Tax Research

311 According to Internal Revenue Service, 1997 Data Book.

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G. Tax Return Accuracy Penalties

1. Overview

Under present law taxpayers and tax preparers are required to make the following statement under penalty of perjury on their Federal income tax return:

I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.

Failure to satisfy the obligations embodied in the foregoing statement are sanctioned with both criminal and civil penalties. It is a felony to sign a return unless the signer believes it to be “true and correct as to every material matter.” However, criminal prosecution and conviction is rare because the government must prove the offending taxpayer’s guilty state of mind beyond a reasonable doubt. Two of the Code’s civil penalties, sections 6662 for taxpayers and 6694 for tax professionals, provide the principal means by which the Federal government assures accuracy of tax return information.

Section 6662 establishes a penalty for substantial understatement of tax liability on an income tax return, but this section does not establish an ethical standard of conduct for taxpayers. Section 6694 imposes a penalty on a tax preparer who prepares a tax return which understates tax liability and fails to meet certain other requirements. As described below, the thresholds for avoidance of a penalty when taking an aggressive position on a tax return are so low, they provide little incentive for taxpayers to determine the appropriate tax treatment for such items on their returns. In addition, the IRS audits only a small fraction of the returns filed in any given year. For 1997, the IRS audited only 1.28 percent of all individual income tax returns and 2.67 percent of all corporate income tax returns.311 This gives rise to what is referred to as the “audit lottery.” As noted in Part V, above, a taxpayer weighs the costs of noncompliance with the potential benefits in determining whether to engage in noncompliant behavior. One of the costs of noncompliance is the risk of getting caught. Thus, a low audit rate will make it more likely that a taxpayer will engage in noncompliant behavior.

Most tax professionals recognize a dual responsibility to their clients and to the integrity of the tax system as a whole. However, in cases in which tax professionals view their role as predominantly one of advising a client as to the most aggressive tax return position, the self- assessment aspect of our tax system is undermined. To combat this problem, section 6694

312 Sec. 6694.

313 Sec. 6696.

314 Secs. 6700-6701, and 6703. (See Part VIII, below, for Joint committee staff recommendations relating to corporate tax shelters.

315 Sec. 6662.

316 Treas. Reg. sec. 1.6662-4(d)(3)

317 Treas. Reg. sec. 1.6662-4(d)(3)(ii).

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penalizes return preparers who assist taxpayers in understating tax liabilities on their returns.312

Specific procedural rules govern these “preparer penalties.”313 Preparers also may be subject to penalties aimed generally at abusive tax shelter promoters and at people who aid or abet tax understatements.314

2. Present law

a. Accuracy-related penalty

The accuracy-related penalty is imposed on taxpayers at a rate of 20 percent of the portion of any underpayment that is attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any substantial valuation misstatement, (4) any substantial overstatement of pension liabilities, or (5) any substantial estate or gift tax valuation understatement.315 If the correct income tax liability for a taxable year exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 ($10,000 in the case of most corporations), then a substantial understatement exists and a penalty may be imposed equal to 20 percent of the underpayment of tax attributable to the understatement.

In determining whether a substantial understatement exists, the amount of the understatement generally is reduced by any portion attributable to an item if (1) the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax treatment of the item were adequately disclosed and there was a reasonable basis for its tax treatment. Substantial authority is an objective measure of accuracy which requires a balancing of various authorities by assessing their relative weight of persuasiveness and relevance. Regulations identify the relevant authorities permitted to be used for this analysis.316 While reasonable basis along with disclose generally avoids imposition of a penalty, in no event does a corporation have a reasonable basis for its tax treatment of an item attributable to a multi-party financing transaction if such treatment does not clearly reflect the income of the corporation.317

318 Treas. Reg. sec. 1.6662-3(b)(2).

319 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B).

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The accuracy-related penalty also applies to that portion of the understatement of tax attributable to the taxpayer’s negligence without regard to whether the understatement is substantial in proportion to the taxpayer’s tax liability. Negligence involves the failure to use reasonable care by taking a position on the return which does not have a reasonable basis. This has generally been interpreted to mean whether a “reasonably prudent person” would have acted in a similar manner as the taxpayer. Negligence also arises if the taxpayer carelessly, recklessly, or intentionally disregards a rule or a regulation. For this purpose, rule or regulation generally means Code provisions, final and temporary regulations, and published revenue rulings and notices.

