NAEA Letter Regarding New Reporting Standards for Tax Preparers

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.