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.

Practical Questions

The new law raises a number of difficult 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.

5.         Methods of Disclosure

Disclosure is, and was under the old law, an important means by which both the preparer and the taxpayer could avoid penalties.  Regulations under the old statute provide that the necessary disclosure could be made in different ways by different preparers.  A person who signs a return or claim for refund as preparer could disclose a position (i.e., one with no realistic possibility of being sustained on the merits) either by describing the position on Form 8275-R (Regulation Disclosure Statement, used to disclose positions contrary to Treasury regulations) or on Form 8275 (Disclosure Statement, used to disclose all other items or positions), or by complying with the annual Revenue Procedure (e.g., Rev. Proc. 2006-48) issued to provide guidance on standards for adequate disclosure of certain specific items and positions. ³²  The revenue procedures offer guidance on the disclosure of a limited number of common items (e.g., certain itemized deductions, certain trade or business expenses, and moving expenses) ³³; therefore, with respect to less common items or positions, the preparer would need to file Form 8275 or 8275-R with the tax return.

A preparer who did not sign a return, but advised a taxpayer directly with respect to a specific entry, could also meet the disclosure requirement by disclosing on Form 8275, 8275-R, or as advised by the annual revenue procedure.  In addition, such preparer could also satisfy his or her disclosure obligations by including with his advice a statement that the position taken is not supported by substantial authority, and inform the taxpayer of his or her obligation to disclose under Code Section 6662(d). ³⁴  This statement had to be written if the advice itself was written, but could be oral if the advice was oral.  The determination of whether oral advice was actually given is based on all facts and circumstances, although generally, contemporaneously prepared documentation of the oral advice is considered sufficient.  Similarly, a preparer who advised another preparer (rather than signing a return or advising a taxpayer directly) could meet the disclosure requirement if a Form 8275 or 8275-R is filed, if the annual revenue procedure is followed, or if, in advising the other preparer, the preparer had included a statement that the position was not supported by substantial authority and needed to be disclosed under Code Section 6694(a). ³⁵

Although old Section 6694 (like the current version) did not provide a disclosure exception to the penalty for intentional disregard of rules or regulations, the regulations under the old Section 6694 do provide one.  If a position contrary to a rule or a regulation is not frivolous and, in the case of a position contrary to a regulation, represents a good faith challenge to the validity of the regulation, then a preparer will not be considered to have “recklessly or intentionally” disregarded the regulation if the position is adequately disclosed.  Disclosure is only adequate, in the case of signing preparers, if made on Form 8275 or 8275-R (the annual revenue procedure is not applicable), and the rule or regulation being challenged is adequately identified.  Nonsigning preparers who advise taxpayers can similarly rely on disclosure on Form 8275 or 8275-R (along with identification of the challenged rule), or include with their advice a statement that the position is contrary to a rule or regulation (and if the latter, must represent a good faith challenge to the validity of the regulation) and must be disclosed under Code Section 6662(c).  Nonsigning preparers who advise other preparers can also rely on disclosure and identification on Form 8275 or 8275-R, or include a statement that disclosure under Section 6694(b) is required.

Those are the regulations under the previous version of the statute, which for income tax return preparers remain in effect during the transitional period.  For all other types of tax return preparers, the transitional relief in Notice 2007-54 provides that the reasonable basis standard set forth in the regulations under Code Section 6662 will be applied, without regard to the disclosure requirements contained therein.  This means that a preparer will not be subject to penalty with respect to any position with a 20 percent or greater chance of success will not be penalized, even if undisclosed.

But what of the future?  The new law leaves the same statutory disclosure language in place, which implies that the regulatory requirements will also remain the same.  In Notice 2007-54, the IRS stated that new guidance, procedures, and forms would be needed with respect to disclosure, although under both the old and the new versions of the statute, disclosure would be adequate if made on Form 8275 or 8275-R.  The IRS did not expressly state that new regulations would be needed on the topic of disclosure.  Accordingly, it seems likely that the disclosure provisions will remain largely unchanged.

6.         Circular 230

Circular 230, Section 10.34, provides standards specifically for practitioners advising a client with respect to a position on a tax return, or practitioners preparing or signing a tax return.  These standards are essentially identical to the requirements under old Section 6694.  Therefore, under the stricter new Section 6694, this part of Circular 230 imposes no additional burdens.