Reasonable basis is the minimum accuracy standard for negligence. If a return position lacks reasonable basis, then negligence applies. If a taxpayer takes a position contrary to a rule or regulation, the taxpayer is not treated as disregarding the rule or regulation if the position has a realistic possibility of being sustained on its merits.318 A taxpayer may also avoid a penalty for disregard of a rule or regulation if the taxpayer has a reasonable basis for the position and discloses this position. Return positions not having a reasonable basis are by definition to be negligent and subject of the negligence penalty.

Special rules apply for "tax shelters." With respect to tax shelter items of non-corporate taxpayers, the penalty may be avoided only if the taxpayer establishes that, in addition to having substantial authority for his position, he reasonably believed that the treatment claimed was more likely than not the proper treatment of the item. The penalty cannot be avoided in the case of (1) a partnership or other entity, (2) an investment plan or arrangement, or (3) any other plan or arrangement, if a significant purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of Federal income tax.

The understatement penalty generally is abated (even in the case of corporate tax shelters) in cases if the taxpayer can demonstrate that there was "reasonable cause" for the underpayment and that the taxpayer acted in good faith. The relevant regulations provide that reasonable cause exists if the taxpayer "reasonably relies in good faith on an opinion based on a professional tax advisor's analysis of the pertinent facts and authorities [that] . . . unambiguously concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the Internal Revenue Service."319

320 Sec. 6694(a).

321 Sec. 6694(a)(3).

322 Sec. 6694(a).

323 Treas. Reg. sec. 1.6694-2(b)(2).

324 Treas. Reg. sec. 1.6694-2(d).

325 Kahn v. United States, 753 F.2d 1208, 1214 (3rd Cir. 1985)

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b. Preparer tax return penalty

1st tier penalty

A return preparer is subject to a $250 penalty if: (1) a return or refund claim is prepared and reflects a position which does not have a realistic possibility of being sustained on its merits; (2) the taxpayer’s liability is understated as a result of the position; and (3) the preparer knows or should know the position is reflected on the return or claim.320

The 1st tier penalty can be avoided if: (1) a return position that does not have a realistic possibility of being sustained on its merits is disclosed and is not frivolous,321 or (2) if a preparer shows there was reasonable cause for the understatement and that he or she acted in good faith.322 A return position is “not frivolous” if it is not patently improper.323 Reasonable cause and good faith take into account a number of factors including (1) did the error result from a complex, uncommon, or highly technical provision of the law; (2) has the preparer made this sort of error often; (3) is this an isolated error which is so obvious, flagrant, or material that it should have been caught and corrected even in an isolated instance; (4) is the error material; and (5) is the preparer’s normal office practice designed to ensure accuracy and consistency in the preparation of returns. However good office practice will not justify abatement for frequent or flagrant errors, or errors that are part of a pattern.324

The preparers’ “not frivolous” standard, is not well defined. There is very little judicial precedent, for example, to illustrate the meaning of “frivolous.” In one case related to section 6702, which penalizes taxpayers for filing frivolous returns, the Third Circuit U.S. Court of Appeals noted that the statute “does not define the terms ‘position’ or ‘frivolous,’ but whatever else is meant by the term ‘frivolous,’ it is reasonable to conclude that a claim is frivolous when there is no argument on either the law or the facts to support it.”325

A preparer who has been penalized may contest the penalty (and freeze collection action) by paying at least 15 percent of the amount assessed within 30 days of the notice and demand

326 Sec. 6694(c).

327 Sec. 6694(c)(1).

328 Sec. 6696(d)(2).

329 Treas. Reg. sec. 1.6694-1(b)(1); 301.7701-15(a).

330 Treas. Reg. sec. 301.7701-15(a)(1).

331 Treas. Reg. sec. 1.6694-1(b)(1).

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date and then filing a refund claim. If IRS denies the refund claim, the preparer has another 30 days to sue for a refund in U.S. District Court. If the IRS fails to act on the refund claim within six months, the preparer has 30 days (beyond the six month waiting period) to bring suit.326 If a refund suit is filed, IRS can counterclaim for the balance of the penalty.327 A preparer who pays the full penalty has three years from the date of payment to file a refund claim.328

