New Penalties Applicable to Attorneys Who Give Tax Advice

Proposed Tax Regulations under  § §6694 and 7701

Under Sections 6694 and 7701(36) of the Internal Revenue Code of 1986, as amended (the IRC)[1] and applicable Treasury Regulations,[2] attorneys and their firms providing tax advice with respect to events that have occurred, as opposed to contemplated, are subject to substantial monetary penalties and are deemed to be tax return preparers (Preparers). This is true even when the attorney is a pure advisor and never even sees the client's tax return, much less actually prepares it (Pure Advisor).

Although this broad definition of Preparer has been in the regulations for 30 years,[3] it has been largely ignored. Before the 2007 legislation, the penalty was small ($250) and would not apply if (1) the advice reached the standard of "reasonable possibility of success on the merits" (RPSM) (approximately one in three chance of success) or (2) the attorney acted in good faith with reasonable cause. The small penalty combined with (1) the RPSM standard and (2) the good faith and reasonable cause exception created a situation generally perceived as not worth worrying about nor the IRS spending a great deal of effort to enforce. However, with the 2007 amendments and new Proposed Regulations, this is no longer the case. The scope and reach of the new preparer penalties are broad; the standards are high; and the potential penalties severe!

This dramatic change occurred as a result of The Small Business and Work Opportunity Tax Act of 2007, which amended IRC  §6694 in three major ways:

  1. Increased the monetary penalty. Increased the preparer penalty to 50 percent of the income derived (or to be derived) from the preparation of the return or claim with the minimum penalty increasing from $250 to $1,000 (or if willful/reckless from $1,000 to $5,000).[4] Under regulations, advice rendered after the events have occurred and which impacts a substantial portion of a return is deemed to be the preparation of such return.
  2. Expanded the scope to cover all returns. Expanded the scope of the preparer penalty to encompass any federal return or claim for refund, not just income tax returns. The scope now includes estate and gift returns, excise tax returns, generation skipping tax returns, employment tax returns, private foundation tax returns, etc.
  3. Dramatically raised the standard. Raised the standard from RPSM to "more likely than not on the merits" (MLTN) or, if the item is properly disclosed, from "not frivolous" to "reasonable basis."[5]

The preamble to the Proposed Regulations states that the IRS will take administrative steps to no longer automatically require agents to refer attorneys to whom the  §6694 penalty is imposed to the Office of Professional Responsibility for potential sanctions; including censure, additional monetary penalties of up to 100 percent of the fee received (or to be received), etc.

These statutory changes (1) fundamentally alter the responsibility/liability of attorneys providing post-event tax advice, (2) make these attorneys disclosure agents for the IRS either directly by disclosure on tax returns or indirectly by informing taxpayers of the potential penalties, any benefits of disclosure and contemporaneously documenting such action, and (3) fundamentally impact taxpayer planning.

The 2007 amendments, through the adoption of the MLTN standard for Preparers to sign returns and provide advice even when the taxpayer would not be subject to penalty, created an ethical conflict between the taxpayers and the Preparers. Having a higher standard for Preparers than taxpayers places the attorney's self-interest in a conflict with the interest of the client. This is an ethically untenable position and has been recognized as such by Congress.[6]

Notice 2008-13 (the Notice)[7] and the Proposed Regulations somewhat abate the conflict of standards between the attorney tax advisor and the taxpayer by permitting a Preparer to prepare (or, in the case of advising attorneys, be deemed to prepare) a return containing undisclosed positions (other than positions involving tax shelters[8] or reportable transactions) that the attorney does not believe will MLTN be sustained if challenged. The attorney must (1) believe there is at least a reasonable basis (20 percent possibility of success on the merits) for the position, (2) provide specific disclosure to the taxpayer or another advisor, and (3) place contemporaneous documentation of the disclosure into the attorney's file. In the event of an audit and assessment of a taxpayer penalty, the knowledge of the existence and/or contents of such a contemporaneous document may be used by the IRS to defeat the taxpayer's penalty defense of reasonableness and good faith.

At this time it is unclear to the author under what circumstances the ethical rules governing Tennessee attorneys will permit disclosure to the IRS of the existence or the contents of such contemporaneous documentation without the client's consent. In the event of an IRS audit of the client resulting in an understatement with respect to a position on which the attorney gave less than MLTN advice, the failure to establish to the IRS the required disclosure was provided and contemporaneously documented will potentially subject the attorney to penalty.

Will the attorney find himself "at risk" of having to choose between IRS penalties or Tennessee Board of Professional Responsibility sanctions if the taxpayer does not want such communication to be disclosed? The Proposed Regulations define returns and claims for refund to include only those specifically identified in published guidance in the Internal Revenue Bulletin. The preamble to the Proposed Regulations indicates such guidance will be issued upon the finalization of the Proposed Regulations. Exhibit 3 of the Notice provides an extensive listing of forms to which  §6694(a) presently applies and another list of forms to which it will not presently apply.[9] Under the Notice, post-event tax advice given with respect to matters on the non-application list will not subject the attorney to the IRC  §6694(a) penalty. The  §6694(b) penalty for willful or reckless disregard of IRS rules and regulations, however, applies to all tax post-event advice applicable to any return.

