National Association of Tax Professionals Comments on Revisions to Section 6694 Made by the Small Business and Work Opportunity Act of 2007

NATP

National Association of Tax Professionals

Comments on Revisions to Section 6694 Made by the Small Business and Work Opportunity Act of 2007

Tax Return Reporting Standards for Preparers

July 30, 2007

EXECUTIVE SUMMARY -

We understand and support the need and determination on the part of Congress and the Treasury to reduce the "tax gap." Our members are solidly behind reasonable efforts toward this goal. We urge caution, however, as well as support from the public in enacting provisions that impinge upon their rights and relationships in satisfying their compliance with tax law. There was not so much as a hearing on this vital matter nor was there any recommendation from Treasury to create this conflict.

The National Association of Tax Professionals (NATP) was surprised that, on May 25, a tax provision, found in section 8246 of the U.S. Troop Readiness, Veteran's Care, Katrina Recovery, and Iraq Accountability Appropriations Act of 2007 ("the Act"), was enacted without warning and without the characteristic protocol accorded the public to comment. The provision was made under Subtitle B of Title VIII of the Act and is popularly referred to as the "Small Business and Work Opportunity Act of 2007."

Section 6694 of the Internal Revenue Code was thereby amended to revise and raise the standards for tax preparers and those who provide advice, the result of which ends up on a return. The problem arises in that the standards were raised to a point higher or "tougher" than the standards for the taxpayer him or herself. Tax preparers, in order to be protected from a possible imposition of an understatement penalty, must now either hold and be able to demonstrate a reasonable belief that a position taken on a return would "more likely than not" be sustained on its merits, or otherwise insist on a disclosure of the position on the return. Taxpayers, on the other hand, may take a position on a return that has a "substantial authority" for being upheld. Previous to the enactment of this provision, tax return preparers were held to a standard (realistic possibility of success) that was lower than the standard for taxpayers. The Act further extends the penalties for understatement of tax liability to all tax returns including estate and gift tax returns, employment tax returns, and excise tax returns and significantly increases their amounts.

Given the rapid and constant rate at which federal tax law changes, taxpayers increasingly seek the aid of a competent preparer. It is now common to have issues awaiting guidance from Treasury as well as from the IRS in order for professionals, much less taxpayers, to understand the substantively correct position to be taken with regard to an item on a return. It is also now common for technology to challenge guidance previously issued by Treasury and the IRS. One has only to contemplate the continually developing issues affected by the domestic production activities deduction created in the American Jobs Creation Act of 2004 to understand this problem. Preparers and taxpayers are, in these cases, often in the realm of meteorologists in determining the chances of a position being substantively correct. Preparers, however, are subject to penalties for understatement of a tax liability if that reporting standard cannot be satisfied unless they insist on a disclosure of the item. Add to this the fact that the imposition and determination of the appropriateness of the increased penalties are all at the discretion of the IRS and the effect on advocating and representing the taxpayer is indeed chilling.

It appears as though the rights of taxpayers to tax advice and counsel are somewhat less that that of other potential litigants. Imagine standards such as these being imposed in the context of a civil or criminal proceeding. NATP requests a correction to the obvious problems caused by this provision of the Act.

NATP is an eclectic group of tax professionals. Our membership is comprised of attorneys, CPAs, EAs, CFPs, CSAs, BBAs, LLBs, JDs, MBAs, PhDs, as well as Associate degrees, those who have entered the profession as a second career and part-time professionals. Therefore, we have no bias for any one group of tax professionals over another. Our 18,000+ members are employed in offices that assist more than eleven million taxpayers. All of NATP's members are potentially negatively impacted by Section 8246 of the Act, as are all taxpayers. The change in standards resulting from this legislation causes, at a minimum, the following serious problems not only for tax return preparers, but also for taxpayers and the government:

l The change made by the Act raises the tax return reporting standard for preparers above the standard for taxpayers, thereby creating the potential for conflicts of interest between preparers and their clients. As a result, it affects the very nature of the representation of taxpayers and a taxpayer's right to representation. Taxpayers pay for and expect competent service that does not put them at a further disadvantage than the duty to which they are personally held in paying a fair and just tax.

