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Tax Preparer Penalties under Circular 230 and IRC § 6694
By Richard Kellner, CPA

Over the years, legislation has expanded the definition for who or what is considered practice before the IRS and subject to preparer penalties. The preparer penalties have increased substantially and the tax forms that are subject to preparer penalties have also increased. Now anyone who prepares a tax return for compensation is required to be registered with the IRS.

Federal tax return preparers must be able to identify and review these changes in order to be aware of their exposure related to assisting taxpayers with the preparation of federal tax returns.

Practice Before the IRS

Before the changes to Circular 230, "practice before the IRS" was defined in Circular 230 section 10.2(d), which stated, “Practice before the IRS comprehends all matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a taxpayer’s rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service…” but did not include the preparation of a tax return. It allowed individuals with certain designations, including attorneys, CPAs and EAs, to represent and advocate for taxpayers before the IRS. After Aug. 2, 2011, however, Circular 230 section 10.8 included preparation of a tax return as practice before the IRS. To prepare a tax return for compensation, the preparer must have a preparer identification number (PTIN). A new license category of tax return preparer, known as the registered tax return preparer (RTRP) was established. In a transitional period, provisional PTINs will be issued to this new category of preparers in order to give them time to comply with the requirements of becoming a RTRP, including passing the competency exam. The newly licensed preparers are granted limited authority to advocate for taxpayers before the IRS.

Practice before the IRS (including the new PTIN requirement and the new category of RTRP) is governed by Circular 230. The Office of Professional Responsibility (OPR) is responsible for monitoring compliance with the regulations of Circular 230,and the Return Preparer Office is responsible for PTINs and the RTRP competency test.

Preparer Penalties and Avoiding Sanctions

Along with increasing the forms that subject a preparer to penalties, the preparer penalties under IRC section 6694 have dramatically increased over the past few years. For example, in section 6694 (a), understatement due to unreasonable position, the $250 penalty was increased to $1,000 and in section 6694 (b), understatement due to willful or reckless conduct, the $500 penalty was increased to $5,000. Sanctions under Circular 230 and section 6694 include prison as well as monitory actions.

Some of the changes affecting regulation are already in place. For example, Circular 230 section 10.33 (b) requires the responsible party to ensure that proper procedures are in place to meet the requirements of Circular 230. This means that now each tax preparation firm must provide proper procedures to ensure accurate and timely preparation of tax returns.

There are also other significant changes, including revisions of Circular 230 sections 10.34, 10.35, and 10.36 that directly impact how tax preparation businesses conduct themselves.

Now, more than ever, paid tax return preparers must understand and educate themselves to avoid sanctions by the IRS or OPR.

Before we discuss the three categories of preparers identified in Circular 230, we must:

  • visit the levels of confidence in a tax position.
  • know whether or not the issue involves tax shelter or reportable position.
  • consider the overall materiality of the tax issue or position.

As professionals, we must determine the level of confidence that we have in order to uphold a position, should that position ever be challenged by the appropriate authority. We must also know what primary and secondary sources for tax research are allowed to be used and how much weighting we are allowed to place on the different sources. As professionals, we must apply the appropriate weighting to each source. A lower court decision in the taxpayer’s district, for example, can carry a greater weight that the same level court in another jurisdiction. Also, appeals courts can be weighted higher than lower court rulings. Our weighting, however, should be consistent between cases and we should not base the weighting on how it will enhance the desired tax position. We then must provide these weightings to the applicable cases to determine the levels of confidence in a tax position.

The following are levels of confidence in tax positions based on the Tax Advisor, May 2012, Interpretations of SSTS No. 1, Tax Return Positions:

  • The More Likely Than Not (MLTN) standard is normally satisfied if one can reasonably conclude that there is a greater than 50 percent likelihood the position will be upheld on its merits.
  • Substantial Authority (SA) is an objective reporting standard and is satisfied if the weighted authorities supporting a particular position are substantial in relation to the authorities supporting a contrary position. In practice, SA normally requires at least about a 40 percent likelihood that the position will be upheld on its merits. For federal tax purposes and those of many other jurisdictions, any transaction classified as a tax shelter or reportable transaction must satisfy the subjective MLTN standard as well as the objective SA standard.
  • Realistic Possibility of Success (RPOS) normally requires a one-third likelihood that the position will be sustained on its merits.
  • Reasonable Basis (RB) is lower than the RPOS, but is significantly higher than the "frivolous" or not patently improper and "is not satisfied by a return position that is merely arguable or that is a colorable claim," according to the article. A position normally satisfies the RB standard if it’s reasonably based on one or more authorities (considering the relevance and persuasiveness of those authorities). In practice, RB normally requires about at least a 20 percent likelihood that the position will be upheld on its merits.
  • Any position, frivolous, abusive, groundless or other, that delays the IRS in properly administering the tax code and that has less than a 20 percent chance of success, should be scrutinized with these ratings in mind.

