New Law and Punitive New
Penalties Intended to Induce
Tax Return Preparers to Report
Unreasonable Positions in Your
Tax Return to the IRS

The Section 6694 enhanced penalties put at risk the livelihood of the tax return preparers if or when those
large penalties are imposed on preparers when undisclosed positions are exposed in an IRS tax examination.

ALVIN S. BROWN

This is a "heads up" for anyone who has their individual and business tax returns prepared by others. New stiff penalties under Section 6694 of the Internal Revenue Code are imposed on your tax return preparer for his or her failure to disclose unreasonable positions in your IRS tax returns. In effect, Section 6694 is a "whistleblower" statute that creates a conflict of interest between you and your income tax return preparer, who henceforth will be induced to report unreasonable positions in your tax return to the IRS in order to avoid the newly enlarged penalties. Section 6694, as amended, has created a seminal change in how tax returns will be prepared and who you choose to prepare your tax returns by creating a new paradigm for tax planning and tax return preparation by putting financial pressures on tax return preparers to make the disclosures required by Section 6694.

The new legislation is contained in amendments to Section 6694 in the Small Business and Work Opportunity Act of 2007 (the Act), ¹ effective when enacted on May 25, 2007. Section 8246 of the Act amends several provisions of the Code to extend the application of the income tax return preparer penalties to all tax return preparers, significantly expands the definition of a "tax return preparer," alters the standards of conduct that must be met to avoid imposition of the penalties for preparing a return which reflects an understatement of liability, and significantly increases penalties on a return preparer for either failing to make disclosures to the IRS of unreasonable positions to the IRS or making disclosures of unreasonable positions that have no reasonable basis of technical support. Transitional relief was announced by the IRS for returns, amended returns, and refund claims due on or before December 31, 2007. ² Congress enacted the Act to raise revenue and provide greater transparency of taxpayer tax returns.

Taxpayers now have the new task of dealing with their tax return preparers, directly or through outside consultants, to convince them that tax positions to be taken in a tax return are reasonably based on the prevailing law. Tax return preparers or consultants have the risk of being penalized because they cannot recognize an unreasonable position.

for examination.The cost of tax return preparation will increase corresponding to the extra cost needed to support positions taken in a tax return. Informed tax return preparers will be loath to prepare tax returns that appear to have complex factual or legal issues due to the concern that they will be subject to Section 6694 penalties.

Section 6694 has not previously been the focus of the IRS because the penalties on tax return preparers for non-disclosure of unrealistic positions ³ were relatively small. ⁴ Taxpayers need to be concerned that positions reported to the IRS as unreasonable will trigger a dreaded IRS examination. Taxpayers will need to evaluate the competency of their tax return preparer to discern the difference between reasonable position and an unreasonable position . A technically inept tax return preparer has the potential of making unnecessary disclosures to the IRS as a way of avoiding possible Section 6694 penalties. Greater care will be needed for tax planning to evaluate disclosure potential and prepare for disclosures of factual and legal issues. Depending on the technical complexity of the tax issues, return preparation may need to be filed with written technical analysis and technical support to deter the IRS from selecting the tax return for examination.

The new law and higher penalties on tax return preparers are within the context of a larger focus on Congress and the IRS to cut down on return preparer abuses. Return preparers have been the target of the IRS in recent years. The IRS has a computer program that targets the error rate of return preparers. If the return preparer´s clients reflect a high error rate, the customers become audit targets of the IRS and the IRS subjects the return preparer to civil and criminal examination. In the event that the return preparer examination is a criminal examination, the clients of the return preparers are also subject to consideration for criminal investigation. The IRS will also interview clients of targeted return preparers during a civil examination, and those interviews often result in civil examinations of the client.

The IRS Internal Revenue Manual has recently made return preparer penalty cases an Appeals Coordinated issue subject to review by a Technical Guidance Coordinator. ⁵ All Section 6694 issues in Appeals must be reviewed and receive concurrence from the Technical Guidance Coordinator before the 6694 penalty can be resolved. Due to the large penalties, IRS audit programs and examiners are much more likely to target tax return preparers with little training or experience. Untrained and inexperienced tax return preparers are more likely to make errors in preparing tax returns and correspondingly create a high risk that their clients will subject to IRS examination.