Under Treasury regulations, a return preparer for purposes of this penalty is anyone who is paid for preparing a return or a substantial portion of a return.329 A return preparer need not physically put words or numbers on a form or schedule. It is enough if the preparer furnishes sufficient information and/or advice for the return (or a significant portion of it) to be prepared. However, simply giving legal advice about the tax consequences of a situation or transaction is not enough to make someone a preparer. The advice must be about facts already in existence or a transaction that has already taken place, and it must relate to determining the existence, character, or amount of a return entry.330 Since a person can be a preparer without entering information on a return, or signing the return, several persons working for a single organization might satisfy the definition. For example, several members of a law firm might collaborate in giving advice on how to report a particular transaction on a return. Then several members of an accounting firm might be involved in physically preparing and reviewing the forms and schedules on which that same transaction is reflected. When this happens, only one person per firm is considered a preparer with respect to that return. If someone from a firm signs the return, that individual is considered the preparer. If no one at a given firm is the signing preparer, the person with overall supervisory authority with respect to the return or claim is the preparer from that firm.331

The regulations provide that a position has a realistic possibility of being sustained on its merits when someone who is knowledgeable in tax law, having made a reasonable and well informed analysis of the position, would conclude that the chance of winning a contest is at least half as good as the chance of losing, i.e., there is a one in three chance of success. This analysis

332 Treas. Reg. sec. 1.6694-2(b)(1).

333 Treas. Reg. sec. 1.6694-2(c)(3)(i) and 1.6662-4(f).

334 Treas. Reg. sec. 1.6694-2(c)(3)(i)(A)

335 Treas. Reg. sec. 1.6694-2(c)(3)(i)(B).

336 Sec. 6694(b).

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should take into account the same authorities that determine whether taxpayers have “substantial authority” under the accuracy related penalty for positions taken on their returns.”332

The regulations state that a signing preparer must make certain disclosures on IRS forms 8275 or 8275-R (which require adequate identification of the rule being challenged by the return position) to avoid the 1st tier penalty. For a limited class of return positions (specified in annual Revenue Procedures issued by the IRS), disclosure of all relevant facts on the regular tax return forms and schedules without attaching forms 8275 or 8275-R is sufficient.333 For a non-signing preparer who gives return advice directly to a taxpayer, disclosure on the return itself is sufficient. If disclosure on the return is not feasible, the non-signing preparer must (1) tell the client about any return position that does not have a realistic possibility of success and, (2) notify the client that taking the position on a return without disclosing it may trigger an accuracy-related penalty. If the position involves a tax shelter, the client should be told that even disclosure may not help the client avoid the penalty. If the preparer’s advice on the return position is in writing, the disclosure and penalty warning must also be in writing. A preparer who gives oral advice may make the disclosure warning orally as well. But the preparer must then be able to prove the warning was given. A contemporaneously prepared written memorandum of the oral warning will usually satisfy this requirement.334 For a non-signing preparer who gives return advice to another tax preparer, actual disclosure on the return is adequate. When disclosure on the return is not feasible, the preparer may notify the other preparer of the need to make disclosure under the 1st tier preparer penalty rules. Written advice must be accompanied by a written disclosure warning. Oral advice may be accompanied by an oral disclosure warning, but the preparer must be able to prove the oral warning was provided; this generally done through the preparation of a contemporaneous memorandum.335

2nd tier penalty

A preparer is subject to a $1,000 penalty if she prepares a return on which tax liability is understated as a result of (1) the preparer’s willful attempt at understatement, or (2) a return position that intentionally or recklessly disregards rules or regulations. If a single position falls under both the 1st tier and 2nd tier penalties, the 2nd tier penalty is reduced to $750, so that the combined penalties add up to $1,000.336 The same procedure for contesting the penalty is

337 Sec. 6694(c).

338 Treas. Reg. sec. 1.6694-3(b).

339 Treas. Reg. sec. 1.6694-3(c) and (f).

340 Treas. Reg. sec. 1.6694-3(c) and (f).

341 Treas. Reg. sec. 1.6694-3(c)(2) and (3).

342 Treas. Reg. sec. 1.6694-3(e).

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available as with the 1st tier penalty (i.e., paying 15 percent, filing a refund claim, then filing suit in U.S. District Court if the refund claim is denied or not acted upon).337

