Legislation effective May 25, 2007 (Small Business and Work Opportunity Act of 2007, Pub. L. no. 110-28) establishes a "more likely than not" standard for tax advisers to avoid Internal Revenue Code section 6694 understatement penalties for advice on a US tax return position that is not separately disclosed. A monetary penalty of up to 50 percent of the income derived by the adviser may be imposed if a US federal return or claim for refund that is filed does not disclose a position for which the adviser did not reach a more-likely-than-not opinion.

The more significant changes are as follows. (1) The standard for a position on a return without form 8275 ("Disclosure Statement") disclosure has been raised from "realistic possibility" to a reasonable belief that the position would "more likely than not" be sustained on its merits. (2) The former "not frivolous" standard for a return with disclosure increases to a "reasonable basis" standard; thus, the preparer cannot under any circumstances sign a return if he or she knows that the return contains a position that is not supported on a reasonable basis. (3) The section 6694 penalty is expanded to apply to estate tax, gift tax, and information and other returns. (4) The amount of the penalty has been increased.

Under prior law, an income tax adviser was open to penalty if he advised vis-à-vis a position that resulted in an understatement of tax on a return and if (1) there was no "realistic possibility" of its being sustained on its merits, (2) the position was undisclosed or was frivolous, and (3) the adviser knew or reasonably should have known of the position. The penalty was $250 if the adviser knew or reasonably should have known of the position taken; a second-tier penalty of $1,000 was imposed if the adviser engaged in specific wrongful or reckless conduct.

Both the prior and the new penalty provisions apply specifically to a "return preparer," but the definition of that phrase is broad enough to include, for example, a person who gives advice on specific issues of law before a transaction occurs. Thus, an individual who provides tax-planning advice may be subject to the penalty provision.

The new rules broaden the scope of the penalties to capture advisers with respect to returns for estate and gift tax, employment tax, and excise tax returns, and returns of tax-exempt organizations. The new rules also alter the standards of conduct sufficient to avoid penalty with respect to a return that understates tax. Thus, the provision replaces the "realistic possibility" standard for an undisclosed position with a requirement that the adviser hold a reasonable belief that the position's tax treatment was more likely than not the proper treatment. Moreover, the "not frivolous" standard that previously applied to a disclosed position is replaced with the requirement that there must be a reasonable basis for the tax treatment of the disclosed position. Under the new rules, the first-tier penalty increases from $250 to the greater of $1,000 and 50 percent of the income derived or to be derived from the preparation of the relevant return (or refund claim); the second-tier penalty, formerly $1,000, increases to the greater of $5,000 and 50 percent of the income derived by the tax adviser.

The legislation does not provide for transitional relief, but new Notice 2007-54 (2007-27 IRB 12) addresses various questions regarding the penalty's scope and application. The notice acknowledges that the amendments raise questions: What activities represent preparation of a tax return? Who is the return preparer? How does the statute apply to signing and non-signing preparers? Under the transitional relief, income tax return preparers are subject to the existing regulations for returns due before 2008; for non-income tax returns due before 2008, a "reasonable basis" standard applies.

Treasury Department Circular 230 requirements that govern professional conduct apply the same standard for avoiding a penalty as the old Code section 6694: a return position must have a "realistic possibility of being sustained on its merits" (a 33 1⁄3 percent likelihood of success) or must be disclosed and not be frivolous (a 5-10 percent likelihood of success). IRS Notice 2007-30 (2007-14 IRB 883) establishes that any violation of the circular may trigger a monetary penalty. An adviser who fails to meet the standards in both the circular and the new Code section 6694 may be exposed to a penalty as high as 150 percent of his or her fees from the engagement.

More than ever before, an adviser on a US tax return position has a significant incentive to communicate clearly with the client to ensure proper reporting and disclosure. The new "more likely than not" standard for advisers under the new Code section 6694 is higher than the standard for taxpayers, unless the issue involves a tax shelter. An understatement penalty is imposed on a taxpayer with a substantial understatement of tax attributable to an undisclosed position only if it lacks "substantial authority." The "substantial authority" standard is less stringent than the "more likely than not" standard, but more stringent than the previous "reasonable basis" standard for advisers.

Alice A. Joseffer
Hodgson Russ LLP, Buffalo