Expansions in the regulatory environment in recent years are forcing CPA tax practitioners to consider many new compliance issues. Those issues include expanded statutory penalty provisions, revisions to regulations, and modifications to binding AICPA ethics rules related to tax engagements. CPAs subject to this wide array of rules and regulations include those who take a tax position on or prepare covered federal tax returns, represent clients before the IRS, or are engaged professionally for tax services. Failure to comply with the rules can result in significant monetary penalties and/or professional disciplinary actions.
All CPAs should understand the regulatory environment that applies to tax practice and determine how they will comply with these increasingly restrictive rules of practice. This article discusses the regulatory and penalty provisions that apply to tax practitioners and offers compliance recommendations.
The Internal Revenue Code contains several penalties that can be asserted against CPA tax practitioners. Some of these penalties specifically address tax shelter and reportable transactions and are beyond the scope of this article. Other penalties are broader in scope and thus present compliance concerns for all CPAs providing tax services.
Section 6694. In the Small Business and Work Opportunity Tax Act of 2007 (PL 110-28), Congress revised IRC § 6694 effective for tax returns prepared after May 25, 2007, to increase both the standard that tax return preparers must meet for positions taken on tax returns and the amounts of penalties that apply if the standard is not met.
Before the revision, section 6694 imposed a penalty on income tax return preparers who knew or had reason to know that an undisclosed “unreasonable” position on the return resulted in a tax liability understatement and did not have a “realistic possibility” of success—defined as a conclusion by a reasonable and well-informed person knowledgeable in the tax law of a one-in-three chance of being sustained on the merits (former Treas. Reg. § 1.6694-2(b)(1), before amendment by TD 9436 on Dec. 15, 2008). The amendments raised the standard to more likely than not—a greater than 50% chance of being sustained on the merits. The dollar amount of the penalty was raised to the greater of $1,000 or 50% of the income derived from the return—$5,000 or 50% if the understatement was caused by the preparer’s willful or reckless conduct. (Previously, the penalty was $250 or $1,000, respectively, without the 50%-of-income provision.) The act also removed the word “income” from the section’s application to “income tax preparers,” thus extending the penalty provisions to preparers of various types of tax returns.
Then, on Oct. 3, 2008, in the Emergency Economic Stabilization Act of 2008 (PL 110-343), Congress synchronized the penalties under section 6694 with those that generally apply to taxpayers under section 6662 by changing the standard for a supportable position in most cases to those for which there is “substantial authority” (defined as more stringent than the one-in-three, realistic- possibility standard but less so than the more-likely-than-not standard). Congress made this amendment retroactive to the effective date of the more-likely-than-not standard. For tax shelters and reportable transactions, however, the more-likely-than-not standard was retained.
The section 6694 penalties for positions that have a reasonable basis but not substantial authority can be avoided with proper disclosure. The regulations (Treas. Reg. § 1.6694-2(d)) provide guidance on what a preparer must do to properly disclose positions. The disclosure must be specific to the taxpayer and address the taxpayer’s unique facts and circumstances. Boilerplate disclosures will not be treated as sufficient.
If the signing preparer concludes that the substantial authority standard is not met, the preparer must adequately disclose the position as described in Treas. Reg. § 1.6694-2(d)(3) either by: (1) properly completing Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, as appropriate, or disclosing it on the tax return in accordance with the applicable annual revenue procedure; (2) providing the taxpayer with the tax return containing such disclosure; or (3) for returns or claims for refund that are subject to penalties pursuant to section 6662 other than the accuracy-related penalty attributable to a substantial understatement, by advising the taxpayer of the penalty standards applicable to the taxpayer under section 6662. In the last case, the preparer must contemporaneously document compliance with the disclosure requirement in his or her files. Note that even though section 6694 will not apply to the preparer who properly meets this disclosure requirement, section 6662 may still apply to the filing taxpayer (for example, if the preparer delivered a return that includes the required disclosure but the taxpayer removed it prior to filing). Nonsigning preparers are also subject to similar disclosure requirements.
The regulations suspend application of section 6694 where all facts and circumstances support a conclusion the understatement was due to reasonable cause and the preparer acted in good faith. Important considerations include the nature of the error, the frequency with which errors manifest themselves, the materiality of errors in relation to the correct tax liability, the preparer’s normal office practice, and reliance on the advice of other preparers.
Covered returns for the general preparer penalty of section 6694 include forms 706, 709, 940, 941, 990PF, 990T, 1040, 1065, 1120, 1120S and 5500. Willful or reckless behavior in the preparation of other forms, such as forms SS-8, W-2, 1099 and 990, will also expose the preparer to penalties.
Section 6695. Under section 6695, tax return preparers are expected to provide taxpayers with signed copies of the tax return, including the preparer’s identification number, as well as comply with other administrative duties. The 2007 changes extended the section 6695 duties to a broader set of returns than income tax returns. These include forms 706, 709, FUTA returns, FICA returns and certain excise tax returns.
WHO IS A PREPARER?