l Applying the tougher "more likely than not" standard to a tax return preparer results in a fundamental change in the role of the preparer, from that of an advocate to that of an advisor or even an auditor.

l It is frequently extremely difficult, if not impossible, to determine the probable correctness of the treatment of some routine items with the degree of certainty required for the higher "more likely than not" standard because: (1) there sometimes is little guidance, if any, for the tax treatment of an item at the time the item must be reported on a return; and (2) the proper treatment of an item frequently depends on an analysis of unique or unusual facts and circumstances that were not contemplated in published guidance.

l A disclosure made under a system with a "more likely than not" standard could be viewed as a concession on the merits.

l The potential penalties on a preparer for failure to satisfy that high standard are so severe that preparers will feel compelled to protect themselves by urging their clients to include disclosures for virtually every item for which there is even the slightest uncertainty regarding the proper treatment. This problem is compounded by the fact that the preparer could be subject to disciplinary action by the IRS Office of Professional Responsibility. These excessive disclosures for routine tax return positions will overburden tax administration, thereby defeating the purpose of the disclosure system and also undermining the electronic filing initiative, which currently is not capable of processing a large number of disclosures in a return.

To avoid this disruption to our tax system and the resultant unfairness to the taxpayer and tax return preparer, NATP recommends that the section 6694 tax return preparer standards be either restored to their standard before the Act (realistic possibility of success) or, at most, raised to a point equal with the taxpayer standards (substantial authority). We would agree that for tax shelter ("tax avoidance") items the "more likely than not" standard should continue to apply. For non-tax shelter ("non-tax avoidance") items, however, the "substantial authority" standard should apply. The rationale for these recommendations is set forth in more detail below.

About NATP

Whereas we could claim here that the National Association of Tax Professionals (NATP) represents the hundreds of thousands of tax return preparers affected by this proposed bill, we believe in stating facts that are not misleading. NATP's 18,000 members are employed in offices that assist more than 11 million taxpayers. Our members include individual preparers (81% of which have undergraduate or graduate degrees), Enrolled Agents, Certified Public Accountants, accountants, attorneys, and Certified Financial Planners. NATP is a nonprofit professional association that is committed to the integrity of the tax administration system and the application of tax laws and regulations by providing education, research, and information to tax professionals. For almost 30 years, we have existed to serve professionals who work in all areas of tax practice. We provide our members with over 200 tax education offerings in over 100 cities throughout the United States, a service unmatched by any other national tax association. In addition, our 35 Chapters and National headquarters serve the public through regular news releases, client brochures and newsletters, and a designated taxpayer website. Our Chapters provide significant member involvement in local and state communities. Our headquarters are located in Appleton, Wisconsin. Our members are served by a staff of 42 employees, 14 of which are CPAs, attorneys, and EAs.

General Comments

The changes brought about by section 8246 of the Act to section 6694 of the Internal Revenue Code surprised tax professionals in every industry association and industry media publication as well as those in government administration. There is a time-honored protocol usually followed by Congress when pursuing legislation that will have a profound effect on the American public at large. There are usually hearings with attendant publicity and subsequent study over such momentous matters. Commentary is sought from respected authorities, academicians, independent policy institutes and the public. Additional debate quite often emanates from Congressional committees and subcommittees. These changes, however, were contained in an appropriations bill introduced on May 8 to help fund the war in Iraq among other things. It passed on May 25. Somehow, in all the fervor, Congress either side-stepped or forgot about this protocol.

We read, in the June 4 edition of Tax Notes Today, that the IRS Chief Counsel commented about the sudden and unexpected change to section 6694, indicating that the IRS had been "blind-sided" by this provision in the Act. It constitutes a major change in tax policy. Although the Treasury Department did ask for and increase in the dollar amount of the section 6694 penalty, it did not recommend a change in the preparer standards. No one, other than Congressional staff, had the chance to view and comment on this legislation. Little time, if any, was given to its study. . .which could easily lead one to conclude that the full consequences of this particular provision were not studied by Congress. Indeed, there is already a proposal to amend a portion of the Act for this very reason.

