Ethics, Professional Responsibilities and Federal Tax Procedures

Regulations Governing Practice Before the Internal Revenue Service

A. Circular 230 contains the IRS's rules of practice governing CPAs and others who practice before the agency. The government may censure, fine, suspend, or disbar tax advisors from practice before the IRS if they violate Circular 230's standards of conduct. "Practicing" entails primarily preparing and filing documents, and communicating and meeting with IRS representatives on behalf of a taxpayer. B. Subpart A of Circular 230 sets forth rules governing authority to practice before the IRS. Most importantly, Section 10.3 provides that "[a]ny certified public accountant who is not currently under suspension or disbarment from practice before the Internal Revenue Service may practice before the Internal Revenue Service by filing with the Internal Revenue Service a written declaration that he or she is currently qualified as a certified public accountant and is authorized to represent the party or parties." C. Who may practice before the IRS? As long as they are not under suspension or disbarment: 1. Attorneys 2. CPAs 3. Enrolled agents 4. Enrolled actuaries (enrolled by the Joint Board for the Enrollment of Actuaries), but their practice is generally limited to issues related to qualified retirement plans 5. Enrolled retirement plan agents, but their practice is limited to issues related to employee plans and to IRS forms in the 5300 and 5500 series Substantive Provisions A. Furnishing Information—A practitioner must promptly submit to the IRS any records or information that its agents and officers request properly and lawfully, "unless the practitioner believes in good faith and on reasonable grounds that the records or information are privileged." In other words, Section 10.20 requires prompt cooperation with all IRS requests for information. B. Client's Omission—What if you learn that your client has not complied with the laws or made an error or omission on a tax return? Consistent with AICPA ethics guidelines, Section 10.21 requires the practitioner to promptly notify the client of the error and its potential consequences, but the practitioner need not notify the IRS of the error and may not do so without the client's permission. C. Due Diligence and Reliance on Others—Practitioners must exercise due diligence in all aspects of their tax practice, including preparing tax returns and making representations to the IRS. Section 10.22 allows a practitioner to rely on the work product of others, if the practitioner used reasonable care in engaging, supervising, training, and evaluating them, although Sections 10.34 and 10.37 contain a couple of slight limitations on this reliance. D. Delays—Practitioners may not unreasonably delay the prompt disposition of any matters before the Service. Stalling tactics are strongly discouraged by Section 10.23. E. Assistance from the Disbarred—What if your former partner violated regulations and has been disbarred by the IRS? She still needs a job and wants to continue to do the same work as before, but have you sign off on everything since you are still in good standing. Section 10.24 provides that a practitioner should not knowingly accept even indirect assistance from any person disbarred or suspended from practice by the IRS. F. Practice by Former IRS Agents—The IRS is concerned about abuses by former IRS agents who might try to exploit their former position when they leave the Service. Therefore, Section 10.25 contains extensive rules meant to prevent conflicts of interest, such as IRS employees going into private practice and working on cases they had knowledge of when they worked for the government. For example, if IRS agent Fred worked on a matter involving taxpayer Stan within one year before he left the IRS, he could not join an accounting firm and represent Stan in that matter within two years of leaving the Service. Fred should not use his knowledge or influence in assisting or representing Stan in IRS proceedings during that two-year period. G. Notaries—A practitioner must not act as a notary public with respect to matters before the IRS in which he or she is involved or interested (Section 10.26) H. .Fees 1. Unconscionable fees—No practitioner may charge an unconscionable fee for representing a client before the IRS. 2. Contingent fees—The rest of Section 10.27 relates to contingent fees, providing that a practitioner may not charge a contingent fee for providing services before the IRS, with three exceptions. A contingent fee may be charged: a. For services rendered in connection with an IRS examination or challenge to either (i) an original tax return or (ii) an amended return or claim for refund when they were filed within 120 days of receiving a written notice of examination or written challenge to the original exam b. Where a claim for refund is filed solely in connection with determination of statutory interest or penalties c. When the accountant is representing the client in judicial proceedings In these three situations, the threat that the tax practitioner and client will play the "audit lottery" (taking an aggressive position because it is unlikely that the Service will substantively examine it) is small. 