However, since a nonsigning preparer may satisfy his or her disclosure obligations via a statement to another preparer or the taxpayer, such preparer must consider the possible application of Circular 230.  Circular 230 requires advisors to meet certain standards with respect to written “covered opinions” concerning federal tax advice.  Broadly speaking, these covered opinions include any tax opinion regarding:  (i) a transaction identified by the IRS as a “listed transaction” pursuant to Code Section 6011, (ii) a plan or entity having a principal purpose of tax avoidance, or (iii) any plan or entity having a significant purpose of tax avoidance, if the opinion is a reliance opinion or a marketing opinion or is subject to confidentiality or contractual protection. ³⁶

The only type of covered opinion that turns upon confidence level is the reliance opinion.  Circular 230 defines a reliance opinion as one that concludes at a confidence level of at least more likely than not that one or more significant federal tax issues would be resolved in the taxpayer’s favor, unless the practitioner who wrote the opinion prominently discloses that it may not be relied upon for penalty protection. ³⁷  However, under new Section 6694, a preparer will only be prompted to prepare a statement if the confidence level is less than more likely than not that the position would be upheld.  Thus, a statement made by the preparer solely to protect himself or herself from penalties under 6694 generally would not be subject to Circular 230 (though it may still be, if it fits one of the other categories of covered opinion). 

On the other hand, if a preparer, or a non-preparer advisor, concludes that a position is more likely than not to be sustained, he or she may be asked by another preparer (or by the taxpayer) to prepare written advice to that effect, so that the other preparer can rely on that advice for his or her own protection from Section 6694 penalties. ³⁸  Such advice, if written, would constitute a reliance opinion, and would be subject to Circular 230.  Note, however, that in order to avoid being considered a reliance opinion, advice produced by non-preparer advisors sometimes includes a statement that it was not intended to be used, and cannot be used by the taxpayer, for the purposes of avoiding penalties that may be imposed on the taxpayer.  If such language, specific to “taxpayer” is used, it may be possible to argue that, while the statement is not a covered reliance opinion, it may yet be used by a preparer for purposes of avoiding penalties under Section 6694.  This possibility obviously has not been tested.

Theoretically, another way for a preparer to receive some protection from penalties under Section 6694 without requiring that a formal Circular 230 covered opinion be prepared would be to rely upon oral advice.  Oral advice from a preparer or other advisor, stating that a particular position is more likely than not to be sustained, is not covered by Circular 230, but may be relied upon to protect the preparer from penalties (at least under the old Section 6694 regulations). ³⁹  However, we cannot recommend this strategy, because the preparer who relies on such oral advice would bear the burden of establishing that he or she actually received such advice.

7.         Reliance on Other Preparers
           
Taxpayers often rely on the advice of multiple parties in the preparation of a specific tax return.  For example, a taxpayer may hire an attorney to determine the appropriate tax treatment of a specific transaction, and later hire an accountant to prepare the income tax return for the year in which the transaction occurred.  An obvious question is whether each preparer is required to make his or her own separate determination of the strength of each position, or whether a preparer is allowed to rely on the opinion of others (even those who are not technically preparers).

Both the current version and the previous version of Section 6694 contain a reasonable cause exception to the penalty, under which no penalty will be imposed if the preparer can show that there was reasonable cause for the understatement and that the preparer acted in good faith. ⁴⁰  The language in both versions is similar, so it may be safe to assume that the regulatory guidance produced under the prior version will remain in place.  Those existing regulations explain that the applicability of this exception depends on all the facts and circumstances.  Several potentially relevant factors are listed, including “reliance on the advice of another preparer.” ⁴¹  The regulation states that the “reasonable cause and good faith exception applies if the preparer relied in good faith on the advice of another preparer . . . who the preparer had reason to believe was competent to render such advice.” ⁴²   A preparer can also rely on the advice of a non-preparer – e.g., a law firm that provides a tax opinion before a transaction is carried out – if the non-preparer would have been considered a preparer had the advice constituted preparation of a substantial portion of the return. 

This broad language indicates that a preparer is protected if he or she relies on the advice of another.  However, the reliance must be in good faith, and the regulations state that there is no good faith if (i) the advice is unreasonable on its face, (ii) if the preparer knew or should have known that the advisor was not aware of all relevant facts, or (iii) if the preparer knew or should have known (“given the nature of the preparer’s practice”) at the time the return was being prepared that the advice was no longer reliable because of changes in the law. ⁴³  Thus, while a preparer is not necessarily required to re-examine an issue that has already been passed upon by another advisor, he or she cannot blindly accept the advice of another.  A preparer must review the advice for reasonableness, and must consider whether or not the advisor was aware of all relevant facts and applicable law at the time he or she rendered the opinion.