Preparers Under Proposed Regulations

The Proposed Regulations provide for a "Signing Preparer" with the other Preparers classified as "Non-signing Preparers." A Signing Preparer is any preparer who signs or who is required to sign a return of tax or claim for refund as a preparer.[10] The Proposed Regulations further identify five kinds of preparers that may be subject to the penalty based on function. These are: (1) the Classic Preparer[11]; (2) the Shadow Preparer[12]; (3) the Pure Advisor[13]; (4) the Schedule Preparer[14]; and (5) the Indirect Preparer.[15] Although a law firm may provide services falling into several of these categories, this article will focus on the Pure Advisor, which is likely to be the primary role of the attorney.[16]

The existing regulations provide there can only be one Preparer per firm. The Proposed Regulations change that paradigm and provide that there may be more than one Preparer per firm. If more than one attorney in a firm is involved in providing post-event tax advice to a client, and there is no Signing Preparer in the firm, the individual within the firm with overall supervisory responsibility for the position(s) giving rise to the particular understatement is the tax return Preparer potentially subject to penalty.[17] This determination is made on a per tax return position giving rise to an understatement.

Therefore, if attorney A gave post-event advice to a client concerning a transaction giving rise to an understatement and attorney B gave post-event advice to the same client concerning expensing vs. capitalization, attorney A would be the Preparer of some entries and attorney B of others. If understatements occurred with respect to both positions, each could be subject to potential  §6694 penalty with respect to the matters on which each is deemed to be a Preparer. If there is a Signing Preparer in the firm, that person is initially considered to be the Preparer potentially subject to the  §6694 penalty, but if such person can show (or other evidence shows) that another attorney had the responsibility for the position(s) giving rise to the understatement, the other attorney will be the Preparer potentially subject to the  §6694 penalty.[18] The Proposed Regulations provide there may be more than one tax return Preparer who is primarily responsible for a single position giving rise to an understatement if multiple tax return Preparers are employed by, or associated with, different firms.[19] Although the IRC only speaks of imposing a penalty on the individual Preparer, the Proposed Regulations provide for a firm penalty as well.[20]

Pure Advisor as a Preparer

An attorney who gives written or oral tax advice without ever discussing or seeing the return is a Pure Advisor. However, for the Pure Advisor to be a Preparer, the advice must be (1) given with respect to events that have occurred, as opposed to being contemplated, at the time the advice is given, (2) directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund, (3) with respect to a substantial portion of a return, and (4) for compensation. An attorney engaged by a taxpayer after the return has been filed is not a Preparer unless the attorney recommends or is involved in amending a return.

The Proposed Regulations do not flesh out exactly what is the nature or scope of advice that IRC  §6694(a) reaches. One would hope that there would be coordination between the Circular 230 levels of advice and the  §6694 penalty. Will advice with a Circular 230 legend stating it cannot be relied upon for penalty protection be advice that nevertheless can trigger the  §6694(a) penalty? Logic would indicate this should not be the case, but ... hopefully, there will be guidance indicating that the advice must be of a scope and nature that it could be reasonably relied upon by a prudent person for the taking of positions on the tax return.

The following is an analysis of the requirements for an attorney to be a Preparer:
1. Advice given with respect to events that have occurred as opposed to being contemplated. While this element was present in the existing regulations, it was unclear as to how it would be applied where there was substantial pre-event work performed and some post-event work. The Proposed Regulations resolved this issue by providing that a deminimus amount of post-closing time (less than 5 percent of the aggregate time incurred by such individual with respect to the position(s) giving rise to the understatement) shall not be taken into account.

While the deminimus concept is easy to articulate, determining the amount of time spent on a specific position may not be easy in all but the simplest situations. Often attorney time records are kept for matters and not positions within matters. Many situations will be complex with multiple positions for which it may be a difficult issue for triers of fact to determine how much time was spent on a particular position. As discussed later, the same difficulty occurs in determining the fees that are attributable to the positions giving rise to the understatement vs. fees for all of the positions involved in the work undertaken by the attorney.

2. Directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim. Generally professional tax advice, schedules and opinions will meet this requirement. Clients are paying for advice or schedules that impact their tax liability and/or reporting. Generally such tax advice will ultimately impact a return.

Can advice or an opinion be directly relevant to the determination of the return position if the return is prepared by someone other than the taxpayer and the actual Signing Preparer is unaware of the advice or opinion? If the initial advising attorney and the Signing Preparer are in the same firm, the Proposed Regulations start with the concept that the Signing Preparer is the one subject to the penalty unless the facts and circumstances indicate another person in the firm is primarily responsible for the position(s) giving rise to an understatement. If the Signing Preparer is unaware that the taxpayer received advice from his colleague, how can the colleague be responsible for the position actually taken on the return? Is there a deemed relevance of any advice given to the taxpayer whether or not the actual preparer of the return is even aware of the advice? All are unanswered questions.