3. PCAOB—Remember that the PCAOB believes that a public company auditor is not independent from an audit client if it offers that client any services on a contingent fee basis. I. Return of Client Records—What if you have fired the client, or the client has fired you? You still have the client's tax records, but perhaps the client has not paid you. You don't want to give the client's records back until you are paid. Section 10.28 instructs the practitioner to promptly return any and all records needed for the client to comply with federal tax obligations. The practitioner may keep a copy. The rule specifies that the existence of a fee dispute does not change this obligation but recognizes that if applicable state law permits retention in the case of a fee dispute, the practitioner need return only those records that must be attached to the taxpayer's return. However, the rule further provides that the practitioner "must provide the client with reasonable access to review and copy any additional records of the client retained by the practitioner under state law that are necessary for the client to comply with his or her Federal tax obligations." The rule broadly defines "records of the client," but states that" [t]he term does not include any return, claim for refund, schedule, affidavit, appraisal or other document prepared by the practitioner . . . if the practitioner is withholding such documents pending the client's performance of its contractual obligation to pay fees with respect to such document." J. Conflicts of Interest—Section 10.29 provides that practitioners should not represent a client before the IRS if to do so would create a conflict of interest. 1. Such a conflict exists if the representation of one client would be adverse to that of another, or if there is a significant risk that the representation of one client would be materially limited by the practitioner's responsibilities to another client. 2. Notwithstanding the existence of a conflict of interest, however, practitioners may represent a client if they: a. Reasonably believe that they can provide competent and diligent representation to the client; b. The representation is not prohibited by law; and c. The affected client gives informed consent in writing. Practitioners should keep the consents on file for at least three years, although they need not do so in their advertisements. Unsolicited e-mails and letters are permissible. Although it is not expressly forbidden, practitioners should not guarantee refunds. K. Solicitation—Section 10.30 contains several limitations on solicitation of clients. Among others, false advertising is, of course, prohibited. But practitioners may publish accurate written schedules of fees and hourly rates. L. Check Negotiation—A practitioner who prepares tax returns may not endorse or otherwise negotiate any check issued to a client by the IRS, according to Section 10.31. M. Practicing Law—Tax accountants, typically, learn quite a bit of tax law, but nothing in Circular 230 is meant to authorize persons who are not members of the bar to practice law (Section 10.32). N. Best Practices—Section 10.33 sets forth best practices for tax advisers, including: 1. Communicating clearly with the client regarding the terms of the engagement, including the purpose, use, scope, and form of the advice 2. Establishing the facts, determining which facts are relevant, evaluating the reasonableness of assumptions or representations, relating the applicable law to the relevant facts, and arriving at a conclusion supported by the law and the facts 3. Advising the client regarding the import of the conclusions reached, including whether taxpayers may avoid accuracy-related penalties if they rely on the advice; 4. Acting fairly and with integrity when practicing before the IRS 5. Exercising any firm supervisory powers to ensure that firm employees act in accordance with best practices O. Tax Return Standards—Section 10.34 instructs practitioners not to willfully, recklessly, or through gross incompetence sign a tax return or claim for refund that the practitioner knows or reasonably should know contains a position that: (1) lacks a reasonable basis; (2) is an unreasonable position as defined by the Internal Revenue Code (Section 6694(a)(2)); or (3) is a willful attempt to understate the tax liability or a reckless or intentional disregard of IRC rules. Nor should a practitioner advise a client to take such unreasonable positions. 1. Additionally, practitioners should not advise clients to take "frivolous" positions on documents filed with the IRS. 2. Practitioners must inform clients of penalties reasonably likely to be imposed with respect to positions taken. 