A willful attempt to understate tax liability involves factual distortions, such as ignoring, disregarding, or misstating information furnished by the taxpayer in order to reduce the liability. For example, listing six dependents when the taxpayer informs the preparer he has two dependents, or failing to include items of income the taxpayer has disclosed to the preparer will subject the preparer to this penalty.338

Intentional disregard of the rules or regulations includes taking a return position that contradicts a Code provision, a final or temporary Treasury regulation issued under the Code, or a Revenue Ruling or IRS Notice published in the Internal Revenue Bulletin of which the preparer is aware.339 Reckless disregard of the rules or regulations constitutes taking a return position that contradicts a Code provision, a final or temporary Treasury regulation issued under the Code, or a Revenue Ruling or IRS Notice published in the Internal Revenue Bulletin of which the preparer did not know because the preparer made little or no effort to find out about it under circumstances indicating substantial deviation from conduct a reasonable preparer would observe.340

A preparer may take a return position that contradicts a known rule or regulation without penalty if (1) the position has a realistic possibility of being sustained on its merits, or (2) the position is adequately disclosed and is not frivolous.341 Disclosure is adequate for a signing preparer if the disclosure is made on Form 8275 or 8275-R. A nonsigning preparer providing advice to a taxpayer has adequate disclosure if the position is disclosed on Form 8275 or 8275-R. The nonsigning preparer is also protected by advising the taxpayer that the position is contrary to IRS rules and regulations and that the taxpayer may be subject to the accuracy-related penalty unless the challenge is made in good faith and the position is disclosed on form 8275 or 8275-R. A nonsigning preparer providing advice to another preparer is protected by pointing out that the position must be disclosed in accordance with the 2nd tier penalty rules.342

343 Sec. 6696(d)(1).

344 Lamb v. U.S. 977 F.2d 1296 (8th Cir., 1992); Capozzi v. U.S. 980 F.2d 872 (2nd Cir., 1992).

345 Sec. 6694(d).

346 Sec. 6695.

347 Sec. 6695(a).

348 Sec. 6695(b). For exceptions to this general signature rule see Treas. Reg. sec. 1.6695- 1(b)(2), Rev. Rul. 78-370, 1978-2 CB 355, and PLR 9821038.

349 Sec. 6695(c).

350 Sec. 6695(d).

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Other 1st and 2nd tier issues

The 1st tier preparer penalty is subject to a 3-year statute of limitations starting from the date the relevant return is filed.343 There is no statute of limitations on assessment of the 2nd tier preparer penalty.344 The 1st and 2nd tier penalties can only be assessed against a preparer whose actions lead to understatement of a taxpayer’s liability.345

c. Other preparer penalties

Preparers are subject to certain information reporting and record-keeping penalties. For each category of improper behavior the penalty equals $50 per occurrence, with an annual cap of $25,000. A preparer can avoid any one of these penalties by showing the preparer had reasonable cause and was not willfully neglectful.346 Penalized behavior includes the following:

(1) Failure to furnish a taxpayer with a copy of any return or claim prepared for the taxpayer’s signature.347

(2) Failure to sign any return or claim the preparer is required to sign.348

(3) Failure to include a preparer’s ID number or, where applicable, the ID number of a preparer’s employer on a return the preparer is required to sign.349

(4) Failure to retain a copy of the return itself, or a listing of the taxpayer names and ID numbers with respect to each return prepared.350

351 Id.

352 Sec. 6695(e).

353 Sec. 6695(f).

354 Sec. 6695(e).

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(5) Failure to make return copies or client lists available for IRS inspection.351

(6) Failure to file an annual return listing the names and ID numbers of each person employed to prepare returns, or omission of required information on such a return.352

Preparers are subject to a penalty of $50 per occurrence, subject to a $25,000 annual cap, for signing or negotiation of a tax client’s refund check.353

Preparers are subject to a penalty for not exercising due diligence in determining a taxpayer’s eligibility for the earned income credit. The penalty is $100 per occurrence with no annual cap.354

d. Standards for tax return positions

In general

The accuracy-related and return preparer penalties are designed to delineate (1) when an erroneous position should be considered innocent and not subject to penalty, (2) when taxpayers should specifically notify the IRS that they are adopting controversial positions, and (3) when taxpayers are taking unduly aggressive positions and should be penalized for any resulting tax deficiency regardless of disclosure.

