FEDERAL INCOME TAX

Understatement of Taxpayer's Liability by Tax Return Preparer

Significant developments - interim rules and guidance. -- ... 2008FED §39,956A.002

Synopsis - sanctions against return preparers. -- ... 2008FED §39,956A.01

Taxpayers affected - who is a tax return preparer? -- ... 2008FED §39,956A.02

Reliance on information furnished by the taxpayer. -- ... 2008FED §39,956A.021

Abatement of penalty. -- ... 2008FED §39,956A.025

Understatements Due to Unrealistic Positions

Significant developments - interim rules and guidance. -- ... 2008FED §39,957A.002

Synopsis - penalty for understatements due to unrealistic positions. -- ... 2008FED §39,957A.01

Realistic possibility of position being sustained on the merits. -- ... 2008FED §39,957A.021

Reasonable belief that position would more likely than not be sustained on the merits. -- ... 2008FED §39,957A.022

Adequate disclosure exception. -- ... 2008FED §39,957A.023

Reasonable cause and good faith exception. -- ... 2008FED §39,957A.03

Willful or Reckless Conduct

Synopsis - penalty for understatement due to willful, reckless, or intentional conduct. -- ... 2008FED §39,957C.01

Willful understatement. -- ... 2008FED §39,957C.021

Reckless or intentional disregard. -- ... 2008FED §39,957C.023

Adequate disclosure exception. -- ... 2008FED §39,957C.025

Related code sections. -- ... 2008FED §39,957C.09

Assessment, Refund and Appeal ... 2008FED §39,960.01

Return Preparer Penalties: Significant developments - Interim rules and guidance

In December of 2007 the IRS released two Notices, one clarifying Notice 2007-54, I.R.B. 2007-27, June 11, 2007 (discussed below at ¶39,956A.01), and the other providing interim rules implementing and interpreting the expanded Code Sec. 6694 tax return preparer penalty. (Notice 2008-11, I.R.B. 2008-3, December 31, 2007, at ¶46,227, and Notice 2008-13, I.R.B 2008-3, December 31, 2007, at ¶46,229). Notice 2008-11 clarifies that the transitional relief provided by Notice 2007-54 applies to original returns, timely amended returns and claims for refund (other than 2007 employment and excise tax returns) filed on or before December 31, 2007, including original returns filed before December 31, 2007 but due on extension after such date. It further clarifies that the transitional relief also applies generally to nonsigning preparers for advice provided on or before December 31, 2007.

The interim rules address the relevant categories of tax returns or claims for refund for purposes of Code Sec. 6694, clarify the definition of "tax preparer," provide guidance concerning the standards of conduct applicable to tax preparers for disclosed and undisclosed positions taken on tax returns, and discuss the interim penalty compliance obligations applicable to tax preparers. The interim rules are generally effective for all tax returns, amended tax returns, and claims for refund (other than 2007 employment and excise tax returns) filed on or after January 1, 2008 with respect to advice provided after that date, and 2007 employment and excise tax returns filed on or after February 1, 2008, with respect to advice provided on or after that date (Notice 2008-13, I.R.B 2008-3, December 31, 2007, at ¶46,229). The following explanations reflect these Notices.

The IRS supplemented Notice 2008-13 by expanding the list of returns and other documents to which the tax return preparer penalty may apply effective as of April 16, 2008 (Notice 2008-46, I.R.B. 2008-18, April 16, 2008, at ¶46,405).

Synopsis - sanctions against return preparers

The scope of return preparer penalties was expanded to apply to all tax return preparers for returns prepared after May 25, 2007 (Code Sec. 6694, as amended by the Small Business Tax Act of 2007 (P.L. 110-28)). The phrase, "tax return preparer," covers preparers of not only income tax returns but, also, estate and gift tax, employment tax, excise tax, and exempt organization returns (see Code Sec. 7701(a)(36)(A), as amended by P.L. 110-28).

Under Code Sec. 6694(a), as amended, an "unreasonable position" penalty applies to preparers if the preparer knew (or reasonably should have known) of the position, did not have a reasonable belief that the position would more likely than not be sustained on its merits, and either did not disclose the position as provided in Code Sec. 6662(d)(2)(B)(ii) or did not have a reasonable basis for the position. Prior to amendment, Code Sec. 6694(a) imposed the penalty with respect to a position which had no "realistic possibility" of being sustained on its merits. The Small Business Tax Act of 2007 replaces the "realistic possibility" standard with a requirement that the preparer have a reasonable belief that the tax treatment of an undisclosed position would more likely than not be sustained on its merits. A proposed amendment to §10.34 of Treasury Department Circular 230 governing duties and restrictions in practicing before the IRS reflects the revised "more likely than not" standard contained in Code Sec. 6694(a) (see ¶43,808.031).

For disclosed positions, Code Sec. 6694(a) requires that there be a reasonable basis for the tax treatment of the position; this replaces the not-frivolous standard previously applied.

An enhanced penalty is imposed on willful or reckless conduct, although the Small Business Tax Act of 2007 (P.L. 110-28) did not alter the standard of conduct under Code Sec. 6694(b).

The return preparer penalty for understatement of a taxpayer's liability due to an unreasonable position is increased to from $250 to the greater of $1,000 per return or 50 percent of income derived from the return (Code Sec. 6694(a)(1), as amended by P.L. 110-28) while understatement due to willful or reckless conduct is increased to the greater of $5,000 per return or 50 percent of income derived from the return (Code Sec. 6694(b)(1), as amended by P.L. 110-28). See ¶39,957A.01 et seq. and ¶39,957C.01 et seq.

Transitional Relief. For income tax returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing), the standards set forth under the previous law and current regulations under Code Sec. 6694 will be applied in determining whether the IRS will impose a penalty under Code Sec. 6694(a). Generally, in applying transitional relief for income tax returns, amended returns or refund claims, disclosure would be 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 Reg. §1.6694-2(c)(3) and Reg. §1.6662-4(f)(2). For all other returns, amended returns, and claims for refund, including estate, gift, and generation-skipping transfer tax returns due on or before December 31, 2007 (determined with regard to any extension of time for filing), 2007 employment and excise tax returns due on or before January 31, 2008, and 2007 estimated tax returns due on or before January 15, 2008, the reasonable basis standard set forth in the regulations issued under Code Sec. 6662, without regard to the disclosure requirements contained therein, will be applied in determining whether a penalty under Code Sec. 6694(a) will be imposed (Notice 2007-54, I.R.B. 2007-27, June 11, 2007).

Interim guidance clarifies that the transitional relief applies to timely amended returns or claims for refund (other than 2007 employment and excise tax returns) filed on or before December 31, 2007, and to timely amended employment and excise tax returns or claims for refund filed on or before January 31, 2008. Such transitional relief also applies to original returns (other than 2007 employment and excise tax returns) filed on or before December 31, 2007 which were due on extension after that date, and to original employment and excise returns filed on or before January 31, 2008. (Notice 2008-11, I.R.B. 2008-3, December 31, 2007 at ¶46,227). However, no transitional relief is available under Code Sec. 6694(b) for return preparers who exhibit willful or reckless conduct, regardless of the type of return prepared.