NATP joins with many others in the industry on behalf of American taxpayers to voice the need and urge Congress to correct the problems and inequities in Section 8246 of the Act. We have held discussions with the AICPA on these matters. We support the positions put forth in their July 10 paper on these issues. We also agree with the AICPA that this matter requires expeditious treatment for the tax profession, taxpayers and the tax administration system. It is in that spirit that the National Association of Tax Professionals hereby submits the detailed commentary below on the nature and consequences of this provision in the hope that it will be studied and that a correction to the problems therein set forth will be expedited. Whereas we have made some original comment, we believe there is no need or time to "reinvent the wheel" by otherwise restating the eloquent positions already set forth by the AICPA. The detailed commentary submitted is largely that of the AICPA, used with their permission.

SPECIFIC COMMENTS

Having Different Reporting Standards for Taxpayers and Preparers is Bad Policy

Section 6694 as revised by the Act, requires that a preparer must satisfy a higher standard ("more likely than not") than the standard the taxpayer must satisfy ("substantial authority") in order to avoid the imposition of an understatement penalty with respect to an undisclosed, non-tax avoidance item reported on the taxpayer's return. Thus, it is possible for a preparer to be subject to a penalty with respect to a position taken on a return he or she prepared, even though the taxpayer would not be subject to a penalty with respect to that same tax return position. That is just plain bad tax policy.

Having a higher standard for the preparer may result in a conflict of interest situation between the preparer and the taxpayer. If the higher preparer standard is not satisfied for a tax return position, the preparer can be protected from the imposition of the section 6694 penalty only if that position is disclosed on the taxpayer's return. Thus, in some situations, even though the taxpayer is not required to disclose a position on a return, the preparer might be forced to encourage the taxpayer to do so, to protect the preparer from a penalty. This is also, clearly, bad policy.

Section 10.29 of Circular 230 specifies generally that "a practitioner shall not represent a client ... before the Internal Revenue Service if the representation involves a conflict of interest." It then defines "conflict of interest" to include a situation where there is "a significant risk that the representation of one or more clients will be materially limited by ... a personal interest of the practitioner." The provision in the Act that raises the preparer standard above that of the taxpayer for penalty purposes creates the potential for conflict of interest situations that could put preparers in violation of Circular 230; thus, it is contrary to a fundamental policy underlying practice before the IRS.

Further, the preparer does not control the taxpayer's tax return and cannot force the taxpayer to disclose a position on a return. If the taxpayer does not agree to disclose the position, the preparer could be placed in a professionally difficult situation of not being able to sign the taxpayer's return, which would be particularly problematic in view of the section 6695 penalty for failure to sign returns that an individual prepares. The very nature of tax representation and a taxpayer's right to representation could be adversely affected if the preparer is required to withdraw from an engagement because the taxpayer will not include a disclosure in the taxpayer's return. It also puts the preparer in an economically disadvantaged position in trying to collect for services rendered.

In addition, a preparer's withdrawal from an engagement because of the taxpayer's refusal to disclose may result in the taxpayer seeking out a preparer who is less knowledgeable about the merits of the position or who feels less constrained by ethical standards and is, therefore, willing to prepare and sign returns that do not comply with the section 6694 reporting standards. Alternatively, the difference in standards between taxpayers and paid preparers may result in the taxpayer deciding to prepare returns in house, in which case the section 6694 standard would not apply.

Accordingly, for the sake of equity in the application of understatement penalties, the ethical operation of the tax compliance system, sound tax policy and the preservation of the nature of taxpayer representation and the taxpayer's right to representation, it is critical that the standards applicable to tax return preparers be, at most, equalized with the standards applicable to taxpayers.

