Shhhh! Don't Tell the Tax Guy! (He's now from the IRS and he's here to help)

I address this article to attorneys who prepare tax returns for compensation, as such persons are among those classified as "tax preparers” under the Internal Revenue Code (“IRC”). Tax professionals have long recognized the potential for conflict between their role as tax planner for a client versus their duty to adequately disclose potential audit issues in a return (such as by filing F.8275-“Disclosure Statement”, which many consider to increase the risk of an IRS audit) in order to protect the client (and themselves) from penalties.

In Rev. Proc. 2010-15 (issued 1/28/2010), the IRS significantly revised what it considers "adequate disclosure" on 2009 and subsequent year tax returns for a taxpayer to avoid liability under IRC 6662(b) (Accuracy Related Penalty) (1) and for a preparer to avoid liability under IRC 6694(a) (Tax Return Preparer Penalty). (2) The determination of what constitutes “adequate disclosure” is often critical where an uncertain position is taken on a tax return, because the taxpayer and/or the preparer may be subject to penalty if they knew, or reasonably should have known, of a position reasonably taken that is not “adequately disclosed.”  

The new Rev. Proc. recites that for a disclosure to be considered “adequate”:

1.                   taxpayers must furnish all required information in accordance with applicable forms and instructions;

2.                   all amounts must be entered and be verifiable; and

3.                   “additional disclosure” of facts or positions involving many types of issues (such as Itemized deductions, trade/business expenses, book/tax differences, international issues, etc.) is unnecessary, provided that applicable forms and attachments are completed in a clear manner in accordance with IRS instructions.

However, the Rev. Proc. then increases the potential for conflict by advising that IRS now requires any related-party transaction be specifically disclosed for a disclosure to be considered “adequate”. Specifically, “the disclosure of an amount…is NOT adequate when the understatement arises from a transaction between related-parties. If an entry may present a legal issue or controversy because of a related party transaction, then that transaction and the relationship must be disclosed…”

So what does this mean to you and your clients? All tax return preparers should be aware that for this and subsequent filing seasons:

1. be careful what you learn, or you may find yourself compelled to disclose it on a tax return, risking an audit to save the client and/or yourself from potential penalties;
2. taxpayer’s may need to utilize separate firms for tax planning and return preparation, so that the preparer will neither know nor reasonably be expected to know of a particular position taken;
3. you need to practice your speech to clients that inviting IRS to visit is a good thing; and
4. to properly represent and protect your client, to some degree you now must be looked upon as “working for IRS”.

Footnotes

1.             IRC Sec. 6662(a) and (b) generally impose a penalty on the taxpayer if a return contains a “substantial understatement” of income tax. IRC Sec.6662(d)(1) generally defines as “substantial” an understatement on a return exceeding the greater of ten percent of the tax required to be shown or $5,000 (the rule for corporations varies slightly). However, IRC Sec. 6662(d)(2) generally provides that any “understatement” (not attributable to tax shelters) is reduced to the extent attributable to a position for which there is a reasonable basis and it is properly disclosed.

2.             IRC Sec. 6694(a) imposes a penalty on a return preparer when the return contains an understatement of liability due to an "unreasonable position”, if the preparer knew, or reasonably should have known, of the position.  A position generally is considered unreasonable unless: 1). there is substantial authority for it, or 2). there is a reasonable basis and it is properly disclosed.