IRS audit "red flags" include return preparers involved with tax shelters and offshore transactions. The IRS has the further incentive to audit return preparers because the newly enlarged penalties under Section 6694 can be expected to generate larger audit revenue. The IRS has made “return preparer fraud” one of its annual "Dirty Dozen" consumer alerts. ⁶ Congress has held hearings dealing with return preparer abuses on the assumption that erroneous return preparation has contributed to the large Tax Gap approximating $345 billion.

The IRS has an existing criminal investigation strategy and program for return preparers. ⁷ This program is designed for unscrupulous return preparers who knowingly claim excessive deductions and exemptions on returns prepared for clients. In these examinations, the IRS may use undercover operations to evaluate the return preparer. The Department of Justice has a long record of prosecuting tax return preparers and a similarly long list they have enjoined from engaging in the business of preparing tax returns. These DOJ prosecutions of unscrupulous tax return preparers are ongoing and a high priority both for the IRS and the DOJ.

Given this enormous IRS and Congressional focus on return preparers and their abuses, taxpayers need to be aware of the substantial scrutiny on tax returnpreparers. ⁸ When a return preparer discloses an unreasonable position ⁹ to the IRS, and there is no reasonable basis ¹⁰ for the position, the IRS will have cause to investigate the return preparer, the clients of the return preparer, as well as the tax return of the client who is the subject of the disclosure. For these reasons taxpayers should focus on the credentials of their tax return preparer: their training, education, experience, reputation, and now, as will be discussed below, their ability to support technical positions. Although there has long been obvious risk to taxpayers in selecting the wrong return preparer, that risk is exponentially higher now that the return preparers are compelled to report problematical unreasonable positions to the IRS. The worst case scenario imaginable is that unreasonable positions disclosed to the IRS are perceived as "tax fraud" by the IRS, resulting in a criminal investigation of both the return preparer and the preparer´s client. One can never assume that what may be perceived negligence to a taxpayer will not be perceived as tax fraud to an aggressive IRS examiner.

Taxpayers and their tax consultants will likely become more conservative on positions taken in their tax returns and spend the necessary time to make sure that positions taken have strong technical support. The cost of tax return preparation will increase corresponding to the extra time needed to justify positions to be taken in a tax return as well as the need to fund the cost of tax consultants to evaluate the tax impact of position taken or to be taken in tax returns. Complex tax positions and interpretative positions will need to be justified in writing and maintained in tax files in the event the tax return becomes the subject of an IRS audit examination.

SECTION 6694 STATUTORY SCHEME

The Act applies to any tax return preparer who prepares any return or claim for refund to which any part of an understatement of tax liability ¹¹ is due to an unreasonable position. An unreasonable position exists if:

1. The tax return preparer knew (or reasonably should have known ¹² ) of the position, ¹³
2. There was not a reasonable belief that the position would more likely than not be sustained on its merits , ¹⁴ and
3. The position was not disclosed as provided in Section 6662(d)(2)(B)(ii), 15 or there was no reasonable basis for the position. ¹⁶

If the tax return preparer does not make the disclosure required in Section 6662(d)(2)(B)(ii) or if there is a disclosure but the there is no reasonable basis for the position, the new penalty is the amount equal to the greater of $1,000, ¹⁷ or 50% of the income derived (or to be derived) by the tax return preparer. ¹⁸ Section 6694(a)(2)(C)(ii) provides that if the perceived unreasonable position is disclosed to the IRS, the penalty will not apply if there is a reasonable basis for the disclosed position. The Act also increased the Section 6694(a) penalty for understatements from $250 to the greater of $1000 or 50% of the income derived (or to be derived) by the tax return.