In the future, if a Signing Preparer is aware of the advice, the Signing Preparer should request a copy of the advice if it is in writing or ask to speak to the Non-signing Preparer, discuss the position(s) and document the discussion. As discussed later, proving reasonable reliance on another professional is one way a Preparer may avoid the  §6694 penalty. The colliery is the attorney providing such post-event advice may then become the Preparer with respect to such position. Therefore, attorneys giving pre-event advice should not be surprised if they are requested to render the same advice post-event to another Preparer or to have their written advice given to the Signing Preparer. Such attorneys may wish to be careful that their post-event time is less than 5 percent of the total time lest the pre-event attorney become a Preparer.

Is the opinion or advice of an attorney automatically deemed relevant to the determination of the return position? Is it relevant to determine the purpose of the opinion? Existing Treas. Reg.  §301-7701-15(a)(2)(ii) indicates the purpose of the opinion after closing is relevant and that not all post-event opinions are relevant to the determination of the return position. The example in existing Treas. Reg.  §301.7701-15(a)(2)(ii) involves an opinion solely to support the tax accrual for financial statements by an accountant that is not the preparer of the return and the attorney rendering the opinion is determined not to be a Preparer. It should be noted that the Proposed Regulations under IRC  §7701(37) do not include this concept.[21]

3. Substantial portion of a return. Whether the advice impacts a substantial portion is determined based upon whether the person (advisor) knows or reasonably should know that the tax attributable to the schedule, entry or other portion of a return is a substantial portion of the tax required to be shown on the return or claim for refund.[22] Therefore, the substantial portion requirement has two components: (1) what the advisor knew or reasonably should have known and (2) substantively whether the actual position constituted a substantial portion of the return or claim for refund.

The Proposed Regulations do not provide guidance as to what the Preparer or advisor reasonably should have known. The general rule as to what constitutes a substantial portion of a return is rather vague. Proposed Regulations provide that determination factors 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.[23] The Notice states "determination as to whether a person has prepared a substantial portion of a tax return ... will depend on the relative size of the deficiency attributable to the schedule, entry, or other portion."[24]

With respect to a Non-signing Preparer, if the schedule, entry or other portion of the return or claim for refund involves amounts of gross income or deductions less than (1) $10,000 or (2) less than $400,000 and also less than 20 percent of the gross income (for an individual, adjusted gross income) as shown on the return, such schedule, entry or other portion is not considered to be a substantial portion.[25] There is no safe-harbor or deminimus rule for the Signing Preparer in the Proposed Regulations!

As with any safe-harbor, the question arises: will this develop into a negative inference on the part of revenue agents that if the amount involved is greater than (i) $10,000 or (ii) $400,000 and less than 20 percent of the relevant income, such amount is automatically substantial?

Pure Advisors often do not know what the client's tax return will contain. It is extremely difficult if not impossible to know the relative size of the potential impact of advice upon the taxpayer's return when the attorney does not know what else is in the client's return and may not even know the dollar amounts applicable to the matters on which he or she is giving post-transaction advice. In March of 2008, Michael Desmond, the then Tax Legislative Counsel, acknowledged that the draftsmen working on the regulations were struggling with "substantial portion" and that Preparers should be on notice when they might be subject to penalties.[26] Does the Proposed Regulations' concept that the amount involved may be over $10,000 and/or over $400,000 serve to put the Pure Advisor on notice that he or she may be subject to penalty?

The Pure Advisor attorney rendering advice to a pass-through entity may be an Indirect Preparer[27] since the pass-through entity will in turn issue K-1s to its owners who will incorporate the information on the K-1 directly in each owner's tax return. The Indirect Preparer will be considered to be the Preparer of each partner's return if the entry or entries reported on the partnership return are directly reflected on the partner's return and constitute a substantial portion of such return.[28] In this case, the attorney may not even know who the taxpayer partners are, much less whether the taxpayer's portion of the pass-through entity will have a significant impact on the taxpayer's return.

The Notice provides information returns listed on Exhibit 2 thereof will subject the preparer to  §6694(a) penalties if the information reported constitutes a substantial portion of another taxpayer's return.[29] The Notice provides that documents listed in Exhibit 3 thereof (such as Forms W-2, 1099, 990) will not subject the preparer to  §6694(a) penalty but can give rise to a  §6694(b) penalty.[30] Presumably, the Exhibits to the Notice, as amended, will be carried over in the guidance to be issued when the Proposed Regulations are finalized.

For purposes of providing the requisite disclosure for penalty avoidance, in most cases, the Pure Advisor should presume the advice impacts a substantial portion of a return.