3. Practitioners may generally rely in good faith on information provided by their clients but may not ignore inconsistent information in their personal knowledge or other red flags that might appear. P. Competence—Practitioners must be competent, meaning that they possess "the appropriate level of knowledge, skill, thoroughness, and preparation necessary." Section 10.35 indicates that they may acquire competence by studying the relevant law or consulting with experts. 1. Compliance procedures—Section 10.36 provides that practitioners who have or share principal authority and responsibility for overseeing a firm's tax practice may be sanctioned if they either (a) willfully, recklessly, or through gross incompetence fail to take reasonable steps to assure that the firm has adequate procedures in place to ensure that all members and employees are complying with Circular 230 or (b) know or should know that a member or employee is not complying with Circular 230, but through willfulness, recklessness, or gross incompetence fail to take prompt corrective action. The obvious purpose of this provision is to prevent those officials at the top of an accounting firm from placing all the blame for inappropriate tax shelter or other activity on lower-ranking members of the firm. The provision is an exception to Section 10.22's provision that allows a practitioner to rely on the work product of others if the practitioner used reasonable care in engaging, supervising, training, and evaluating them. 2. Other written advice—Section 10.37 provides that tax practitioners may give written advice if the practitioners: a. Base the advice on reasonable factual and legal assumptions; b. Reasonably consider all relevant facts and circumstances that the practitioners know or reasonably should know; c. Use reasonable efforts to identify and ascertain relevant facts; d. Do not rely on others' representations if to do so would be unreasonable;Relate applicable law and authorities to facts; and e. Do not take into account 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. Penalties and Procedures A. Subpart C of Circular 230 sets forth the rules and penalties for disciplinary proceedings. 1. As a general notion, Circular 230 authorizes the IRS to punish any tax professional who is incompetent, disreputable, violates the Treasury Department's rules of practice or with intent to defraud willfully and knowingly misleads or threatens the person being represented. 2. Section 10.50 empowers the IRS to impose a monetary penalty on practitioners who have violated practice rules. The maximum penalty equals 100% of the gross income derived from the conduct and may be added to other penalties, such as suspensions and censures. It may also be added to the 50% penalty of gross income authorized by 26 U.S.C. Section 6694, meaning that the penalty could theoretically be up to 150% of the income derived from an engagement. 3. Section 10.51 lists numerous acts of incompetence or disreputable conduct that are sanctionable under Section 10.50, including: a. Conviction of any crime under federal tax laws b. Conviction of any crime involving dishonesty or breach of trust c. Conviction of any state or federal felony that would render one unfit to practice before the IRS d. Giving false or misleading information to tax officials e. Soliciting employment in violation of Section 10.30 f. Willfully evading taxes g. Being disbarred or suspended from practice as a CPA or an attorney; h. Contemptuous conduct before the IRS

Compliance Responsibilities

Filing Requirements—All taxpayers who have income in excess of a predetermined limit must file an income tax return. A. In general, an individual must file an income tax return if his gross income exceeds the standard deduction. 1. This includes the additional standard deduction for one who is age 65 or over (but not the additional deduction for one who is blind). One is considered 65 on the day before his or her 65th birthday. For example, if Elina turns 65 on January 1, Year 5, she would be considered 65 on December 31, Year 4, and therefore for the Year 4 files as married filing jointly with one additional standard deduction for being age 65 or older. 2. Taxpayers must also file a return if net self-employment income exceeds $400 during the tax year. Penalties—Four major types of penalties may be imposed on taxpayers. First, a penalty is imposed if the taxpayer fails to file a required tax return. Second, a penalty is imposed if the taxpayer fails to make adequate tax payments during the year (underpayment). Third, a penalty is imposed if the taxpayer fails to pay the tax reflected on the tax return (delinquency). Finally, a penalty is imposed if the taxpayer files an inaccurate tax return. A. Nonfiling Penalty—A nonfiling penalty is imposed on taxpayers (who must file a return) if the return is not filed by the due date. 1. The penalty for late filing is 5% per month (or a portion thereof) of the tax due with the return. 