IRS has issued proposed regs that would modify the Circular 230 tax return preparation standards to reflect changes made to the “first-tier” return preparer penalty by the Small Business and Work Opportunity Act of 2007 (the Small Business Act, P.L. 110-28). The changes would be effective when the regs are finalized, but not earlier than Jan. 1, 2008.

Background. Effective for returns prepared after May 25, 2007, the Small Business Act broadened and toughened the return preparer rules. As part of this overhaul, the “first-tier” return preparer penalty of Code Sec. 6694(a) was revised to provide that a tax return preparer who prepares a return or refund claim for which any part of a tax liability understatement is due to an “unreasonable position” must pay a penalty for each return or claim equal to the greater of: (1) $1,000 or (2) 50% of the income derived (or to be derived) by the tax return preparer for preparing the return or claim. A position is “unreasonable” if: the tax return preparer knew (or reasonably should have known) of the position; there was not a reasonable belief that the position would more likely than not be sustained on its merits; and the position was not disclosed as provided in Code Sec. 6662(d)(2)(B)(ii), or there was no reasonable basis for the position. (Code Sec. 6694(a)(2)) However, there's no penalty if it is shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith. (Code Sec. 6694(a)(3)) The Small Business Act also broadened the scope of the preparer rules and toughened the “second tier” willful or reckless conduct penalty.

Earlier this year, in Notice 2007-54, 2007-27 IRB, IRS announced that effective generally for original and amended returns and refund claims due before Jan. 1, 2008, the standards carried in prior law's Code and regs will apply in determining whether IRS will impose the “first tier” return preparer penalty under Code Sec. 6694(a) (see Federal Taxes Weekly Alert 06/14/2007).

Conforming Circular 230 return preparer standards proposed. IRS has determined that the professional standards under §10.34 of Circular 230 should conform with the civil penalty standards for return preparers. Thus, the proposed regs would amend these standards for tax return preparation to reflect changes to Code Sec. 6694(a) made by the Small Business Act.

Under the proposed regs, a practitioner couldn't sign a tax return as a preparer unless the practitioner had a reasonable belief that the tax treatment of each position on the return would more likely than not be sustained on its merits, or there was a reasonable basis for each position and each position was adequately disclosed to IRS. A practitioner couldn't advise a client to take a position on a tax return, or prepare the portion of a tax return on which a position was taken, unless:

(1) the practitioner had a reasonable belief that the position satisfies the more likely than not standard; or
(2) the position had a reasonable basis and is adequately disclosed to IRS (Prop Reg § 10.34(a))

The “more likely than not” standard would be treated as met if the practitioner analyzes the pertinent facts and authorities (carried under the Reg. § 1.6662-4(d)(3)(iii) substantial underpayment penalty rules), and based on that analysis reasonably concludes, in good faith, that there is a greater than 50% likelihood that the tax treatment will be upheld if IRS challenges it. (Prop Reg § 10.34(e)(1))

The “reasonable basis” standard would be treated as met if it is reasonably based on one or more of the authorities described in Reg. § 1.6662-4(d)(3)(iii). Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard would not be satisfied by a return position that is merely arguable or that is merely a colorable claim. The possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be settled could not be taken into account. (Prop Reg § 10.34(e)(2))

Observation: The standards in the proposed regs reflect a growing convergence between the tax rules and the financial accounting rules. Under the Financial Accounting Standards Board's (FASB) FIN 48, which is effective for fiscal years beginning after Dec. 15, 2006, tax benefits (e.g., deductions, credits) from uncertain tax positions that reduce an enterprise's current or future income tax liability are reported in its financial statements only to the extent each benefit is recognized and measured under a two-step approach. Under the first step of this approach, the enterprise must evaluate each tax position to assess whether, based on the “technical merits” (i.e., based on the relevant tax law authorities), it is more-likely-than-not (a likelihood of more than 50%) that the position would be sustained upon examination (including related appeals or litigation processes) by a tax authority that has full knowledge of all relevant information.

Effective date. To apply §10.34 of Circular 230 consistently with the transitional relief under Notice 2007-54, the changes are proposed to apply to returns filed or advice provided on or after the date that the regs are finalized, but no earlier than Jan. 1, 2008.

Other Circular 230 changes on the way. The preamble to the proposed regs says that on Sept. 26, final regs will be issued modifying the Circular 230 standards with respect to documents, affidavits, and other papers, but reserving on tax return preparation standards due to the Small Business Act changes.