4. For compensation. This element is easy to understand and will almost always be present for an attorney giving tax advice.[31] As discussed later herein, the amount of compensation on which the penalty may be computed may be difficult to determine when an engagement involved several services and/or multiple positions.

Many feel that the classification of a Pure Advisor as a Preparer subject to penalty is beyond the scope of the statute and is an unwarranted expansion of the concept of preparing a return.[32] At least one commentator, however, believes that Pure Advisors structuring transactions and giving pre-event advice should be covered.[33] The classification of a Pure Advisor as a Preparer is certainly not intuitive. Nevertheless, an attorney meeting the definition will be treated by the IRS as a Preparer and, in the absence of the courts reaching a contrary conclusion or a dramatic change in the Proposed Regulations prior to finalization, be subject to  §6694 penalty. Under the Proposed Regulations, it appears the Pure Advisor attorney often will not know if he or she will be classified as a Preparer when giving advice in all but the smallest or largest of matters.

Burden of Proof

In the event of a dispute with the IRS, the Proposed Regulations specifically provide that the Preparer bears the burden of proof as to whether (1) the Preparer knew or reasonably should have known the questioned position was taken on the return, (2) whether there is reasonable cause and good faith with respect to such position; and (3) whether the position was disclosed adequately.[34]

Avoiding the Penalty if There Is an Understatement

Under the statute, a Preparer is subject to the  §6694(a) penalty for preparing or being deemed to prepare the return if a position is found to be incorrect (there is an understatement) unless one of the three following circumstances exists: (1) the Preparer held a reasonable belief that the position subject to advice and causing the understatement was MLTN correct and supported by substantial authority, (2) there was a reasonable basis for the position and the position was disclosed as provided in IRC  §6662(d)(2)(B)(ii),[35] or (3) it is shown that there is a reasonable cause for the understatement and the Preparer acted in good faith.[36] As discussed below, the Proposed Regulations do not always require actual tax return disclosure but under some circumstances permit disclosure only to the taxpayer or another Preparer. In addition, the Proposed Regulations provide for different disclosure requirements for a Signing Preparer and Non-signing Preparer to avoid personal and firm penalties. Since the Pure Advisor will not be the Signing Preparer, only the Non-signing Preparer disclosure requirements are discussed herein.

No IRC  §6694 Penalty if MLTN Standard Is Met

Good Faith Belief MLTN. Given the fact the standard has now been raised to MLTN from RPSM, in the minds of the revenue agents, will there almost be a presumption that if an understatement of tax occurred, there was not a good faith belief that MLTN the position would be sustained? The Proposed Regulations developing the RPSM standard look to see if the Preparer exercised due diligence in performing an analysis of the pertinent facts and authorities following the analysis prescribed in the regulations dealing with the determination of whether substantial authority exists. Whether the Preparer meets the standard will be determined based upon all facts and circumstances, including the preparer's diligence. In determining the level of diligence the Preparer's experience with the area of federal tax law and familiarity with the taxpayer's affairs, as well as the complexity of the issues and facts will be taken into account.

The Proposed Regulations expressly permit reliance in good faith, without verification, information provided by the taxpayer, an advisor of the taxpayer, other tax return preparer or another party (including another attorney at the same firm). Indeed a Preparer in a firm may rely upon pre-event advice and opinions rendered by another attorney in the firm if such reliance is reasonable and in good faith. A Preparer "is not limited to reliance on persons who provide post-transactional advice if such reliance is reasonable and in goof faith."[37] In absence of other authority, a position supported by a well-reasoned construction of the applicable statutory provision will support the reasonable belief that a position will more likely than not be sustained on its merits.[38]

MLTN Standard

To meet the MLTN standard the attorney must reasonably determine the position taken (1) is supported by substantial authority and (2) there is a greater-than-50-percent likelihood of prevailing on the merits upon challenge. Neither the audit lottery nor the probability that a position will not be discovered if there is an audit are factors in determining MLTN. While the subjective belief of the Preparer is required by statute, the reasonableness of the subjective belief is objectively tested utilizing the analysis of the pertinent facts and authorities. The advice is tested as of the date the advice is given or with respect to return preparation when the return is signed.[39]

While there can be several Preparers in a single firm with respect to each position of a taxpayer, there can only be one in each firm for purposes of imposing the  §6694 penalty with respect to each position.[40] Technically that specific Preparer is required to have the belief, which may be obtained by reasonable reliance upon others, including others at the Preparer's firm. The ability of an attorney to rely upon the judgment and analysis of other attorneys in the firm with respect to a position is a major improvement of the Proposed Regulations over the Notice and existing regulations.[41] Moving the responsibility from a partner with overall responsibility for the client to the person that is the individual in the firm primarily responsible for the position generating the understatement properly takes the relationship attorney off the penalty hook.