Preparers subject to section 6694 include the person signing the return, any other person who prepares a substantial portion of the return, and any person who provides advice on a substantial portion of a return entry. However, the term “preparer” specifically excludes certain advisers on proposed transactions, VITA and TCE volunteers, clerical workers, people preparing their employer’s return, and uncompensated preparers (Treas. Reg. § 1.6694-1(b), referencing Treas. Reg. § 301.7701-15(f)(1)). For this purpose, it should be noted that the expectation of compensation is sufficient to constitute paid preparation.
The regulations take the position that one preparer per position may be liable for preparer penalties, rather than one preparer per return. Thus, on a complex return with multiple positions and different preparers for the positions taken, more than one person could be at risk of a preparer penalty. Although there are safeguards to prevent stacking of penalties, the risk of exposure for multiple preparers working on complex returns remains. Employers of preparers may be liable if the firm management knew of or participated in the conduct that resulted in the penalty, if it fails to provide appropriate review procedures, or if it has such procedures but did not adequately monitor their implementation (Treas. Reg. § 1.6694-2(a)(2)).
TREASURY DEPARTMENT CIRCULAR 230
Under Circular 230, the regulations (31 CFR part 10) that govern practice before the IRS, practice is defined more broadly than return preparation. It includes preparing and filing documents, corresponding and communicating with the IRS, representing clients at conferences and meetings, and rendering written advice that has the potential for tax avoidance or evasion. Circular 230 applies to CPAs, attorneys, enrolled agents, enrolled retirement plan agents and enrolled actuaries. As it currently exists, Circular 230 (in section 10.7(e)) specifically indicates that it does not apply to tax return preparation by noncovered professionals. However, as a result of the recently announced IRS program for regulation of all tax preparers (see sidebar, “Registration of CPAs, Other Paid Tax Preparers to Start in 2011”), it is expected that portions of Circular 230 will be expanded to include all registered preparers. CPAs and other practitioners already covered by Circular 230 will not be required to meet additional new testing and continuing professional education requirements.
Circular 230 imposes duties that include prompt interaction with the IRS in providing information and disposing of client issues, due diligence, fee arrangements (there is a limited ability to charge contingent fees), avoiding conflicts of interest, and proper disclosures and specific due diligence standards relating to covered opinions. This latter duty is the source of the ubiquitous warnings on virtually every e-mail sent by every CPA and attorney.
Final regulations issued in 2004 (TD 9165) added an “aspirational standard” to section 10.33, stating that covered practitioners should adhere to “best practices” in providing advice and preparing submissions to the IRS. Although this section is not included as an enforceable provision, raising the specter of “best practices” could ultimately lead to an expectation that covered practitioners meet such standards or be subject to penalties. At the time of this writing, Circular 230 had not been revised to address the new section 6694 issues regarding levels of support for tax positions needed to avoid tax preparer penalties.
Circular 230 is enforced by the IRS Office of Professional Responsibility (OPR) through a series of possible sanctions ranging from censure to disbarment. In addition, monetary penalties may be imposed. The imposition of sanctions under Circular 230 can lead to an AICPA ethics referral, which in turn can lead to state-level ethics investigations and possible penalties. Sanctions can be imposed for violating any of the duties of Circular 230 and for conduct that might be deemed professionally disreputable (for example, failing to file personal tax returns, misappropriation of funds, disbarment by a professional licensing body, knowingly or recklessly giving false or misleading information or opinions, or contemptuous conduct in interactions with the IRS). There are rules relating to disciplinary proceedings, including appeal rights. Once a sanction is imposed, the practitioner’s name is disclosed publicly through the IRS Web site. The authors’ analysis of listed disciplinary actions indicates that the primary reason for sanction has been the failure of the practitioner to file personal tax returns, and the primary sanction has been temporary suspension of the right to practice before the IRS. The OPR has recently indicated it will be more aggressive about considering monetary penalties.
REVISIONS TO AICPA TAX ETHICAL STANDARDS
The AICPA Statements on Standards for Tax Services (SSTSs), as revised effective Jan. 1, 2010, are enforceable ethical standards that apply to AICPA members by virtue of the AICPA Code of Professional Conduct and to most non-AICPA members through the general practice of state boards of accountancy in adopting the AICPA Code of Professional Conduct as the states’ code of ethics. The SSTSs are intended to complement other standards of tax practice, including Circular 230 and the statutory penalty provisions.
The SSTSs apply to all tax services by AICPA members, not just those covered by the federal rules discussed above. Thus, SSTSs apply to state, local and foreign tax engagements as well as federal engagements that are beyond the scope of the preparer penalties and Circular 230. The recent revisions to the SSTSs were primarily clarifications and reorganization of presentation.