8.         Privilege

Of course, the sharing of advice and opinions among advisors and preparers raises the issue of privilege.  The hazards of waiving the attorney-client privilege and its statutory accountant-client counterpart (Code Section 7525) can be difficult to navigate when only two parties (the taxpayer and his or her advisor) are involved.  What if there are three or more parties working on the transaction?  What happens to these privileges when a tax return preparer relies on the advice of another preparer or a non-preparer?

Under federal law, privileges are very narrowly construed and strictly applied.  The attorney-client privilege protects communications made in confidence between a taxpayer and his or her professional legal advisor to obtain or render legal advice, unless the taxpayer waives the privilege. ⁴⁴  Code Section 7525 treats certain communications between a taxpayer seeking tax advice and his or her accountant as if they were communications between the taxpayer and an attorney.  Thus, if a taxpayer hires either an attorney or an accountant to provide tax advice with respect to the treatment of an item or a transaction, their communications may be privileged.  In addition, an attorney may retain an accountant to assist in rendering his or her tax advice, such as when an attorney hires an accountant to “translate” the complexities of a client’s financial affairs. ⁴⁵

These rules do not give blanket protection to communications among a taxpayer and his or her attorneys and accountants, especially in combination.  There are two principles that severely limit the privileges. 

First, the privilege only applies with respect to legal advice.  The IRS often argues that much of the work done to prepare tax returns does not involve legal advice.  Many courts have concluded that the preparation of tax returns is outside the scope of the attorney-client privilege, ⁴⁶ although some courts appear to be willing to examine individual cases. ⁴⁷  In any case, do not assume that any work that an attorney performs will automatically be viewed as rendering legal advice.  The accountant-client privilege under Code Section 7525 is technically subject to the same limitations, since that privilege is explicitly co-extensive with the attorney-client privilege.  These limitations are much more burdensome on accountants, however, because a much smaller percentage of their work (as opposed to attorneys’ work) constitutes legal advice; the IRS can be expected to argue (and many courts will agree) that virtually everything an accountant produces relates to non-legal advice, such as the preparation of tax returns, and is thus discoverable.

Second, only communications which are and can reasonably be expected to remain confidential can be privileged.  Obviously, communications of information that will appear on a tax return are not confidential.  But the need for confidentiality is much broader.  As noted above, an attorney hired by a taxpayer to render legal advice can engage the services of an accountant to assist in determining the proper tax treatment.  In such a case, the accountant is considered the agent of the attorney, hired by him to assist in his understanding of the legal issues, and thus there is no waiver of confidentiality.  However, if the client, rather than the attorney, employs the accountant, and if the accountant assists the attorney in the latter’s advice (e.g., by explaining to the attorney the reasoning behind an earlier determination), their communications may not be considered privileged.  Here, the accountant is not the attorney’s agent, but a third party, with whom communications are not privileged.

A taxpayer who seeks to rely on the advice of counsel as a defense may waive the attorney-client privilege with respect to that advice.  For example, when taxpayers responded to government interrogatories concerning an accuracy-related penalty claimed they had reasonable cause based on advice of counsel, that response was deemed a permanent waiver of the attorney-client privilege with respect to the transactions at issue, because it would have been unfair for the taxpayers to raise the defense without allowing the government access to the communications upon which the defense was based. ⁴⁸  This type of implied waiver is particularly dangerous in the context of Section 6694, because not only the taxpayers, but also their preparers, may resort to a reasonable cause defense.  A taxpayer who allows privileged communications from one preparer to be shared with another, knowing that the latter might use such communications in a reasonable cause defense, may be deemed to have waived any confidentiality with respect to those communications, even if they are never actually used in that way. 

For these reasons, attorneys and accountants should anticipate that communications associated with advice a taxpayer or preparer relies upon in reporting a position on a tax return will not be privileged and may be subject to discovery by the IRS.  A taxpayer who keeps this possibility in mind can more precisely direct his advisors in the giving of advice.  For example, a taxpayer might hire an attorney to undertake a detailed analysis of a particular transaction, but request that the attorney draft a much briefer and less detailed statement for the taxpayer’s accountant to use in return preparation.  The accountant should be able to rely upon the less detailed statement, and it along with the rest of the accountant’s files will be discoverable; the more detailed analysis, however, will remain privileged in the hands of the attorney.