Disclosure to Avoid Penalty

If the position does not involve a tax shelter or a reportable transaction,[42] the Preparer will be able to avoid the  §6694 penalty through proper disclosure. Under the Proposed Regulations, a Non-signing Preparer[43] will be deemed to have complied with the requirements of  §6694 with respect to a position for which the attorney believes there is at least a reasonable basis but does not believe meets the MLTN test, if the advice is

  1. given to another Preparer and the first Preparer includes a statement that disclosure under  §6694(a) may be required[44]; or
  2. given to the taxpayer and the attorney includes a statement
    1. informing the taxpayer of any opportunity to avoid  §6662 penalties by disclosure, if relevant,
    2. setting forth the standards of disclosure to the extent applicable, and
    3. contemporaneously documented.[45]

Whether the advice is to a taxpayer or to another Preparer, if the advice is oral, the disclosure statement(s) may be oral. If the advice is written, the disclosure statement(s) must be written. Contemporaneous documentation in the Non-signing Preparer's files will establish that the oral advice was given. The advice to the taxpayer with respect to each position must be particular to the taxpayer and tailored to the taxpayer's facts and circumstances. The Proposed Regulations state: "No form of a general boilerplate disclaimer, however, is sufficient to satisfy these standards."[46]

Although the Proposed Regulations specifically allow one contemporaneous document to cover several positions,[47] a separate document should be developed for each position of concern. In that manner, if the IRS asserts an understatement as a result of one item and not with respect to one or more other items of concern, the documentation, if provided to the IRS, does not disclose the other items of concern.

If a completed and filed Form 8275 or 8275-R, as appropriate, or other disclosure on the return in accordance with an annual revenue procedure described in Treas. Reg.  §1.6662-4(f)(2) is actually made to the IRS, adequate disclosure has occurred.[48]

Reasonable Cause and Good Faith

If there is (1) an understatement, (2) no substantial authority, (3) the position is not reasonably believed to be MLTN correct and (4) no disclosure as provided in the Proposed Regulations, a Preparer will be subject to the IRC  §6694(a) penalty unless it can be shown the Preparer acted with reasonable cause and in good faith. Misinformation, incomplete information, complexity, novelty, etc. are all applicable in the mix to determine reasonable cause and good faith under the specific facts and circumstances.

To determine if the understatement was due to reasonable cause and the Preparer acted in good faith, the Proposed Regulations provide the following factors should be considered: (1) the nature of the error,[49] (2) the frequency of the error, (3) the materiality of the error, (4) the Preparer's normal office practice, (5) reliance on the advice of others, and (6) a new factor " reliance on generally accepted administration or industry practice.[50] For purposes of demonstrating reasonable cause and good faith, the general ability to rely without verification upon the advice and information provided by the taxpayer or other party as provided in Proposed Regulation  §1.6694-1(e) and who the Preparer had reason to believe was competent to render the advice undoubtedly will be a major defense for many Preparers. However, it can be expected that Signing Preparers raising this defense will often be pointing at the Pure Advisor. The advice on which the Preparer relied may be written or oral, but in either case, the burden of establishing that the advice or information was received is on the Preparer.[51]

Although the attorney may rely on such information or advice in good faith and without verification, the attorney may not ignore the implications of information furnished to the attorney or actually known to the attorney. The attorney must also make reasonable inquiries if the information furnished appears to be incorrect or incomplete. The attorney cannot rely upon advice that is unreasonable on its face or on which the attorney knows or should have known the person providing the advice or information was not aware of all relevant facts or that at the time the return or claim for refund was prepared the advice or information was no longer reliable due to developments in the law since the advice was given.[52] The Proposed Regulations specifically provide the Preparer cannot rely on information provided by the taxpayer with respect to legal conclusions on Federal tax issues.[53]

The reliance on generally accepted administrative or industry practice is a major new relief factor introduced by the Proposed Regulations. Just as with reliance on advice, the Preparer cannot rely on administrative or industry practice if the Preparer knew or should have known (given the nature of the Preparer's practice) the administrative or industry practice was no longer reliable due to developments in the law or IRS administrative practice since the time the industry or administrative practice developed.[54]

Exception for In-House Tax Counsel

The Proposed Regulations follow the existing regulations and provide in-house attorneys are never Preparers of their employer's return.[55] An in-house attorney is considered to be preparing returns (as broadly defined) for his or her employer as long as the returns are for the regular employer, a subsidiary in which the regular employer owns more than 50 percent of the voting power or an entity more than 50 percent of the voting power that is owned by another entity. In other words, an in-house attorney is considered to be an employee of the controlled group. However, if the in-house attorney renders post-event advice to subsidiaries that are 50 percent or less owned (voting power) by the employer, the in-house status is lost.[56] An employee of a general partner is permitted to prepare returns for and give advice to the general partner without becoming a Preparer.[57]

Imposition of  §6694 Firm Penalty

The Proposed Regulations impose the  §6694 penalty on firms that employ a Preparer that is subject to the Penalty or in which the individual penalized Preparer is a partner, member, shareholder or other equity holder if, and only if: (1) one or more persons in principal management of the firm or branch participated in or knew of the conduct penalized under  §6694(a); (2) the firm entity failed to provide reasonable and appropriate procedures for review of the penalized position(s); or (3) the review procedures were disregarded by the firm entity through willfulness, recklessness, or gross indifference (including ignoring facts that would lead a person of reasonable prudence and competence to investigate or ascertain) in the advice or preparation of the return or claim for refund that included the position for which the penalty is imposed.[58] The disjunctive in the circumstances in which a firm will be the subject of penalty should be noted. It appears probable that firm penalties will not be rare occurrences if these Proposed Regulations are finalized and enforced.

