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By Raj Pai and Christopher Murphy
The authors are associates with McKee Nelson LLP in Washington, D.C. Each practices in the area of federal taxation, with a focus on tax controversy and litigation matters. Raj Pai graduated from Harvard Law School in 1999 and is admitted to practice in Pennsylvania and the District of Columbia. Christopher Murphy graduated from The American University Washington College of Law in 2006 and is admitted to practice in New York.
The authors wish to express their appreciation to their colleagues at McKee Nelson LLP for their insightful comments, particularly Ronald L. Buch Jr., Gary R. Huffman, Nathan Clukey, Joshua Eizen, and Caroline Cote for their helpful assistance on earlier drafts of this article.
Introduction
For the last 18 years, Section 6694 of the Internal Revenue Code1
provided a well-defined regime under which income tax return preparers and their clients could operate.
1 All section references, unless otherwise indicated, are to sections of the Internal Revenue Code of 1986, as amended.
As revised in 1989, Section 6694 set forth a standard that matched the professional standards in place for accountants and lawyers. In addition, the return preparer penalty rules as amended in 1989 reflected years of development and consideration by the tax bars, professional organizations such as the American Institute of Certified Public Accountants, the Department of the Treasury, and Congress.
By contrast, the newly amended Section 6694 significantly alters the playing field, putting in place a new standard that is ill-defined, without any clear indication that the new rules will accomplish the legislation's stated goal. The revised Section 6694 appears to have even surprised the Internal Revenue Service in some ways.
The amended statute expands the scope of individuals who are included within its ambit to include individuals other than just income tax return preparers. In addition, the new amendment creates an inconsistency between the standard that applies to a taxpayer and the standard that applies to a return preparer.
The amendment may also create a conflict between the professional duties of advisers and the statutory requirements, potentially creating situations where taxpayers will be more reluctant to seek professional advice on return positions.
The newly amended Section 6694 significantly alters the playing field, putting in place a new standard that is ill-defined, without any clear indication that the new rules will accomplish the legislation's stated goal.
In the end, the amendment may have created an unmanageable regime that generates more problems than it solves.
History of Section 6694
Section 6694 was enacted as part of the Tax Reform Act of 1976.2
It called for a penalty of $100 per return or claim for refund “if any part of any understatement of liability with respect to any return or claim for refund is due to the negligent or intentional disregard of rules and regulations by a person who is an income tax return preparer with respect to such return or claims.”3
2 Pub. L. No. 94-455, Section 1203(b)(1), 90 Stat. 1520.
3 Id. at Section 1203(b)(1)(a).
The penalty increased to $500 per offense if the income tax return preparer made “a willful attempt in any manner to understate the liability.”4
4 Id. at Section 1203(b)(1)(b).
The Tax Reform Act of 1976 also added code Section 7701(a)(36), which defined the term “income tax return preparer”
as “any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return of tax imposed by subtitle A or any claim for refund of tax imposed by subtitle A.”5
5 Id. at Section 1203(a).
According to the legislative history, the section was added in order to curb certain abuses being made by the fast growing field of tax return preparers.6
Prior to the enactment of Sections 6694 and 7701(a)(36), the only way to penalize return preparers was criminally under Section 7206, a process that was time consuming and required prosecutors to overcome a substantial burden of proof.7
Thus, the enactment of civil penalties was intended to assist IRS in deterring increasing abuses committed by income tax return preparers.
6 H. Rept. No. 94-658, at 274 (1975), as reprinted in 1976 U.S.C.C.A.N. 2897, 3170 (stating that some return preparers, for example, were guaranteeing refunds based on expertise, taking fictitious deductions, and increasing exemptions).
7 Id. (“criminal penalties are often inappropriate, cumbersome, and ineffective deterrents because of the costs and length of time involved in trying these cases in court”).
Pre-Existing Professional Standards For Lawyers
ABA Formal Opinion 314.
Because tax return preparers are often lawyers or accountants, ethical and other standards exist outside the Internal Revenue Code that govern these types of tax professionals. Before civil penalties were added to the code, attorneys practicing before IRS in any capacity were required to adhere to the ethical guidance set forth in American Bar Association Formal Opinion 314.8
8 ABA Comm. on Ethics and Professional Responsibility, Formal Op. 314 (April 27, 1965).
Included as part of an attorney's obligation under Formal Opinion 314 was “a duty not to mislead the Internal Revenue Service deliberately and affirmatively, either by misstatements or by silence or by permitting [the attorney's] client to mislead.”9
9 Id.
Formal Opinion 314 also provided specific guidance for “a lawyer who is asked to advise his client in the course of the preparation of the client's tax returns”10
:
10 Id.
where the lawyer believes there is a reasonable basis for a position that a particular transaction does not result in taxable income, or that certain expenditures are properly deductible as expenses, the lawyer has no duty to advise that riders be attached to the client's tax return explaining the circumstances surrounding the transaction or the expenditures.11
11 Id.
The formal opinion also noted that although the guidance related to ethical obligations, or “what [the attorney]
is required to do,” a lawyer may still provide advice that disclosing a transaction may be advantageous, even if such advice would not be necessary under the minimum guidelines detailed in the formal opinion.12
12 Id. Formal Opinion 314 elaborated by stating that such a situation exists where a client may want extra protection against fraud or to “have the protection of a shorter statute of limitations.”
ABA Formal Opinion 85-352.
