American Bar Association Section of Taxation Letter and Comments on Changes to Standards for Imposition of Certain Penalties, November 19, 2007
Defending Liberty Pursuing Justice
Section of Taxation
10th Floor
740 15th Street, N.W.
Washington, DC 20005-1022
E-mail: tax@abanet.org
November 15, 2007
The Honorable Max Baucus
Chairman
Senate Finance Committee
219 Dirksen Senate Office Building
Washington, DC 20510
The Honorable Charles Grassley
Ranking Member
Senate Finance Committee
219 Dirksen Senate Office Building
Washington, DC 20510
Re: Legislative Changes Impacting Standards for Imposition of Penalties
Dear Chairman Baucus and Ranking Member Grassley:
Enclosed are comments on the recent amendment to section 6694 of the Internal Revenue Code of 1986, as amended (the "Code"), which changed the standard for imposition of the tax return preparer penalty, and on a proposal that we understand to be under consideration to enact similar changes to section 6662 of the Code. These comments represent the views of the American Bar Association Section of Taxation. They have not been approved by the Board of Governors or House of Delegates of the American Bar Association and should not be construed as representing the policy of the American Bar
Association.
Sincerely,
Stanley L. Blend
Chair, Section of Taxation
Enclosure
cc: Hon. Charles B. Rangel, Chairman, House Committee on Ways & Means
Hon. Jim McCrery, Ranking Member, House Committee on Ways & Means
Eric Solomon, Assistant Secretary (Tax Policy), Department of the Treasury
Michael J. Desmond, Tax Legislative Counsel, Department of the Treasury
Donald L. Korb, Chief Counsel, Internal Revenue Service
Deborah Butler, Associate Chief Counsel, Internal Revenue Service
AMERICANN BAR ASSOCIATION SECTION OF TAXATION COMMENTS ON CHANGES TO STANDARDS FOR IMPOSITION OF CERTAIN PENALTIES
The following comments ("Comments") are submitted on behalf of the American Bar Association Section of Taxation and have not been approved by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, the Comments should not be construed as representing the position of the American Bar Association.
Principal responsibility for preparing these Comments was exercised by Bryan C. Skarlatos, Chair of the Civil and Criminal Tax Penalties Committee. Substantive contributions were made by Michael Lang. The Comments were reviewed by Gersham Goldstein of the Section's Committee on Government Submissions and by Kathryn Keneally, Council Director for the Civil and Criminal Tax Penalties Committee.
Although members of the Section of Taxation who participated in preparing these Comments have clients who might be affected by the federal income tax principles addressed by these Comments, no such member or the firm or organization to which such member belongs has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments.
Contact person: Bryan C. Skarlatos
Email: bskarlatos@kflaw.com
Date: November 15, 2007
Executive Summary
These Comments, filed on behalf of the American Bar Association Section of Taxation, address the recent amendment to section 6694 of the Internal Revenue Code of 1986, as amended (the "Code"), and proposals that we understand may be under consideration to enact similar changes to section 6662.1
On May 25, 2007, President Bush signed into law H.R. 2206 (Public Law No. 110-28), which among other things amended section 6694 to expand the penalty for tax return preparers and change the standard for imposition of the penalty from "realistic possibility of success" to "a reasonable belief that a position is more likely than not correct." We commend the efforts of Congress to address overly aggressive tax planning and to provide the Internal Revenue Service (the "Service") with sufficient tools to detect and combat abusive tax shelters. However, we regret that the amendment to section 6694 was not fully explored through public hearings and comment prior to enactment. These Comments address several concerns with the new law. First, due to the significant complexity of the Code and the Treasury Regulations, as well as the lack of clear guidance interpreting many of those provisions, many situations arise where it simply is not possible for return preparers to conclude that any position is more likely than not correct. As a result, return preparers (and thus their clients) are likely to incur significantly greater compliance costs, and also are likely to file so many disclosure statements that the disclosures will become practically meaningless. Second, because the amendment to section 6694 established a higher standard for return preparers than is imposed on taxpayers, it creates the potential for conflicts of interest between return preparers and taxpayers. Third, the amended statute is ambiguous in several respects, including the extent to which it can or should be applied to "non-signing" preparers.