The Recognized Right of the Public to Advocacy and Representation and the Right to Practice

Richard Morgante, Commissioner of the Wage and Investment Division of the IRS, spoke at NATP's National Conference in Las Vegas on July 24, 2007. He stated that ". . .the IRS expects the American public to pay only the amount of tax owed, no more. . .but no less." Sixty percent of taxpayers engage the services of a tax professional in order to accurately determine the amount of tax owed. They pay for the knowledge of the complexity of our tax laws so that their tax liability can be fairly determined. A tax return preparer has long been viewed as having dual roles - as an advocate for the taxpayer-client, and as an advisor with a duty not only to the taxpayer-client, but also to the public and the tax system. The advocacy role of the preparer previously had been recognized and accepted by the government, as evidenced by the "realistic possibility of success" reporting standard in section 6694 prior to the recent revision and in the current section 10.34 of Circular 230. The House Committee Report accompanying the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239) stated "[t]he committee has adopted this new standard because it generally reflects the professional conduct standards applicable to lawyers and to certified public accountants." The new, "more likely than not," reporting standard substantially and inequitably changes that, turning preparers into supplemental representatives of the IRS through a form of coercion. What's more, in those cases where a return must be filed before adequate guidance is given with respect to a difficult tax issue, the IRS and the Treasury Department have the luxury of playing "Monday morning quarterbacks" in determining the appropriate treatment of a particular tax item or circumstance.

This is a major change in tax policy that should not have been made without hearings and extensive consideration. For this reason, the change to the "more likely than not" reporting standard for non-tax avoidance items should be overridden. As noted above, NATP recommends that the preparer standards should be, at most, equalized with the "realistic possibility of success" standards that apply to taxpayers.

When a "Higher Standard" Ought to Apply to Tax Return Preparers

The United States income tax system has long been recognized as voluntary on the part of taxpayers. They are expected to report their transactions in accordance with the rules prescribed by the income tax laws. Congress has wisely built into the system the flexibility for taxpayers to reasonably interpret the many grey areas of the law without the threat of having penalties imposed. This flexibility is evidenced in the twotiered approach to the standards applicable to taxpayers; one approach for routine, non-tax avoidance items and one for potentially abusive tax avoidance items.

As part of that approach, Congress, Treasury, and the IRS have developed a disclosure regime to provide the IRS with early knowledge of potentially abusive transactions that merit scrutiny. The regime uses various "filters" (i.e., a focus on certain types of transactions) for capturing useful information from taxpayers and "material advisors" while at the same time minimizing the burden imposed on those individuals. This targeted approach to obtaining disclosures also minimizes the number of unnecessary disclosures that must be dealt with by the IRS.

"Substantial Authority" Standard for Non-Tax Avoidance Items

Currently, section 6662 provides that an understatement penalty will not be imposed on a taxpayer with respect a tax return position taken for a non-tax avoidance item if either: (1) the taxpayer has "substantial authority" for the tax treatment of the item on the tax return (i.e., the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary positions, typically understood to be approximately a 40% likelihood of the treatment prevailing on the merits); or (2) the taxpayer made a specific disclosure of the position on the return and there was a "reasonable basis" for the tax treatment of the item on the tax return (i.e., roughly a 20% likelihood of the treatment prevailing on the merits).

Federal tax law is constantly changing; at any given time, there are many issues awaiting guidance from the Treasury Department and the IRS. For example, Treasury's 2006 - 2007 Priority Guidance Plan lists 264 guidance projects that Treasury planned to address between July 2006 and June 2007. As a result, there is sometimes little or no authority or guidance for the tax treatment of an item at the time the item must be reported on a return. Even if there is some authority, in many instances, the proper treatment of an item may not be clear where there are unique facts and circumstances. Thus, given the exceedingly complex and dynamic nature of the tax law, it may be difficult for taxpayers and preparers to know the probable correctness of many return positions. It is not only unrealistic, but in many cases, impossible, to ensure the proper tax treatment of an item with the high degree of accuracy required by the "more likely than not" standard. In some situations, there simply may be no tax treatment that is "more likely than not" the proper treatment.