In 1985, the ABA reconsidered Formal Opinion 314 and published Formal Opinion 85-352.13
The Committee on Ethics and Professional Responsibility stated that it reconsidered Formal Opinion 314 “as a result of serious controversy over this standard and its persistent criticism by distinguished members of the tax bar, IRS officials and members of Congress.”14
13 ABA Comm. on Ethics and Professional Responsibility, Formal Op. 85-352 (July 7, 1985).
14 Id.
The committee noted that some commenters considered Formal Opinion 314's “reasonable basis” standard too lenient and argued it was being used to “justify the exploitation of the lottery of the tax return audit selection process.”15 In response to these concerns, Formal Opinion 85-352 alters the portion of Formal Opinion 314 that relates to a lawyer's advising a client on tax return positions.16
15 Id.
16 Id.
As a whole, Formal Opinion 85-352 conforms to the standards present in the Model Code and Model Rules.17
In applying these general standards to dealings with IRS, the opinion states that the lawyer must believe that the positions taken on the return are warranted or can be supported by a “good faith argument for an extension, modification, or reversal of existing law.”18
17 Id. (citing Model Rules 3.1 and 1.2(d), stating that a lawyer should not bring or defend a frivolous proceeding nor encourage or assist a client in conduct the lawyer knows is criminal or fraudulent).
18 Id.
Formal Opinion 85-352 introduced the “realistic possibility” standard as the baseline for nondisclosed positions.
The opinion makes it clear that a lawyer may still advise on return positions where the lawyer believes there is no substantial authority and where the client will not disclose the position.19
However, for the lawyer to possess the requisite good faith belief that the position is warranted, there must be “some realistic possibility of success if the position is litigated.”20
19 Id.
20 Id.
Thus, Formal Opinion 85-352 introduced the “realistic possibility” standard as the baseline for nondisclosed positions.
Pre-Existing Professional Standards For Accountants
Just as lawyers had specific guidance on ethical rules in practicing before the IRS through ABA Formal Opinion 314, as amended by Formal Opinion 85-352, in 1988 a professional standard for accountants was created. The AICPA revised its “Statements on Responsibilities in Tax Practice” in July 1988.
21
21 American Institute of Certified Public Accountants, Statements on Standards for Tax Services, current version of applicable standards available at http://ftp.aicpa.org/public/download/members/div/tax/ssts2.pdf. For the text of the 1988 revisions, see Statements on Responsibility in Tax Practice 1988 Revision, 12-88 J. Accountancy 146 (1988).
Statement No. 1 detailed “the standards a [certified public accountant] should follow in recommending tax return positions and in preparing or signing tax returns including claims for refund.” Specifically, the statement mirrors the standard in ABA Formal Opinion 85-352, recommending that an accountant not advise a client on a tax return position unless that position has a “realistic possibility of being sustained administratively or judicially on its merits if challenged.”
Thus, by mid-1988, the relevant ethics rules advised both attorneys and accountants that the proper standard to adhere to when preparing tax returns or claims for refund was the position being taken have a “realistic possibility of success.”
Proposed Standard in Circular 230 (Never Finalized)
In 1986, IRS proposed updates to Circular 230.22
These proposed changes were never finalized as they were criticized as too strict by many practitioners.23
22 Notice of Proposed Rulemaking, Tax Practitioners, 51 Fed. Reg. 29113 (Aug. 14, 1986).
23 See Dennis J. Ventry Jr., Filling the Ethical Void: Treasury's 1986 Circular 230 Proposal, 112 Tax Notes 691 (Aug. 21, 2006) (citing Herbert J. Lerner and Leonard Podolin, American Institute of Certified Public Accountants, to Leslie S. Shapiro, director of practice, 87 Tax Notes 35-9 (Feb. 13, 1987)); David Sachs, chair, Bar Association of the City of New York, to director of practice, 87 Tax Notes 25-44 (Jan. 9, 1987);
Doug Briggs, Tax Attorneys Debate Merits of Amendment to Circular 230, Tax Notes, May 18, 1987, p. 635 (quoting Jules Ritholz of Kostelanetz, Ritholz, Tigue & Fink at a meeting of the D.C. Bar Association Tax Section).
In the proposed amendments, IRS argued that both the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)
and the recently issued ABA Formal Opinion 85-352 indicated a growing concern that “professional responsibility …
with respect to tax return preparation and advice relative to positions on tax returns has eroded over the years.”24
In an attempt to halt this “erosion,” IRS stated that practitioners have a dual responsibility, both to the client and the “tax system.”25
24 51 Fed. Reg. 29113 (Aug. 14, 1986).
25 Id.
Specifically, the drafters noted that the tax return must be a “fair report of matters affecting tax liability”
and that a practitioner has an affirmative duty to make sure the facts and positions taken on tax returns are accurate and “supportable by the law.”26
26 Id.
In an attempt to achieve this objective, the proposed changes dealt directly with the penalties under Section 6661.27
The drafters proposed adding a new Section 10.34 to Circular 230, which:
- would have required practitioners to advise clients of any potential Section 6661 violations;
- would have prohibited practitioners from advising on or recommending a treatment on the return that would leave their client liable for Section 6661 penalties; and
- would also have prohibited practitioners from preparing or signing a return if such return contained any item to which the Section 6661 penalty would apply.28
27 I.R.C. Section 6661 was renumbered as I.R.C. Section 6662 in 1989 as part of the Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239, 103 Stat. 2106.
28 51 Fed. Reg. 29113 (Aug. 14, 1986).
Although these changes were never implemented, the proposal showed the mounting desire for greater oversight of tax practitioners, and tax return preparers in particular, regardless of the impact on the professional ethical obligations of return preparers.
1989 Amendments to Section 6694
As detailed above, Section 6694 was originally added to the code in order to prevent some of the increasing abuses undertaken by tax return preparers. In 1989, Congress acted to amend the existing civil penalty rules to match the professional ethical standards put in place during the 1980s and to provide for stiffer penalties against preparers who violated such rules.