For tax returns, amended tax returns, and claims for refund (other than 2007 employment and excise tax returns) filed on or after January 1, 2008 with respect to advice provided after that date, and for 2007 employment and excise tax returns filed on or after February 1, 2008, with respect to advice provided on or after that date, the returns and claims for refund to which the Code Sec. 6694 penalty may apply have been identified on an exhibit to Notice 2008-13, I.R.B. 2008-3, December 31, 2007. A second exhibit contains a list of those information returns reporting information reported on another tax return which may subject a tax return preparer to the Code Sec. 6694 penalty if the information reported constitutes a substantial proportion of the latter return. Finally, a third exhibit identifies those documents that include information that might otherwise constitute a substantial portion of the taxpayer's return or claim for refund but which will not subject a tax return preparer to the Code Sec. 6694(a) penalty. However, for these documents a tax return preparer remains subject to the Code Sec. 6694(b) willful or reckless conduct penalty if the information reported on the document constitutes a substantial portion of the tax return or claim for refund, and is prepared willfully to understate the tax liability, or in reckless or intentional disregard of the rules or regulations (Notice 2008-13, I.R.B. 2008-3, December 31, 2007, at ¶46,229). The IRS supplemented Notice 2008-13 by expanding the list of returns and other documents to which the tax return preparer penalty may apply effective as of April 16, 2008 (Notice 2008-46, I.R.B. 2008-18, April 16, 2008, at ¶46,405).

Until further guidance is issued, a return or claim for refund is deemed prepared on the date of the tax return preparer's signature; if the signing preparer fails to sign the tax return, the tax return is deemed prepared on the date it is filed. In the case of a nonsigning preparer, the relevant date is the date such person provides the advice, as determined based on all the facts and circumstances. These interim rules will apply instead of Reg. §1.6694-2(b)(5). (Notice 2008-13, I.R.B. 2008-3, December 31, 2007 at ¶46,229)

For returns prepared on or before May 25, 2007, an income tax return preparer is liable to pay a penalty of $250 for an understatement of taxpayer's liability due to an unrealistic position which the tax return preparer knew or reasonable should have known and was not disclosed or was frivolous (Code Sec. 6694(a), prior to amendment byP.L. 110-28). If any part of the understatement was due to willful or reckless conduct, the penalty is increased to $1,000 per return (Code Sec. 6694(b), prior to amendment by P.L. 110-28).

The following chart summarizes the penalties and sanctions that may be imposed.

Description	Code §	Reg. §	Tax Deficiency Required?	Must Be Paid in Full Before Claming Refund?	Willful Cause Standard?	Amount of Penalty
Understatement from unreasonable position	6694(a)	1.6694-2	Yes	No	Yes	$1000
Willful or reckless conduct	6694(b)	1.6694-3	Yes	No	Yes	$5,000
Failure to furnish copy of return to taxpayer	6695(a)	1.6695-1(a)	No	Yes	Yes	$50
Preparer's failure to sign return	6695(b)	1.6695-1(b)	No	Yes	Yes	$50
Failure to show preparer's identification numbers	6695(c)	1.6695-1(c)	No	Yes	Yes	$50
Failure to retain copy of return or list of taxpayers	6695(d)	1.6695- 1(d)	No	Yes	Yes	$50
Failure to file correct information returns	6695(e)	1.6695- 1(e)(2)	No	Yes	Yes	$50
Negotiation of refund check by preparer	6695(f)	1.6695-1(f)	No	Yes	No	$500
Failure to conduct due diligence in claiming EIC	6695(g)	--	No	--	No	$100
Promoting Abusive Tax Shelters	6700	--	Yes	No	Yes	$1,000
Aiding and abetting understatements of tax liability	6701	--	Yes	No	Yes	$1,000
Per failure, with a maximum of $25,000 for any calender year.

In addition to these penalties, the IRS has the authority to seek an injunction prohibiting a preparer from engaging in certain prohibited practices (Code Sec. 7407).

The IRS has also instituted the "Return Preparers Program" for the purpose of monitoring return preparers. As part of this program, IRS examiners must determine during field and office examinations whether there has been any violation by a paid return preparer (Internal Revenue Manual 20.1.6.1.2, July 31, 2001). In particular, an IRS examiner must determine whether a paid tax return preparer has negligently, intentionally, or willfully understated a client's tax liability in the preparation of a return or claim for refund. An examiner who determines that return preparer violations exist is instructed to document this fact for purposes of a penalty investigation.

Also a part of the IRS's Return Preparers Program, is procedure called "Program Action Cases" under which returns prepared by a particular preparer may be examined if information indicates a pattern of noncompliance with the return preparer provisions. (Internal Revenue Manual 20.1.6.1.6)

Taxpayers affected - who is a tax return preparer?

For returns prepared after May 25, 2007, a "tax return preparer" is a person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return or claim for refund of tax imposed by this title (Title 26 - Internal Revenue Code). The preparation of a substantial portion of a return or claim for refund shall be treated as if it were the preparation of such return or claim for refund (Code Sec. 7701(a)(36)(A), as amended by Small Business and Work Opportunity Tax Act of 2007 (P.L. 110-28)).

For returns prepared on or before May 25, 2007, the preparers' penalties apply only to an "income tax return preparer" who prepares, for compensation, any income tax return or any claim for refund (under subtitle A - Income Taxes) (Code Sec. 7701(a)(36), prior to amendment by P.L. 110-28). For example, the following qualify as income tax return preparers:

(1) A person who does not physically prepare an income tax return is considered a preparer if that person furnishes to a taxpayer or other preparer sufficient information and advice so that completion of the return or claim for refund is largely a mechanical matter (Reg. §301.7701-15(a)(1)).

(2) A preparer of a partnership or an S corporation return is an income tax return preparer with respect to a partner's or S corporation shareholder's return only if the entry or entries on the return reportable on the individual's return constitute a substantial portion of the partner's or shareholder's return (Reg. §301.7701-15(b)(3)). For example, an attorney who provides a partnership with advice regarding the preparation of Schedules K-1 may be considered the preparer of all the partners' personal tax returns (see R.S. Goulding, CA-7, 92-1 USTC ¶50,174, at ¶39,960.70).

(3) A firm that offers computerized tax preparation services to practitioners is an income tax return preparer if the program makes substantive tax determinations (Rev. Rul. 85-187, at ¶39,970.75).

(4) A person who prepares a computer program and sells it to taxpayers to use in preparing their returns is an income tax return preparer if the program provides substantive tax instructions (Rev. Rul. 85-189, at ¶39,970.75).

(5) A general partner who prepares a partnership return can be an income tax return preparer with respect to a limited partner's return in certain circumstances (Rev. Rul. 81-270, at ¶39,960.55).