The following is a brief overview of the standards contained in the accuracy related penalties for taxpayers and preparers:

Standards which do not require disclosure of tax return position to IRS

Taxpayers’ “more likely than not” standard

The substantial understatement penalty does not apply in the case of a tax shelter item of a non-corporate taxpayer if the taxpayer had substantial authority for his or her position and the taxpayer can demonstrate that he or she had a reasonable belief that the position is “more likely

355 The Uruguay Round Agreements Act of 1994, P.L.103-465, eliminated the use of this exception for corporate taxpayers. Thus, corporate taxpayers with a substantial understatement from a tax shelter item will have to rely on the reasonable cause exception in section 6664(c) to avoid an understatement penalty. The reasonable cause exception is a facts and circumstances test, but having a reasonable belief that the taxpayer’s position is “more likely than not” the proper position will be an important factor in determining whether reasonable cause exists.

356 Treas. Reg. sec. 1.6662-4(g)(4)(ii).

357 Sec. 6662(d)(2)(B)(i).

358 Treas. Reg. sec. 1.6662-4(d)(2).

359 Treas. Reg. sec. 1.6662-4(d)(3).

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than not” the proper treatment.355 This standard generally has been interpreted to mean there is a greater than 50 percent likelihood of prevailing if the taxpayer’s position is challenged by the IRS. A taxpayer will be considered to have a reasonable belief that the treatment is more likely than not the proper treatment if the taxpayer relies upon the opinion of a professional advisor and the opinion is based upon the pertinent facts and authorities analyzed similar to the manner described in the substantial authority standard.356

Taxpayers’ “substantial authority” standard

A taxpayer is not subject to an accuracy related penalty for an undisclosed erroneous return position--even a position that leads to a substantial understatement of tax liability-- provided there is “substantial authority” for the position.357 The regulations describe substantial authority in terms of a spectrum. It means a position that has a less than 50 percent chance of being sustained if it were challenged, but has a greater chance of success than a position which has a “reasonable basis”.358

In assessing whether a position was supported by substantial authority when it was adopted, certain specified sources of authority may be consulted.359 None of these sources of authority are to be viewed in isolation. For example, a judicial opinion in favor of a particular position must be weighed against other specified authority (if there is any) that contradicts the position. The regulations describe a balancing process. A taxpayer can rely on favorable authority and consider it substantial only if its weight is substantial in relation to any

360 Id.

361 Treas. Reg. sec. 1.6662-4(d)(3)(iii).

362 Sec. 6694(a). Treas. Reg. sec. 1.6694-2(b)(1), described above.

363 Treas. Reg. sec. 1.6694-2(b)(1).

364 Sec. 6662(d)(2)(B)(ii).

365 H.Rept. 103-213, Conference Report, Omnibus Budget Reconciliation Act of 1993, Aug. 4, 1993, at 669.

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countervailing authority that may exist.360 The regulations list the specific authorities that may be consulted.361

Tax professionals’ “realistic possibility of being sustained” standard

A tax advisor who is a “preparer” with respect to a tax return or refund claim is subject to a 1st tier penalty if, among other items, the position did not have a realistic possibility of being sustained on its merits.362

A return position is considered to have had a realistic possibility of being sustained on its merits if a hypothetical tax professional making a reasonable, well-informed analysis would conclude that the likelihood of the position being upheld was approximately one in three or better.363

Standards requiring disclosure of tax return position to IRS

Taxpayers’ “reasonable basis” standard

For individuals, the substantial understatement penalty does not apply to any understatement related to a position that (1)was adequately disclosed on the return, (2)the position does not relate to a tax shelter, and (3)it has a “reasonable basis.”364

Legislative history indicates that reasonable basis is intended to be “a relatively high standard of tax reporting.” A return position that merely represents a colorable claim or an arguable position would not meet this standard. Significantly, the standard is not met if the best that can be said of a return position is that it is not patently improper.365 Under the regulations, “patently improper” defines the minimum standard for a tax preparer to avoid penalty through

366 Treas. Reg. sec. 1.6694-2(c)(2).

367 A signing preparer, in effect, would have to require adequate disclosure as a condition of signing the return. A nonsigning preparer would have to provide a warning concerning the taxpayer’s exposure to an accuracy related penalty if the item is not disclosed or, in the case of a tax shelter item, even if it is disclosed. Treas. Reg. sec. 1.6694-2(c)(3).

