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1. Death (in immediate family)
2. Illness (serious)
3. Unavoidable Absence (incarceration, detainment)
4. Bankruptcy
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6. IRS Error
7. Incorrect Verbal Advice from the IRS
8. Incorrect Written Advice from the IRS
9. Postal Service Error
10. Tax Professional Error
11. Lack of forms
12. Inability to obtain forms
13. Fire (that destroyed records)
14. Theft (of records)
15. Official disaster area (place of residence falls within)
16. Unknown filing requirements
17. Tax law change

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The Tax Governance Institute (TGI), a forum dedicated to the analysis of corporate issues relating to day-to-day and long-term tax risk management, recently hosted a live video-cast panel discussion to review the implications of the new, heightened tax return preparer penalties.

Moderated by TGI Director Hank Gutman, the panel included: Anita Soucy, Attorney-Advisor in the Office of Tax Policy, U.S. Department of Treasury, and one of the principal authors of the recently released Treasury guidance on the new tax return preparer penalties; Chris Rizek, a former Treasury associate legislative counsel and currently a member of the Washington, D.C. office of the law firm of Caplin & Drysdale; and Mike Dolan, a former deputy commissioner of the Internal Revenue Service and a member of the Washington National Tax practice of KPMG LLP.

This executive summary highlights the discussion of the heightened standards imposed on paid tax return preparers, and its influence on company policies:

Overview of the New Legislation

In May 2007 Congress approved a provision that extended the application of the income tax return preparer penalties to all tax return preparers, altered the level of confidence that must be met to avoid imposition of penalty for preparing a tax return that reflects an understatement of liability, and increased applicable preparer penalties.

Under the provision, the return preparation standard for undisclosed positions reported on any federal tax return was changed from “realistic possibility of success on the merits” to “reasonable belief that the position would more likely than not be sustained on its merits.” Effective for any tax return positions taken on tax returns due after December 31, 2007, the provision subjects to penalties return preparers who fail to meet the higher standard.

Though the new law affects only tax return preparers, uncertainty about a number of definitions, including the important question of who is a “tax return preparer,” left its scope somewhat unclear and created uncertainty among many companies regarding the effect of the law on tax advice and tax return services provided by their tax advisers. On December 31, 2007, Treasury released interim guidance—Notices 2008-11, -12, and -13—that addresses this definition and related matters. But questions remain.

Treasury Guidance

Treasury guidance issued in June 2007 deferred the original effective date of the application of the new preparer penalties and has afforded many companies and advisers more time to contemplate the effect of the law change. However, the transitional relief also engendered a number of questions concerning the timing and scope of the relief for certain tax returns and for tax advice rendered by non-signing preparers. Notice 2008-11 clarifies previous guidance deferring the effective date of the new law. Notices 2008-12 and -13 clarify other questions arising from the new preparer penalty provisions.

Anita Soucy explained that Treasury and the IRS did not have time to rewrite the entire applicable regulatory regime. The interim guidance modifies existing regulations and must be read in conjunction with them. “Folks who are not familiar with this regime need to read both the existing regulations and the notices. We [Treasury] point out where certain positions in the existing regulations are replaced with the interim guidance.”

Notice 2008-11 states that the transitional relief applies (1) to timely amended returns or claims for refund (other than 2007 employment and excise tax returns) filed on or before December31, 2007, and (2) to timely amended employment and excise tax returns or claims for refund filed on or before January 31, 2008. Notice 2008-11 also clarifies that the transitional relief applies to non-signing preparers for advice provided on or before December 31, 2007.

The new legislation also includes an amendment that imposes a penalty on a tax return preparer of any return or claim for refund who fails to sign a return when required by regulations. Notice 2008-12 provides interim guidance concerning the scope of the penalty provisions of the preparer signature requirement. The guidance identifies the return and refund-claim forms that must be signed by a tax return preparer to avoid preparer penalties under the current and contemplated regulations. Additionally, the notice states that if more than one tax return preparer is involved in the preparation of a return or claim for refund, the preparer with primary responsibility for the overall substantive accuracy of the return is the tax return preparer for purposes of the preparer signature penalty provisions. Notice 2008-13 provides guidance on several issues:

• Relevant categories of tax returns or claims for refund for purposes of section 6694

• The definition of tax return preparer for purposes of the return preparer penalties

• Standards of conduct applicable to tax return preparers for disclosed and undisclosed positions taken on tax returns

• Interim penalty compliance obligations applicable to tax return preparers

The “More Likely Than Not” Standard

The recent legislation introduces a number of new issues and questions—chief among them is the heightened standard now imposed on tax return preparers only. Mike Dolan observed that the crucial element of the code change is the replacement of the original standard with “more likely than not.” “It’s easier to say than to know exactly what it means,” he said. “The injection of the ‘more likely than not’ standard for the preparer is at the heart of the potential disconnect between the taxpayer and the preparer.”