(6) A preparer (first preparer) can be a preparer with respect to a return prepared by another preparer (second preparer) if the second preparer relied on information contained in a return prepared by the first preparer (this occurs, for example, when the first preparer negligently overstates the expenses on a prior year's return, thus creating a net operating loss (NOL) and the second preparer, in good faith, applies the NOL carryover in preparing the subsequent year's return) (Rev. Rul. 81-171, at ¶39,960.75).

The following are excepted from the definition of a tax return preparer:

(1) a person who furnishes typing, reproducing or other mechanical assistance;

(2) one who prepares a return or refund claim for the employer by whom he or she is regularly and continuously employed;

(3) a person who prepares as a fiduciary a return or refund claim for any person; and

(4) one who prepares a refund claim for a taxpayer in response to any notice of deficiency issued to that taxpayer or in response to any waiver of restriction after the commencement of an audit of that taxpayer or another taxpayer if a determination in such audit of the other taxpayer directly or indirectly affects the tax liability of such taxpayer (Code Sec. 7701(a)(36)(B), as amended by P.L. 110-28 and Reg. §301.7701-15(d)).

Low income taxpayer clinics (LITC). Qualified LITCs, and employees and volunteers of such LITCs, that provide assistance with a tax return or claim for refund will not be treated as income tax return preparers if the following two requirements are satisfied: First, any such return preparation assistance must be directly related to a controversy with the IRS for which the LITC is providing assistance, or an ancillary part of an LITC's English as a second language (ESL) outreach program. Second, the LITC cannot charge a separate fee or vary a fee based on whether the LITC provides assistance with a tax return or claim for refund, or charges more than a nominal fee for its services (Reg. §301.7701-15(a)(7)).

Signing and nonsigning return preparers. For purposes of Code Sec. 6694, no more than one individual associated with a firm (e.g., a partner or employee) may be treated as a return preparer with respect to the same return or claim for refund (Reg. §1.6694-1(b)(1)). A signing return preparer, who is associated with a firm, is solely liable any penalties imposed for failure to comply with applicable reporting and recordkeeping requirements, regardless of whether he or she relied on the advice of a nonsigning return preparer in completing the return.

§1.6694-2(d)). If two or more individuals associated with a firm are nonsigning preparers of a return or claim for refund, and there are no signing preparers, only one of the individuals is a preparer for purposes of the understatement penalty. Generally, the individual with overall supervisory responsibility with respect to the return or refund claim is treated as the preparer for penalty purposes (Reg. §1.6694-1(b)(1)).

Example:

Attorney A provides advice to Client C on the proper treatment of a significant item on C's tax return. The advice constitutes preparation of a substantial portion of the return. Before he provided the advice, A discussed the matter with Attorney Y, who is associated with the same firm as A, but A is the attorney with direct supervisory responsibility for the matter.

A is the preparer of C's return and is subject to the Code Sec. 6694 penalty with respect to C's return. Y, on the other hand, is not a preparer of C's return and, therefore, is not subject to the Code Sec. 6694 penalty with respect to a position taken on C's return. Y is not liable for the penalty even if Y recommends that C take a position that has no realistic possibility of being sustained. Finally, A may not avoid the penalty by claiming that he relied on Y's advice (Reg. §1.6694-1(b)(3)).

Firm liability. For purposes of the former unrealistic position penalty of Code Sec. 6694(a) prior to amendment by the Small Business Tax Act of 2007 (P.L. 110-28), and the willful or reckless conduct penalty of Code Sec. 6694(b), an employer or partnership of a return preparer subject to the penalty is also subject to penalty as a firm only if:

(1) one or more members of the principal management of the firm or branch office participated in or knew of the proscribed conduct;

(2) the employer or partnership failed to provide reasonable and appropriate review procedures; or

(3) such review procedures were disregarded (Reg. §1.6694-2(a)(2) and Reg. §1.6694-3(a)(2)).

The term "firm" includes a sole proprietorship. It is unclear how these regulations will be applied under the new" unreasonable position" standard in Code Sec. 6694(a).

Two letter rulings (IRS Letter Ruling 8034159 and IRS Letter Ruling 8035069, CCH IRS LETTER RULINGS REPORTS) indicate that certain organizations and some of their employees may be considered return preparers even though they do not intentionally hold themselves out as such. Organizations that should beware of unintentional classification are those that utilize computer systems to process financial information to prepare financial reports. For example, a farmers' cooperative was classified as an income tax return preparer because it prepared Schedules F for its members from the financial information it gathered in connection with its lending activities. Further, an employee of the co-op was also a return preparer because of the informal tax-planning advice he rendered to members (Rev. Rul. 85-188, at ¶39,960.70).

Interim guidance on tax preparer definition. Until further guidance is issued, the definition of "tax return preparer" will conform to amendments made by the Small Business and Work Opportunity Tax Act of 2007 (P.L. 110-28). Thus, for purposes of Proposed Regs. §§16694-1 and 1.6694-3 the word "income" will not modify the phrase "tax return preparer," and the returns to which the penalty may apply will include returns of tax and claims for refund under subtitles A through E of the Code. In addition, the term "substantial portion" under Reg. §301.7701-15(b)(1), which is used in determining whether a person will be considered a tax return preparer, will mean a schedule, entry or other portion of a tax return or claim for refund that, if adjusted or disallowed, could result in a deficiency determination or disallowed refund claim that the preparer knows or reasonably should know is a significant portion of the tax liability (or tax originally reported, or previously adjusted, in the case of a refund claim) (Notice 2008-13, I.R.B. 2008-3, December 31, 2007 at ¶46,229).

Reliance on information furnished by the taxpayer

Generally, for purposes of the penalties imposed under Code Sec. 6694(a) and Code Sec. 6694(b), a tax preparer may rely on the information provided by the taxpayer and a preparer need not audit, examine or review books and records, business operations or documents in order to verify the taxpayer's information. However, a preparer may not ignore the implications of the information provided or actually known. The preparer is required to make reasonable inquiries if furnished information seems incomplete or incorrect. The preparer is also required to make relevant inquiries where certain prerequisites are imposed before a certain treatment is claimed (e.g., whether specific documents are retained before a deduction is claimed) (Reg. §1.6694-1(e)).

Abatement of penalty

The penalties imposed under Code Sec. 6694(a) or (b) apply only in cases where there is an understatement of a taxpayer's tax liability (Code Sec. 6694(a)(1), as amended by the Small Business Tax Act of 2007 (P.L. 110-28)). However, penalties will not apply if there is a reasonable cause for the understatement and the tax return preparer acted in good faith (Code Sec. 6694(a)(1), as amended by P.L. 110-28). Such an understatement occurs only if the net amount payable with respect to any income tax is understated or if the net amount that is refundable or creditable against taxes is overstated. These penalties can be imposed against a preparer regardless of what administrative or judicial actions the IRS has taken against the taxpayer involved if it is shown that an understatement does exist (Code Sec. 6694(e)).

In determining whether an understatement exists, the net amount payable in a tax year with respect to the return for which the preparer engaged in the prohibited conduct is not reduced by any carryback. Tax imposed does not include additions to tax under Code Sec. 6654 and Code Sec. 6655, relating to underpayments of estimated tax. Further, no final administrative or judicial determination with respect to any taxpayer is required as a prerequisite to imposition of the preparer penalties (Reg. §1.6694-1(c)).

