Practical Questions

The new law raises a number of questions:

1.         Who is a Preparer?

As mentioned above, Section 6694 refers to the new definition of “tax return preparer” under Section 7701(a)(36), which encompasses those who prepare returns for all federal taxes.  While the regulations under Section 7701(a)(36) have not yet been revised, it is worth noting that the current regulations defining “income tax preparer” do so very broadly.  An income tax return preparer is any person who, for compensation, provides information and advice sufficient to enable a taxpayer or another preparer to complete an income tax return, or relevant to the determination of the existence, characterization, or amount of a substantial entry on an income tax return. ¹⁶  The statute provides exceptions for IRS workers and volunteers, and for anyone who simply provides mechanical assistance, or who prepares a return as an employee or fiduciary of the filing taxpayer. ¹⁷  In addition, the regulations state that a person who provides advice only on specific issues of law with respect to contemplated actions that have not yet occurred, or who, with respect to a completed transaction, provides advice that is not directly relevant to an entry on a return (e.g., something used only for accounting purposes), is not considered a preparer. ¹⁸

Illustration:  Suppose accountant A relies on an opinion drafted by lawyer B (in which lawyer B opined before the transaction on the likely tax effects of such a transaction) and after the transaction discusses the tax characterization of the event with attorney C (not associated with lawyer B).  Based on all that information, accountant A provides detailed instructions for his assistant D to report the proper values in the tax return of taxpayer F.  In that scenario, accountant A and attorney C are both considered preparers, because both have provided advice relevant to the treatment of a specific entry of taxpayer F’s return.  Lawyer B is not a preparer, as he produced his opinion before the transaction at issue took place.  Assistant D is also not a preparer, since he merely mechanically entered the data into the return.  If assistant D had instead added substantive information, he would nevertheless not be considered a preparer for purposes of Section 6694 (at least under current regulations), because only one person within a firm will be considered a preparer with respect to a specific return. ¹⁹  The accounting firm itself, however, can also be considered a preparer, along with accountant A. ²⁰

The new law, in amending Code Section 7701(a)(36), simply substitutes the phrase “tax return preparer” for “income tax return preparer.”  Thus, the activities that define a preparer are likely to remain the same; only the types of returns are being broadened.

2.         Determining Level of Confidence

Much of the distress caused by the new law has been generated by the new standards it imposes upon preparers, in particular the requirement that a preparer disclose any position that he or she does not reasonably believe is more likely than not to be sustained on the merits.  This new rule could lead to a conflict of interest between preparers and the taxpayers they represent, if a position on which a tax return is based has substantial authority but is not more likely than not to be upheld.  Defining the gray area in which there is substantial authority for a position but no reasonable belief that it is more likely than not to be upheld has thus become of crucial importance.

Having “substantial authority” under Section 6662 means that the weight of authorities supporting the position, determined in light of the pertinent facts and circumstances, is substantial in relation to the weight of authorities supporting contrary treatment. ²¹  Treasury regulations state that only certain items constitute “authority”: broadly speaking, rules and rulings produced by a branch of the government (i.e., Code provisions, regulations, revenue rulings, court decisions, committee reports, Blue Books, private letter rulings, and the like). ²²  Applicable authority must be weighed based on relevance and persuasiveness, taking into consideration factors such as age, precedential value, and cogency of argument. ²³  Treasury regulations do not specify a specific level of certainty at which point “authority” becomes “substantial authority.”  However, commentators have noted that since the latter seems to be a higher standard than the “realistic possibility of success” standard that regulations specifically define as one-in-three, ²⁴ so it is fair to say that a finding of a 40 percent chance of success is sufficient. ²⁵

Treasury has not yet issued any regulatory guidance on the determination of whether a belief that a position is “more likely than not” to be sustained is reasonable under Section 6694.  The standard is mentioned, however, in the regulations under Sections 6662 and 6664, and in both places the guidance is the same; therefore, we expect similar guidance under Section 6694.  The existing guidance states that the nature of the analysis here is similar to that of the “substantial authority” analysis, i.e., pertinent facts and authorities must be weighed based on relevance and persuasiveness, taking into consideration factors such as age, precedential value, and cogency of argument. ²⁶  However, it is not specifically stated that the types of authority relevant to a “more likely than not” analysis are limited to those official documents allowed for a “substantial authority” analysis.  Another important distinction is that the “substantial authority” standard is objective; it does not matter if the taxpayer believed, or even reasonably believed, that there was substantial authority, only that there actually is substantial authority. ²⁷  The “more likely than not” standard is subjective; assuming the same regulatory rules under Sections 6662  and 6664 are used under Section 6694, the preparer will only have to show that he or she reasonably believed that there was a greater than 50 percent chance the position would be upheld.  This reasonable belief would be established by showing that the preparer relied on the analysis of a professional tax advisor. ²⁸

