A tax preparer will likely incur a penalty when a tax position is supported by only one authority, is contradicted by several other authorities, and is not disclosed on the tax return.
Understanding Tax Preparer Penalties
Tax preparers play a crucial role in the U.S. tax system, helping individuals and businesses navigate complex tax laws. To ensure accuracy and compliance, the Internal Revenue Service (IRS) imposes various penalties on preparers who fail to meet professional standards. These penalties are designed to deter negligence, intentional misconduct, and the promotion of frivolous tax positions.
Common situations that can lead to preparer penalties include:
- Understatement of tax liability: This is a key focus, often resulting from unreasonable positions or willful misconduct.
- Failure to exercise due diligence: Not asking appropriate questions, verifying information, or keeping adequate records.
- Failing to provide clients with a copy of their return.
- Not signing the tax return as the preparer.
- Negotiating an IRS refund check.
The Specific Penalty-Prone Scenario
The situation where a tax preparer takes a position supported by one authority, contradicted by several other authorities, and not disclosed on the tax return is a prime example of an "unreasonable position" that can trigger penalties under IRC Section 6694.
Here's why this scenario is problematic:
- Lack of Sufficient Authority: For a tax position to avoid penalties without disclosure, it generally needs to have "substantial authority." Having only one supporting authority while multiple others contradict it indicates a significant weakness in the position's legal basis.
- Undisclosed Aggressive Position: By not disclosing such a thinly supported or aggressive position on the tax return (e.g., via Form 8275, Disclosure Statement), the preparer essentially presents it to the IRS as if it were a robust, well-established interpretation of tax law. This lack of transparency can be viewed as an attempt to hide a potentially problematic tax stance.
- Risk of Understatement: This combination significantly increases the likelihood of an understatement of the taxpayer's liability, which is a primary trigger for preparer penalties.
Key Concepts for Tax Positions
When advising on tax positions, preparers must consider the level of authority supporting their stance. The IRS and courts often refer to the following standards:
| Standard | Description | Disclosure Required (Generally) |
|---|---|---|
| Substantial Authority | An objective standard. It exists if the weight of authorities supporting the position is substantial in relation to the weight of authorities supporting contrary positions. This is a high standard, but it doesn't require a 50/50 chance of success or greater. | No, if the position meets this standard, disclosure is generally not needed to avoid penalties. |
| Reasonable Basis | A lower standard than "substantial authority," meaning the position is arguable but not necessarily strong. It's significantly higher than "not frivolous." This standard requires a preparer to have a good faith belief that the position has a realistic possibility of being sustained on its merits. | Yes, if the position relies only on reasonable basis (and not substantial authority), it must be adequately disclosed to avoid most preparer penalties. |
In the scenario provided, having only one authority supporting a position contradicted by several others often falls short of "substantial authority." Without disclosure, it also fails the "reasonable basis with disclosure" standard, making it an "unreasonable position" for penalty purposes.
Practical Implications for Preparers
To mitigate the risk of incurring penalties, tax preparers should adhere to rigorous professional standards:
- Thorough Research: Always conduct comprehensive research to ascertain the strength of a tax position. Do not rely solely on a single source of authority, especially if contradictory guidance exists.
- Understand Authority Hierarchy: Be familiar with the hierarchy of tax authorities (e.g., Treasury Regulations, court cases, revenue rulings) and their persuasive weight.
- Evaluate All Sides: Consider all relevant authorities, both favorable and unfavorable, when forming an opinion on a tax matter.
- Client Communication: Discuss the risks associated with aggressive or weakly supported tax positions with clients. Ensure they understand the potential for audit and penalties.
- Diligent Disclosure: When a tax position does not meet the substantial authority standard, or if there's significant uncertainty, it is crucial to disclose the position adequately on the tax return using appropriate forms like Form 8275 or Form 8275-R. Disclosure acts as a shield against many preparer penalties.
Avoiding Penalties
Tax preparers can significantly reduce their risk of penalties by adopting best practices:
- Maintain Professional Competence: Stay updated on tax law changes, IRS guidance, and judicial decisions through continuing education.
- Exercise Due Diligence: Thoroughly review client information, ask probing questions, and verify supporting documents.
- Document Everything: Keep detailed records of research, conclusions, client communications, and any disclosures made. This documentation is vital in defending against penalty assessments.
- Adhere to Circular 230: Follow the regulations governing practice before the IRS, which outline duties and restrictions for tax professionals.
- Seek Second Opinions: If a tax position is particularly complex or ambiguous, consult with colleagues or other tax experts.
By diligently adhering to these principles, tax preparers can navigate the complexities of tax law effectively while protecting themselves and their clients from penalties. More information on tax preparer responsibilities and penalties can be found on the IRS website.