Increase in Penalties for Understatement of Tax Due to Willful or Reckless Conduct. The Act increased the Section 6694(b) penalty for willful or reckless conduct from $1,000 to the greater of $5,000 or 50% of the income derived (or to be derived) by the return preparer. The conduct of a tax return preparer is willful ¹⁹ if the tax return preparer in any manner attempts to understate the liability for tax on the return or claim. The larger penalty also applies if the tax return preparer is reckless or intentional in the disregard of rules or regulations. ²⁰

The fact that penalties are imposed under Section 6694(b) for willful or reckless conduct will not

problematical unreasonable positions to the IRS.preclude the application Section 7201 ²¹ or 7206 ²² felony statutes. Voluntary disclosures by return preparers to the IRS virtually eliminate the IRS ability to prove the "willful" intent to evade a tax or the “willful” making of a false statement. The tax fraud issues become important for undisclosed positions. Under prior law, ²³ Section 6694(a) provided for a $250 penalty on an "income tax return preparer" who understated a taxpayer´s tax liability on an income tax return or claim for refund if the understatement was due to a position for which there was not a realistic possibility of being sustained on its merits and the preparer know or reasonably should have known of the position. The penalty did not apply if the position was not frivolous and adequately disclosed, of if there was reasonable cause for the position taken and the preparer acted in good faith. The penalty under Section 6694(b) was $1,000 where there was a willful attempt to understate tax liability.

Interim Guidance on "Reasonable Belief." The IRS has provided interim guidance to determine whether there is not a reasonable belief that the position would more likely than not be sustained on its merits ²⁴ in Section D of Notice 2008-13, ²⁵ as follows:

Notice 2008-13 sets a high technical standard for tax return preparers by requiring an "analysis" the pertinent facts and authorities. The burden of providing the necessary amount and quality of the "analysis" of the pertinent facts and authorities lies with the tax return preparer and indirectly the client represented who will have the obvious burden of paying for the cost of that effort. Proof of that analysis, under the standards of Reg. 1.6662-4(d)(3)(ii), will need to be documented in the client´s files for "undisclosed" positions or documented to accompany client´s tax returns for positions "disclosed"e; to the IRS.

It is likely that the IRS will review the disclosed positions and at that time consider whether there is a reasonable basis ²⁸ for the position. The goal of a technical "analysis" filed with the tax return is to dissuade the IRS from selecting the tax return with the disclosed position from examining the tax return. Once a tax return is selected for examination, the IRS quickly looks at all tax issues and other tax years. The strategy for all taxpayers is to minimize the prospects that the IRS will select a tax return for examination. Given the choice of examining a disclosed position with competent technical analysis or a tax return without that analytical memorandum, the IRS is more likely to select the tax return without the written technical support for examination.

As a practical matter, the authoritative memorandum is more important for disclosed positions because the position taken is presented and disclosed to the IRS as unreasonable and the IRS is expected to evaluate the position, even if the standard of analysis and authority is less than the standard for undisclosed positions. The strategy must always be to persuade the IRS that the position taken is firmly supported under the facts as applied to the law. The goal of the written memorandum is to convince the IRS that disclosure was not necessary because the position taken is "reasonable" notwithstanding the fact that the position disclosed to the IRS was earmarked as "unreasonable." Although this sounds contradictory on its face, the return preparer has no alternative but to argue that the position taken might appear to be unreasonable but that there is substantial analysis and authority to make the case that there is a reasonable basis for that position within the meaning of Section 6694(a)(2)(C)(ii). Taxpayers have a stronger interest in justifying the disclosed position because of the need to avoid the 20‰ negligence penalty and also prevent the IRS from using the disclosure to initiate a tax examination. For these reasons taxpayers should want the technical analysis and support for disclosed positions to be at this highest level because the risk for disclosed position is higher for the taxpayer than on the return preparer.

For undisclosed positions, where the quality of the analysis and the authorities cited are much higher than the disclosed positions, it is prudent to prepare the analytical support for retention in the client´s administrative file in the event of a subsequent IRS examination. IRS examinations will normally occur approximately two years after a tax return is filed. At that time the return preparer may not be available, records get lost, those involved with the issue tend to forget the germane facts, etc. For these reasons undisclosed positions need analytical and technical documentation at the time the return is filed when the issues are fresh, the documentation is available, and all contributors to the tax return are reachable. In the event that the disclosed position becomes the subject of an IRS examination, the client will need an articulate representative to present the analysis and technical support to IRS examination to advocate and explain the support for the positions taken in the tax return.