However, penalties assessed against a preparer can be abated later if it is established at any time during a final administrative determination or a final judicial decision that there was, in fact, no understatement of liability underlying the penalty. Any amount of preparer penalty paid must be refunded to the penalized party as if the payment were an overpayment of tax and without any consideration to any period of limitations (Code Sec. 6694(d) and Reg. §1.6694-1(d)).

Understatements Due to Unreasonable Positions: Synopsis - penalty for understatements due to unreasonable positions

The scope of return preparer penalties was expanded to apply to all tax return preparers for returns prepared after May 25, 2007 (Code Sec. 6694, as amended by the Small Business Tax Act of 2007 (P.L. 110-28)). Penalty for understatement of taxpayer's liability due to unreasonable positions is increased to $1,000 per return or 50 percent of income derived from the return, whichever is greater (Code Sec. 6694(a)(1), as amended by P.L. 110-28). See ¶39,957A.022 for discussion of "unreasonable position."

Transitional Relief. For income tax returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing), the standards set forth under the previous law and current regulations under Code Sec. 6694 will be applied in determining whether the IRS will impose a penalty under Code Sec. 6694(a). Generally, in applying transitional relief for income tax returns, amended returns or refund claims, disclosure would be 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 Reg. §1.6694-2(c)(3) and Reg. §1.6662-4(f)(2). For all other returns, amended returns, and claims for refund, including estate, gift, and generation-skipping transfer tax returns due on or before December 31, 2007 (determined with regard to any extension of time for filing), 2007 employment and excise tax returns due on or before January 31, 2008, and 2007 estimated tax returns due on or before January 15, 2008, the reasonable basis standard set forth in the regulations issued under Code Sec. 6662, without regard to the disclosure requirements contained therein, will be applied in determining whether a penalty under Code Sec. 6694(a) will be imposed (Notice 2007-54, I.R.B. 2007-27, June 11, 2007).

The IRS has clarified that the transitional relief described in Notice 2007-54 applies to timely amended returns or claims for refund (other than 2007 employment and excise tax returns) filed on or before December 31, 2007, and to timely amended employment and excise tax returns or claims for refund filed on or before January 31, 2008. Such transitional relief also applies to original returns (other than 2007 employment and excise tax returns) filed on or before December 31, 2007 which were due on extension after that date, and to original employment and excise returns filed on or before January 31, 2008 (Notice 2008-11, I.R.B. 2008-3, December 31, 2007 at ¶46,227).

Until further guidance is issued, the returns and claims for refund to which Code Sec. 6694 can apply have been identified on an exhibit to Notice 2008-13, I.R.B. 2008-3, December 31, 2007. Also identified are which information returns reporting information reported on another tax return may subject a tax preparer to the Code Sec. 6694 penalty if the information reported constitutes a substantial proportion of the other tax return. Other documents that include information which constitute a substantial portion of the taxpayer's return or claim for refund will be treated as a return to which the Code Sec. 6694(a) penalty can apply unless such documents are identified on an exhibit attached to the Notice. For documents falling in this last category, even though the Code Sec. 6694(a) penalty may not apply, a tax preparer remains subject to the Code Sec. 6694(b) willful or reckless conduct penalty if the information reported on the document constitutes a substantial portion of the tax return or claim for refund, and is prepared willfully in any manner to understate the tax liability on a tax return or claim for refund, or in reckless or intentional disregard of the rules or regulations.

A return or claim for refund is deemed prepared on the date of the tax return preparer's signature; if the signing preparer fails to sign the tax return, the tax return is deemed prepared on the date it is filed. In the case of a nonsigning preparer, the relevant date is the date such person provides the advice, as determined based on all the facts and circumstances. These interim rules will apply instead of Reg. §1.6694-2(b)(5) (Notice 2008-13, I.R.B. 2008-3, December 31, 2007).

For returns prepared on or before May 25, 2007, a return preparer may be liable for a penalty in the amount of $250 if:

(1) any part of an understatement of liability with respect to a return or claim for refund is due to a position that did not have a realistic possibility of being sustained on its merits;

(2) the return preparer with respect to that return or refund claim knew or reasonably should have known of the unrealistic position; and

(3) such position was not adequately disclosed in order to avoid the accuracy-related penalty for understatement of income tax (Code Sec. 6662(d)) or was frivolous (Code Sec. 6694(a), prior to amendment by P.L. 110-28).

The penalty will not be imposed, however, where there is reasonable cause for the understatement and the preparer acted in good faith (Code Sec. 6694(a)(3), as amended by P.L. 110-28). The return preparer has the burden of proving that a position taken on a return or in a claim for refund has a reasonable probability of being sustained on its merits, there was reasonable cause for the position and that such position was maintained in good faith, or that the position was adequately disclosed (Reg. §1.6694-2(e)).

Imposition of the penalty under Code Sec. 6694(a) is not intended to automatically initiate a referral to the IRS Director of Practice for an investigation of the return preparer. Instead, the IRS must exercise discretion in selecting the specific cases that are referred for further examination as described in ¶39,956A.01 (House Committee Report on the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239), at ¶39,955.19).

Realistic possibility of position being sustained on the merits

A position is considered to satisfy the realistic possibility standard if a reasonable and well-informed analysis by a person knowledgeable in tax law would lead that person to conclude that the position has approximately a one-in-three, or greater, likelihood of being sustained on its merits (Reg. 1.6694-2(b)(1)). This numerical benchmark, which applies to returns prepared on or before May 25, 2007, is intended to help prevent erosion of the standard.

In determining whether a position has a realistic possibility of being sustained, the authorities considered are the same as those analyzed for purposes of the substantial authority determination made for purposes of the accuracy-related penalty (Reg. §1.6694-2(b)(2)). Thus, a preparer may not rely on conclusions reached in treatises, legal periodicals, legal opinions, or opinions rendered by other tax professionals. Further, the possibility that a position will not be challenged by the IRS may not be taken into account (Reg. §1.6694-2(b)(2)).

Example (1):

A taxpayer has engaged in a transaction that is adversely affected by a new statutory provision. Prior law supported a position favorable to the taxpayer. The preparer believes that the new statute is inequitable as applied to the taxpayer's situation. The statutory language is unambiguous as it applies to the transaction (e.g., it applies to all manufacturers and the taxpayer is a manufacturer of widgets). The committee reports do not specifically address the taxpayer's situation. A position contrary to the statute does not satisfy the realistic possibility standard.

Example (2):

Assume the same facts as in Example (1), except the committee reports indicate that Congress did not intend to apply the new provision to the taxpayer's transaction (e.g., widget manufacturers). Thus, there is a conflict between the general language of the statute, which adversely affects the transaction, and the specific statement in the committee reports that transactions such as the taxpayer's are not adversely affected. A position consistent with either the statute or the committee reports satisfies the realistic possibility standard. However, a position consistent with the committee reports constitutes disregard of a rule or regulation and, therefore, must be adequately disclosed in order to avoid the willful or reckless conduct penalty of Code Sec. 6694(b) (and possibly a penalty imposed under the negligence component of the accuracy-related penalty).

