The Small Business and Work Opportunity Tax Act (P.L. 110-28, Section 8246) enacted on May 25, 2007 includes changes that have raised serious concerns for tax preparers.  In addition to creating a new penalty on erroneous claims for refund or credit that are filed without any reasonable basis under IRC §6676, the law includes revisions to IRC §6694 which extends its application from federal income tax return preparers to all federal tax return preparers under IRC §7701(a)(36).  Preparer penalties have been raised from $250 per violation to the greater of $1,000 or 50% of the income derived from the fees received for preparing a tax return with an “unreasonable tax position” and from $1,000 to the greater of $5,000 or half the income for an “understatement due to willful or reckless conduct” under IRC §6694(a)(2) and §6694(b)(2).  Furthermore, the “realistic possibility” standard for an undisclosed position has been replaced by the standard of “a reasonable belief that the position would more likely than not (MLTN) be sustained on its merits” and the “not-frivolous” standard for a disclosed position has been replaced by “a reasonable basis” for the tax treatment standard.

Subsequently, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, (Div. C. of P. L. 110-343, Section 506, October 3, 2008) changed the general standard under IRC §6694(a) from MLTN to substantial authority for positions other than tax shelters (IRC §6662(d)(2)(C)(ii)) and reportable transactions (IRC §6662A).  Please refer to Notice 2009-5 for the definition of substantial authority and other interim guidance, e.g., penalty compliance rules, until the IRS issues further guidance.

The IRS generally considers a disclosure as adequate 1) if it is made on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, and attached to the return, amended return, or refund claim; or, 2) if the position taken is not frivolous and is adequately disclosed as described in Treas. Regs. §1.6694-2(c) (3) and §1.6662-4(f).  The reasonable basis standard will be applied without regard to the disclosure requirements for all other returns, amended returns, and refund claims. 

The 2008 Act’s revisions to IRC §6694 uphold a higher standard on tax shelters and reportable transactions. Potentially, the different treatment can create conflicts between CPAs and their clients concerning disclosure of tax positions with respect to a tax shelter or reportable transaction to be taken on returns, as taxpayers might feel disadvantaged by having their returns prepared by a tax practitioner and propose implausible solutions to circumvent the requirement.  Under IRC §7701(a) (36) and Treas. Regs. §301.7701-15 and §1.6695-1, a compensated tax practitioner who obtains information from taxpayers to determine the proper application of tax laws and the taxpayer’s tax liabilities and reviews the accuracy of the returns can be considered a non-signing tax return preparer, even if taxpayers perform the mathematical computations and print their tax returns. Both signing and non-signing tax return preparers can be subject to preparer penalties, subject to a determination by the IRS.

Preparer penalties can often be avoided by complying with tax laws and professional standards such as the AICPA Statement on Standards for Tax Services (SSTS) and Treasury Department Circular No. 230 when rendering advice on tax return positions and by documenting the advice in writing.  Consider documenting advice to clients about tax return positions in writing, using the following format:

·    Taxpayer inquiry or proposed transaction(s);

·    Relevant facts, including business purpose, if applicable;

·    Reasonable factual assumptions and representations;

·    Analysis on how pertinent law applies to relevant facts;

·    Evaluation of significant tax issues;

·    Conclusions on each issue with associated benefits and risks. This should include an analysis on the probability of the undisclosed tax return position being sustained on its merits if challenged by tax authorities[1];

·    Remedial actions recommended if subsequent developments invalidate conclusions,[2] and

·    As applicable, a prominent disclosure that the tax advice was not intended or written by the tax practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under the law.

If a client is a tax shelter, has created a tax shelter, or has entered into a reportable transaction as defined in Sections 6662(d)(2)(C)(ii) or 6662A of the IRC, consider including a disclosure in client engagement letters that explains the application of the more stringent preparer standard to avoid later disputes with clients about disclosure of tax return positions.  An example of such a disclosure could read as follows:

Section 506 of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 requires our firm as tax return preparers to conform to a higher standard than the taxpayer when a tax position with respect to a tax shelter or reportable transaction 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.

You are required to disclose the tax shelter or reportable 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 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.  

You may also consider adding the following paragraphs to your engagement letter, if applicable:

Unless an undisclosed tax position taken by you meets the substantial authority or "more likely than not" standards, as applicable under the Internal Revenue Code, our firm will be unable to prepare the return and will withdraw from the engagement.

If a tax position to be taken on your tax return is based on the advice of another advisor, you will be required to obtain a written statement from the advisor that the position should meet the substantial authority or more likely than not standards, as applicable under the Internal Revenue Code.  We reserve the right to review such written statement and withdraw from the engagement without preparing the return.

The above engagement letter language is provided for example only. Always confer with an attorney with respect to the wording and enforceability of specific engagement letter provisions including the right to suspend services and withdraw from the engagement. To avoid confusion and potential conflicts with clients, it will be necessary to explain to clients prior to presenting the engagement letter and commencing services how this change will affect the preparation of their tax returns and the additional cost to provide written tax advice on undisclosed tax positions.

The IRS is expected to provide additional guidance to tax practitioners on this matter.  Until such time, all tax practitioners should familiarize themselves with the revisions and be prepared to discuss their impact with their tax clients. 

Updated April 2009

CNA, Accountants Professional Liability, CNA, 333 South Wabash Ave., 39 South, Chicago, IL 60604

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