The Section 6694 amendment came in 1989, following two years of hearings and studies in Congress, the reports of an IRS task force created to study the penalty, and input from professional organizations.29
The Omnibus Budget Reconciliation Act of 1989 revised the penalties that apply to any understatement of tax caused by an income tax return preparer.30
29 Lisa M. Dinackus, AICPA Urges Congress to Reconsider Preparer Standards, J. Acct. Online, September 2007.
30 Pub. L. No. 101-239, Section 7732 (1989).
The new law provided for multiple levels of penalties. A $250 penalty was imposed on any income tax return preparer if:
- any part of an understatement of tax or claim for refund was attributable to a position that lacked a “realistic possibility of being sustained on its merits”31
;
- the income tax preparer knew (or reasonably should have known) of the position; and
- the position was not disclosed or was frivolous.32
31 A position meets the realistic possibility standard when, after a “reasonable and well-informed analysis,” a person well-informed as to the tax law would conclude that the position has at least a one in three likelihood of being sustained if challenged by IRS. Treasury Regulations Section 1.6694-2(b).
32 I.R.C. Section 6694(a)(1)-(3) (1989).
This penalty did not apply to income tax return preparers who could show reasonable cause for the understatement and that the return preparer acted in good faith.33
33 Id.
A stiffer $1,000 penalty was imposed on income tax return preparers if any part of “any understatement of liability with respect to any return or claim for refund” was due to a willful attempt to understate the liability or reckless or intentional disregard of the rules or regulations.34
34 I.R.C. Section 6694(b)(1)-(2) (1989).
Overall, these changes were significant as the statutory requirements for income tax return preparers changed to match the ethical standards already in place for accountants and lawyers.
Additionally, the pre-1989 version of Section 6694 contained no provision by which an income tax return preparer could lessen a potential penalty by disclosing specific positions taken on a return.35
The new Section 6694(a) changed that rule, resulting in return preparers being able to advise clients on positions that were greater than “not frivolous” but did not have a realistic possibility of success, as long as such a position was disclosed to IRS.36
35 The House Conference Report for the Tax Reform Act of 1976 indicated that “while there may be instances in which some form of disclosure … would be necessary to avoid penalties under section 6694(a), that would depend on all the relevant facts and circumstances in the particular case, as is true under section 6653(a).” H. Rept. No. 94-658, at 274 (1975), as reprinted in 1976 U.S.C.C.A.N. 2897, 3170.
36 Disclosure can be achieved in two ways. For signing preparers, disclosure can be made on Form 8275 or 8275-R, as appropriate, or on the return in accordance with an annual revenue procedure. Treas. Reg. Section 1.6694-2(c)(3)(i). For nonsigning preparers, disclosure can be made in the same manner as a signing preparer, or if the nonsigning preparer includes a statement with the advice that states the “position lacks substantial authority and, therefore, may be subject to penalty under section 6662(d) unless adequately disclosed.” Treas. Reg. Section 1.6694-2(c)(3)(ii)(A).
2007 Amendments to Section 6694
The most recent amendments to Section 6694 were signed into law by President Bush May 25 as part of the Small Business and Work Opportunity Act of 2007 (the “2007 Act”).37
The amendments make the following key changes:
- Section 6694 now applies to all tax return preparers, as opposed to just income tax preparers;
- the threshold standard for positions taken on a tax return has been revised, such that tax return preparers will now be subject to penalties if a position taken on a return is “unreasonable”
as defined within Section 6694; and
- Section 6694 imposes a much higher penalty on return preparers.38
37 Section 8246 (Pub. L. No. 110-28, 121 Stat. 190).
38 Section 6694 (a)–(b).
Unlike its predecessor, the expanded statute applies to all tax return preparers, imposing penalties on any individual that prepares any federal tax return in exchange for compensation.
As a result, the code has been amended to include not only income tax preparers, but also those who prepare employment tax returns, excise tax returns, and estate and gift tax returns.
However, the amendments to Section 6694 did not alter the definition of who will qualify as a tax return preparer, as defined in Section 7701. As before, the definition of tax return preparer includes any person who prepares for compensation all or a substantial portion of a return,39
but also includes a much broader group of individuals.
40
39 Section 7701(a)(36).
40 See Treas. Reg. Section 301.7701-15. Exceptions to the rule also exist. See infra.
For example, the Treasury Regulations state that this definition is broad enough to include an attorney advising on a client's treatment of a single item on a return.41
As noted later in this article, the definition of return preparer has taken on new importance in light of the changes to Section 6694.
41 Treas. Reg. Section 301.6694-1(b)(3).
The amendments to Section 6694 also adjust the standard to be met by a tax return preparer in order to avoid penalties for preparing a return that includes an understatement of tax. A tax return preparer is now subject to a penalty for a position taken on a return if that position is “unreasonable” as defined by Section 6694.
For positions that are not disclosed, the previously established “realistic possibility” standard has been replaced—the preparer must now have a reasonable belief that the undisclosed tax position that creates the understatement would more likely than not be sustained on its merits, or the position will be regarded as unreasonable. As a practical matter, the return preparer must now raise the bar effectively to determine that a position taken on the tax return must have a better than one in two chance of being sustained, in contrast to the prior realistic possibility standard of one chance in three.
In addition, the standard for positions that are disclosed has been raised as well—the tax return preparer must now have a reasonable basis for the tax treatment of an item to avoid penalties associated with an understatement related to that item, rather than simply determining the position is not frivolous, as under the prior Section 6694.42
42 It should be noted that the amended version of Section 6694 contains a reasonable cause exception that is virtually identical to the reasonable cause exception within the former version of Section 6694.
Notice 2007-54 acknowledged that the amendments to Section 6694 “raise questions regarding activities representing preparation of a tax return, who is a return preparer within the meaning of section 7701(a)(36) (as amended), and how the statute applies to signing and non-signing preparers.”
The higher standard is accompanied by the enactment of higher penalties. The amendments to Section 6694 increased the penalty for violations resulting from an unreasonable position from
$250 per return to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the preparer from the preparation of a return or claim for which the penalty is imposed.43
<43 I.R.C. Section 6694(a).