Example (3):

In the course of researching whether a position has a realistic possibility of being sustained on the merits, a preparer discovers that identical language appearing in another place in the Code has consistently been interpreted in a manner that would be favorable to the taxpayer if the interpretation were applied to the phrase applicable to the taxpayer's situation. No authority has interpreted the phrase applicable to the taxpayer's situation. The interpretations of identical language are relevant in arriving at a well reasoned construction of the language at issue, but the context in which the language arises also must be taken into account in determining whether the realistic possibility standard is satisfied (Reg. §1.6694-2(b)(3)).

Exceptions precluding imposition of understatement penalty due to unrealistic position. There are two exceptions to the realistic possibility standard. If the requirements of either the adequate disclosure or the reasonable cause and good faith exception are met, then no penalty is imposed under Code Sec. 6694(a) even if the position taken on the return or refund claim does not satisfy the realistic possibility standard (see ¶39,957A.023 and ¶39,957A.03). The preparer bears the burden of proof with respect to these issues (Reg. §1.6694-2(e)).

Reasonable belief that position would more likely than not be sustained on the merits

For returns prepared after May 25, 2007, the understatement of taxpayer's liability must be due to unreasonable position for the Code Sec. 6694 penalty to apply. A position is unreasonable if:

(1) the tax return preparer knew, or reasonably should have known, of the position;

(2) there was no reasonable belief that the position would more likely than not be sustained on its merits; and

(3) the position was not disclosed or there was no reasonable basis for the position (Code Sec. 6694(a)(2), as amended by the Small Business Tax Act of 2007 (P.L. 110-28)).

The standards of conduct that must be met to avoid imposition of the penalties for preparing a return with respect to which there is an understatement of tax was altered. First, the realistic possibility standard for undisclosed positions was replaced with a requirement that there be a reasonable belief that the tax treatment of the position was more likely than not the proper treatment. Moreover, the provision replaces the not-frivolous standard accompanied by disclosure with the requirement that there be a reasonable basis for the tax treatment of the position accompanied by disclosure (Joint Committee on Taxation, Technical Explanation of the Small Business and Work Opportunity Tax Act of 2007 (JCX-29-07) at ¶39,955.185).

Transitional Relief. For income tax returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing), the standards set forth under the previous law and current regulations under Code Sec. 6694 will be applied in determining whether the IRS will impose a penalty under Code Sec. 6694(a). Generally, in applying transitional relief for income tax returns, amended returns or refund claims, disclosure would be 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 Reg. §1.6694-2(c)(3) and Reg. §1.6662-4(f)(2). For all other returns, amended returns, and claims for refund, including estate, gift, and generation-skipping transfer tax returns due on or before December 31, 2007 (determined with regard to any extension of time for filing), 2007 employment and excise tax returns due on or before January 31, 2008, and 2007 estimated tax returns due on or before January 15, 2008, the reasonable basis standard set forth in the regulations issued under Code Sec. 6662, without regard to the disclosure requirements contained therein, will be applied in determining whether a penalty under Code Sec. 6694(a) will be imposed (Notice 2007-54, I.R.B. 2007-27, June 11, 2007).

Until further guidance is issued, a tax return preparer is considered to have a reasonable belief that the tax treatment of an item is more likely than not the proper tax treatment (without considering that the return might not be audited, that if audited the issue would not be raised, or that the issue might be settled) if such preparer analyzes the pertinent facts and authorities in the manner described in Reg. §1.6662-4(d)(3)(ii) and, based upon such analysis, reasonably concludes in good faith that there is a greater than fifty percent likelihood that the tax treatment of the item would be upheld if challenged by the IRS. This standard will apply instead of Reg. §1.6694-2(b) (Notice 2008-13, I.R.B. 2008-3, December 31, 2007, at ¶46,229). In determining the reasonableness of the tax return preparer's belief that the position satisfies the more likely than not standard, the tax return preparer may rely in good faith and without verification upon information furnished by the taxpayer as well as by another advisor, tax return preparer or other third party, and is not required to independently verify the items reported on tax returns, schedules, or other third party documents to determine if the items meet the reasonable belief standard, but such preparer may not ignore the implications of information received or actually known.

Example:

During an interview conducted by Farley, a tax return preparer, the taxpayer provided a schedule prepared by Smith, another advisor in Farley's firm, for use in preparing the taxpayer's tax return. The schedule did not appear to be incorrect or incomplete, and based on the information Farley completed the tax return. Later the IRS determines there is an understatement of liability for tax resulting from incorrect information on the schedule. Farley was not required to audit or review the schedule to verify independently that it satisfied the standard requiring a reasonable belief that the position would more likely than not be sustained on the merits. Farley should not, therefore, be subject to the penalty under Code Sec. 6694(a).

Adequate disclosure exception

Penalties for understatement due to unreasonable positions will not be imposed even there is no reasonable belief that the position would more likely than not be sustained on its merits if the position is adequately disclosed and there is a reasonable basis for the tax treatment of such item (Code Sec. 6694(a)(2), as amended by Small Business Tax Act of 2007 (P.L. 110-28)). For returns prepared on or before May 25, 2007, penalties will not be imposed even though a position does not have a realistic possibility of being sustained, provided that the position is not frivolous and is adequately disclosed (Reg. §1.6694-2(c)(1)). A frivolous position is one that is patently improper (Reg. §1.6694-2(c)(2)).

Generally, disclosure is adequate if made on Form 8275 (Disclosure Statement) or Form 8275-R (Regulation Disclosure Statement), attached to the return, amended return or refund claim. For certain items, proper representation on the return is sufficient disclosure for purposes of Code Sec. 6694(a) (Rev. Proc. 2001-11, at ¶39,960.20).

Transitional Relief. For income tax returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing), the standards set forth under the previous law and current regulations under Code Sec. 6694 will be applied in determining whether the IRS will impose a penalty under Code Sec. 6694(a). Generally, in applying transitional relief for income tax returns, amended returns or refund claims, disclosure would be 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 Reg. §1.6694-2(c)(3) and Reg. §1.6662-4(f)(2). For all other returns, amended returns, and claims for refund, including estate, gift, and generation-skipping transfer tax returns due on or before December 31, 2007 (determined with regard to any extension of time for filing), 2007 employment and excise tax returns due on or before January 31, 2008, and 2007 estimated tax returns due on or before January 15, 2008, the reasonable basis standard set forth in the regulations issued under Code Sec. 6662, without regard to the disclosure requirements contained therein, will be applied in determining whether a penalty under Code Sec. 6694(a) will be imposed (Notice 2007-54, I.R.B. 2007-27, June 11, 2007).