When Congress created the current section 6662 taxpayer substantial understatement penalty in 1982, it recognized these problems and, as a result, for non-tax avoidance items, decided against imposing a standard requiring certainty, such as the "more likely than not standard" does. The Joint Committee on Taxation Blue Book for Public Law 97-248, section 323 (a) specifically notes that: "Congress did not adopt an absolute standard that a taxpayer may take a position on a return only if, in fact, the position reflects the correct treatment of the item because, in some circumstances, tax advisors may be unable to reach so definitive a conclusion. Rather, Congress adopted a more flexible standard under which the courts may assure that taxpayers who take non-disclosed highly aggressive filing positions are subject to the penalty while those who endeavor in good faith to fairly self-assess are not penalized."

The IRS task force that studied the penalty regime in 1989 likewise pointed out that:

"...a variety of factors limit the ability of taxpayers to report positions disclosing a liability that is probably correct. Perhaps the most significant limitation is the ambiguity inherent in applying a complex and changing set of tax rules to an infinite variety of factual situations, which may themselves be of ambiguous import. These complexities may result in failure to recognize issues, incorrect conclusions as to the probability that a particular position will prevail, and differences of opinion regarding probability that are not resolvable short of the courthouse. The complexity of modern financial affairs, when coupled with the legal requirement to file a return by a statutory deadline and the costs of making the best possible assessment of each individual issue may also provide practical limits on the pursuit of a theoretically perfect return." Witness the myriad questions and factual diversity in the pursuit of the domestic production activity deduction fostered by the American Jobs Creation Act of 2004.

The current taxpayer standard of "substantial authority" for non-tax avoidance items strikes a balance, taking into account the uncertainties that exist when reporting an item on a return and the IRS' need to focus on information that will enable it to prevent abuses to the tax system. In contrast, a standard of "more likely than not" for non-tax avoidance transactions would pose an unworkable burden on the tax system. Accordingly, NATP strongly recommends that both the taxpayer and preparer standard for reporting non-tax avoidance items be, at most, "substantial authority." NATP also recommends an expansion of the authorities that can be relied on in determining if the "substantial authority" standard is met, to include field service advices, treatises, and legal scholarly literature.

"More Likely Than Not" Standard for Tax Avoidance Items

Section 6664(d) provides that an understatement penalty under section 6662A will not be imposed on a taxpayer for tax deficiencies that are assessed with respect to tax avoidance transactions if there was reasonable cause for the understatement and the taxpayer acted in good faith. Further, these requirements will be satisfied only if: (1) the taxpayer made a specific disclosure of the position on the return; (2) there was "substantial authority" for the tax treatment of the item on the return; and (3) the taxpayer reasonably believed that the tax treatment of the item on the return was "more likely than not" the proper treatment (i.e., a greater than 50% likelihood of the treatment prevailing on the merits).

NATP strongly supports well-targeted efforts to eliminate abusive transactions and close the "tax gap." Such transactions undercut the large majority of honest taxpayers and tax return preparers who strive every day to obey the increasingly complex tax laws. NATP believes that the most effective way to combat abusive transactions without interfering with a taxpayer's right to legally minimize taxes is through disclosure and penalties. But, for a disclosure system to be effective in combating abuse, it must be able to focus on the transactions that are the most likely to be abusive. If the "more likely than not" standard is applied to all items, including routine, non-tax avoidance items, the ability of the disclosure system to focus on abusive transactions will be seriously impaired.

Given the complexity of the tax law, the lack of guidance from the Treasury Department and the IRS on many issues, and the factual nature of many issues, the "more likely than not" standard for taxpayers has heretofore wisely been reserved for tax avoidance transactions rather than imposed as a uniform rule for all transactions. NATP recommends that the "more likely than not" standard be applied to taxpayers and preparers only with respect to tax avoidance items. This would be consistent with the approach that Congress and Treasury have taken in recent years to utilize directed disclosures that focus on the potentially problematic transactions without either overburdening the IRS with unnecessary disclosures or inhibiting the electronic filing system.