2. The maximum penalty is 25% of the tax due, and the minimum penalty (due if return is not filed within 60 days of the due date) is the lesser of $435 (2021) or the amount of the tax due. If the minimum tax applies and is greater than the maximum tax, then the minimum tax must be paid. 3. If the failure to file is fraudulent (intentional), the penalty is increased to 15% per month up to a maximum of 75% of the tax due with the return. Note No penalty is imposed if no tax is due with the return, or the taxpayer is eligible for a refund. B. Underpayment Penalty—An underpayment penalty is imposed for failure to remit taxes during the year (i.e., on the required estimated payment dates). The penalty equals the tax underpayment multiplied by an interest rate (the applicable federal short-term rate plus 3 percentage points). Definition Tax Underpayment: The difference between the tax due and the amount of tax paid on or before the filing of the return plus credits. 1. Required tax payments for individuals a. Taxes are remitted during the year through withholding or, if withholding is insufficient, through estimated tax payments. Taxpayers must make estimated payments (on the 15th of April, June, September, and January) if the amount of tax owed is at least $1,000 after subtracting withholding and credits. b. No penalty is imposed if the tax due with the return is less than $1,000. c. No penalty is imposed if the tax payments during the year were: i. At least 90% of current year taxes, or ii. 100% of last year's taxes. If the taxpayer's AGI exceeds $150,000, then tax payments during the year must be at least 110% of last year's taxes. d. The penalty can also be avoided if the annualization exception is met. For this exception the actual income for each quarter is computed, and then each estimated tax payment is based on that income computation. 2. Required corporate tax payments a. Estimated tax payments are due (if annual tax payments are at least $500) on April 15, June 15, September 15, and December 15 for a calendar-year corporation. b. There is no estimated tax underpayment penalty if the payments are at least equal to the lower of: i. 100% of current year's tax, or ii. 100% of the preceding year's tax. iii. The penalty can also be avoided if the annualization exception is met. c. A corporation with $1 million or more of taxable income in any of its three preceding tax years can use the preceding year's tax exception only for its first installment. The other installments must be based on the current year's tax to avoid penalty. d. If a taxpayer had a net operating loss in the previous tax year, the previous year's tax liability exception cannot be used to avoid an underpayment penalty. Annualization method a. The annualization exception can be used by individuals and corporations. b. The amount due with an installment is: i. The tax due for the months ending before the due date of the installment, less ii. The amount required to be paid for previous installments. c. Different exceptions can be used for different installments. For example, the 100% of previous year's tax might be used for the first quarter, and the annualization method for the second quarter. d. If a taxpayer determines that the installment under the annualized income method is less than the required installment under the regular method, any reduction in a required installment is recaptured by increasing the amount of the next required installment by the amount of the reduction. Nonpayment Penalties (and Interest)—Are imposed if the taxes shown on the return are not paid on the filing date. 1. Interest on late payments starts on the due date for filing and is calculated using the Federal short-term interest rate. 2. Any tax due must be paid at the time of filing, or else a penalty of 0.5% of the underpayment is imposed per month or portion thereof (up to 25% in total). 3. If both the nonpayment penalty and the non-filing penalty are imposed, the maximum penalty is limited to 5% of the tax due per month. 4. Neither the nonfiling nor the nonpayment penalties are imposed if the taxpayer has a reasonable cause for failing to file or failing to pay. Definition Reasonable Cause: A cause outside the control of the taxpayer and not due to neglect, such as irregularities in mail delivery, death or serious illness, unavoidable absence, or disaster. A taxpayer, generally, has the burden of proving that a failure was due to reasonable cause. D. Accuracy Penalties—Additional penalties may be imposed if the taxpayer underpays the actual tax because of an inaccurate position taken on a tax return. Definition Inaccurate Position: This occurs when a taxpayer disregards the tax rules without reasonable cause. 1. A penalty of 20% of the tax due to the inaccuracy is imposed if the inaccurate position is due to negligence. The penalty is waived if the taxpayer had a reasonable basis for the position taken. 2. A penalty of 20% of the tax due to the inaccuracy is imposed if the taxpayer substantially understates the tax. This penalty is waived if there was substantial authority for the position taken, or if the position was adequately disclosed on the tax return. The substantial authority standard is less stringent than the more likely than not standard, but more stringent than the reasonable basis standard. Definition Negligence: An intentional disregard of rules and regulations without intent to defraud. Definition Substantial Understatement: For individuals, a substantial understatement results when the additional tax due exceeds the greater of $5,000 or 10% of the total tax on the return. For corporations, a substantial understatement results when the understatement exceeds the lesser of 10% of the tax required to be shown on the return (or $10,000 if that is greater) or $10 million. 