The substantive revisions to SSTS no. 1, Tax Return Positions, emphasize that CPAs must observe the level of support for tax positions expected by the applicable taxing authority. However, the minimum level of support required for an undisclosed tax position recommended by a CPA is a good-faith belief that there is at least a realistic possibility of the position’s being sustained administratively or judicially on its merits if challenged. This level of support applies if the taxing authority has no standards or has less rigorous standards than the realistic-possibility standard. Obviously, the CPA must adhere to the taxing authority’s standards if they are higher than the realistic-possibility standard. A CPA may recommend a position for which there is a reasonable basis of support if the CPA advises the client to disclose the position. (Previously in the SSTSs, this standard was at the “not frivolous” level). The STSSs do not define these levels of support, but prior Interpretation 1-1 stated that the realistic-possibility standard was less stringent than the IRC standards of substantial authority and more likely than not, and stricter than the reasonable-basis standard (revisions to Interpretation 1-1 are being developed currently). Notice 2009-5 indicates that, until further guidance, substantial authority for § 6694 is less stringent than more likely than not, and stricter than reasonable basis.
Implicit in the SSTSs is the tax practitioner’s need to document how the conclusions have been reached regarding the applicable reporting standards. The tax practitioner may consider well-reasoned articles, treatises or pronouncements issued by the taxing authority regardless of whether such authorities would be considered as “authority” under section 6662. In circumstances where the tax practitioner discovers that more than one tax position meets the SSTS criteria (SSTS no. 1, paragraphs 4 and 5), the tax practitioner’s advice may include a discussion of the various positions and an assessment of whether a particular position may increase the likelihood of the return’s being examined by the taxing authority (SSTS no. 1, paragraph 13).
IMPLICATIONS FOR PRACTICE
The expansion of the regulatory environment means that all CPAs who engage in any type of tax work are at a greater risk of challenge for violation of preparer penalties, IRS practice guidelines and AICPA ethical standards. At a minimum, all CPAs should:
Self-audit or engage an outside professional to assess the level of risk present in the current practices and procedures followed by the practitioner and the practitioner’s firm;
Monitor compliance with the system of quality control; and
Regularly modify the system of quality control to address issues that arise as a result of the quality-control system.
Changes to IRC §§ 6694 and 6695 in recent years have expanded the penalties that can be imposed on tax return preparers in amounts, types of tax returns covered, and the rigor of standards that preparers must meet to avoid penalties.
IRC § 6694 now requires “substantial authority” supporting tax positions unless they are adequately disclosed. Tax shelter or reportable transactions must be “more likely than not” to be sustained on their merits.
Circular 230 imposes broader duties upon practitioners in an array of tax engagements and can be the basis for administrative sanctions when practitioners fail to meet requisite standards. Although Circular 230 currently applies only to CPAs and certain other covered tax practitioners, the IRS has recently announced it will extend the ethical aspects of its requirements, but not the practice rights, to paid tax preparers besides those currently authorized to practice before the IRS.
The AICPA Statement on Standards for Tax Services no. 1 has been recently revised to elevate the required professional reporting standards in all tax engagements. The other SSTSs were reworded and reissued in revised form. The SSTSs apply to federal tax engagements, including those not covered by statutory preparer penalties and Circular 230, and to state, local and foreign tax engagements.
Thomas J. Purcell III (email@example.com) is a professor of accounting and professor of law at Creighton University in Omaha, Neb., and is a member of the AICPA Tax Legislation and Policy Committee. James W. Sansone (firstname.lastname@example.org) is senior director, tax quality and risk management for RSM McGladrey Inc. and is a member of the AICPA Responsibilities in Tax Practice Committee. Donald J. Tracy (email@example.com) recently retired from Deloitte and is an adjunct instructor in accounting at Creighton University.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
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Practical Steps to Ensure Quality Control
CPAs who practice in small or medium-size firms should consider developing a quality-control system for tax engagements that contains elements similar to those that apply to attest engagements. Common policy elements address:
Advocacy, integrity and objectivity;
Acceptance and continuance of clients and engagements;
Engagement performance; and
To facilitate these control objectives, practitioners should consider preparing a policies and procedures statement that addresses the IRC penalties that apply to tax practitioners, the requirements of Circular 230, and the SSTSs. The statement should establish policies that set forth how the firm intends to comply with the various standards. Specifically, the statement should establish documentation standards for:
Written advice given to clients;
Oral advice given to clients; and
Electronic advice given to clients.
In addition, many small and medium-size firms have found it advantageous to create tax return and tax research dockets that accompany information retained in their files. The dockets not only identify those professionals who prepared and reviewed the particular project but also can be used to capture other information important in documenting CPA compliance with the various standards. For example, the docket could summarize a position taken in the return that does not meet the substantial authority standard in section 6694 and the disclosure the CPA has included in the return provided to the client to facilitate avoidance of the penalty.
CPAs should carefully document the nature of a professional undertaking with a client in an engagement letter. Besides addressing the scope of the engagement, fee considerations and other practice-related issues, properly prepared engagement letters address issues such as the client’s overall responsibility for tax positions, record retention and filing. Sample engagement letters are provided annually in the AICPA Tax Section’s Tax Practice Guides and Checklists practice aid.
CPAs also should consider how to document actions taken regarding the engagement. Contemporaneous documentation of written advice to clients, conversations, positions to be taken on tax returns, and tax examinations and other similar issues should be properly retained in the files. A well-conceived record-retention system as part of an overall system of tax practice quality control can provide the CPA with support for professional actions taken in later challenges by regulatory authorities or if the client seeks judicial remedies for alleged malpractice.