When the understatement is the result of willful or reckless conduct on the part of the tax return preparer, the amendments to Section 6694 increased the penalty from $1,000 to the greater of
$5,000 or 50 percent of the income derived (or to be derived) by the tax return preparer.44
44 I.R.C. Section 6694(b). Penalties that are payable as the result of willful or reckless conduct will be reduced by the amount of any penalty that is payable resulting from unreasonable positions under Section 6694(a). See I.R.C. Section 6694(b)(3).
In each instance, the new penalties are a significant increase from the prior regime.
Amended Section 6694 is effective for all returns filed on or after May 25, 2007, the date the 2007 Act was signed into law. However, soon thereafter, IRS set forth what it termed as “transitional relief” when it issued Notice 2007-54.
Notice 2007-54 acknowledged that the amendments to Section 6694 “raise questions regarding activities representing preparation of a tax return, who is a return preparer within the meaning of section 7701(a)(36) (as amended), and how the statute applies to signing and non-signing preparers.”
In light of these and other issues, Notice 2007-54 stated that the realistic possibility standard applied under the former version of Section 6694 would continue to apply to all income tax returns, amended returns, and refund claims due on or before Dec. 31, 2007.45
45 Notice 2007-54, 2007-27 I.R.B. 12 (June 11, 2007). For all other returns affected by the new standard, the reasonable basis standard set forth in Section 6662 will be applied in determining whether a penalty will be imposed, without regard to disclosure requirements. The transitional relief for other returns also applies through Dec. 31, 2007, with two exceptions:
the transitional relief applies (1) to 2007 estimated tax returns due on or before Jan. 15, 2008; and (2) to 2007 employment and excise tax returns due on or before Jan. 31, 2008.
With that being said, Notice 2007-54 does not provide any transitional relief as to the amount of the penalties—the new penalty thresholds continue to apply to all returns filed after May 25, 2007.
Will the New Standard Actually Satisfy Its Intended Goals?
The language that appears in the amended version of Section 6694 first materialized as part of the proposed Telephone Excise Tax Repeal and Taxpayer Assistance Act of 2006 (the “2006 Taxpayer Assistance Act”).46
The language proposed in the 2006 Taxpayer Assistance Act with regard to the revised standards and increased penalties is identical to the language enacted as part of the amended Section 6694.
46 The 2006 Taxpayer Assistance Act was not enacted by the 109th Congress. S. Rept. No. 109-336, at 51 (2006).
The Senate Finance Committee's report on the 2006 Taxpayer Assistance Act is instructive as to the apparent intent of the eventual amendments to Section 6694:
Existing preparer penalties do not adequately deter and prevent noncompliance with tax laws. They should be broadened to include returns other than income tax returns. The thresholds of behavior to establish preparer noncompliance should be raised so that scams and schemes and other abusive transactions are discouraged. Penalty amounts have remained constant for years and are considered by some preparers to be a cost of business instead of an economic deterrent. The amounts should be increased to restore their deterrent impact.
The report makes clear that this is the intent of the legislation to amend Section 6694. However, the authors believe, for the reasons outlined in this article, that these amendments will fail to accomplish the goals outlined above.
While the language from the 2006 Taxpayer Assistance Act was resurrected and inserted into the 2007 Act, no additional justifications were provided for the revisions to the standards of conduct or for the increased penalties. While the rationale for the increase in the penalty amounts can be justified rather easily (these amounts had been unchanged for 18 years), no support was offered for the assertion that preparers consider such penalties “a cost of business,” as Congress believed.
Similarly, no evidence exists that raising the threshold of behavior for return preparers would discourage scams and transactions. Indeed, as at least one other author has noted, the alleged scams and schemes that Congress apparently sought to discourage with the amendments to Section 6694 would likely have failed scrutiny under the previously existing version of Section 6694.47
47 Jonathan S. Brenner, New Standard for Tax Return Positions Is Inappropriate, 116 Tax Notes 559, 560 (Aug. 13, 2007).
In fact, Congress held no hearings on these provisions, and the authors are not aware of any attempts by Congress to consult with the Treasury Department, tax practitioners, the AICPA or the ABA regarding these changes. This contrasts sharply with the work Congress did prior to amending Section 6694 in 1989, as referenced above.
In addition, while the Treasury Department recommended increasing the penalty on tax return preparers in its 2007 Blue Book of recommended legislation, no recommendation was made to change the standard for tax return preparers.48
In fact, IRS Chief Counsel Don Korb stated that he was completely surprised by the inclusion of the provision changing the standards for tax return preparers in the 2007 Act.49
48 See American Institute of Certified Public Accountants Comments on Revisions to Section 6694 Changing Tax Return Reporting Standards for Preparers at http://tax.aicpa.org/NR/rdonlyres/1519AB81-8421-415D-91C5-2DE721DB9995/0/Comments_071007_FINAL.doc.
49 Dustin Stamper, Treasury to Address Preparer Disclosure Standard Changes, 115 Tax Notes 1008 (June 11, 2007).
In reality, the new standards appear certain to impose substantial new compliance costs on both return preparers and taxpayers. The authors have not seen any estimates of the costs associated with such compliance;50
however, it seems clear that the new standard will likely require tax return preparers as a matter of due diligence to perform the complicated and costly analyses normally associated with complex transactions, but in connection with more routine tax positions. The absence of a rigorous analysis on the level associated with complex transactions could subject the preparer to the substantially increased penalties.
50 The authors note that the estimated revenue effects of the changes amount to $82 million by 2017. However, these revenue effects do not include any estimate with regard to taxpayer and practitioner compliance. Estimated Revenue Effects of the Tax Provisions Contained in H.R. 1591, as Passed by the Senate on March 29, 2007, Joint Committee on Taxation, JCX-22-07 (April 4, 2007).
