The Small Business and Work Opportunity Act of 2007, enacted on May 25, 2007, made several important changes that broadened and toughened tax return preparer penalties applicable to undisclosed positions on a prepared tax return. As enacted, the provisions were effective immediately, but IRS Notice 2007-54 postponed the effective dates for the changes until after December 31, 2007, which means they are here for the 2008 tax season.
The relevant changes are as follows:
(a) The definition of income tax return preparer has been replaced by a definition of tax return preparer, which expands the reach of covered preparers to those involved in any tax submission to the federal government. Thus, rather than just covering income tax returns, the new definition includes income, estate, gift, employment and excise taxes, as well as returns for exempt organizations. The definition includes substantial assistance in the preparation of a submission, including any written opinion provided in connection with a return.
(b) The standard applicable to tax preparers to avoid the imposition of preparer penalties where an undisclosed position results in an understatement of liability has been heightened. Previously, preparers would not be subject to penalty as long as there was a â€œrealistic possibilityâ€ that the position would be sustained. Now, the preparer must have a â€œreasonable belief that the position would more likely than not (MLTN) be sustained on its meritsâ€ to avoid penalty.
(c) The preparer penalties applicable to this scenario have been increased from $250 per violation to the greater of $1,000 or 50% of the preparerâ€™s fee for each violation.
The first thing to note about the change in the preparer standard for taking undisclosed positions is that the standard applicable for taxpayer-prepared returns has not changed. A taxpayer need only have â€œsubstantial authorityâ€ for taking an undisclosed position on a return prepared without the assistance of a paid preparer. This difference in standard could create some tension between the preparer and the taxpayer. The tension arises from the fact that the principal way for the preparer to avoid imposition of a penalty is to disclose the position on Form 8275. Since the taxpayer without the assistance of a preparer has a lower standard, some feel that there is at least some tension, if not a conflict, because the taxpayer may be more inclined to omit the disclosure due to the lower standard.
However, in most situations there really is not much to this concern. Once a preparer has been engaged, and renders substantial assistance in the preparation of the return, the professional is the preparer and would be in violation of IRS regulations if the accountant did not sign the return as the preparer. Moreover, as noted above, the reach of the new definition for tax return preparer also includes any written advice in connection with a return. Thus, unless your connection to the taxpayer and the return is very limited, you are the preparer and cannot avoid the reach of the new law by having the taxpayer finish the return and submit it without a preparer signature.
To reduce the impact of the difference between the two standards, and put the client on notice of the change, we recommend including a disclosure in your engagement letter, which could read as follows:
Due to the nature of the tax forms proscribed by the Internal Revenue Service (â€œIRSâ€), certain tax positions will not be fully disclosed unless they are specifically set forth on a separate form. Where it is determined that your liability has been understated as a result of an undisclosed position, it is possible that penalties may be assessed. These penalties frequently can be avoided if the separate disclosure noted above is included with the return, usually on Form 8275.
Under federal legislation passed in May 2007, which is effective in 2008, we are now required to conform to a higher standard in order to avoid these penalties. Thus far, the standard has not been raised for taxpayers. We must now have a reasonable belief that the position would more likely than not be sustained on its merits by the IRS to avoid penalty.
As a result of this change in the law, we may be required to spend additional time preparing your return to determine whether the undisclosed positions taken on the return are more likely than not to be sustained on their merits. If we determine that additional disclosure is required on Form 8275 or otherwise, you agree to the inclusion of that disclosure in your return after discussing the matter with us. To the extent that the inclusion of any such additional disclosure may result in any inquiry, audit or assessment of tax, interest or penalties, you acknowledge that the resultant financial impact is your responsibility and agree to indemnify our firm from any claims related thereto. If you do not consent to the inclusion of a disclosure we feel is necessary to avoid such penalties, we will not be able to complete your tax return.