New Preparer Penalties in 2007

New and Expanded Return Preparer Penalties

and Disclosure Requirements

 

Commentary and Internet Citations

by Vernon K. Jacobs, CPA

Starting in 2008, your tax preparer is likely to insist that your return should include a document (Form 8275 or 8275-R) to disclose to the IRS any return position (deduction, credit, exclusion or valuation) that would reduce your taxes and for which the preparer is unsure about whether the IRS would agree with the treatment on the return.  This web page provides an extensive discussion of the new rules with numerous links to IRS documents and other explanations of the applicable law.

Any visitor to this web site is welcome to copy and forward this information to others or to post the information on a web site so long as the copy is complete and unedited.




The Small Business and Work Opportunity Act of 2007 (P.L. 110-28, Section 8246) included a revenue raising provision that imposed dramatically higher penalties on return preparers who do not disclose return positions that fail to meet dramatically higher standards of legal authority.

As written, the Act requires tax preparers to disclose return positions unless the preparer has a reasonable belief the position is "more likely than not" to be sustained in the event of a dispute with the IRS.

The act was effective on the date the law was enacted – which was May 25, 2007. A great many tax preparers were immersed in completing returns for their clients who had requested extensions of time to file and were not aware of the new rule until much later in 2007. Because the IRS had not issued any guidance on the subject, they issued a Notice (# 2007-54) late in 2007 that the effective date for the new rules would be for returns prepared and filed after 2007.

Disclosure requirements for self-prepared returns by taxpayers are not as stringent as the new rules for tax preparers. Taxpayers are not required to disclose return positions unless they involve reportable or listed transactions (See Tax Advisors vs. Taxpayers) or fail to meet a standard of a “realistic possibility” of being sustained in the event of a dispute with the IRS. Some high level IRS officials indicated that the new rules were a surprise to them. There had been no public discussion of the expanded penalty rules prior to passage.

Early in 2008, the IRS released notices with interim guidance for tax preparers until more complete regulations could be developed and published later in 2008. In Notice 2008-11, the IRS elaborated on the transitional relief provided in Notice 2007-54. In Notice 2008-12, the IRS elaborated on the expanded definition of a return preparer and a list of the returns to which the new rules would apply. And in Notice 2008-13, the IRS provided interim guidance on the expanded penalty provisions with a list of (1) returns that involve a tax liability, (2) returns that may subject a preparer to the new penalties even though the returns do not report a tax liability, and (3) a list of returns that do not subject the preparer to the penalty unless they are prepared willfully to understate a taxpayer’s tax liability.

Most of the tax information forms that I prepare for investors in foreign entities or foreign  investments are not listed in Notice 2008-13 even though they are information returns that may include income that should be included in the return of the taxpayer. I have absolutely no doubt that the omission of these information returns such as forms 8621, 3520, 3520-A, 5471, 8865, 8858 and others will be included in any revised Regulations or Rulings by the IRS.  I’m therefore not willing to rely on this obvious oversight by the IRS as a justification for failing to provide disclosure that would otherwise be required on other tax returns.

A tax advisor and/or preparer who fails to prepare a disclosure form about a tax issue that the IRS is likely to dispute could be subject to a penalty of 50% of the total fee received or to a minimum penalty of $1,000 – regardless of the fee. The preparer would either have to pay the penalty or spend a lot of time and money to appeal the imposition of a penalty.

Tax preparers and advisors can either quit preparing returns (or giving advice) or they can insist on full disclosure of any issues they regard as issues the IRS might dispute.

As a practical matter, preparers and advisors generally would not treat any exclusion, deduction, credit or valuation item as requiring disclosure if the item has been sanctioned by the tax code and the IRS has not indicated that they regard the item as being abusive in any manner. But if the preparer believes that the IRS is likely to dispute the treatment of an item on a tax return, he will need to prepare a disclosure statement in order to avoid penalties. He will also need to prepare disclosure statements with respect to any transaction that is either a “listed transaction” or a “reportable transaction” as described on the IRS web site.

However, based on the information in Notice 2008-13, preparers are only required to provide the disclosure statement to their client with an explanation as to the potential penalties that may apply to the client if the disclosure statement is not included with the final return. However, the client  is not subject to penalties unless the return position fails to meet the "realistic possibility standard" -- which is substantially less stringent than the "more likely than not" standard.

As indicated in my article on Tax Advisors vs. Taxpayers, taxpayers are also required to disclose certain listed or reportable transactions that are described on the IRS web site. 

The following links provide Internet access to the citations given above and to some additional information that may be of interest to anyone reading this document.

Other web sites are welcome to link to this document on my web site at http://www.offshorepress.com/preparer_penalties.htm  Copies of this document may be forwarded to others via email or archived on other web sites subject to the condition that the document is transmitted or archived without ANY alteration.