The corresponding increase in costs resulting from the more restrictive standard may leave some taxpayers unwilling to pay for quality representation and advice. Without the advice of seasoned return preparation professionals, taxpayers acting on their own may opt to take more aggressive reporting positions, perversely creating a situation where the new legislation actually leads to decreased compliance by taxpayers.51
51 As we note later in this article, the authors believe taxpayers may be further dissuaded from seeking advice due to the fact that new standards may create conflicts between the duties of a tax return preparer to provide advice to a client and their duties to disclose positions pursuant to the amended Section 6694.
Who Qualifies as a Return Preparer?
With the new Section 6694 in place, the exact definition of “income tax return preparer” takes on new importance.
When Section 6694 changed earlier this year, Section 7701(a)(36) only received minor adjustments to match the removal of the word “income” before “tax return preparer”
as in Section 6694. Additionally, no new regulations or interim guidance that further defines “tax return preparer” have been issued to date.
Section 7701(a)(36) provides the broad statutory definition:
The term “tax return preparer” means any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return of tax imposed by this title or any claim for refund of tax imposed by this title.
For purposes of the preceding sentence, 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.
This guidance taken alone is limited; however, the Treasury Regulations under Sections 6694 and 7701 give further guidance regarding the current definition of tax return preparer and what it means to prepare a substantial portion of a return or claim for refund.
With the new Section 6694 in place, the exact definition of “income tax return preparer” takes on new importance.
Treas. Reg. Section 301.7701-15(b)(1) states that “substantial portion is determined by comparing the length and complexity of, and the tax liability or refund involved in, that portion to the length and complexity of, and tax liability or refund involved in, the return or claim for refund as a whole.”
The Treasury Regulations also provide a mechanical test for substantiality, stating that if the entry on the return or claim for refund is “(i) less than $2,000; or (ii) less than
$100,000 and also less than 20 percent of the gross income …
as shown on the return or claim for refund, then the … portion is not considered to be a substantial portion.”52
52 Treas. Reg. Section 301.7701-15(b)(2).
While this guidance does not provide absolute certainty as to exactly what IRS or the courts will deem a “substantial portion” of the return or claim for refund, it provides some assistance. The regulations also note that the preparer of a partnership return can be deemed the preparer of a partner's return “if the entry or entries on the partnership … return reportable on the partner's … return constitute a substantial portion of the partner's … return.”53
53 Treas. Reg. Section 301.7701-15(b)(3). The Seventh Circuit upheld this approach in the face of a direct challenge in Goulding v. United States, 957 F.2d 1420 (7th Cir. 1992).
Other individuals who may not actually sign the return can also be considered return preparers. Treas. Reg. Section 301.7701-15(a)(1) states that a person who furnishes sufficient information and advice to a taxpayer or other preparer “so that completion of the return or claim for refund is largely a mechanical or clerical matter is considered an income tax return preparer, even though that person does not actually place or review placement of information on the return or claim for refund.”
Additionally, a person is a return preparer if such person gives advice on specific issues of law with respect to events that have already occurred at the time the advice is issued and the advice is “directly relevant to the determination of the existence, characterization, or amount of any entry on a return or claim for refund.”54
54 Treas. Reg. Section 301.7701-15(a)(2)(i)-(ii).
Conversely, the Treasury Regulations provide examples of individuals who are not return preparers. For example, merely typing or providing mechanical assistance in completing a return or claim for refund does not make an individual a return preparer.55
55 Treas. Reg. Section 301.7701-15(d)(1).
Additionally, a continuously employed person who prepares an employer's return is not a return preparer, nor are individuals who prepare a claim for refund in response to a notice of deficiency.56
56 Treas. Reg. Section 301.7701-15(d)(2), (4).
While these guidelines have existed for some time, the financial impact of not adhering to the guidelines is now heightened. And with the new changes to Section 6694, practitioners must take notice of the substantial penalties.
IRS has indicated in Notice 2007-54 that questions exist over “who is a return preparer” and that the service is currently considering whether new regulations are necessary to help answer this question.
Based on the new penalty regime, an attorney that issues an opinion and also qualifies as a tax return preparer may have all fees received from the preparation of that opinion at risk.57
A potential result of such high risk for attorneys drafting opinions is that they may only be willing to give opinions that easily pass the more likely than not standard, such as opinions that reach a “should” or “will”
conclusion.
57 For example, if an attorney earns
$100,000 for drafting a detailed tax opinion and a court finds: (1)
that the attorney was a tax return preparer; (2) that the position at issue was not disclosed; and (3) that the position was less than more likely than not correct, then the statutory fine will be $50,000 and the taxes on the income earned for preparing the return will be
$35,000. Additionally, if the case went to court, the attorney would almost certainly spend more than $15,000 defending the case. Thus, giving the opinion would result in an overall loss for the drafting attorney.
As a corresponding result, taxpayers are less likely to receive advice on the most complex return positions because their counsel will not provide it. This lack of counsel with respect to complex positions could, in turn, lead to taxpayers taking more aggressive positions on their returns because an open dialogue with an experienced tax attorney never occurred.
Finally, even for attorneys writing “should”
or “will” opinions, if a judge determines that the position taken on the return did not, in reality, meet the more likely than not standard, the opinion writer can still be penalized. This represents a significant risk to the opinion writer. In addition to this risk, the opinion writer also faces the risk of violating Circular 230 under the proposed revisions to those regulations (see below), and therefore potentially incurring the penalties applicable thereunder (including the loss of the right to represent clients before IRS).
Based on the guidance that currently exists, in many instances attorneys cannot be confident whether or not they will be considered tax return preparers. With the high level of risk under the new Section 6694 penalty regime, advisers face more severe consequences when issuing written opinions to their clients.
Divergent Standards for Taxpayers And Return Preparers
Perhaps the most disturbing issue associated with the amendments to Section 6694 stems from the fact that the new standard will likely result in conflicts between taxpayers and return preparers.