Chris Rizek agreed, “That’s where a real problem is…Treasury is in a quandary [because] the standards now are higher for return preparers than they are for taxpayers.” He noted that, generally, unless the position involves a tax shelter, the taxpayer needs only substantial authority to avoid penalty, whereas the return preparer is now required to disclose that same position to avoid penalty.

“A lot of these issues were there in the prior statute, [but] people didn’t really pay a lot of attention to it,” said Rizek. “The standards were in the right order: the taxpayer standards were higher than the tax return preparer standards, which I think is logical because the return preparer does not have full access to all the facts the way the taxpayer does, and it’s the tax-payer’s liability that is being reported, so [he or she] should bear the ultimate responsibility for the return.”

Rizek said many of the regulatory concepts had been lingering under the old statute: non-signing preparer, substantial portion of the return, the implications of information from third parties. “These issues have been in there for a long time, but they weren’t as critical because the standard was less stringent.”

Increased Penalty

“And then there’s the penalty,” Dolan said. The penalty under the old regime was USD250for an undisclosed tax position if an income tax preparer knew, or reasonably should have known, of an understatement of liability on a return or refund claim due to a position that did not have a realistic possibility of being sustained on its merits. Under the new law, the heightened standard for undisclosed tax positions is complemented with an increased penalty. Tax return preparers are now subject to a penalty of the greater of USD1,000 or 50 percent of the preparer’s fees for undisclosed tax positions failing to meet the “more likely than not” standard.

Rizek said, “…while we don’t like to think people make their determinations based on the amount at risk, nonetheless because the fine was small and because the IRS rarely enforced it… these kinds of issues were sort of glossed over.” Now, Rizek said, “Suddenly people really went back and refocused on these things, and that’s the source of a lot of the angst that Treasury and the IRS have heard from taxpayers.”

“You’d like to think that, as a responsible practitioner, the amount of a penalty does not influence behavior. Well, the government thought it might influence behavior,” said Dolan.

Penalty Exceptions

Soucy pointed out that Notice 2008-13 contains four exceptions to the requirement that a tax return preparer should possess a reasonable belief that a tax position would “more likely than not” be sustained on the merits.

Until further guidance is issued, Notice 2008-13 states that a signing tax return preparer shall be deemed to meet the requirements of the heightened preparer penalty standards with respect to a position for which there is a reasonable basis but for which the signing tax return preparer does not have a reasonable belief that a tax position would “more likely than not” be sustained on the merits, if one of the following four conditions is met:

• The taxpayer discloses the position

• The preparer provides the taxpayer with a return that includes disclosure

• Where the position is supported by substantial authority, the preparer advises the taxpayer (and documents the advice) of the difference between the taxpayer penalty standards and the preparer standards

• In the case of a potential tax shelter transaction, the preparer advises the taxpayer (and documents the advice) of penalty standards for tax shelters and their difference, if any, from those of the preparer standards.

The fourth case would protect the preparer who was not in a position to know whether a transaction has a significant purpose of avoidance or evasion of federal income tax, Soucy said. “They may suspect a transaction has significant purpose, but ultimately the preparer cannot in all instances get into the taxpayer’s head.”

Soucy noted that Treasury and the IRS requested comments in Notice 2008-13. Treasury intends to overhaul the entire regime. In particular, it is working to clarify the rules for non-signing preparers. She said Treasury also would review the “more likely than not” standard, which was derived from the section 6662 regulations regarding the “more likely than not” requirement applicable to taxpayers for tax shelter positions.

Non-signing Preparers

Another significant question that has emerged from the new law and resulting increased focus on tax return preparer penalties is the definition of and the application of the new standards to a “non-signing preparer.”