368 Sec. 6694(a).

369 Treas. Reg. sec. 1.6694-2(c)(2).

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disclosure of a return position.366 Thus, there is a higher standard for taxpayers than for tax professionals who advise them. Despite the legislative history’s “relatively high standard” description, logic dictates that the term “reasonable basis” must imply something less than substantial authority. This is so since a position supported by substantial authority need not be disclosed to avoid the sec. 6662 penalty.

Tax preparers’ “not frivolous” standard

If a tax professional is a preparer with respect to a return or refund claim, and the preparer knows or should know of a position taken on the return that falls short of the “realistic possibility of being sustained” standard, and the position causes the tax liability on the return to be understated, then the preparer is subject to penalty unless (1) the preparer took steps to ensure disclosure of the position,367 and (2) the position is “not frivolous.”368 The regulations define a frivolous position as one that is patently improper.369 This standard is similar to the litigation standard in the Tax Court under Rule 33 where claims may be litigated if well grounded in fact and warranted by existing law.

The current standards for taxpayers and tax preparers discussed above are summarized in Table 7, below.

370 Commissioner of Internal Revenue v. Lane Wells Co. 321 U.S. 219, 223 (1944).

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Table 7.--Existing Standards for Tax Return Positions

Taxpayers’ Substantial Understatement of Tax (Sec. 6662)

Practitioners’ Preparer Penalty (Sec. 6694)

Standard Likelihood of Success if

Challenged 1

Effect of Meeting Standard

Standard Likelihood of Success if

Challenged

Effect of Meeting Standard

More likely than not Greater than 50 percent

No penalty exposure for non- corporate tax shelter items where substantial authority also exists

No similar standard N/A N/A

Substantial authority

40 percent No penalty exposure

Realistic possibility of being sustained

33a percent or greater

No penalty exposure

Reasonable basis2 20 percent No penalty exposure if disclosed and not a tax shelter item

Not frivolous 5 to 10 percent

No penalty exposure if disclosed. Applies to tax shelter and non-tax shelter items

1 It is recognized that describing the accuracy standards in terms of their arithmetical probability of success might seem to indicate a high degree of precision. No such precision is intended or implied. The numerical values shown in this table are meant to indicate in general terms the relative levels of accuracy to which taxpayers and practitioners are held. While some may question the value of quantifying these standards due to their inherently uncertain terms, most students of professional conduct standards use these or similar methods to describes these standards. The 33 1/3 percent standard for realistic possibility of being sustained appears in the Treasury regulations under section 6694. All other numerical values shown in the chart represent a general consensus of scholars and practitioners based on a survey of the literature. 2 Reasonable basis is also the standard that defines negligence.

3. Recommendations

Federal tax law is complex and constantly evolving. It is unrealistic to expect taxpayers to file “perfect” returns, on which every position taken is unquestionably correct. Still, the U.S. Supreme Court has pointed out that “self assessment...is the basis of our American scheme of income taxation.”370 Self assessment requires a high degree of cooperation from the taxpayer to file an accurate tax return. While some have questioned whether the IRS should audit more returns, it is impractical to propose that audits should be a routine fact of life for even a significant minority of taxpayers other than the large multinational firms that are covered by the IRS’s Coordinated Examination Program (CEP).

However, as discussed in Part V, above, a self-assessment system will work properly if taxpayers perceive the system to be fair and believe that the costs of noncompliance outweigh

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the benefits of such noncompliance. Among the costs of noncompliance are (1) the risks of noncompliance being detected by the IRS and (2) the penalties that are imposed when noncompliance is detected.

The present-law standards for imposition of accuracy-related penalties on taxpayers and return preparers arguably permit taxpayers to take positions on tax returns that have an inappropriately low chance of success if challenged by the IRS. Such a low standard has the effect of increasing perceptions of unfairness because taxpayers who take aggressive positions on their returns are unlikely to be penalized. The low standard also reduces the potential costs of noncompliance because the IRS is less likely to prevail when a return position is challenged.