Those return preparers who have not identified the issue of whether there is or is not an unreasonable position will obviously have no choice but to defend that position at the time of an IRS examination of their client´s tax return. This class of tax return preparer includes those without the skill to identify an unreasonable position, those who rely on client misinformation, and those dealing with targeted IRS examinations. Going forward, if an IRS examination determines that there is an understatement of tax liability, even one that does not trigger the Section 6662 negligence penalty, we should expect that the IRS will also be motivated to target the tax return preparer for the Section 6694 penalties.

One can argue that the preparation of tax returns is now a "trap for the unwary" tax return preparer, victimized by an aggressive IRS examiner whenever

there is an understatement of tax. There are several important points that may be underscored:

1. Lack of knowledge of an unreasonable position is not a defense to the imposition of the penalty. A tax return preparer cannot have a reasonable belief that the position would more likely than not be sustained on its merits if the return preparer did not know about the position.
2. The return preparer has the burden of proof to rebut the assessment of a Section 6694 penalty.
3. "Mistakes" identified by the IRS are ipso facto errors that are unsupported by the required analysis identified in Notice 2008-13. Any mistake in a tax return could be recast as a non- disclosed unreasonable position . Even corrections made by an IRS Service Center may result in a Section 6694 penalty from an IRS Service Center Computer program.
4. There is no de minimus standard for a mistake in a tax return that might trigger the assessment of the Section 6694 penalty.
5. IRS examiners should be expected to be aggressive as they are in many examinations. The Act was enacted as a legislative "revenue raiser," and any tax deficiency can be classified by the IRS as an unreasonable position.

It is readily apparent that taxpayers are better off if they choose tax return preparers who are more likely to identify unreasonable positions to enable analysis and technical support for the position. Taxpayers involved with complex factual, legal or even aggressive tax positions will need to consider whether their tax return preparer has the ability to draft a memorandum that meets the standards of Reg. 1.6662-4(d)(3)(ii) to provide an analysis of the relevant legal or technical support for the positions taken in the tax return. With filing deadlines limiting the time to prepare a qualifying analysis or lack of technical ability of many tax return preparers, taxpayers will likely want to invite opinions from tax attorneys or other consultants to research and draft

technical memoranda to justify the positions taken. Adequate time is needed for analysis, research, and drafting written support for the positions taken in a tax return in order to meet filing deadlines. Notice 2008-13, and the tax regulations that will follow in its wake, create a new paradigm for tax return preparers and tax consultants, not necessarily because of higher standards for positions taken in tax returns, but because

Notice 2008-13 expressly requires technical analysis of the pertinent facts and authorities sufficient to justify (i.e., document) the higher standards. More importantly, the documented analysis is the best way to minimize the potential for the imposition of the Section 6694 penalties.

Tax return preparation depends on tax law, tax regulations, case law, and the other recognized technical authority as described in Reg. 1.6662-4(d)(3)(iii). The ability to research and interpret tax law and draft an interpretative analysis to support a factual or legal position is a skill that requires education, training and experience presently lacking in a large body of those who presently prepare tax returns. Without that background, skill, and experience, tax return preparers will be vulnerable to the Section 6694 penalties, and their clients will correspondingly be disadvantaged by that lack of ability. Going forward, the educated taxpayer will likely want to engage tax return preparers who have the fundamental technical skills to meet the "analysis" standards of Notice 2008 13. Although Notice 2008-13 is about standards for the Section 6694 penalties for tax return preparers, it is their clients who will suffer and pay for the lack of technical skill of the tax return preparers through avoidable tax audits, negligence penalties and more.