Under interim guidance for all tax returns, amended tax returns, and claims for refund (other than 2007 employment and excise tax returns) filed on or after January 1, 2008 with respect to advice provided on or after that date, and for employment and excise tax returns filed on or after February 1, 2008 with respect to advice provided on or after that date, reasonable basis will be interpreted in accordance with Reg. §1.6694-3(b)(3). In determining whether the tax return preparer has a reasonable basis for a position, the tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, another tax preparer, or other third party, but may not ignore the implications of information furnished to, or actually known to, the tax return preparer. The tax return preparer must also make reasonable inquiries if the information furnished by another tax return preparer or a third party appears to be incorrect or incomplete (Notice 2008-13, I.R.B. 2008-3, December 31, 2007, at ¶46,229).

Example (1):

Hannah, a tax preparer, interviews her client, Paul, .in the process of preparing Paul's 2008 income tax return. Paul stated that he made a $75,000 charitable contribution of real estate in 2007, but such statement is false. Hannah did not inquire about whether Paul had a qualified appraisal for the contribution or otherwise satisfy the reporting and substantiation requirements for the donation. Hannah reports a charitable contribution deduction on Paul's 2008 tax return, resulting in an understatement of liability for tax. Hannah is subject to a penalty under Code Sec. 6694.

Signing and nonsigning return preparers. Different disclosure rules are prescribed for signing and nonsigning preparers (see ¶39,956A.02). For a signing preparer, disclosure is adequate if it complies with the adequate disclosure standards of the substantial understatement penalty (Reg. §1.6694-2(c)(3)(i)). These standards permit disclosure on Form 8275 (Disclosure Statement), on Form 8275-R (Regulation Disclosure Statement), or by proper representation on a return in accordance with Rev. Proc. 2001-11, at ¶39,960.20 (Reg. §1.6662-4(f)).

A nonsigning preparer adequately discloses advice to a taxpayer concerning a position not meeting the realistic possibility standard if the advice includes a statement that the position lacks substantial authority and, therefore, may subject the taxpayer to the substantial understatement penalty unless adequate disclosure is made. For a tax shelter item, the statement must note that the taxpayer may be subject to the substantial understatement penalty regardless of whether adequate disclosure is made. If the advice is in writing, the statement must also be in writing. If the advice is oral, the statement may be oral. The determination as to whether an oral statement was given is based on all the facts and circumstances. Contemporaneously prepared documentation of the oral statement usually is sufficient to establish that the statement was made to the taxpayer (Reg. §1.6694-2(c)(3)(ii)(A)).

Transitional relief for signing and nonsigning return preparers. Interim guidance has been provided to signing and nonsigning tax return preparers with respect to a position for which there is a reasonable basis, but for which the tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits (Notice 2008-13, I.R.B. 2008-3, December 31, 2007 at ¶46,997). The Code Sec. 6694(a) penalty will not be imposed if there is disclosure in accordance with Reg. §1.6662-4(f) (which permits disclosure on a properly completed and filed Form 8275 or Form 8275-R, or on the return in accordance with the annual revenue procedure described in Reg. §1.6662-4(f)(2)). If the taxpayer does not have substantial authority for the position, and therefore would be required to make disclosure in order to avoid the accuracy related penalty under Code Sec. 6662(d)(2)(B), the tax return preparer will also not incur the Code Sec. 6694 penalty by providing the taxpayer with the prepared return which includes the disclosure in accordance with Reg. §1.6662-4(f). If the taxpayer does not file the return with such disclosure, the tax return preparer can avoid the Code Sec. 6694 penalty by establishing that the return as provided to the taxpayer included the required disclosure.

The interim guidance also addresses the situation in which the taxpayer is not required to make disclosure because the taxpayer has substantial authority for the position, but the signing tax return preparer cannot avoid the Code Sec. 6694 penalty because the tax return preparer cannot satisfy the more likely than not standard. This creates a potential conflict between the taxpayer and the tax return preparer, the former perhaps wanting to avoid disclosure because the substantial authority threshold is met, and the signing tax return preparer needing the taxpayer to make such disclosure in order for the tax return preparer to be protected against the Code Sec. 6694 penalty. While this potential conflict might be addressed in the tax return preparer's engagement letter with the taxpayer, the interim guidance offers an alternative approach. The tax return preparer can advise the taxpayer of the difference between the penalty standards applicable to the taxpayer under Code Sec. 6662 and the penalty standards applicable to the tax return preparer under Code Sec. 6694, and contemporaneously document that such advice was given in the tax return preparer's files.

Similarly, if the taxpayer is involved in a tax shelter as described in Code Sec. 6662(d)(2)(C), and therefore disclosure will not protect the taxpayer from the Code Sec. 6662 penalty even if there is a reasonable basis for the position, the signing tax return preparer can avoid the penalty by advising the taxpayer of the penalty standards applicable to the taxpayer under Code Sec. 6662(d)(2)(C) and the difference, if any, between such standards and the standards under Code Sec. 6694, and by contemporaneously documenting in the tax return preparer's files that this advice was provided (Notice 2008-13, I.R.B. 2008-3, December 31, 2007 at ¶46,229).

Example (2):

Kerry, an accountant, is hired by Meca, Inc. to prepare its 2008 corporate income tax return. Kerry does not reasonably believe that a position on the return would more likely than not be sustained on the merits, although there is substantial authority for the position. Kerry prepares and signs a 2008 tax return for Meca which does not disclose the position, but advises Meca about the difference between the penalty standards applicable to Meca under Code Sec. 6662, and the penalty standards applicable to Kerry under Code Sec. 6694. Kerry also contemporaneously documents in his file for Meca that this advice was provided. Meca signs and files its 2008 tax return without disclosing the position. The IRS later audits the Meca return and determines that there is an understatement of liability reported on the tax return. Kerry should not be subject to the penalty under Code Sec. 6694.

For a nonsigning tax preparer, if the position on the return would satisfy the reasonable basis standard, but neither the substantial authority or more likely than not standard, the taxpayer can avoid the Code Sec. 6662 penalty, and the tax return preparer can avoid the Code Sec. 6694 penalty, by making disclosure on the return. However, if the taxpayer does not include the disclosure statement with the return, the nonsigning tax return preparer will still avoid the penalty if the advice to the taxpayer includes a statement informing the taxpayer of the opportunity to avoid the Code Sec. 6662 penalty by making disclosure, and explaining the requirements for such disclosure. The statement must be made in the same manner, oral or written, as the advice given to the taxpayer. Contemporaneously documenting the advice in the nonsigning tax return preparer's files is sufficient to document that the statement was given to the taxpayer (Notice 2008-13, I.R.B. 2008-3, December 31, 2007 at ¶46,229).