Vernon K. Jacobs, CPA

© Copyright, Jan., 2008, All rights reserved.

http://www.vernonjacobs.com

http://www.offshorepress.com

 

Notice 2008-13: IRS Interim Guidance on Expanded Preparer Penalties

http://www.irs.gov/pub/irs-drop/n-08-13.pdf

Notice 2008-12: IRS Interim Guidance on Preparer Signature Requirements

http://www.irs.gov/pub/irs-drop/n-08-12.pdf

Notice 2008-11: IRS Guidance on Expanded Definition of Return Preparers

http://www.irs.gov/pub/irs-drop/n-08-11.pdf

Notice 2007-54: Change Effective Date of Preparer Penalties to 12/31/07

http://www.irs.gov/pub/irs-drop/n-07-54.pdf

NAEA Letter Regarding New Reporting Standards for Tax Preparers

http://www.naea.org/MemberPortal/Advocacy/Comments/letter_aug_6_2007.htm

IRS Instructions for Form 8275

http://www.irs.gov/instructions/i8275/ch01.html 

IRS Instructions for Form 8275-R

http://www.irs.gov/pub/irs-pdf/i8275r.pdf

IRS Web Site Description of Listed Transactions

http://www.irs.gov/businesses/corporations/article/0,,id=120633,00.html

IRS Guidance on Requirements for Disclosing Reportable Transactions

http://www.irs.gov/newsroom/article/0,,id=131368,00.html

Treasury Dept. Guidance on Reportable Transactions

http://www.treas.gov/tigta/auditreports/2006reports/200630058fr.html

CPA Journal on Reportable Transactions

http://www.nysscpa.org/cpajournal/2007/107/essentials/p36.htm

CCH Summary of the Small Business & Work Opportunity Act of 2007

http://tax.cchgroup.com/legislation/2007-small-business-work.pdf

Highlights of the Small Business & Work Opportunity Act of 2007

http://goliath.ecnext.com/coms2/gi_0198-421919/Another-new-tax-law-2007.html

Joint Committee on Taxation Explanation of the SB&WOA of 2007 (Page 37)

http://www.house.gov/jct/x-29-07.pdf


 

The following is my explanation of the new rules, which was written in the November, 2007 issue of the International Wealth Protection Monitor, with some minor editing in January, 2008.  Some of this information is duplicated above, but not much. 


An obscure law passed in 2007 will result in a potential conflict of interest between taxpayers and their tax preparers. The bottom line is that tax preparers are now subject to a higher standard of certainty than taxpayers with respect to any ambiguous or potentially aggressive tax positions.   In addition, tax preparers  must file a disclosure form about  any questionable tax  positions on a return in order to avoid severe penalties.   The disclosure form will be like a neon light to the IRS to identify returns with aggressive tax positions.

The Small Business and Work Opportunity Tax Act (P.L. 110-28, Section 8246) enacted on May 25, 2007 included a provision that imposed significantly greater penalties on tax preparers for preparing a tax return with an “unreasonable tax position” or an “understatement due to willful or reckless conduct”.  Most conscientious preparers are not going to be concerned about being penalized for willful or reckless conduct, but the laws that define an “unreasonable tax position” are a source of considerable concern to tax professionals. This law also extended the definition of return preparers to include preparers of estate and gift tax returns, employment and excise tax returns and to some tax advisors (such as lawyers) who have no direct involvement in the preparation of any tax forms.

In addition, the new law requires preparers to disclose any positions taken on a return unless the preparer believes the position is more likely than not (MLTN) to be sustained on its merits in the event of a dispute with the IRS. By contrast, taxpayers are only required to have an expectation of a “realistic possibility” that an undisclosed position will be sustained on its merits in the event of a dispute with the IRS.

Disclosure of a position taken on a tax return is realistically seen as a red light and an invitation for an audit by most taxpayers and preparers. Obviously, taxpayers want to avoid the chances of being audited if only because of the time and cost. But taxpayers also want to utilize every reasonable opportunity to minimize their taxes and many taxpayers want to utilize some very aggressive tax saving arrangements without having to disclose them in a separate statement. 

But the new penalties represent a much greater financial risk to preparers. Previously, a preparer could be penalized as much as $250 for an unrealistic position that is not disclosed on Form 8275. Now, the penalty is the greater of $1,000 or 50% of the fees received. For the majority of simple tax returns, the potential penalty would be greater than the total fee. Where a preparer is only charging an average fee of $200, a penalty of $1,000 on a disputed item would result in being VERY conservative about ambiguous transactions and a tendency to disclose every item that isn’t absolutely clear and supported by case law.