We understand that your Committee may be considering an amendment to section 6662 to increase the standard for imposition of the accuracy related penalty to match the standard established for tax return preparers in section 6694 as amended by Public Law No. 110-28. We understand that such a change may be motivated, in part, by a desire to avoid the conflicts that can arise between return preparers and taxpayers under current law, and we agree that the penalty standards for return preparers and taxpayers should be aligned. However, we respectfully submit that a "more likely than not" standard is not advisable given the complexity and ambiguity inherent in our tax system and the potential costs and problems that will be created by such a standard. We recommend that the penalty standard for both return preparers and taxpayers should be substantial authority.
Discussion
A. The Recent Amendment to Section 6694 Is Difficult to Apply and Will Increase Burdens on Taxpayers, Return Preparers and the Service
The tax law is exceedingly complex and the correct interpretation of a position on a tax return is often ambiguous and uncertain. As a result, the law traditionally did not penalize taxpayers and return preparers for taking a good faith reasonable position on a tax return even when they were not sure that the position was correct. Section 6662(d) generally provides that an individual taxpayer can avoid a penalty with respect to an understatement arising from a position for which there is "substantial authority." Substantial authority is an objective standard that is less stringent that the "more likely than not" standard, but more stringent than the "reasonable basis" standard. A return position that is arguable, but fairly unlikely to prevail in court does not satisfy the substantial authority standard.2
Ten years ago, the law was changed to raise the penalty standard for tax-motivated transactions. Under current law, a taxpayer will be subject to a penalty on any substantial understatement arising from a position attributable to a "tax shelter" unless there is both substantial authority for the position and the taxpayer reasonably believed that the position was more likely than not proper.3 A tax shelter is defined broadly to include any entity, plan or arrangement that has a significant purpose of avoiding (i.e. , reducing) taxes.4
We believe that the reasonable belief/more likely than not standard is an appropriate standard to be applied to tax-motivated transactions because such transactions deserve more scrutiny and justify higher transaction costs. However, the majority of positions asserted on tax returns for which the law is unclear arise from transactions that are not tax-motivated. Accordingly, we believe the benefits to be derived from raising the penalty standard with respect to regular non-tax shelter transactions do not outweigh the resulting costs and problems in the administration of the tax system.
1. The New Standard Is Difficult to Apply
Because the tax law is complex and ambiguous, it is often difficult to quantify the likelihood of success on the merits of a particular position, particularly when factual issues are involved. This is one of the reasons why Congress originally chose "substantial authority" as the applicable taxpayer penalty standard in section 6662(d). The substantial authority standard is a reasonably high standard of conduct and recognizes that many bona fide tax return positions do not benefit from settled law. In contrast, the more likely than not standard is a very specific standard that requires a positive determination regarding the likelihood of success of return positions. It will not always be possible to make such precise determinations in situations involving complicated legal and factual issues. Even relatively simple determinations, such as whether an expenditure should be expensed or capitalized, may not be susceptible to a precise quantification regarding the likelihood of success.
The difficulty in determining whether a return position satisfies the more likely than not standard is exacerbated by the regular amendment of the Code, and the lack of regulations providing clear guidance to taxpayers on the operation of many complex rules. When the statute is ambiguous, and the Treasury Department has not filled in the gaps through regulations or other interpretive rules, taxpayers and return preparers are left to reason their way to an appropriate return position. Likewise, the Service is likely to have significant difficulty applying a more likely than not standard to situations where the law is not completely clear.5 When a statute is clear on its face, these determinations obviously can be made much more easily than where the taxpayer, return preparer, or revenue agent instead is faced with the difficult task of sorting through varying shades of gray.