Example (3):

Attorney Laura advises Bigco, Inc. in writing about the proper treatment of certain complex entries on Bigco's 2008 corporate tax return. Laura knows that if such treatment is disallowed the resulting tax liability would be a significant portion of Bigco's 2008 tax return liability. At the time the advice is rendered, Laura concludes that one position with respect to the entries satisfies the reasonable basis standard, but neither the substantial authority nor the more likely than not standards. Laura advises Bigco in writing that the position lacks substantial authority, and may subject Bigco to the Code Sec. 6662 penalty unless disclosed on its return. Laura contemporaneously documents in her files that she gave such written advice to Bigco. Bigco files its 2008 return without including the disclosure statement. Although Laura does not sign the return, she is still considered a tax return preparer because her advice constitutes preparation of a substantial part of Bigco's return. However, because she gave Bigco written advice about the accuracy-related penalty, and contemporaneously documented giving such written advice to Bigco, Laura will not be subject to the Code Sec. 6694 preparer penalty.

Advice to another preparer. A nonsigning preparer who provides advice to another preparer can adequately disclose a position that does not have a realistic possibility of being sustained by including a statement in the advice that disclosure under Code Sec. 6694(a) is required. The statement must be made in the same manner, oral or written, as the advice given to the other preparer (Reg. §1.6694-2(c)(3)(ii)(B)).

Transitional relief for advice to another preparer. If the reasonable basis standard, but not the more likely than not standard, is satisfied with respect to an item for which a nonsigning tax return preparer provides advice to another tax return preparer, the nonsigning tax return preparer will be deemed to meet the requirements of Code Sec. 6694 by including a statement in the advice to the tax return preparer that disclosure under Code Sec. 6694(a) may be required. The statement must be made in the same manner, oral or written, as the advice given to the other preparer. Contemporaneously documenting the advice in the nonsigning tax return preparer's files is sufficient to document that the statement was given to the other tax return preparer. (Notice 2008-13, I.R.B. 2008-3, December 31, 2007). This interim guidance rule will apply instead of Reg. §1.6694-2(c)(3)(ii) until further guidance is issued.

Reasonable cause and good faith exception

If the preparer shows that an understatement was due to reasonable cause and the tax return preparer acted in good faith, no penalty shall be imposed (Code Sec. 6694(a)(3), as amended by the Small Business Tax Act of 2007 (P.L. 110-28)). This is a "facts and circumstances" determination made with reference to the nature of the error, the frequency and materiality of the errors, the preparer's normal office practice, and reliance on another preparer's advice (Reg. §1.6694-2(d))

Transitional Relief. Until further guidance issued, for all tax returns, amended tax returns, and claims for refund (other than 2007 employment and excise tax returns) filed on or after January 1, 2008 with respect to advice provided on or after that date, and for all 2007 employment or excise tax returns filed on or after February 1, 2008 with respect to advice provided on or after that date, the factor regarding reliance on advice found in Reg. §1.6694-2(d)(5) is replaced by a different rule. A tax return preparer will be found to have acted in good faith when he or she relied on the oral or written advice of a third party who is not in the same firm, and who the former had reason to believe was competent to render the advice. The burden of establishing that the advice was received is on the tax return preparer, and the penalty cannot be avoided if the advice is unreasonable on its face, if the tax return preparer knew or should have known that the third party advisor was not aware of all relevant facts, or if, because of developments in the law, the tax return preparer knew or should have known at the time the tax return or claim for refund was prepared that the advice was no longer reliable. (Notice 2008-13, I.R.B. 2008-3, December 31, 2007 at ¶46,229).

Example (1):

In preparing a 2008 tax return, George, an accountant, relies on the advice of an actuary not in George's accounting firm concerning the limit on deductibility of a contribution by an employer to a qualified pension trust. There is a later determination of an understatement of liability for tax because the actuary's advice is incorrect. George had no reason to believe that the advice was incorrect or incomplete at the time he prepared the return, or that the actuary did not know all the relevant facts, and the advice appeared reasonable. George was also not aware of any development in the law since the time the advice was given which would have rendered it unreliable. George is not subject to a penalty under Code Sec. 6694.

Synopsis - penalty for understatement due to willful, reckless, or intentional conduct

For returns prepared after May 25, 2007 , a penalty of $5,000 or 50 percent of income derived from the return, whichever is greater, ($1,000 for returns prepared on or before May 25, 2007) may be imposed on a return preparer who:

(1) willfully attempts to understate the tax liability of another person on a return or in a claim for a refund, or

(2) recklessly or intentionally disregards rules and regulations (Code Sec. 6694(b)(1) and (2), as amended by Small Business Tax Act of 2007 (P.L. 110-28)).

To avoid the stacking of penalties, a penalty imposed for an understatement resulting from the willful or reckless conduct of a return preparer is reduced by the amount of the penalty paid for any understatement due to an unreasonable position (Code Sec. 6694(b)(3), as amended by P.L. 110-28; see also ¶39,957A.01).

The IRS bears the burden of proving that a return preparer willfully attempted to understate the tax liability. However, the return preparer bears the burden of proving that no rule or regulation was recklessly or intentionally disregarded, that any position contrary to a regulation represented a good faith challenge to the validity of the regulation, and that disclosure was adequately made (Reg. §1.6694-3(h)).

"Rules and regulations" are defined to include the provisions of the Internal Revenue Code, temporary or final Treasury regulations issued under the Code, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the IRS and published in the Internal Revenue Bulletin (Reg. §1.6694-3(f)).

Willful or Reckless Conduct: Willful understatement

A willful attempt to understate the liability of a taxpayer occurs if the preparer disregards, in an attempt to wrongfully reduce the tax liability of the taxpayer, information furnished by the taxpayer or others (Reg §1.6694-3(b)).

Example (1):

John indicates to his return preparer that he has three dependents. Preparer X reports six on John's final return. Preparer X has willfully attempted to understate John's tax liability.

Willful or Reckless Conduct: Reckless or intentional disregard

A preparer is considered to have recklessly or intentionally disregarded a rule or regulation if a position contrary to a rule or regulation is taken on a return or claim for refund and if the preparer knows of, or is reckless in not knowing of, the rule or regulation in question. A preparer is reckless in not knowing a rule or regulation if the preparer makes little or no effort to determine whether the rule or regulation exists, under circumstances demonstrating a substantial deviation from a reasonable preparer's standard of conduct (Reg. §1.6694-3(c)(1)).

In the case of a position contrary to a revenue ruling or notice (other than a notice of proposed rulemaking), a preparer is not considered to have acted recklessly or intentionally disregarded the ruling or notice if the position taken has a realistic possibility of being sustained on the merits (Reg. §1.6694-3(c)(3); see also ¶39,957A.021).

Example (2):

A revenue ruling holds that certain expenses incurred in the purchase of a business must be capitalized. The Code is silent as to whether these expenses must be capitalized or may be deducted currently, but several cases from different courts hold that these particular expenses may be deducted currently. There is no other authority. Under these facts, a position taken contrary to the revenue ruling on a return or refund claim is not a reckless or intentional disregard of a rule, since the position contrary to the revenue ruling has a realistic possibility of being sustained on its merits. Thus, the preparer will not be subject to the Code Sec. 6694(b) penalty even though the position is not adequately disclosed (Reg. §1.6694-3(d)).

