 1.6694-2(b) sets forth the realistic possibility standard in terms of percentage odds. A position meets the realistic possibility standard when it is one that would be taken by a person knowledgeable in the tax law who, after a "reasonable and well-informed analysis," would conclude that the position has at least a one in three likelihood of being sustained if challenged by the IRS. In reaching this conclusion, the knowledgeable person cannot consider the chances of audit by the Services or the chances that the issue will be raised if an audit does occur.

This reasonable and well-informed standard requires a preparer to use essentially the same analysis as in determining whether the position has "substantial authority" under the tests of Sec. 6662 (relating to the substantial understatement penalty assessable against taxpayers). Similarly, acceptable authorities for determining whether a position has a likelihood of being sustained are the same as those authorities under the Sec. 6662 regulations. Thus, the preparer's analysis must rely on the Code, regulations, court cases, congressional reports and IRS rulings. Textbooks and tax treatises are not acceptable authority by themselves, but the reasoning of such documents and authorities cited therein might be useful in determining if a particular case meets the realistic possibility standard. The Sec. 6694 regulations give extensive examples of the type of analysis needed to meet the realistic possibility standard.

Regs. Sec. 1.6694-2(c) provides a safe-harbor exception to the $250 penalty if two conditions are met. 1. The position taken is not "frivolous," defined as "patently improper." 2. The position is "adequately disclosed."

For a preparer required to sign the return in...