3. A penalty is imposed if there is a substantial or gross overstatement of the value or basis of any property. The penalty is 20% of the tax understatement for a substantial misvaluation and 40% for a gross misvaluation. Definitions Substantial Misvaluation: This occurs if the property is stated at 150% or more of the correct amount. Gross Misvaluation: This occurs if the property is stated at 400% or more of the correct amount. 4. The penalty for fraud is 75% of underpayment and an addition of 50% of the interest due on the underpayment. Definition Fraud: A deliberate action by the taxpayer to conceal, misrepresent, or deceive tax authorities about a tax deficiency. Preparer Penalties—Penalties may also be imposed on tax preparers. Note that you may want to review Section IV below before continuing to reference definitions of key terms used in this section. A. These penalties apply to all tax return preparers, including preparers for estate, gift, employment, excise, and exempt organization returns. B. A tax return preparer who prepares a return or refund claim that includes an unreasonable position must pay a penalty of the greater of $1,000 or 50% of the income derived by the preparer for preparing the return. 1. There is an exception to this rule if the position was disclosed and there is a reasonable basis for it. However, this exception applies to reportable transactions and tax shelters only if the position has a more likely than not chance of being sustained. 2. The reasonable cause and good faith exceptions apply. Definition Unreasonable Position: A position is unreasonable if it does not have substantial authority. Substantial authority generally means that the taxpayer has at least a 40% chance of winning if the IRS challenges the position in court. C. If the understated tax liability is due to an unreasonable position and the preparer willfully attempts to understate the tax liability or recklessly or intentionally disregards rules or regulations, the penalty is the greater of $5,000 or 75% of the income earned by the tax preparer for preparing the return or claim. D. Additional penalties may be imposed on preparers for: 1. Not signing returns done for compensation ($50 per failure; maximum of $27,000 per year; 2021) 2. Not providing a copy of the return for the taxpayer ($50 per failure; maximum of $27,000 per year; 2021) 3. Not keeping a list of returns filed ($50 per failure; maximum of $27,000 per year; 2021). The same penalty applies for not keeping a list of tax return preparers hired to prepare returns. 4. $545 (2021) for each instance of endorsing or negotiating a refund check. 5. Failure to provide the taxpayer's identifying number on the return ($50 per failure; maximum of $27,000 per year; 2021) 6. A preparer can be fined $545 (2021) per failure if he or she does not exercise due diligence in determining if a taxpayer is eligible for the earned income credit, child tax credit, or American Opportunity tax credit. 7. Providers may not base their fees on a percentage of the refund amount or compute their fees using any figure from tax returns. E. Tax preparers are subject to penalties related to knowingly or recklessly disclosing tax return information. If a tax preparer uses or discloses tax return information without the client's explicit, written consent, each violation could result in a fine of up to $1,000, one year imprisonment, or both. Exceptions are provided for disclosures related to quality or peer reviews. If the disclosure results in taxpayer identity theft, the penalty is $1,000 for each disclosure with an annual maximum of $50,000. Summary of Terminology for Penalties A. Not frivolous = Not patently improper B. Reasonable basis = At least one authority that has not been overruled (Treas. Reg. 1. Sec.6662-3(b)) C. Substantial authority = More than a reasonable basis (approximately 40%) D. More likely than not = More than 50% chance of succeeding Uncertain Tax Positions—Corporations that have at least $10 million of assets and uncertain tax positions have to file Schedule UTP if the corporation or a related party has issued audited financial statements. Disclosure requirements include a concise description of each UTP ranked by the current year's relative magnitude based on the financial statement reserve. IRS Registration—Individuals preparing federal tax returns for compensation must register with the IRS and receive a PTIN (Paid Preparer Tax Identification Number). The required annual amount is usually the lower of 90% of the tax shown on the taxpayer's current year return or 100% of the tax shown on the taxpayer's prior year return. If the taxpayer's adjusted gross income exceeded $150,000 in the prior year and the taxpayer elects to base his/her required annual amount on the prior year, then the taxpayer would have to use 110% of the prior year's return. Thus, Baker must base his required annual amount on 90% of the current year's tax liability or, since his adjusted gross income exceeded $150,000, 110% of the prior year's liability. Other assessable penalties with respect to the preparation of income tax returns for other persons include: (a) Failure to furnish copy to taxpayer; (b) Failure to furnish identifying number; (c) Failure to retain copy or list; (d) Failure to file correct information returns; (e) Negotiation of check