Further, the more likely than not standard is the same standard that the Service and courts use in determining whether a tax return position should be upheld. When the standard for imposition of a penalty is the same as the standard used to determine whether a position is, in fact, correct, there will be almost a presumption, imposed with the benefit of hindsight, that any position resulting in an understatement should also be subject to a penalty. Give the complexity and ambiguity of the tax law, it is not appropriate to presume that taxpayers and return preparers should be subject to a penalty simply because the taxpayer's or preparer's interpretation of those complex or ambiguous rules turns out not to be upheld by the Service (or a court).
2. The New Standard Will Increase the Cost of Tax Return Preparation
By requiring a positive determination regarding the accuracy of a return position, the new standard will require a significant amount of research and diligence to ensure compliance with the law. More taxpayers likely will be required to hire a professional return preparer to help them review their return positions. Further, the only way taxpayers can avoid a penalty for a return position that ultimately is not upheld by the Service (or a court) is to prove that they reasonably believed that the position was correct. The best way for taxpayers to prove that they believed that a return position was correct is to hire and rely on a return preparer to make that determination for them. Indeed, hiring a tax return preparer will provide almost automatic insurance against a penalty in cases were there is an understatement on a tax return.
As a result, we believe the new standard will cause more taxpayers to hire tax return preparers and return preparers will spend more time analyzing the positions taken on the returns. Some preparers may charge a premium simply for providing penalty protection.6 This will dramatically increase the cost of return preparation for taxpayers. If each taxpayer who currently hires a professional to prepare his or her return has to pay and average of just $10 in additional fees, the overall cost of return preparation could increase by more than one billion dollars annually.7 Moreover, taxpayers who are better informed or are more able to afford professional advice will be able to establish greater penalty protection than less informed or less affluent taxpayers. While the additional diligence and higher cost may be appropriate with respect to tax-motivated transactions, it is not justified in the case of ordinary everyday transactions that were not motivated by a desire to reduce taxes but for which the tax treatment is unclear.
3. The New Standard Will Result in Over-Disclosures
Under prior law, taxpayers and return preparers evaluating a non-tax shelter item would consider the objective strength of the return position and evaluate whether penalties were likely if the position was disallowed. In light of the recent amendment to section 6694, there will be close to a presumption that penalties will be imposed in every case in which a return position is disallowed by the Service or a court. This means that return preparers likely will err on the side of attaching a Form 8275 disclosure statementto every return they prepare that contains a position that potentially could be disallowed. We are concerned that such over disclosure will result in the Service being flooded with so many disclosure statements that the statements will become practically meaningless.
B. The Amended Statute is Ambiguous
When Congress originally enacted section 6694 and the Regulations were promulgated interpreting that statute, the term "income tax return preparer" was defined to include both signing preparers and non-signing preparers.8 The definition of non-signing preparer is very broad and can include a person who provides oral advice regarding a substantial portion of a return. We understand that the reason non-signing preparers were included within the scope of the statute was to ensure that preparers who really did all the work to prepare the return could not insulate themselves against liability under section 6694 simply by delegating the actual signing of the return to someone else. However, to the extent that this definition includes practitioners who have nothing to do with actually preparing the return, it goes far beyond the situation it was intended to reach. Indeed, it is entirely possible that a practitioner who gives advice to a taxpayer could become a non-signing preparer without even knowing whether the advice was used by the taxpayer or whether the advice affected a substantial portion of the return. In such case, a practitioner could unwittingly become subject to the return preparer penalty.9
While this situation has existed for many years, it has not been a problem because there were very few practitioners who would give advice to a taxpayer that did not satisfy the old "realistic possibility of success" standard, so there was little chance of a penalty. However, under the new "more likely than not" standard, there is a possibility of a penalty every time the Internal Revenue Service or a court determines that a position is wrong. As described above, it will become very burdensome and unduly expensive to require tax practitioners to conduct the legal and factual research and diligence necessary to try to ensure that a position is absolutely correct every time they give oral or written tax advice to a client. In some situations, regardless of the effort expended, it will not be possible to determine the correct position because the law is unclear or because the facts remain subject to change at the time the non-signing "preparer" is consulted. Accordingly, we strongly suggest that the definition of tax return preparer be clarified to include only signing preparers and others directly involved in the actual preparation of line items on a return.10
C. The Penalty Standard for Taxpayers and Return Preparers Should be Set at Substantial Authority for Non-Shelter Positions
We agree with the commentators who have suggested that the current mismatch between the taxpayer penalty and the return preparer penalty creates a conflict of interest between taxpayers and return preparers. However, we do not believe that the answer is to raise the taxpayer penalty standard to a reasonable belief/more likely than not standard with respect to all understatements. As discussed above, we believe that this standard is unworkable in many situations and will result in significant additional costs being imposed on taxpayers in order to try to ensure that they are in full compliance with the tax laws. Instead, we recommend that the penalty standard for tax-shelter items be set at reasonable belief/more likely than not with respect to both taxpayers and return preparers but that the penalty standard for non-tax shelter transactions be set at substantial authority with respect to both taxpayers and return preparers. These recommendations will enhance the quality of tax return positions by raising the penalty standard for return preparers from realistic possibility of success to substantial authority, eliminate problems caused by a conflict in the standards applicable to taxpayers and return preparers and avoid unnecessary return preparation costs and a proliferation of disclosure statements.