Computing the Penalty

The  §6694(a) penalty is equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) with respect to the position(s) taken on the return or claim for refund giving rise to the understatement. It is now clear the penalty is based on gross income. With respect to an individual, income derived means all compensation the Preparer receives from the firm that can reasonably be allocated to the engagement of preparing the return or claim for refund or providing tax advice (including research and consultation) with respect to the position(s) taken that gave rise to the understatement.[59] With respect to a firm, income derived (or to be derived) means all compensation the firm receives or expects to receive with respect to the engagement with respect to the positions giving rise to the understatement.[60] Where multiple engagements related to the return or claim for refund giving rise to the understatement are involved, only those giving rise to the understatement are considered for purposes of calculating the income derived or to be derived.[61] If a lump sum fee is received, a reasonable allocation of such lump sum between tax advice giving rise to the penalty and advice not giving rise to the penalty is permitted.[62]

A refund to the taxpayer of a portion of the fee will not reduce the penalty.[63] The penalty includes amounts not yet received. Presumably an after-the-fact waiver of a portion of the fee after an IRS controversy will not reduce the penalty.

The Proposed Regulations sanction an allocation of fees based on hours associated with the positions giving rise to the understatement versus total hours.[64] However, in absence of a reasonable method of allocation, the total amount of compensation from the engagement will be the amount of income derived for purposes of calculating the  §6694 penalty.[65] Only post-event income is considered for purposes of computing the penalty. Therefore, if an engagement involves both pre- and post-event advice, only the post-event advice gives rise to the deemed preparation of the return and is subject to penalty.[66]

When both the individual Preparer and the firm are subject to the  §6694 penalty, the Proposed Regulations impose a cap on the aggregate penalty base of the income received or to be received by the firm with respect to the positions giving rise to the understatement.[67] The preamble to the Proposed Regulations indicates the Circular 230 penalty of 100 percent and the  §6694 penalty of 50 percent will not be stacked. In determining which Preparer in a firm is subject to penalty, the IRS may notify several individuals of potential  §6694 penalty and encourage the individuals to come forward with information as to which is the appropriate person to penalize.[68] An inquiry of this nature will undoubtedly produce great stress within a firm. The author presumes that such intelligence will also be used to assist in determining whether to impose a penalty on the firm.

Many firms have policies to reimburse members of the firm for liabilities incurred in furtherance of the firm's business for authorized activities. The statutory language appears to encompass such reimbursements under the phrase "to be derived" if the reimbursement is considered to be compensation. Presumably the total amount is limited to what the client has paid or is required to pay the firm since that is the cap if both the individual and firm are penalized.[69]

Conclusion

The new  §6694 penalty represents a massive change to the nature of the business of providing tax advice and assisting in tax compliance matters. IRC  §6694 by incorporating a standard for Preparers higher than the standard for taxpayers creates a conflict. The Notice and the Proposed Regulations attempt to minimize this conflict by permitting certain disclosures to be made to the taxpayer or other Preparers but does not eliminate all potential conflicts. There is a potential conflict if the attorney is requested to disclose the advice given and the contemporaneous documentation but the taxpayer/client does not want it disclosed and takes the position it was in fact not used in the preparation of the return. While the IRS believes that no materials provided or associated with the preparation of a tax return are subject to the attorney-client privilege, the relevant disciplinary and ethics authorities for Tennessee attorneys may agree or disagree. It is anticipated that this issue will have to be addressed.

If the taxpayer standards remain the same, attorneys giving tax advice, at least if the Non-signing Preparer rules are retained and upheld by the courts, are now on the verge of being (1) a direct informant to the IRS of positions which do not rise to the level of MLTN for any advice after the event and prior to actual controversy or (2) an indirect informant to the IRS that the taxpayer was in fact warned of the substantive risk and possible penalties and the role of disclosure, if applicable.

When planning, the Pure Advisor will have to be mindful of the potential impact of the penalty on the ultimate Preparer and whether the positions recommended and planned will be able to be reported on the return of the client without disclosure either on the return or by virtue of the discussion of penalty sections with the client and preparation of contemporaneous documentation. Since Preparers can rely upon the pre-event advice and opinions, Signing Preparers will likely request copies of the pre-event opinions or advice to review and reasonably rely upon. Once in the Signing Preparer's hands, the advice or opinion is used in the preparation of the return and is therefore discoverable by the IRS.