Non-signing preparers are a problem, Rizek said. “[It] is sort of a creature of the regulations… Congress really didn’t know there was a concept of a non-signing preparer.” If law firms are caught by the rules, “it’s usually as a non-signing preparer.”

Gutman commented, “I’m sure you have a lot of tax directors who have taken advice from a lot of sources [and the tax directors] have not always seen that advice in the context of, ‘Well wait a minute, this is a non-signing preparer and now under this new standard he is going to have an obligation to disclose.’”

Part of the reason for this shift in focus, Rizek said, “…is that [preparers] used to be able to proceed relatively blithely if they were above the ‘realistic possibility’ standards.” Under the new standard, a taxpayer may have a variety of potential positions, each of which could have substantial authority but might fail under “more likely than not.” “That kind of opinion suddenly, at least theoretically, subjects the preparer to a section 6694 penalty if the position is not disclosed.”

That, Rizek explained, creates a conflict between the practitioner or the non-signing preparer and the taxpayer. To avoid penalty, the non-signing preparer would generally need the position to rise to a “more likely than not” standard—or be disclosed. But the taxpayer would need the position to rise only to substantial authority.

Soucy agreed that it is important to define preparers who do not sign the return. A determination of whether a person has prepared a substantial portion and is thus considered a tax return preparer will depend on the relative size of the deficiency attributable to the portion prepared by the preparer. The government specifically has requested comments to help draw a brighter line, she said.

Soucy noted that the government drew a distinction between signing preparers and non-signing preparers in the interim penalty compliance standards as an attempt to bridge the change in the tax return preparer penalties and the regime governing the taxpayer penalties. However, she stated that “[t]hese rules are interim in nature and we need to do a lot more thinking.”

Interplay with Circular 230 and FIN 48

Revisions to Circular 230, proposed in September 2007, incorporated the “more likely than not” standard. According to Soucy, “The existing rule in [Circular 230 section] 10.34 had incorporated the ‘realistic possibility’ standards that existed in section 6694, and we thought there is a policy reason for directly making these two provisions related.” But she noted that in-house practitioners not now subject to section 6694 would be subject to its standard “via the back door of Circular 230, and that’s a very interesting question that I think we need to further consider.” Treasury may review the connection in those standards, particularly because other provisions could subject practitioners to overlapping penalties.

Gutman noted that FIN 48 introduced into the financial accounting world the notion of reaching a “more likely than not” standard with respect to the financial reporting of uncertain tax positions, and he questioned the interplay between the analyses performed under FIN 48 and the work that may potentially need to be performed by tax return preparers to comply with the new preparer penalty standards.

“You can’t ignore that there are two delivery processes that are going at the same objective, which is trying to determine whether or not a tax position meets ‘more likely than not,’ and I don’t have any way of understanding how those could proceed on fundamentally different tracks,” said Dolan. “They might produce a different level of transparency—a [disclosure form] 8275 or an inclusion in a footnote—but I don’t see how the process can be any different.”

Rizek said that the fact that a preparer may rely in good faith on information from a third party to believe that the position meets the “more likely than not” standard, may also allow the “tax side” to rely on analyses by the auditors, without incurring section 6694 exposure. But whether the auditors can rely on the tax practitioners is a different subject.

The question is whether the standards of the tax return preparer penalties and FIN 48 “are truly the same” and are completely objective, Soucy said. “I think in section 6694 [tax return preparer penalties] there is certainly a subjective element. So I think it certainly is questionable if people will interpret them exactly the same.”

“There may well be legitimate reasons to differentiate,” Dolan said, “but…you kind of have to go down some parallel level of analysis, because you’re getting to roughly the same kind of result.”

On one hand, Rizek concluded, if the taxpayer standard is raised to “more likely than not,” then it will be simpler for the preparer and for the external auditors. “On the other hand, simplicity is going to come along with its own risks to all parties.”

About the Tax Governance Institute (TGI)

Established by the U.S. audit, tax and advisory firm KPMG LLP, the Tax Governance Institute is an open forum for corporate management, stakeholders and government representatives to share knowledge regarding issues relating to management of corporate tax risk, including transfer pricing risk, tax considerations when converting from U.S. GAAP to IFRS and accounting for tax uncertainties in current tax law.