By contrast to return preparers, taxpayers may be able to avoid penalties with a mere reasonable basis for their positions.58
Even in the case of the substantial understatement penalty under Section 6662(d), substantial authority is sufficient for a taxpayer to avoid the penalty, so long as the item in question is not a tax shelter item.59
58 Treas. Reg. Section 1.6662-3(b)(1).
59 Treas. Reg. Section 1.6662-4(a).
According to the Treasury Regulations, “[t]he substantial authority standard is less stringent than the more likely than not standard”60
—which means that the amendments to Section 6694 impose a higher standard on return preparers than taxpayers for non-tax shelter items. If there is substantial authority for an item on the return, the taxpayer need not disclose the position—but if the same position does not also meet the higher more likely than not standard, tax return preparers could not sign the return or provide advice on the return.
60 Treas. Reg. Section 1.6662-4(d)(2).
Signing and nonsigning preparers can avoid the Section 6694 penalty by insisting on disclosure of a position that does not satisfy the more likely than not standard on a properly completed Form 827561
; however, taxpayers may object to filing the form when they have substantial authority for the same position. Signing preparers may refuse to sign the return in the absence of the disclosure, leaving the parties at loggerheads and the taxpayer without the advice of the preparer—although as a practical matter, the taxpayer would essentially be ignoring the advice of the tax return preparer.
61 Treas. Reg. Section 1.6694-2(c)(3)(i)-(ii).
For nonsigning preparers, the regulations state that disclosure of a position that does not satisfy the realistic possibility standard is adequate if “the advice includes a statement that the position lacks substantial authority and, therefore, may be subject to penalty under section 6662(d) unless adequately disclosed”
on a Form 8275.62
In other words, if a nonsigning preparer believed a position on a return lacked substantial authority, the regulation noted above provided the return preparer with a safe harbor—the return preparer merely had to advise the taxpayer about the risks of nondisclosure.
62 Treas. Reg. Section 1.6694-2(c)(3)(ii)(A).
These regulations appear to be outdated and in need of revision in light of the amendments to Section 6694. Now, if a particular item on a return has substantial authority but does not meet the more likely than not test, the nonsigning return preparer could advise the taxpayer that the position does not meet the more likely than not standard and urge disclosure.
However, a taxpayer only needs a confidence level of substantial authority to protect against any penalty under Section 6662. Thus, the taxpayer would not recognize a direct benefit from disclosing. A return preparer demanding disclosure in such a situation could effectively be viewed as advising the taxpayer against that taxpayer's best interest, which can be construed as a violation of certain ethical rules.63
63 E.g., D.C. Bar, Rule of Professional Conduct 1.7(b)(4) (stating that “[e]xcept as permitted by paragraph (c) below, a lawyer shall not represent a client with respect to a matter if: … (4) The lawyer's professional judgment on behalf of the client will be or reasonably may be adversely affected by the lawyer's responsibilities to or interests in a third party or the lawyer's own financial, business, property, or personal interests.”). See infra (discussion in greater detail of the ethical quandaries the amended Section 6694 rules create).
In fact, the existing regulations do not even contemplate a situation where a preparer advises a client that a position does not meet the more likely than not standard, but has substantial authority.64
The regulations almost certainly require revision in order to help nonsigning preparers.
64 In fact, practitioners in the tax bar have already expressed this point in discussing the recent proposed regulations for tax practitioners under Circular 230. One practitioner recently asked, “Does a non-signing preparer/adviser have to police the client to see if the disclosure is made?”
See Allison Bennett, Treasury Proposes Tougher Standards for Advising Clients, Preparing Returns, Daily Tax Report (BNA), Sept. 25, 2007 at G-7 (185 DTR G-7, 09/25/07).
If a return preparer demands disclosure of a position when issuing a more likely than not opinion, IRS could argue that the return preparer was not confident that the position was more likely than not correct.
As a result of this conflict, some tax return preparers may only agree to give a client a more likely than not opinion if the client agrees to disclose the relevant positions when filing the return. While taking such action may appear to offer the tax return preparer protection, it in fact raises considerable issues.
First, it creates the conflict of interest detailed above. Second, if a return preparer demands disclosure of a position when issuing a more likely than not opinion, IRS could argue that the return preparer was not confident that the position was more likely than not correct.
The crux of IRS's argument would be that if the return preparer was confident in the more likely than not conclusion, then no disclosure was actually necessary under Section 6694 because the return preparer believed the position would more likely than not be sustained on the merits.
Thus, even where a return preparer is acting with caution, such actions could undermine the strength of the opinion and effectively hurt the taxpayer when trying to defend against penalties.
The end result may again leave taxpayers without assistance in return preparation—specifically in those cases where such advice may be most helpful in preventing the taxpayer from taking a position that may be too aggressive or not well grounded in law.
Taxpayers may choose to prepare their own returns, which may lead them to be even more aggressive, leading to a thoroughly undesirable public policy result where taxpayer compliance decreases in the absence of professional advice. Otherwise, taxpayers may be forced to disclose a position on Form 8275 simply to protect their advisers, although taxpayers would likely balk at such requests and may well be correct in refusing to do so.
Ethical Quandaries for Attorneys Who Qualify as Tax Return Preparers
The new standard also leaves attorneys in a particularly difficult ethical position. Attorneys who are assisting in filing a claim for refund could be subject to the amended standard.65
65 Section 7701(a)(36)(B)(iii) clearly establishes that an individual preparing a claim for refund in response to a notice of deficiency will not be considered a return preparer; however, this exception does not apply in assisting with filing claims for refund in other circumstances.
However, these attorneys are also subject to ethical rules requiring that they provide their clients with zealous representation. For example, the District of Columbia Rule of Professional Conduct 1.3 states that a lawyer “shall represent a client zealously and diligently within the bounds of the law.”
Comment 4 to the rule provides more context, stating in part “[i]n serving a client as adviser, a lawyer, in appropriate circumstances, should give a lawyer's professional opinion as to what the ultimate decision of the courts would likely be as to the applicable law.” Comment 6 to the rule may be even more direct in stating that “[i]n the exercise of professional judgment, a lawyer should always act in a manner consistent with the best interests of the client.”