9.         Practitioner Skill

Do different preparers face different standards in the application of Section 6694?  Specifically, are more sophisticated or specialized preparers held to a higher standard?

According to existing regulations, all preparers are held to the same standard in the determination of the likelihood of success of a position taken on a tax return, because the regulations define an objective measurement.  However, if there is an understatement of tax and the preparer argues that there was reasonable cause and that he acted in good faith, one of the factors that the IRS must consider is whether “the preparer’s normal office practice, when considered together with other facts and circumstances such as the knowledge of the preparer, indicates that the error in question would rarely occur.” ⁴⁹  Here, the reference to the “knowledge of the preparer” appears to place a higher burden on the more sophisticated preparer.  However, to the extent that the standards of practice are defined by reference to the more sophisticated preparers, less sophisticated preparers are subject to greater risk, and might be expected to institute more meticulous office practices (such as checklists and review procedures) to compensate for his or her lesser knowledge in guarding against errors.

On the other hand, while all preparers appear to be held to the same objective standard in their determination of the strength of a position, there is some latitude in the existing regulations to account for the sophistication of particular preparers.  In preparing tax returns, for example, preparers may generally rely upon the information given to them by taxpayers without making independent verification.  However, a preparer “may not ignore the implications of information furnished to the preparer or actually known by the preparer.” ⁵⁰  This mandate leaves room for the argument that a more knowledgeable preparer may face a higher burden than someone less familiar with tax law, to whom “the implications” of certain information may not be apparent.
In sum, all preparers must adhere to an objective standard in determining the reasonableness of a position, standards may demand more care and effort from a less sophisticated preparer.  Such preparers might also be expected to put into place more detailed office practices to minimize errors.  A more sophisticated preparer, though, might be assumed to have a greater awareness of the implications of the information provided to him or her by a taxpayer, giving him or her a greater responsibility to follow up on those implications.

10.       Penalty Payments

As noted above, the penalties have been increased to the greater of $1,000 or 50 percent of the income derived by the preparer with respect to the return or claim, and $5,000 or 50 percent of the income derived with respect to the return or claim, in the case of willful or reckless conduct. ⁵¹  Because the trigger for the penalty is the preparation of “any return or claim for refund” with an understatement of liability, not the treatment of any particular item or position, it appears that any preparer can only be penalized once with respect to a particular return, but that the amount of the penalty will be based on all the income derived with respect to that return.  In other words, if a preparer provides advice on five different issues, affecting five separate items on one return, and there is a violation under Section 6694 with respect to two of those items, the preparer will only be subject to one penalty, but that penalty will be the greater of $1,000 or 50 percent of the income derived from the preparer’s work on all five issues.

The language of the statute provides for a reduction in the amount of the latter penalty for any amounts charged under the former, so that the maximum penalty under Section 6694 would be the greater of $5,000 or 50 percent of the income derived. ⁵²  There are no similar abatements stated with respect to multiple returns or to multiple preparers who worked on one return.  Therefore, it appears that, as was clearly intended under the old law, a preparer who takes the same erroneous position on several different returns will be required to pay full penalties with respect to each return.  Also, where two different preparers give advice on the same erroneous position in a single return, each could be penalized in an amount equal to 50 percent of its respective income derived.  Note that if Circular 230 applies to the advice given by a preparer, and if that advice does not meet Circular 230 standards, such preparer may be subject to an additional penalty of 100 percent of the income derived. ⁵³

Because penalties may be based on “the income derived . . . with respect to the return,” preparers should exercise care in defining such income.  Preparers who perform multiple tasks for a taxpayer, only one of which is the preparation of a tax return, should separately itemize the amount billed for return preparation, to forestall IRS claims that the penalty should be based on a larger amount.

As noted above, penalties levied under Section 6694 would not be deductible as business expenses under Code Section 162(a).  Section 162(f) explicitly denies deductibility for “any fine or similar penalty paid to a government for violation of any law,” and Treasury regulations make it clear that this includes any civil penalty imposed under chapter 68 of the Code (which includes Section 6694). ⁵⁴

What Does This Means for Taxpayers and Preparers?

The combination of being subject to stricter standards than taxpayers and the current absence of official guidance seems to put preparers into an uncomfortable position, having to urge their clients to secure opinions as to the tax treatment of transactions and report positions that the clients themselves have no obligation to report.  However, the situation need not be seen or presented as a conflict of interests.  Rather, preparers should take the opportunity to point out to their clients that their recommendations for obtaining opinions and disclosing positions are consistent with the ethical obligations and best practices of both the preparer and the taxpayer.  The establishment of such practices across the board for tax preparers appears to be one of the long-term goals of Treasury and the IRS, and professionals who put such practices into place now will best serve their clients and themselves.