Regulations have provided recent guidance on the economic substance doctrine, which preparers should consider to avoid penalties. If a transaction does not have a business, income or other profit motive, other than reduction of tax, the economic substance doctrine will not allow that position. .

If a position involves a tax shelter or reportable position, the MLTN position must be met, in order to give favorable advice on the position Circular 230 (c) (4) (i).

Preparers Subject to Sanctions and Corresponding Circular 230 Sections

The preparer with overall responsibility for the tax return and the signing of the tax return is subject to sanctions under Circular 230 and the IRC, as is the firm that employee this preparer. A preparer who is not required to sign the return, however, may also be subject to sanction under Circular 230, if this person is considered to have prepared a substantial portion of the return. This preparer is considered a non-signing preparer stated under Treas. Reg. 301.7701-15(b) (2). Factors to consider in determining whether a schedule, entry or other portion of a return or claim for refund is a substantial portion of the may include, but are not limited to, the size and complexity of the item relative to the taxpayer’s gross income and the size of the understatement attributable to the item compared to the taxpayer’s reported tax liability (Treas. Reg. 301.7701-15(b)(3)(i)).

For purposes of applying the aforementioned rules to non-signing preparers, the schedule or other portion of the return is not considered to be a substantial portion if the schedule, entry or other portion of the return or claim for refund involves amounts of gross income, amounts of deductions, or amounts on basis of which credits are determined that are either:

1. Less than $10,000
2. Less than $400,000 and also less than 20 percent of gross income as shown on the return or claim for refund (or, for an individual, the individual’s adjusted gross income) (Treas. Reg. 301.7701-15(b) (3) (ii) (A)).)

The three categories of preparers subject to sanctions are the signing preparer (i.e. the responsible paid tax return preparer, covered in Circular 230 section10.34), the firm (or employer) of the signing preparer (covered in Circular 230 section 10.36), and the non-signing preparer (that does not include the new designation of RTRP, covered in Circular 230 section 10.35).

Circular 230 section 10.34, standards with respect to tax returns and documents, affidavits and other papers, begins with the usage of the terms willfully, reckless, or through gross incompetence. These terms are not defined in Circular 230, but rather are subject to interpretation by the IRS or OPR and the alleged perpetrator has the right to have these assertions confirmed or dismissed by the courts.

The willful, reckless or through gross negligence position must lack reasonable basis, be an unreasonable position, (for example, not meet the substantial authority level of confidence IRC 6694(a) (2), or be a willful attempt to understate the tax liability or reckless or intentional disregard of the regulations.

We can look at some cases to see how the courts have ruled on specific issues. For example, there are many disciplinary actions brought on because the preparers did not file their personal tax returns. The courts have not been very forgiving in these cases. Generally the courts take a dim view if the preparer does not provide information requested by IRS. If this issue, however, is the result of an uncooperative taxpayer, or a fiduciary relationship between the preparer and the taxpayer, the courts have been a little more forgiving.

In Circular 230 section 10.36, procedures to ensure compliance, section (a) relates to covered opinions and section (b) relates to tax returns. These sections provide sanctions for the person with principal authority to oversee the firms practice and are in addition to the sanctions for the preparer.

There is a responsibility for the firm to take steps to ensure the firm has adequate procedures in effect for all members, associates and employees for purposes of complying with section 10.35.

The Circular 230 section 10.35, request for covered opinions, includes written advice and provides definitions and specific requirement reliance opinions, marketed opinions, opinions subject to conditions of confidentiality and opinions subject to contractual protection, (e.g., advice on tax shelters). Generally, to recommend these decisions, a MLTN standard must be met.

In summary, paid tax return preparers must understand the new regulations in Circular 230, and IRC sections 6694 and 6695, and must implement procedures and exercise judgment to avoid the enhanced sanctions provided by these regulations.


Richard Kellner, CPA, who owned and operated a CPA firm with offices in Massachusetts and Florida for over 20 years, now works for Drake Software, in Franklin, N.C. He is a member of the AICPA and has a B.S. in accounting from Bentley College, an M.B.A. from Babson College and a master's degree in taxation from Florida International University. He can be reached at 786.427.1695 or rick@richard-kellner.com.

 
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The views expressed in articles published in Tax Stringer are those of the authors and not necessarily those of Tax Stringer, unless otherwise indicated. Articles contain information believed by the authors to be accurate as of original publication. The reader should not construe the content included in Tax Stringer as accounting, legal or other professional advice. If specific professional advice or assistance is required, the services of a competent professional should be sought.