Transitional Relief. In order to provide sufficient time to address issues pertaining to the implementation of the Act, the Treasury Department and the IRS issued Notice 2007-54 on July 2, 2007, ²⁹ which provides the following transitional relief: for income tax returns, amended returns, and refund claims, the standards set forth under pre-Act law and current regulations under Section 6694 will be applied in determining whether the IRS will impose a penalty under Section 6694(a), as amended by the Act. In applying transitional relief for income tax returns, amended returns, or refund claims, disclosure will be deemed adequate if made on a Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, attached to the return, amended return, or refund claim, or pursuant to the annual Revenue Procedure authorized in Regs.1.6694-2(c)(3) and 1.6662-4(f)(2). Notice 2007-54 further provides that for all other returns, amended returns, and claims for refund, including estate, gift, and generation-skipping transfer tax returns, employment tax returns, and excise tax returns, the reasonable basis standard set forth in the regulations issued under Section 6662, without regard to the disclosure requirements, will be applied in determining whether the IRS will impose a penalty under Section 6694(a).

Notice 2008-11 ³⁰ clarifies that the transitional relief applies to any timely filed original or amended return, any timely filed original or amended employment or excise tax return filed on or before January 31, 2008, and advice provided on or before December 31, 2007 by a non-signing preparer. Notice 2008-12 ³¹ provides interim guidance regarding the tax return preparer signature requirement to take into account the May 2007 expansion of that requirement beyond income tax returns.

Notice 2008-12 provides that a preparer will not be subject to a penalty under Section 6695(b) in connection with non-income tax returns or refund claims filed during 2008. The Notice identifies a list of forms for which a signature will be required in 2008.

THE SUBSTANTIAL AUTHORITY STANDARD FOR NEGLIGENCE (SECTION 6662)

In order to do an interpretative analysis of Section 6694, dealing with a reasonable position that is more likely than not a position that will be accepted by the IRS, one has to understand the pre-Act standard as well as the normal standard for negligence for taxpayers. Section 6694, as amended and as interpreted by the IRS, borrows heavily from longstanding technical standards described under the Section 6662. Sections 6662 and 6694 both deal with underpayments of tax. The more likely than not standard under the Act, as well as the realistic possibility standard ³² prior to the Act, were designed and intended to be higher than the standards for establishing the Section 6662 negligence penalty. Section 6694 deals with an understatement of liability and Section 6662(d)(1)(a) pertains to a substantial understatement of income tax. Therefore, in evaluating whether a position is an unreasonable position for the unreported positions, reference may be made to the law under Section 6662 as a measuring baseline.

An additional reason to examine Section 6662 is that it may be expected that the IRS is likely to consider filing the negligence penalty against taxpayers either when the IRS determines that there was an unreasonable undisclosed position within the meaning of Section 6694(a)(2) or if there is no reasonable basis for a disclosed position within the meaning of Section 6694(a)(2)(C)(ii).

Section 6662(b) notes that the 20% penalty applies: for negligence or disregard or rules or regulations; any substantial understatement of income tax; any substantial valuation misstatement; any substantial overstatement of pension liabilities and any substantial estate or gift tax valuation understatement. Negligence is defined under Section 6662(c):

Section 6662(d)(1)(A) indicates that there is a substantial understatement of income tax for any taxable year if the amount of the understatement for the taxable year exceeds the greater of 10% of the tax required to be shown on the return for the taxable year, or $5,000.

Regulation 1.6662-4(d)(3)(ii) considers the nature of analysis of the pertinent facts and authorities. The weight accorded an authority depends on its relevance and persuasiveness and the type of document providing the authority. Some authority is more factually and legally relevant than other authority. Some authority is more current than other authority. The context of this regulation is a part of the determination of the term substantial authority of Reg. 1.6662-4(d) and the sub-topic determination of whether substantial authority is present in Reg. 1.6662-4(d)(3)(iii).

Regulation 1.6662-4(d)(3)(iii) identifies the types of authority needed to establish substantial authority. ³³ The analysis described in Reg. 1.6662-4(d)(3)(ii) would be meaningless without an analysis of the relevant tax law. Substantial authority for the tax treatment of an item includes: applicable provisions of the Internal Revenue Code and other statutory provisions; proposed, temporary and final regulations construing such statutes; revenue rulings and revenue procedures; tax treaties and regulations, and Treasury

Department and other official explanations of such treaties; court cases; Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill´s managers; general explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin. Whether substantial authority exists for a position is determined at the time the return was filed or on the last day of the tax year to which the return relates. ³⁴