Non-signing preparers have more flexibility than signing preparers, since (at least under existing regulations) non-signing preparers can meet their disclosure requirements by including, with their advice to the taxpayer or to another preparer, a statement that the position at issue needs to be disclosed.  Signing preparers currently have no such option.  It is possible that Treasury will recognize the awkward position in which signing preparers could find themselves if they have a duty to disclose but the taxpayer does not.  Treasury may, therefore, offer regulatory relief to signing preparers.

In practice, there may only be a limited number of situations in which preparers are required to disclose but the taxpayer is not.  In order to avoid disclosure, a taxpayer must be able to demonstrate the objective existence of specific authority (statutes, rulings, regulations, cases, and the like) that indicate at least a 40 percent chance of success.  A preparer must demonstrate a subjective reasonable belief that the position is more likely than not to be upheld, and there is no limit to the authority upon which this belief can be based.  Therefore, it may often be possible that while a taxpayer could not marshal “authority” strong enough to show more than a 40 percent chance of success, a preparer could nevertheless have a reasonable belief that the position is more likely than not to succeed.  If this belief is based at least in part on advice received from another preparer or advisor, then the preparer could also benefit from the reasonable cause and good faith exception.

If it does come to the point where the taxpayer feels he has substantial authority but the preparer has no reasonable belief in more likely than not status, the preparer should explain to the taxpayer that disclosure is necessary not merely to protect the preparer from penalty but to conform with the new standards of practice that Section 6694 put into place.  Treasury and the IRS have long sought to shift some of the burdens of oversight to tax preparers, in pursuit of their ultimate goal of increasing the reliability of our self-reporting tax system, and the modification of Section 6694 represents a major leap forward towards this goal.  Preparers are now expected take responsibility for the positions on which they rely in return preparation, to institute internal policies and procedures to minimize errors, and to seek outside advice when necessary.  Preparers should institute these best practices and apply them consistently.  While on a case-by-case basis, such practices might lead to apparent conflicts of interest with the taxpayer, in the long run they demonstrate a reliability and integrity that can only enhance the preparer’s representation of the taxpayer. 

The apparent conflict of interests may serve to protect the taxpayer: if a preparer cannot subjectively take the position that the whole universe of authority does not justify a reasonable belief in a 51 percent likelihood of success, that may indicate that the IRS will have an easier time showing that authority gleaned from a more limited subset of that universe does not reach the 40 percent threshold.  Also, while disclosure is traditionally associated with an increased audit risk, it is likely that under new Section 6694, disclosures will increase dramatically, given the stricter standards, higher penalties, and the broader definition of “preparers.”  In the face of such an avalanche of paper, the IRS may not have the resources it needs, and may need to alter the way it addresses disclosures ⁵⁵.  In practical terms, this may mean that disclosure will carry less risk for the taxpayer than in the past.

In the long term, it may be that the changes in Section 6694 are a harbinger of future movement in the law towards the synchronization of taxpayer and preparer penalties.  Another sign of such movement was the creation (in the same statute that altered Section 6694) of Code Section 6676.  This new Section provides a penalty for taxpayers who make an excessive claim for refund or credit without a reasonable basis.  Before the creation of Section 6676, a taxpayer could be penalized for underpayments of tax, but not (except with respect to listed or reportable transactions) for erroneous claims for refund.  Under old Section 6694, however, preparers could be penalized for unreasonable claims for refund.  Thus, the introduction of Section 6676 was another step in the synchronization of taxpayer and preparer penalties.  The disparity introduced by Section 6694 may only be temporary, and it may well be resolved not by another change to 6694, but by a change in 6662 increasing the taxpayer’s threshold for disclosure.
Such synchronization can already be seen between Section 6662 and Circular 230.  Section 6662 already provide a more-likely-than-not standard for taxpayers with respect to tax shelters, which are defined as partnerships or other entities, plans, or arrangements with a significant purpose of avoiding federal income tax. ⁵⁶  The more-likely-than-not standard and significant purpose of avoiding federal income tax also defines what constitutes a reliance opinion under Circular 230. ⁵⁷  In the face of such a trend, it is best practices for both taxpayers and preparers to harmonize their disclosure efforts.