Does Disclosure Unfairly Concede the Issue?

A disclosure made in a tax system that has "more likely than not" as the reporting standard could be viewed as a concession of the issue disclosed, since the disclosure would only be required if an analysis of the applicable authorities and facts by the taxpayer or preparer resulted in the conclusion that the tax treatment "more likely than not" was not the proper treatment. If the preparer has concluded that the standard has not been satisfied, but the taxpayer wishes to pursue the matter and not disclose, the preparer could be forced to withdraw and the taxpayer's right to tax representation would be affected. So would the tax preparer's right to practice and the preparer's ability to collect for services rendered at that point. To avoid these results, with respect to non-tax avoidance items, NATP recommends that the "more likely than not" standard be applied to taxpayers and preparers only with respect to tax avoidance transactions.

As Ubiquitous as Circular 230 Disclosure Disclaimers

Because of the difficulty of satisfying the "more likely than not" standard, in many routine situations, and the severe penalties for understating tax liabilities, disclosures may be made for numerous tax return positions with respect to which there is any uncertainty regarding the ultimate tax treatment. The resulting increase in the number of disclosures will not create the desired outcome of the disclosure regime, which is the "weeding out" of abuses in the system. This doesn't even take into account the possibilities of multiple professionals covering their bases because they may be deemed "preparers" under this provision of the Act. Consider the recurring circumstance of inherited items and the treatment of their basis on a 1040. Who does the appraisal to determine basis? Will that appraiser be deemed a preparer for these circumstances? Will they want some disclosure of that fact on the taxpayer's return?

Adding to this problem is the fact that, if an understatement penalty is imposed on a preparer who is subject to Circular 230, the preparer may be subject not only to a high section 6694 monetary penalty, but also to an additional fine under Circular 230 and disciplinary action by the IRS Office of Professional Responsibility. Rather than risk such severe penalties, with a "more likely than not" standard, it is likely that preparers will strongly encourage disclosures, even on routine, non-tax avoidance items.

Clearly, this is not a desired outcome. The IRS will be swamped with paper; the ability of the IRS to focus its attention on potentially abusive tax avoidance transactions will be obstructed; the electronic filing system will be undermined, since currently it is not designed to accept a large number of disclosures per return; important disclosures will be overlooked; and a large percent of the voluminous disclosures will be meaningless. If you doubt that the IRS will be swamped with such disclosures, consider the ubiquitous disclaimers under Circular 230 that accompany every and any e-mail or other correspondence from a Circular 230 professional.

The Internal Revenue Service Advisory Council noted in the Briefing Book for its November 15, 2006 public meeting that, even under the current system of targeted disclosures, there is a continuing problem with overdisclosure. The Council gave an example of tens of thousands of unnecessary disclosures received during the year for just one type of transaction. The Council also noted that there is anecdotal evidence that little or nothing was being done with disclosures that had been made. In discussing this problem, the Council cautioned that although it was "fully supportive of the IRS' attack on "abusive tax shelters," it believed that "it is important for the IRS to distinguish between "abusive transactions and transactions that reduce a taxpayer's liability through appropriate tax planning." This situation of excessive disclosures will be drastically worsened if the standard for non-tax avoidance items is "more likely than not."

Given the overwhelming burden that will be imposed on the tax system by excessive disclosures that are made as a result of the high "more likely than not" standard, NATP strongly recommends that the taxpayer and preparer standard for reporting non-tax avoidance items be "substantial authority."

6. Conclusion

NATP recommends that the section 6694 tax return preparer standards be returned to their previous standard of the "realistic possibility of success" or, at most, equalized with the standards currently applicable to taxpayers (substantial authority) for non-tax avoidance items. For tax avoidance items, the "more likely than not" standard should continue to apply. Thank you for the opportunity to share these comments.