1 Unless otherwise indicated, all references to "sections" are to sections of the Code.
2 Reg. §1.6662-4(d)(2).
3 See Section 6662(d)(2) and Reg. §1.6662-1(g).
4 Section 6662(d)(2)(C)(ii).
5 For example, although more than three full years have now passed since the enactment of section 409A, and although Treasury and the Service published more than one hundred pages of final regulations in the Federal Register more than six months ago, on October 22, 2007 Treasury and the Service issued Notice 2007-86 to extend the transition relief period through December 31, 2008. The extension of this relief was necessary due to the complexity of the rules and the time required for taxpayers (and their advisors) to analyze deferred compensation arrangements and take steps to ensure compliance with the new rules. Pursuant to Notice 2007-86, taxpayers are not required to comply with the final regulations under section 409A in 2008, but are required to operate their plans applying a "reasonable, good faith interpretation of the statute." In such circumstances, it is difficult to comprehend why a taxpayer (or a return preparer) should be required to conclude to the certainty of the more likely than not standard that a particular return position is correct.
6 Preparers will be forced to incur such costs up front in an effort to avoid any potential assertions of a penalty. Although section 6694(a)(3) provides a reasonable cause exception to the return preparer penalty, the costs imposed on a preparer to mount such a defense can often be significant, particularly when the root cause of the dispute lies in the complexity or ambiguity of the Code or Regulations.
7 Data from the Statistics of Income, Individual Tax Statistics, printed on the IRS Web Site indicate that, in 2006, 133,917,068 individual tax returns were filed, most of which presumably were for tax year 2005. The same data indicate that 59.6% of individuals used paid return preparers for their 2005 tax returns. Thus, approximately 79,814,572 taxpayers used paid return preparers for their 2005 tax returns. An additional $10 per return would translate into an additional overall cost of $798,145,720. Obviously, as the number of taxpayers continues to increase, this figure will likewise increase. Moreover, because it does not take into account the cost incurred by the Service to apply and administer the standard, or for preparers and taxpayers to defend against assertions of the penalty, the true cost will be significantly higher.
8 The term "income tax return preparer" is defined under Section 7701(a)(36).
9 In addition to the penalty imposed on return preparers under section 6694, Treasury and the Service recently proposed amending section 10.34 of Circular 230 (31 CFR 10.34) to conform the standard imposed there to the more likely than not standard now applicable under section 6694. 72 Fed. Reg. 54621 (Sept. 26, 2007). The Section of Taxation anticipates providing comments to Treasury and the Service on those proposed amendments in the coming months.
10 Although Treasury and the Service issued Notice 2007-54, 2007-27 IRB 12 (July 2, 2007) promptly after the enactment of the amendments to section 6694, no additional guidance on these rules has been issued to date. In light of the looming date of applicability of the amended statute, we respectfully request that Congress act promptly to clarify or revise the amended statute, or to provide an extension of time for Treasury to issue detailed guidance and for taxpayers and return preparers to understand and apply that guidance.