Privileged Communications, Confidentiality, and Privacy Acts

I. Privileged Communications A. Introduction—There are two broad types of privileges. 1. Testimonial privileges—Classic privileged communications include attorney-client, doctor-patient, and priest-penitent. Where applicable, the protected party (client, patient, penitent) can prevent the party who received the protected communications (attorney, doctor, priest) from testifying. 2. Work product privilege—This privilege typically prevents one party in a lawsuit from learning the other side's attorney's strategies for litigation. B. Accountant-Client Testimonial Privilege 1. The federal courts have refused to recognize an accountant-client testimonial privilege. 2. The state courts have refused to recognize a common law accountant-client testimonial privilege. 3. Approximately 15 states have statutorily recognized an accountant-client privilege. In those states, remember: a. The privilege belongs to the client, not to the accountant; b. The privilege can be waived by the client, either expressly or through voluntary and knowing disclosure of the relevant information; c. Waiver of the privilege as to part of the communication is waiver as to all; and d. The privilege applies only in state court, where state procedural rules apply. C. Tax Practitioners' Privilege 1. Section 7525 of the Internal Revenue Code extends a modest testimonial privilege to clients of all tax advisers authorized to practice before the IRS, including accountants. However, the privilege has several exceptions and has been construed narrowly by the courts. 2. Exceptions—The privilege does not apply to: a. Criminal matters; b. Matters not before the IRS or federal courts in cases brought by or against the United States; c. Tax advice on state or local matters; or d. Written advice in connection with promotion of a tax shelter. 3. Construed narrowly—Courts have not been uniform in their construction or application of the Section 7525 tax practitioners' privilege, but many have held that: a. It does not apply to information communicated to the practitioner solely for the purposes of facilitating tax return preparation. b. It merely extends to tax practitioners the same privilege accorded in the attorney-client relationship. c. Legal advice is protected, but not general accounting advice. d. The exceptions to the privilege are to be broadly construed. D. Accountant's Working Papers 1. Working papers are the notes, evidence, computations, and so on that accountants accumulate when doing professional work for their clients. 2. These working papers belong to the accountants, absent express agreement to the contrary. 3. Accountants must keep working papers confidential absent: a. Client consent to disclosure, or b. An enforceable government subpoena. II. Confidential Communications A. General Rule—According to the AICPA Code of Professional Conduct, absent client consent, a CPA shall not disclose confidential information disclosed by clients. B. Exceptions—Recognized exceptions include: 1. GAAP calls for disclosure 2. An enforceable subpoena or summons has been issued 3. An ethical examination is being conducted 4. A peer review requires disclosure 5. Disclosure is to other firm members on a "need-to-know" basis C. Miscellaneous Rules 1. CPAs may utilize outside computer services to process tax returns, as long as there is no release of confidential information. 2. CPAs may reveal the names of clients without client consent, unless such disclosure releases confidential information. 3. In divorce proceedings, a member who has prepared joint returns for the couple should consider both of them to be clients for purposes of requests for confidential information relating to tax returns. If given conflicting instructions, the CPA should consider the legal implications of disclosure with an attorney. 