The more-likely-than-not standard is the same as a taxpayer’s burden of proof in a civil tax case.  Thus, this standard is really another way of saying that the preparer must reasonably believe that the taxpayer would win on the position in court. ²⁹

3.         Information Received from Taxpayers

Given the new emphasis on having a reasonable belief that a position is more likely than not to be sustained, and the motivation to avoid harsh new penalties, tax return preparers may wonder if they need to question everything they rely upon in preparing a tax return.  However, while the new law clearly holds preparers to a higher standard with respect to the determination of the nature and tax treatment of transactions, there is nothing in the new statute that indicates any change in how preparers must deal with information furnished to them by their taxpayer clients.  Under the current regulation, preparers may rely in good faith upon such information, and generally preparers are not obligated to independently verify facts provided by taxpayers. ³⁰  “Good faith” means that a preparer cannot accept such information blindly if such information, either by itself or in the context of other information known to the preparer, appears to the preparer to be either incomplete or incorrect.  The preparer in such a situation must look deeper.

Still, the regulations require nothing more than “reasonable inquiries,” and if, in good faith, a taxpayer’s response satisfies the preparer’s concern, then even in the absence of documentation or other evidence, the preparer need not inquire further.  The regulation does require a preparer to make the necessary inquiries to determine that prerequisite facts and circumstances exist when called for by the Code, giving as an example the need to ask the taxpayer about the existence of the appropriate documentation of travel and entertainment expenses. ³¹  Even in that situation, though, the preparer can rely on the response given to him by the taxpayer; the preparer does not need to examine the claimed travel expense documentation, for example, if the client assures the preparer that such documentation exists.

4.         Multiple Issues Affecting the Tax Treatment of a Transaction

Multiple issues often affect the tax treatment of a single transaction.  In determining the likelihood that a particular tax treatment will be upheld, a preparer may have to consider several different aspects of the transaction, and make an evaluation of the likely strength of each individual aspect before coming to an overall conclusion.  What does a preparer need to disclose if he or she concludes that some issues are more likely than not to be sustained, but other positions – or the overall transaction – are not likely to be sustained?

Section 6694 focuses on “positions” that lead to the understatement of liability, and it is those positions that must be disclosed.  Unfortunately, neither the statute nor the current regulations define “position.”  Nor is there any analogous helpful definition anywhere else in the Code or Regs, or in any IRS or Treasury guidance or court case.  Note that the taxpayer penalty provisions under Code Section 6662(d) require a taxpayer to disclose “items” for which the taxpayer’s tax treatment has no substantial authority.  Common sense and the plain meaning of the term indicate that a taxpayer takes a position whenever the taxpayer chooses a particular tax characterization, whether of (i) an overall transaction, (ii) a series of transactions, or (iii) a particular item of income, gain, credit, loss, or deduction as part of a larger transaction.

Suppose, then, a preparer is preparing a return that reports the tax consequences of a multi-step transaction.  Suppose, further, that the preparer (or another preparer or advisor) has determined that the reported tax consequences of each of the first several steps of the transaction should be sustained, and thus he or she has a confidence level substantially higher than “more likely than not”.  Finally, suppose that the position taken with respect to the final step, however, has only a “reasonable basis,” i.e., there is no reasonable belief that the position would more likely than not be sustained on the merits.  In such a case, it seems clear that there is no requirement to disclose the first several steps of the transaction.  It also seems clear that the position with respect to the final step of the transaction must be disclosed.

What about the overall transaction?  This breaks down into two questions:  First, is the overall transaction not likely to be sustained, because the final step is not likely to be sustained?  Second, should the preparer disclose the overall transaction or position, or can the preparer determine his or her disclosure obligations by reference to the separate parts of the transaction?  In the absence of further guidance, such questions may need to be addressed on a case-by-case basis.