Applying tax laws to existing facts is not always a black and white affair. Many times there is uncertainty as to how the law should apply in a given situation. This creates issues for taxpayers and tax return preparers as to how to report such items, and penalty risks if an incorrect position is adopted.
In the past, the standards for imposing penalties on preparers were less strict than the standards for imposing penalties on the taxpayers. Recent law changes have flipped this - now preparers labor under more strict standards than the taxpayers.
The standards for imposing penalties are and were:
-FOR PREPARERS UNDER OLD LAW - "unrealistic positions", or an enhanced penalty for "wilful or reckless" conduct (IRC Section 6694);
-FOR TAXPAYERS - "no substantial authority" (IRC Section 6662(d)); and
-FOR PREPARERS UNDER NEW LAW - "no reasonable belief that the position would more likely than not be sustained", or an enhanced penalty for "wilful or reckless" conduct (IRC Section 6694).
Also, the penalties on preparers were previously only $250, or $1,000 if the preparer was wilful or reckless. Now, the penalties are the GREATER OF $1,000 (or $5,000 for wilful or reckless conduct) and 50% of the fees earned by the preparer. For many returns, including estate tax returns, this 50% penalty can run into the tens of thousands or even hundreds of thousands of dollars. Also, in addition to monetary penalties, preparers who incur penalties may also be referred to the Director of Practice.
With this new setup, preparers may now face return reporting positions which pass muster under the "no substantial authority" standard, and thus should not incur penalties for the taxpayer if the IRS disagrees, but for which the preparer is uncertain will fly under the "more likely than not" standard under which the preparer labors. This can create a conflict of interest between the preparer and the taxpayer - the preparer may need to be more conservative to protect its own interests than would be necessary to protect the interests of the taxpayer. The conflict of interest issues can be further exacerbated when the return preparer is also a fiduciary of the taxpayer - e.g., corporate fiduciaries for estates and trusts often prepare income tax returns and estate tax returns for the estate or trust.
Note that both taxpayers and preparers can avoid these penalties if they disclose the issue in a prescribed manner on the tax return. Of course, taxpayers often are concerned about disclosure as a "red flag" to the IRS to audit the return or examine the particular issue.
A preparer caught in this situation has the following basic alternatives:
a. Prepare the return with the uncertain position, and run the risk of incurring the preparer penalty;
b. Obtain a covered tax opinion that meets the Circular 230 requirements, thus substantiating the preparer's reasonable belief that the position is more likely than not to be sustained by the IRS (assuming that this is a valid belief and a tax practitioner is willing to provide the opinion). This takes time and generates the additional expense of obtaining the opinion; or
c. Provide adequate disclosure on the tax return to the IRS. This raises the "red flag" concerns addressed above.
Interestingly, by increasing the penalties and standards of the preparers, Congress has in effect increased the standards for taxpayers who need the services of a return preparer.
Special thanks to my partner, Marvin Gutter, for his analysis of these issues.
IRC Sections 6662; 6694.
A HAPPY AND HEALTHY NEW YEAR TO YOU ALL!