Similarly, Rule 11 of the Federal Rules of Civil Procedure allows attorneys to argue positions in court as long as they are “warranted by existing law or by a nonfrivolous argument for the extension, modification, or reversal of existing law.”
These rules establish that attorneys may advance nonfrivolous arguments on behalf of their clients, and should indeed do so; in the context of tax law, attorneys should be willing to assist their clients in making claims to extend existing law.66
66 A good example of such a nonfrivolous argument resulted in the D.C. Circuit's decision in Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 2006), where the D.C. Circuit held Section 104(a)(2) was unconstitutional under the 16th Amendment. While the panel later reversed itself, the taxpayer's attorneys asserted a claim the court certainly found nonfrivolous.
These ethical rules and similar rules in other jurisdictions leave attorneys in a precarious position. A lawyer may not be able to provide a taxpayer with a “more likely than not” opinion on a particular item on a return, but where the taxpayer has substantial authority for a position, that taxpayer is permitted to take the position on the return.
Arguably, the duty to zealously represent one's client would argue in favor of advising the client to take such a position on the return or file a claim for refund where a realistic possibility of success exists. However, encouraging a client to adopt such a position could leave the adviser subject to penalties under the amended Section 6694 if the position on the return or the claim for refund does not meet the more likely than not standard.
As a related matter, attorneys will also face problems with regard to the disclosure of positions that have substantial authority but fail to meet the more likely than not standard. The Rules of Professional Conduct typically prohibit an attorney from revealing client confidential information.67
67 D.C. Bar, Rule of Professional Conduct 1.6; American Bar Association, Model Rule of Professional Conduct 1.6.
In light of such rules, an attorney who qualifies as a tax return preparer may face ethical bars to disclosing information if the client refuses to do so. However, following these ethical rules may leave the attorney in question subject to penalties under the amended Section 6694.
The Proposed Circular 230 Regulations
Treasury Sept. 26 proposed regulations (REG-138637-07)
updating Circular 230 to match the standards present in the new Section 6694.68
The proposed regulations amend Section 10.34 of Circular 230.
68 Notice of proposed rulemaking, Regulations Governing Practice Before the Internal Revenue Service, 72 Fed. Reg. 54621-22 (proposed Sept. 26, 2007).
Specifically, Section 10.34 is changed so that:
a practitioner may not sign a tax return as a preparer unless the practitioner has a reasonable belief that the tax treatment of each position on the return would more likely than not be sustained on its merits, or there is a reasonable basis for each position and each position is adequately disclosed to the Internal Revenue Service. A practitioner may not advise a client to take a position on a tax return, or prepare the portion of a tax return on which a position is taken, unless (1) the practitioner has a reasonable belief that the position satisfies the more likely than not standard; or (2) the position has a reasonable basis and is adequately disclosed to the Internal Revenue Service.
Clearly, and as the “Background and Explanations of Provisions” section in the proposed regulation states, the purpose behind this amendment is to align the Circular 230 standards with the statutory standards imposed by Congress. However, the changes actually fail to perfectly mirror the current statutory system.
In particular, the statute, as discussed above, permits attorneys to give advice on a position with less than substantial authority but greater than a reasonable basis if the return preparer advises the client that the position lacks substantial authority and may be subject to penalties.69
The proposed Circular 230 regulations include no such safe harbor. Rather, the language in the proposed regulations states that a practitioner may not advise on a position that is less than more likely than not unless such position is “adequately disclosed to the Internal Revenue Service.”
69 Supra n. 36.
If these regulations were to be finalized in their proposed form, practitioners subject to the Circular 230 rules would be put in a position where they could not provide taxpayers with honest advice without running afoul of Circular 230. This is especially true where a position meets the substantial authority standard, but fails to satisfy the more likely than not threshold.
Based on submissions to date by the AICPA, these proposed changes are likely to be met with a great deal of criticism and concern.70
As discussed throughout this article and in the recommendations section below, any comments on these proposed regulations should be given adequate consideration due to the substantial impact this change in the law has on tax professionals.
70 See Letter from Jeffrey Hoops, chair, Tax Executive Committee, AICPA, to Kevin Brown, acting commissioner of the Internal Revenue Service (June 7, 2007), in Tax Notes Today, 2007 TNT 125-24; see also Letter from Jeffrey Hoops, chair, Tax Executive Committee, AICPA, to Charles Rangel and Jim McCrery, House Committee on Ways and Means and Mac Baucus and Charles Grassley, Senate Finance committee (July 16, 2007), in Tax Notes Today, 2007 TNT 136-79.
Recommendations
As detailed above, IRS has postponed enforcement of the new Section 6694 rules until 2008. Thus, practitioners presumably can expect additional guidance on the new tax return preparer penalty standards before the end of the year.
IRS may be well served to further delay enforcement of the new rules with an extension of the existing transitional relief in order to provide more time for comments and consideration of the new rules by tax professionals.
Specifically, the authors of this article recommend that such guidance clarify who qualifies as a tax return preparer and exactly what actions a practitioner can and cannot take when assisting in the structuring of a transaction.
In light of the questions that exist, the authors also believe IRS may be well served to further delay enforcement of the new rules with an extension of the existing transitional relief in order to provide more time for comments and consideration of the new rules by tax professionals.
Because of the increased risk facing “tax return preparers,” prudent tax professionals desire clear rules that define what actions transform an attorney or accountant from an adviser outside the scope of Section 6694 to a return preparer subject to the code's heightened penalties. In many instances, attorneys finalize a tax opinion after the transaction has occurred and before the return is filed, but in fact the attorneys drafting the opinion were advising their clients long before the closing of the transaction.