A preparer will not be considered to have recklessly or intentionally disregarded a rule or regulation if the position is not frivolous, is adequately disclosed and, in the case of a position contrary to a regulation, the position represents a good faith challenge to the validity of the regulation (Reg. §1.6694-3(c)(2); see also ¶39,957C.025).

Example (3):

Certain expenses incurred in the purchase of a business must be capitalized. One Tax Court opinion expressly invalidated that portion of the regulations. If a preparer takes this position that is contrary to the regulation this will be considered a good-faith challenge to the validity of the regulations and the preparer will not be subject to the Code Sec. 6694(b) penalty if the position is adequately disclosed.

Special rule for employers and partnerships. If a return preparer is subject to the Code Sec. 6694(b) penalty, his or her employer or partnership will also be subject to the penalty if:

(1) one or more members of the principal management (or principal officers) of the firm or a branch office participated in or knew of the proscribed conduct;

(2) the business failed to provide reasonable and appropriate procedures for review of the position subject to the penalty; or

(3) such review procedures were disregarded in the formulation of the advice or the preparation of the return or refund claim that included the position subject to the penalty (Reg. §1.6694-3(a)(2)).

Adequate disclosure exception

A preparer will not be considered to have recklessly or intentionally disregarded a rule or regulation for purposes of the understatement penalty imposed pursuant to Code Sec. 6694(b) if the position taken is not frivolous and is adequately disclosed and, in the case of a position contrary to a regulation, such position must be a good faith challenge to the validity of the regulation (Reg. §1.6694-3(c)(2)).

The disclosure requirements that apply for purposes of the penalty imposed for the willful or reckless understatement of tax liability, vary slightly from the disclosure requirements that apply with respect to an understatement attributable to an unrealistic position that are described in ¶39,957A.023. Like the requirements applicable to understatements attributable to an unreasonable position and the penalty imposed for such understatement under Code Sec. 6694(a), disclosure of a position that is contrary to a rule or regulation by a return preparer is adequate for purposes of the penalty imposed under Code Sec. 6694(b), only if made on Form 8275 (Disclosure Statement) or 8275-R (Regulation Disclosure Statement) as set forth in (Reg. §1.6662-4(f)). However, the provisions of Reg. §1.6662-4(f)(2), under which the proper representation of certain items on a return constitutes adequate disclosure, in accordance with Rev. Proc. 2001-11, at ¶39,960.20, do not apply (Reg. §1.6694-3(e)(1)).

Nonsigning preparers may disclose in the same manner as signing preparers. Their additional disclosure options depend on whether they rendered advice to a taxpayer or to another return preparer. If a nonsigning preparer provides advice directly to a taxpayer with respect to a position that is contrary to a rule or regulation, disclosure is adequate if the advice includes a statement that

(1) because the position is contrary to a rule or regulation, it is subject to the negligence penalty unless adequately disclosed, and

(2) in the case of a position contrary to a regulation, the position must represent a good faith challenge to the validity of the regulation (Reg. §1.6694-3(e)(2)).

If the nonsigning preparer's advice was rendered in writing, then the disclosure statement must also be in writing. If the advice was oral, then the disclosure statement may also be given orally. Contemporaneously prepared documentation of the oral disclosure statement is, generally, sufficient to establish that the advice was given to the taxpayer (Reg. §1.6694-3(e)(2)).

If a nonsigning preparer renders advice to another income tax return preparer, disclosure of that position is considered adequate if the advice includes a statement that Code Sec. 6694 disclosure is required. Written advice mandates a written statement and oral advice requires merely an oral statement (Reg. §1.6694-3(e)(2)(ii)).

Willful or Reckless Conduct: Related code sections

Return preparers should note that the IRS has imposed tight restrictions on corporate tax shelters. Tax shelter promoters must comply with strict registration requirements and promoters who fail to comply may also be subject to penalties under Code Sec. 6111 (see ¶37,002.068). Maintenance of investor lists are required under Code Sec. 6112 (see ¶37,022.01). Corporate tax shelters must comply with specific reporting requirements (see ¶35,141.05).

Assessment, Refund and Appeal: Synopsis - assessment, refund and appeal procedures

The penalties imposed against return preparers under Code Sec. 6694(a) and Code Sec. 6694(b) for understating tax liability on a return or in a claim for a refund are assessed independently of any tax deficiencies. As a result, the deficiency procedures for income, estate, gift and certain excise taxes do not apply to these penalties (Code Sec. 6696(b)).

Prior to assessing return preparer penalties under Code Sec. 6694(a) and Code Sec. 6694(b), however, the IRS will send an examination report and, generally, issue a 30-day letter to the return preparer notifying him or her of the proposed penalty and giving the opportunity to pursue administrative remedies prior to assessment of the penalty (Reg. §1.6694-4(a)(1)).

If the IRS makes an assessment of the penalties, a statement of notice and demand will be sent to the preparer. The penalty amount is payable upon assessment (Reg. §1.6694-4(a)(2)). The penalty for an understatement attributable to an unrealistic position must be assessed within three years after the return or claim for refund for which the penalty was assessed was filed. There is no statute of limitations on assessing a penalty for a willful understatement or reckless or intentional disregard of the rules or regulations (Code Sec. 6696(d)(2)).

There are two ways in which a return preparer can appeal assessment of a penalty to the courts. First, he or she can appeal the assessment by paying the entire penalty within 30 days after the notice and demand is made and filing a claim for refund within three years from the date of payment. If the refund is denied, the return preparer can appeal the denial of the refund claim to the appropriate court (Reg. §1.6694-4(a)(3)(i)). Alternatively, a return preparer can appeal a penalty assessment by paying at least 15 percent of the assessed penalty within 30 days after the date on which notice and demand were made and then filing a claim for refund (Reg. §1.6694-4(a)(3)(ii)). If the return preparer takes the 15 percent payment option, the IRS may not proceed to collect the remainder of the penalty until the later of a date that is:

(1) the day the refund claim is denied or six months after the day the preparer filed the claim for refund, or

(2) final resolution of a district court proceeding brought by the preparer (Reg. §1.6694-4(a)(4)).

If the IRS does not act on the refund claim within six months after the date on which the claim was filed, the return preparer may commence a suit in the appropriate district court within 30 days after the end of the six-month period. If the preparer does not initiate a refund action within the 30-day period, the IRS may collect the remaining 85 percent of the penalty. If the IRS denies the claim, the return preparer may bring suit within 30 days after denial of the refund (Reg. §1.6694-4(b)). The IRS may counterclaim for the balance of the penalty where the preparer brings suit after making partial payment of the penalty (Code Sec. 6694(c)(1)).

Whether or not the imposition of a penalty under Code Sec. 6694(a) or Code Sec. 6694(b) is appealed by the return preparer, any payment of either penalty will automatically be refunded if a final administrative or judicial action indicates there was no understatement of liability on the return or refund claim for which it was assessed.

The 10-year statute of limitations (Code Sec. 6502) on collection is suspended for the period during which the IRS is prohibited from collecting the unpaid amount of the penalty (Code Sec. 6694(c)(3) and Reg. §1.6694-4(c)).