For large and complicated returns where the fee might be $10,000, a single undisclosed position that does not meet the more likely than not standard would result in a penalty of $5,000. I suspect the penalty would not be deductible, which would have the effect of consuming the entire fee for most tax preparers. (A $10,000 fee might result in $5,000 after taxes, which would be consumed by the 50% penalty.)

Preparers are left with a huge amount of ambiguity as to what constitutes an unrealistic position and whether a particular deduction, exclusion or credit is more likely than not to be sustained (by the courts) on its merits.

By way of an example, the U.S. Tax Court recently ruled in favor of a taxpayer in a dispute with the IRS about the proper tax treatment of a reimbursement of medical expenses for the spouse and family of a proprietor. It’s been my view for many decades that this was a settled and non-controversial issue. Suddenly, the IRS decides to take it to court. And there is currently no indication whether they will continue to dispute the issue. If I have a client who is using such a plan, should it be disclosed? If in doubt, I want to disclose it even if I might think it meets the standard of being more likely than not to be sustained. But the client reasonably would not want to disclose the issue because it certainly satisfies the realistic possibility standard that applies to the taxpayer.

What if the taxpayer says, “Let me prepare the return and I’ll pay you to review it for me”?

Well, that’s a catch-22 because the tax law essentially states that if a preparer reviews a return for compensation before it is filed, he or she has to sign the return as a paid preparer.  This means that taxpayers who want to utilize the realistic possibility standard are going to have to do so without the benefit of help from tax professionals.

So preparers have two choices.

We can either quit preparing returns and exposing ourself to these preposterous penalties or, if we continue to prepare returns, we will have to inform clients that we can’t include any undisclosed transactions on their return with which the IRS might not agree. Anything less than that puts us in the position of having to guess about the possible outcome and whether there is a “more likely than not” possibility that the disputed item would be sustained in the appeals process or in a court to which the dispute might be taken. 

And --- if the taxpayer decides to foregoe the time and expense of an appeal, the tax preparer is left with having to pay the penalty if the IRS asserts that the tax item should have been disclosed.

Here is an example of an addition that many tax preparers will begin to include in their engagement letters.

The 2007 Small Business and Work Opportunity Tax Act requires our firm as tax return preparers to conform to a higher standard than the taxpayer when an undisclosed tax position is being taken on your tax return.  This higher standard requires the preparer to have a reasonable belief that the undisclosed tax position would more likely than not be sustained on its merits if challenged by the IRS, and that there be a reasonable basis for the tax treatment.  Moreover, we may have to spend additional time preparing your return because of the extra research and analysis necessary to meet the standard. Accordingly, by signing this letter you acknowledge that you are aware of this difference in standards, and consent to our preparation of your federal income tax return in accordance with the standards applicable to our firm as tax preparers.

 If we conclude as a result of our research that you are required to disclose a transaction on your tax return, you consent to attach a completed Form 8275 or 8275R to your tax return after we discuss the situation with you and you also agree to hold our firm harmless with respect to any and all actual and consequential damages (including but not limited to taxes, penalties, interest, and attorneys fees and costs) that you incur as a result of including such disclosures with your filed tax returns. 

The actual wording in various engagement letters will differ to some extent from this example. 

With the adoption of the earlier rules that effectively eliminated the opportunity for taxpayers to avoid penalties by getting a written opinion from a tax professional -- and now with the much higher penalties that are imposed on tax preparers for failing to disclose a tax position with which the IRS might not agree -- the government has effectively eliminated any reasonable opportunity for aggressive tax avoidance. To avoid penalties, tax preparers will have to either require clients to disclose all questionable positions or will have to prepare returns based on positions that are clearly acceptable to the IRS – even if the IRS is being aggressive in how they interpret and administer the law.

The only other alternative that I can see is to prepare a return based on very conservative positions and to then prepare an amended return to take advantage of any uncertain positions -- but that would be an even higher level of disclosure.

Whatever choice will be made by taxpayers and their tax advisors or preparers, it will result in more time by tax preparers and higher fees for taxpayers and more work for the IRS. I suspect that some preparers will respond to this new law by inundating the IRS with a huge volume of disclosure forms for every vaguely uncertain position in the return. If every tax return included half a dozen disclosure forms, they would lose their effectiveness in highlighting potentially aggressive return positions.

Late in 2007, the IRS issued Notice 2007-54 to extend the effective date of this new law from May 25, 2007 to returns prepared after 2007.

In addition, in January of 2008, they issued three notices to provide iterim guidance to tax preparers until proposed regulations could be issued.

Some commentators believe this law may be challenged in the courts because it puts taxpayers and their tax advisors at odds with each other and effectively forces taxpayers to utilize the more conservative position that applies to their preparers than the position that still applies to self-prepared returns.

Vernon Jacobs
Dec. 15, 2007
 
The Offshore Press Home Page
VKJ CPA Home Page

Contact Information