Therefore, the Joint Committee staff finds it appropriate to make a number of recommendations to increase both (1) the standards for taxpayers and preparers applicable under the accuracy-related penalties and (2) the amount of the return preparer penalty. In addition, the Joint Committee staff makes a recommendation relating to IRS recordkeeping with respect to taxpayer disclosures. The Joint Committee staff believes that these recommendations will improve both the equity and administrability of the accuracy-related penalty system.

a. New minimum tax return standards for taxpayers and tax preparers

Recommendation

The Joint Committee staff recommends that for both taxpayers as well as tax preparers, the minimum standard for each undisclosed position on a tax return is that the taxpayer or preparer must reasonably believe that the tax treatment is “more likely than not” the correct tax treatment under the Code. This standard would imply that at the time the return was signed, there was a greater than 50 percent likelihood that all undisclosed positions would be sustained if challenged. The reasonable cause exception for substantial understatement is repealed.

Analysis

The fact that a tax return is signed under penalty of perjury implies a high standard of diligence in determining the facts and substantial accuracy in determining and applying the rules that govern those facts. An issue with the present-law tax return and preparer standards as well as the professional ethical standards as described by the American Bar Association and the American Institute of Certified Public Accountants is that none of them require the advisor or taxpayer to seek a tax return position that is “probably right.” The current standards arguably legitimize taking positions that have at least a 67 percent chance of being unlawful without any requirement of disclosure to the IRS that such aggressive positions are being taken. A more appropriate standard would require that a taxpayer or a tax advisor, who does not disclose an uncertain position, be required to show that any undisclosed positions taken on the return are at least probably correct.

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Some of the comments received in connection with this study alluded to a confusing multiplicity of standards for taxpayers and for tax professionals relating to positions taken on tax returns. “More likely than not” is a simple threshold that is easily understood. It would apply for both taxpayers and tax preparers and, therefore would reduce the complexity inherent in the five present-law standards for taxpayers and tax preparers.

Opponents to a stricter disclosure standard (such as the Joint Committee staff recommendation) have argued that the tax reporting process is an adversarial one similar to the judicial process, and should have similar standards. They assert that the present law “not frivolous” preparer standard is appropriate because it is similar to the “well grounded” standard in the Tax Court. However, because the position on the tax return is assumed to be correct under present law and the risk of challenge by the IRS to that assumption is low, the relationship between taxpayers and the IRS is not strictly analogous to litigants. In litigation, procedural rules have been developed to require full disclosure of facts and legal authority, mandate the presence of an independent arbiter, and permit full examination of the parties’ positions. The absence of these or similar items in the tax reporting process justifies standards requiring a higher degree of accuracy than for litigation. Furthermore, it could be argued that the success of a self-assessment system is undermined if taxpayers and the IRS are assumed, for disclosure purposes to be adversaries.

b. New minimum tax return standards for taxpayers and preparers for disclosed return positions

Recommendation

The Joint Committee staff recommends that, for any position taken or advised to be taken on a tax return, substantial authority should be required and such position should be adequately disclosed. For non-corporate tax shelter items, the present-law standard of “more likely than not” will continue to apply as a means to avoid an understatement penalty, but only if such position is also disclosed. The reasonable cause exception for substantial understatement is repealed.

The revised standards for tax return positions as described in the above recommendations are summarized in the following table.

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Table 8.–Proposed Standards for Tax Return Positions

Taxpayers’ Accuracy Penalties (Sec. 6662)1,2

Practitioners’ (Sec. 6694)

Standard

Likelihood of Success if

Challenged

Effect of Meeting Standard

Standard

Likelihood of Success if

Challenged

Effect of Meeting Standard

More likely than not

Greater than 50 percent

Generally, no penalty exposure. For non-corporate tax shelter items, no penalty exposure if disclosed.

More likely than not

Greater than 50 percent

Generally, no penalty exposure. For non-corporate tax shelter items, no penalty exposure if disclosed.

