On May 25, 2007, Congress unexpectedly made changes to Internal Revenue Code (“Code”) Section 6694, which imposes penalties upon accountants, lawyers, and others who participate in the preparation of a tax return that understates the taxpayer’s tax liability. ¹  The changes themselves were not entirely unforeseen – the Joint Committee on Taxation and the Treasury Department called for such changes in 1999. ²  However, those recommendations had been made in the context of more sweeping proposed changes that would have affected and equalized the penalty provisions governing both return preparers and taxpayers themselves. 

The new provisions were passed as part of an Iraq war funding bill with no debate and no additional commentary by Treasury, and because the changes address only preparer penalties, they leave preparers in the position of having to adhere to a stricter standard than taxpayers.  The new law also drastically increases potential penalties and substantially broadens the class of persons subject to preparer penalties.

Treasury was caught by surprise by both the suddenness and the breadth of the changes Congress made to these rules. ³  Treasury quickly issued a notice providing transitional relief for 2007, buying itself some time to address the changes in the law more comprehensively. ⁴  Treasury will likely promulgate new rules, procedures, and forms in the near future.

This article will (i) analyze the standards of practice a preparer was obligated to adhere to under the old Section 6694, (ii) describe the more stringent standards imposed by the revised statute, (iii) address potential conflicts of interest between preparers and taxpayers, and (iv) discuss practical issues that arise in complying with the stringent new rules.
In a Nutshell

Before the new provisions were passed, old Code Section 6694 imposed a penalty of $250 on any person who prepared a return or claim for refund ⁵ on which there was an understatement of tax liability and who knew, or reasonably should have known, such return contained a position that was undisclosed to the IRS and had no realistic possibility of being sustained on its merits. ⁶  However, the preparer was not subject to this penalty if the return disclosed the preparer’s non-frivolous position or if the preparer could show that there was reasonable cause for the understatement and the preparer acted in good faith. ⁷  Old Section 6694 also provided a penalty of $1000 for persons who prepared an income tax return on which there was an understatement of liability if the preparer made a willful attempt to understate the liability, or if the preparer recklessly or intentionally disregarded rules or regulations.  The total penalty under both these provisions could not exceed $1000 with respect to any one return.

The recent law made three changes:

1.         Applicable to All Federal Tax Returns
           
New Code Section 6694 applies to preparers of all federal tax returns (not just to income tax preparers). ⁸  The Blue Book explanation and the newly revised Code Section 7701(a)(36) specify that these returns include estate and gift taxes, employment taxes, excise taxes, and returns of exempt organizations. ⁹ 

2.         Stricter Standards

Under the old law, a preparer could be penalized if he took a position on a return that led to an understatement of tax and if either that position was frivolous or that position had no realistic possibility of success and remained undisclosed. ¹⁰  In comparison, taxpayers are subject to penalties if they rely on a disclosed position without any reasonable basis of success, or if they rely on an undisclosed position without substantial authority. ¹¹  Thus, taxpayers were held to higher standards, and could sometimes be in situations in which they might have the burden of disclosure, or should consider refusing to rely on a position, while their preparers might not have been subject to penalty for not advising them to disclose their position.
           
The new law has inverted this situation by making some of the standards for preparers stricter than those for taxpayers.  A preparer can now be penalized for taking a disclosed position with no reasonable basis of success, which is the same standard applicable to taxpayers. ¹²  However, a preparer can also be penalized for taking an undisclosed position if he had no reasonable belief that the position was more likely than not to be sustained on its merits. ¹³  Thus, unless a preparer reasonably believes that the position has at least a 50 percent chance of success, he must counsel disclosure, even if the taxpayer need not disclose because the position has substantial authority.

3.         Higher Penalties
           
The new provisions also radically change the penalty structure.  The previous penalty of $250 per return for frivolous or unrealistic undisclosed positions has been replaced with a penalty for preparing returns based on positions with no reasonable basis or undisclosed but not more likely than not positions of the greater of (i) $1000 per return, or (ii) 50 percent of the compensation derived by the preparer with respect to the return. ¹⁴

The penalty for preparing returns in a willful attempt to understate liability or with a reckless or intentional disregard of rules or regulations is similarly increased, from $1000 per return to the greater of (i) $5000 per return, or (ii) 50 percent of the income derived by the preparer with respect to the return.  If this penalty is levied on top of the penalty for returns with no reasonable basis or improper nondisclosure, it is reduced in amount by the latter, so that the maximum penalty faced by a preparer with respect to any one return under Section 6694 is the greater of (i) $5000, or (ii) 50 percent of the income derived. ¹⁵

Note:  The preparer may not claim a deduction for these penalties on his or her personal tax returns.  Accordingly, when local, state and federal income taxes are taken into account, the 50 percent penalty is effectively a forfeiture of the compensation the preparer received for his or her work on behalf of the taxpayer.
Effective Dates and Transitional Rules

The statute provides that these new rules were to have become effective on the date of enactment, which was May 25, 2007.  However, acknowledging its own surprise and the difficulty of complying with the new law without specific guidance, the Internal Revenue Service (“IRS”) issued Notice 2007-54, in which it provided transitional relief while the Treasury Department considers the need for new regulations and makes necessary changes to relevant forms, publications, and procedures.

Under Notice 2007-54, the new rules which impose penalties on preparers with respect to positions without a reasonable basis or improperly nondisclosed positions will not come into effect until the end of 2007.  In these cases, transitional rules will apply for all returns and claims for refund due on or before December 31, 2007, all estimated tax returns due on or before January 15, 2008, and all 2007 employment and excise tax returns due on or before January 31, 2008.  The applicable transitional rules depend on the type of tax return involved.  For income tax returns (which were the only returns covered under old Section 6694), the previous standards will apply.  For all other types of returns (such as estate and gift tax returns or excise tax returns), the reasonable basis standard set forth in the regulations under Section 6662 will apply, without regard to the disclosure requirements contained therein.  These are the guidelines to which all taxpayers are subject under Section 6662, so preparers and taxpayers are subject to the same standards.

Note:  Transitional relief does not apply in cases of willful or reckless conduct, so all tax return preparers, regardless of the type of return prepared, are (as of May 25, 2007) subject to the increased penalties for preparing returns if he or she acts in a willful attempt to understate liability or in a reckless or intentional disregard for rules or regulations.