Pure Advisor attorneys will need to be more careful in their post-event discussions and other communications with other Preparers lest they unknowingly find themselves a potential Preparer of a return and potentially subject to the  §6694(a) penalty when the IRS starts looking for Preparers and other Preparers are pointing fingers. What constitutes the threshold level of advice to which  §6694 is applicable? Will "off the cuff" and relatively informal advice with the appropriate Circular 230 legend be covered or must the advice reach the level of Circular 230 application before  §6694 comes into play? Will "off the cuff" and relatively informal oral advice which is not covered by Circular 230 be subjected to  §6694 penalty?

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Notes

  1. Small Business and Work Opportunity Act of 2007. Pub. L. No. 110-28, 121 Stat. 190.
  2. Proposed Treasury Regulations under IRC  § §6694, 6695, 7701 and other sections released on June 16, 2008 (the "Proposed Regulations"). REG - 129243-07.
  3. TD 7519 (Nov. 23, 1977) finalized the regulations with the concept of non-signing preparer.
  4. IRC  §6694(b) imposes this greater penalty for understatements due to willful, reckless or intentional conduct. This article does not provide analysis of this penalty. However, a Preparer for purposes of IRC  §6694(a) is a Preparer for IRC  §6694(b) and the scope of IRC  §6694(b) is the same as  §6694(a).
  5. Although the statutory amendment was effective for returns filed and advice given after May 25, 2007, Notice 2007-54 when combined with Notice 2008-11 effectively eliminated the application of the MLTN standard for tax returns due on or before Dec. 31, 2007, estimated tax returns for 2007 due on or before Jan. 15, 2008, 2007 employment and excise tax returns due on or before Jan. 31, 2007 and advice given prior to Jan. 1, 2008. It appears that advice given and returns prepared in 2008 (other than as described above) will be governed by Notice 2008-13. The Proposed Regulations are anticipated to govern for returns prepared and advice given after Dec. 31, 2008.
  6. In recognition of this issue, there is current legislation in both the House and the Senate to make the standard "substantial authority" rather than "more likely than not." H.R. 6049, the Renewable Energy and Job Creation Act of 2008; H.R. 5719, the Taxpayer Assistance and Simplification Act of 2008; and S. 3125 the Energy Independence and Tax Relief Act of 2008.
  7. Notice 2008-13 provides interim guidance on the application of the  §6694 penalty until the Proposed Regulations are finalized.
  8. For this purpose tax shelter is defined in IRC  §6662(d)(2)(C) as involving "a" significant purpose the avoidance or evasion of tax.
  9. Notice 2008-13, Exhibit 1, Tax Returns Reporting Tax Liability and Exhibit 2, Information Returns That Report Information That Is or May Be Reported on Another Tax Return That May Subject a Tax Return Preparer to the Section 6694(a) Penalty if the Information Reported Constitutes a Substantial Portion of the Other Tax Return. The list of forms was updated by Notice 2008-46.
  10. Proposed Treas. Reg.  §301.7701-15(b)(1).
  11. This is the person who actually prepares the return and is generally required to sign the return.
  12. Proposed Treas. Reg.  §301.7701-15(c).
  13. Proposed Treas. Reg.  §301.7701-15(b)(3).
  14. Proposed Treas. Reg.  §301.7701-15(b)(3).
  15. Proposed Treas. Reg.  §301.7701-15(b)(3)(iii).
  16. For a discussion of the other forms of Preparers and the application of the  §6694 penalty pursuant to the Notice to them, see J. Leigh Griffith, "New Tax Return Preparer Penalties for Signing and Non-Signing Preparers," Tennessee CPA Journal, vol. 53, no. 2, March, 4-6 and "New Tax Return Preparer Penalties Part II- Advisors, Tennessee CPA Journal, vol. 53, no 4, May 2008, 24-25.
  17. Proposed Treas. Reg.  §1.6694-1(b)(3).
  18. Proposed Treas. Reg.  §1.6694-1(b)(2).
  19. Proposed Treas. Reg.  §1.6694-1(b)(1).
  20. Proposed Treas. Reg.  §1.6694-1(b)(4). "... an individual and the firm that employees the individual, or the firm of which the individual is a partner, member, shareholder, or other equity holder, may both be subject to penalty under section 6694 with respect to the position(s) on the return or claim for refund giving rise to an understatement."