Substantial authority

40 percent No penalty exposure if disclosed and not a tax shelter item

Substantial authority

40 percent No penalty exposure if disclosed and not a tax shelter item

1 It is recognized that describing the accuracy standards in terms of their arithmetical probability of success might seem to indicate a high degree of precision. No such precision is intended or implied. The numerical values shown in this table are meant to indicate in general terms the relative levels of accuracy to which taxpayers and practitioners are held. While some may question the value of quantifying these standards due to their inherently uncertain terms, most students of professional conduct standards use these or similar methods to describes these standards. All other numerical values shown in the chart represent a general consensus of scholars and practitioners based on a survey of the literature These standards will also apply to negligence penalties under sec. 6662. 2 These standards will also apply for negligence.

Analysis

It seems anomalous under present law that “nonfrivolous” return positions that have a less than 10 percent likelihood of being correct do not expose tax preparers to penalty if they are disclosed. The appropriate standard should be one that requires more than a highly speculative possibility of accuracy.

The present-law standards that define erroneous tax positions are explicitly lower for tax professionals than for their clients. Numerous courts have held a taxpayer may have a reasonable basis for an opinion and thus escape penalty, if he or she reasonably relied on a return preparer’s advice. Since the preparer is held to a lower standard than the client, it becomes possible under some circumstances to take positions that have no reasonable basis with neither the preparer nor the client at risk of incurring a penalty. The Joint Committee staff recommendations will correct this anomaly by making the standards consistent for both taxpayers and preparers.

With adequate disclosure, a position with a less-than-probable likelihood of success can be tolerated. Under current guidelines, this would allow taxpayers and their advisors to assert controversial tax return positions that fail to satisfy the “more likely than not” standard, provided

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they make adequate disclosure, and provided that a well reasoned analysis of authoritative sources would support the conclusion that there exists a greater than 33-1/3 percent likelihood of success. Requiring disclosure of these items while maintaining the present-law standard of requiring taxpayers to reasonably believe that their tax treatment is proper represents the proper balance for these items in comparison to the other recommended tax return standard changes in this study for corporate tax shelters.

It must be recognized that positions that fall short of a “more likely than not standard” may ultimately be vindicated. Thus taxpayers and their professional advisers should be allowed, within reasonable limits, to take return positions that fall short of a “more likely than not standard,” provided such positions are adequately disclosed.

However, disclosure has limited usefulness. Even with disclosure, taxpayers should not be allowed to take any position on a tax return that has less than a 10 percent likelihood of being correct. A standard that low puts a nearly impossible burden on IRS efforts to use disclosures effectively.

c. IRS usage of disclosures made by taxpayers

Recommendation

Current IRS records do not provide adequate detail to judge how effectively the IRS has used taxpayer disclosures to monitor and counter unduly aggressive return positions. The Joint Committee staff recommends that the IRS be required to maintain records that will make monitoring IRS’ usage of taxpayer disclosures possible, and that the IRS report periodically to the Congress on the efforts it is making to use taxpayer disclosures for purposes of effective enforcement. If situations exist where the disclosures are not of use to the IRS, the IRS should recommend that such disclosures be eliminated.

d. Revise preparer penalty amounts

Recommendation

The Joint Committee staff recommends that the section 6694 penalties be revised to better reflect the potential tax liabilities involved. In general, the practitioner’s fee for preparing or advising a taxpayer with regard to a return is likely to be roughly commensurate with the client’s actual or potential exposure to tax liability and the complex issues reported on the return. Under the Joint Committee staff recommendation, the 1st tier section 6694(a) penalty would be changed from a flat $250 amount to the greater of $250 or 50 percent of the tax preparer’s fee. The 2nd tier section 6694(b) penalty would be changed from a flat $1,000 amount to the greater of $1,000 or 100 percent of the preparer’s fee.

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Analysis

Under certain circumstances, the present-law preparer penalty amounts may be inappropriately low and, therefore, an inadequate deterrent to noncompliance, when substantial dollar amounts of tax are involved. Thus, the Joint Committee staff believes that increases in the amounts of the penalty that can be assessed by the IRS is appropriate.

The Joint Committee staff believes that it is appropriate to assess the amount of the penalty imposed on a preparer by reference to the amount of the preparer’s fees, which represent the best measure of the preparer’s stake in the taxpayer’s return. In general, the preparer’s fees are likely to be determined, in part, by the amount of tax liability involved.

The Joint Committee staff considered recommending an increase in the dollar amount of the penalties generally, but concluded that such an approach might lead to anomalous results in situations in which the amount of the penalty outweighed the amount of tax in question.