The final return preparer regulations.

• Author: Gardner, John C.

Federal regulation of tax return preparers, which began in 1976, has accelerated during the past 16 years. In response to charges that the "reasonable basis" standard permitted under old Sec. 6694 had become too lax, both the American Bar Association (ABA) and the American Institute of Certified Public Accountants (AICPA) substantially revised their standards for taking a tax return position.(1) The "realistic possibility of success" standard adopted by the ABA and AICPA was subsequently codified by the Omnibus Budget Reconciliation Act of 1989 (OBRA) in revised Sec. 6694.(2)

This article will examine and analyze the final regulations under revised Sec. 6694, issued on Dec. 30, 1991 and generally applicable to returns or refund claims filed after Dec. 31, 1991. Sec. 6694(a) provides for the imposition of a $250 penalty on a tax preparer "who . . . knew (or reasonably should have known)" about any undisclosed tax return position that results in the understatement of tax liability and that does not meet the realistic possibility standard as defined in the final Sec. 6694 regulations.(3) Revised Sec. 6694(b) imposes a $1,000 preparer penalty if there is any understatement of tax liability derived from a willful attempt to understate tax liability or due to reckless or intentional disregard of IRS rules or regulations.

Sec. 6694(a) Penalty

* Unrealistic tax return positions

Any preparer (and his employer or partnership in certain cases) may be subject to a $250 penalty under Sec. 6694(a) if there is an understatement of tax liability on a return or claim for refund that resulted from a tax return position "for which there was not a realistic possibility of being sustained on its merits. . . ."(4) The preparer of the return or refund claim will be subject to the penalty if he knew or reasonably should have known about the unrealistic return position.(5)

The realistic possibility of success standard, as defined in the Sec. 6694 regulations, differs somewhat from the applicable professional standards promulgated by the AICPA and the ABA.(6) In assessing whether a tax return position has a realistic possibility of success, the regulations provide that the standard is met "if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits . . .",(7) without consideration of the audit lottery. Although the AICPA and other commentators severely criticized the percentage odds approach when it was first proposed by the Service as both difficult, if not impossible, to determine, and inconsistent with AICPA standards (which should have been reflected in the regulations as evidenced by the legislative intent), it remained in the final regulations.(8) According to the Service, the one-in-three requirement was retained in the final regulations "because a numerical benchmark helps prevent erosion of the standard and because other definitions suggested by commentators would not provide any more meaningful guidance."(9)

In determining whether a tax return has a "realistic possibility of success," the Sec. 6694 regulations adopt the same analysis used by Regs. Sec. 1.6662-4(d)(3)(ii) for determining "substantial authority." Thus, under Regs. Sec. 1.6694-2(b)(1), tax preparers may sign a tax return with an undisclosed tax return position if their "reasonable and well-informed analysis" leads them to conclude that the position has a realistic possibility of being sustained on the merits. Preparers should heed the guidance contained in AICPA Statement on Responsibilities in Tax Practice (SRTP) No. 1, however, to advise clients if a taxpayer penalty (e.g., under Sec. 6662) could be asserted. The explanation to SRTP No. 1 states, "Disclosure [of the tax return position] should be considered when the CPA believes it would mitigate the likelihood of claims of taxpayer penalties . . . or would avoid the possible application of the six-year statutory period for assessment. . . ."(10)

* Types of authority

Regs. Sec. 1.6662-4(d)(3)(iii) identifies the types of authorities a preparer must use in determining whether a tax return position has a realistic possibility of success. This new regulation, which expands the list of authorities recognized by former Sec. 6661 regulations in defining substantial authority, is now applicable to both taxpayers and preparers. Recognized authorities include the Internal Revenue Code and other applicable statutes; temporary, proposed and final Treasury Department regulations; revenue procedures and rulings; and tax treaties, applicable regulations and official explanations of these treaties. In addition, the regulation recognizes court cases; congressional intent as found in committee reports, joint statements by managers of legislation in conference reports, and in statements by "one of a bill's managers" before legislation is enacted; Joint Committee on Taxation explanations of legislation (the "Blue Book"); technical advice memoranda and private letter rulings published after Oct. 31, 1976; actions on decisions and general counsel memoranda issued after Mar. 12, 198 1, as well as those published in Cumulative Bulletins before 1955; IRS press or information releases; announcements, notices and administrative pronouncements appearing in the Cumulative Bulletins.

Sources that are not authority for purposes of Secs. 6662 and 6694 include "[c]onclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals . . . ." However, the opinion of a tax professional outside the preparing firm may help the preparer establish that a realistic possibility exists to avoid a Sec. 6694(a) penalty under the reasonable cause and good faith exception.(11)

Under Regs. Sec. 1.6694-2(b)(4), if the taxpayer has received a written determination from a revenue agent that substantial authority exists for a return position, the position will meet the realistic possibility standard. The written determination may be in a ruling or determination letter given to the taxpayer, in a technical advice memorandum that specifically names the taxpayer, or in the report of a revenue agent issued to the taxpayer when an affirmative statement was made regarding the issue for an earlier year. Both taxpayers and tax preparers should check Regs. Sec. 1.6662-4(d)(3)(iv)(A) for additional detail on when a written determination is no longer applicable for either Sec. 6662 or Sec. 6694 purposes.

* Nature of "substantial authority/realistic possibility" analysis

General guidelines for analyzing whether there is substantial authority for taxpayers or realistic possibility for preparers are found in Regs. Sec. 1.6662-4(d)(3)(ii). This regulation stresses that "[t]he weight accorded an authority depends on its relevance and persuasiveness. . . ." For example, the similarity between the material facts applicable to a particular taxpayer and the facts in a case or revenue ruling should be carefully weighed, along with an evaluation of whether the particular authority "is otherwise inapplicable to the tax treatment at issue." Moreover, an authority that simply states a result is less persuasive than a source "that reaches its conclusion by cogently relating the applicable law to pertinent facts."

The nature and age of a document, as well as the depth of analysis within the document, must also be carefully analyzed. Deletion of material facts used in arriving at the ultimate conclusion, for example, may be a critical factor in evaluating private letter rulings as authority. In addition, revenue rulings are accorded more weight than private letter rulings. Older technical advice memoranda, actions on decision and private letter rulings, moreover, generally will be given "less weight" than more recently issued ones. And, any authority listed in the preceding sentence "that is more than 10 years old generally is accorded very little weight," although the regulation concedes that a document's "persuasiveness and relevance" must be evaluated along with its age and in light of subsequent developments. Finally, the regulation admits that a "well-reasoned construction" of the Code without additional supporting authority might meet both the substantial authority and realistic possibility of success standards.

* Reasonable cause and good faith exceptions

The $250 penalty under Sec. 6694(a) may be avoided if the tax understatement was the result of reasonable cause and the CPA acted in good faith.(12) One factor to be considered in deciding whether this...