The current rules are unclear on whether this makes the opinion drafter a tax return preparer. On one hand, the opinion is technically written after the transaction has occurred. On the other hand, the opinion drafter was advising the client prior to the execution date, and the Treasury Regulations clearly state that “a person who only gives advice on specific issues of law shall not be considered an income tax return preparer, unless—(i)
The advice is given with respect to events which have occurred.”71
71 Treas. Reg. Section 301.7701-15(a)(2)(i).
The current guidance fails to account for situations such as the one described above. For a successful penalty regime to which tax practitioners can adhere, the guidance needs to be more explicit where the stakes are this high.72
72 The seriousness of the current situation is highlighted in a recent article recounting the discussion on the new return preparer standards at the fall meeting of the ABA Section of Taxation meeting in Vancouver, British Columbia. Alison Bennett, Preparer Penalty Rules Spark Controversy; Officials Stress Guidance Still in Progress, Daily Tax Report (BNA), Oct. 2, 2007, at G-7 (190 DTR G-7, 10/2/07). Specifically, the author noted that the program outline concerning the new Section 6694 was entitled “New Return Preparer Rules: Harsher Standards and Harsher Penalties—Is it Time to Retire Early?” and that one practitioner said “ ‘we need to know what it means to advise a client and take a position.’ ”
One straightforward change to the regulations would be to create a carve-out for attorneys that assist in the structuring of a transaction. By clearly stating that tax planning attorneys who participate in structuring a transaction (even if those attorneys issue an opinion after the transaction is consummated but before the return is filed) are not tax return preparers, clients could continue to interact with tax professionals in order to receive detailed analysis and advice concerning their transactions.
Such interaction is necessary for the efficient and orderly operation of the federal income tax system as a whole because it adds an extra layer of review to the transaction being considered. Additionally, such a change to the regulations would be in line with the general privilege rule that tax planning constitutes legal advice,73
whereas mere tax return preparation is not protected by the attorney client privilege.74
73 See, e.g., In re Grand Jury Subpoena Duces Tecum, 731 F.2d 1032, 1037-38 (2d Cir. 1984); Matter of Federated Dept. Stores Inc., 170 B.R. 331, 355 (S.D. Ohio 1994); United States v. Mobil Corp., 149 F.R.D. 533, 538 (N.D. Tex. 1993).
74 See, e.g., United States v. Frederick, 182 F.3d 496, 500 (7th Cir. 1999); United States v. Textron Inc., No. 06-198T, 2007 WL 2458325, at *6 (D.R.I. Aug. 28, 2007) (stating that hiring a lawyer to prepare a tax return will not “cloak the documents generated in that process with a privilege” because the mere preparation of a tax return is viewed as accounting work).
The regulations should also be amended so that a nonsigning tax return preparer can effectively disclose a position by informing the taxpayer that the position at issue fails to meet the more likely than not threshold. While the authors understand that such a change creates a disparity between the penalty regimes under Section 6662 and 6694, such an addition is necessary to clear up the confusion the current regulations create.
Additionally, such a change would not affect the taxpayer in making a decision whether to disclose. Rather, it would just provide return preparers with a safe harbor in instances where the opinion given meets the substantial authority standard, but fails to meet the more likely than not threshold.
The authors also believe Congress should reconsider the new standard. The increased penalty amounts likely pass muster in accomplishing the goal of discouraging preparer noncompliance.
However, Congress has never established that the new standard will accomplish the stated goal of discouraging scams, schemes, and other abusive transactions.
In fact, the new standard may actually encourage taxpayers to engage in abusive transactions and fail to disclose such positions—advisers may be more reluctant to assist taxpayers, and taxpayers may be more reluctant to engage advisers who may push for disclosure under a higher standard than the one that applies to the taxpayers themselves.
Congress should determine whether the change in the standard will actually create a more harmful environment for taxpayer compliance. Full hearings, with testimony from people within the industry, would assist in determining how to modify the regulations.
As a related matter, Congress should determine the impact that the increased costs of compliance under the amended Section 6694 will have on taxpayers' willingness to engage competent advisors.
Finally, Congress should consider the impact that divergent standards for taxpayers and tax return preparers will have on compliance. Equalizing the standards for taxpayers and return preparers would serve to eliminate the conflicts faced by all return professionals and at least alleviate the ethical issues confronting attorneys who qualify as tax return preparers.
In addition, Treasury must revise the regulations consistent with the changes in the standards. Creating a legitimate safe harbor for nonsigning preparers under the new standard should be a high priority, both to ensure compliance and to prevent conflicts between taxpayers and advisers.
Conclusion
The amended Section 6694 raises the threshold for all tax return preparers and accompanies the heightened standard with significant monetary penalties. Overall, while the idea behind the change is to achieve greater overall compliance, such a change in the standards relating to return preparers is not certain to effect such a result.
Rather, the new standards have only created confusion and concern among tax professionals. Specifically, the changes raise serious conflicts of interest questions between return preparers and taxpayers.
Additionally, the existing rules governing who qualifies as a return preparer are insufficient to guide practitioners in a high risk environment. While IRS has provided transitional relief through Notice 2007-54, they have created greater confusion with the issuance of the proposed Circular 230 regulations that eliminate the effective disclosure carve-out for return preparers present in Treas. Reg. Section 1.6694-2(c)(3)(ii)(A).
Before making these new changes effective, IRS needs to issue new or amended regulations clarifying who qualifies as a return preparer, specifically excluding attorneys that provide tax planning advice, even if they issue a formal opinion after the transaction is closed.
Such changes to the regulations should also resolve the current confusion that exists with regard to opinions that satisfy substantial authority but do not meet the more likely than not standard.
Additionally, although unlikely, Congress should reconsider the new rules and analyze whether or not they will actually meet intended goals.
A possible solution to this overall issue would be for Congress to change the code so that the return preparer standards mirror the penalty standards for taxpayers. This way, practitioners'
interest would be aligned with their clients' interest, and a great deal of conflicts and ethical issues could be remedied.
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