  21. This redaction is not surprising given the IRS's litigation posture with respect to tax accrual workpapers and Fin. 48. See Robert Pope, "Disclosure Decisions: Two Recent Opinions Shape IRS Access to Work Product," Tennessee Bar Journal, vol. 44, no. 3, March 2008, 12-18 and J. Leigh Griffith and Robert Pope, "The Hunt for Tax Accrual Workpapers, IRS Leads the Charge. Will the Courts Follow?" Tennessee CPA Journal, vol. 52, no 9, November 2007, 24-26.
  22. Proposed Treas. Reg.  §301.7701-15(b)(3)(i).
  23. Proposed Treas. Reg.  §301.7701-15(b)(3).
  24. Notice 2008-13 B.3
  25. Proposed Treas. Reg.  §301.7701-15(b)(3)(ii)
  26. Comments of Michael Desmond, then-Tax Legislative Counsel, speaking at New York City Bar Association meeting on March 26, 2008. 2008 TNT 61-5.
  27. Although this term is not used in the Proposed Regulations, the concept continues in Proposed Treas. Reg.  §301.7701-15(b)(3)(iii).
  28. Proposed Treas. Reg.  §301.7701-15(b)(3)(iii).
  29. Notice 2008-13 A.2.(a).
  30. Notice 2008-13 A.2.(c). Michael Desmond, then Tax Legislative Counsel, speaking at New York City Bar Association meeting on March 26, 2008, indicated the IRS was reconsidering the exemption of the W-2 from the penalty. 2008 TNT 61-5.
  31. The Proposed Regulations has a discussion of persons who are not tax return preparers when involved in certain specific activities even though compensation may be involved. Proposed Treas. Reg.  §301.7701-15(f).
  32. See, for example, the comments of Patrick Gallagher of the New York State Bar Association Tax Section of December 20, 2007. 2007 TNT 247-51.
  33. "Diluting the Preparer Penalties by Regulation," Lee A. Sheppard, 2008 TNT 117-1 (June 24, 2008).
  34. Proposed Treas. Reg.  §1.6694-2(e).
  35. IRC  §6694(a)(2).
  36. IRC  §6694(a)(3).
  37. Proposed Treas. Reg.  §1.6694-1(f)(4). Example 3.
  38. Proposed Treas. Reg.  §1.6694-2(b)(1).
  39. Proposed Treas. Reg.  §1.6694-1(a)(2). If the return is unsigned, the date of mailing is the date tested.
  40. Proposed Treas. Reg.  §1.6694-1(b).
  41. Under the Notice and existing regulations, there was only one Preparer in a firm and a Preparer could only rely upon the analysis of other Preparers. Therefore, a Preparer could not rely upon others in the same firm. Notice 2008-13.
  42. A "tax shelter" for this purpose is defined in IRC  §6662(d)(2) and "reportable transaction" in IRC  §6662A.
  43. The disclosure requirements for a Signing Preparer are different and in some cases more stringent. These requirements are not discussed herein.
  44. Proposed Treas. Reg.  §1.6694-2(c)(3)(ii)(B).
  45. Proposed Treas. Reg.  §1.6694-2(c)(3)(ii)(A).
  46. Proposed Treas. Reg.  §1.6694-2(c)(3)(iii).
  47. Id.
  48. Proposed Treas. Reg.  §1.6694-2(b)(3)(ii).
  49. Did the error result from a provision that was complex, uncommon, or highly technical and a competent Preparer of the type at issue reasonably could have made the error? Proposed Treas. Reg.  §1.6694-2(d)(1).
  50. Proposed Treas. Reg.  §1.6694-2(d).
  51. Proposed Treas. Reg.  §1.6694-2(d)(5).
  52. Proposed Treas. Reg.  §1.6694-2(d)(5).
  53. Proposed Treas. Reg.  §1.6694-1(e) concerning reliance in performing due diligence. Presumably, this would also be relevant in the reasonable cause and good faith relief analysis.
  54. Proposed Treas. Reg.  §1.6694-2(d)(6).
  55. Proposed Treas. Reg.  §301.7701-15(f)(1)(ix) and (x).
  56. Proposed Treas. Reg.  §301.7701-15(f)(4).
  57. Proposed Treas. Reg.  §301.7701-15(f)(1)(x).
  58. Proposed Treas. Reg.  §1.6694-2(a)(2).
  59. Proposed Treas. Reg.  §16694-1(f)(1).
  60. Id.
  61. Proposed Treas. Reg.  §16694-1(f)(2).
  62. Proposed Treas. Reg.  §1.6694-1(f)(2)(ii).
  63. Proposed Treas. Reg.  §1.6694-1(f)(2)(iii).
  64. Proposed Treas. Reg.  §1.6694-1(f)(2)(ii).
  65. Proposed Treas. Reg.  §1.6694-1(f)(2)(iv)..
  66. Proposed Treas. Reg.  §1.6694-1(f)(2)(ii).
  67. Proposed Treas. Reg.  §1.6694-1(f)(3).
  68. Proposed Treas. Reg.  §1.6694-1(f)(4). Example 2 and 3. See also Prop. Treas. Reg.  §1.6694-1(b)(2).
  69. Preamble to the Proposed Regulations citing Proposed Treas. Reg.  §1.6694-1(f).

J. Leigh Griffith J. LEIGH GRIFFITH is a partner at the law firm of Waller Landsden Dortch & Davis LLP. An attorney and certified public accountant, he has extensive experience in state and federal tax law and estate planning. He has been recognized in The Best Lawyers in America for more than a decade.