4. Outsourcing and offshoring place a responsibility on the member who sends business, such as tax return preparation, to outside firms or to foreign shores (1 million U.S. tax returns per year are prepared in India) to ensure the confidentiality of clients' tax information. D. Internal Revenue Code Provisions—As noted elsewhere in these materials, the IRC has several provisions dealing with confidentiality, including: 1. Section 6713, which imposes a civil penalty for each unauthorized disclosure or use of tax information by a tax return preparer; and 2. Section 7216, which imposes a criminal fine and potential imprisonment for knowingly or recklessly: a. Disclosing any information obtained in connection with the preparation of a return or b. Using such information for any purpose other than to prepare or assist in preparing a return. E. Violations—Violation of confidentiality obligations is also grounds for a civil malpractice lawsuit by a client. III. Privacy Acts A. Introduction—In addition to the provisions referred to above, other privacy provisions relevant to the accountant-client relationship should not be ignored. B. Generally Accepted Privacy Principles—Voluntary guidelines that the profession developed to assist accounting firms in establishing procedures and policies that will protect clients' information in their possession from hackers and others. There are 10 broad principles. 1. Management—An accounting firm should define, document, communicate, and assign accountability for its privacy policies and procedures. 2. Notice—An accounting firm should provide notice about its privacy policies and procedures and identify the purpose for which any personal information about clients is collected, used, retained, and disclosed. 3. Choice and consent—An accounting firm should describe the choices available to clients and obtain implicit or explicit consent with respect to the collection, use, and disclosure of personal information. 4. Collection—An accounting firm should collect personal information only for the purposes identified in the notice described above. 5. Use, retention, and disposal—An accounting firm should limit the use of personal information to the purpose identified in the notice and for which the client has provided consent. 6. Access—Firms should provide clients with access to their personal information for review and update. 7. Disclosure to third parties—Accounting firms should disclose information to third parties only for the purposes identified in the notice and only with the client's implicit or explicit consent. Accountants remain ultimately responsible for ensuring that this information is kept confidential. 8. Security for privacy—Accounting firms should protect personal information against unauthorized access, as identity theft is a growing problem. 9. Quality—Accounting firms should maintain accurate, complete, and relevant personal information for the purposes identified in the notice. 10. Monitoring and enforcement—The accounting firm should monitor compliance with its privacy policies and procedures and have procedures to address privacy-related inquiries, complaints, and disputes. C. E-Mails—Some states require accountants to encrypt e-mails that contain clients' personally identifiable information, and several other states are considering this requirement. D. Reasonable Measures—Some states also have statutes requiring firms, such as accounting firms, which have possession of individuals' social security numbers, to take reasonable measures to preserve the confidentiality of those numbers, including by taking precautions against identity theft. E. Section 7216—As noted in the Tax Return Preparer (TRP) discussion elsewhere in these materials, Section 7216 of the IRC imposes criminal penalties for unauthorized disclosure or use of taxpayer information. 1. This provision applies not just to TRPs but to anyone who assists in preparing a return or provides auxiliary services in connection with return preparation regardless of whether they are paid. 2. The IRS does allow TRPs to use tax return information "for the purpose of providing other legal or accounting services to the taxpayer." For example, when the tax law changes, an accountant could use client tax return information to identify affected taxpayers for purposes of informing them about the change. 3. The IRS allows tax return preparers to use client information for purposes of sending newsletters to clients containing tax, general business, or economic information but not for purposes of soliciting business other than tax return preparation services. 4. A TRP may generally disclose to its insurance carrier tax return information considered necessary for obtaining and maintaining a professional liability insurance policy. F. Section 6713—As noted in the TRP materials, Section 6713 imposes civil fines for: 1. Disclosure of any information furnished in connection with preparation of a federal tax return and/or 2. Use of such information for any purpose other than to prepare the return G. Bank Secrecy Act and Foreign Bank Accounts 1. Under the Bank Secrecy Act (BSA), taxpayers have an obligation to report foreign bank accounts (FBAR). 2. Evidence indicates that only about 30% of such accounts are currently being reported, and the IRS has ratcheted up enforcement. 3. While FBAR penalties are aimed primarily at the taxpayer, a TRP who, perhaps not fully understanding the FBAR rules, checked the "No" box in answering the question as to whether the client has a foreign financial account might be punished under Internal Revenue Code provisions such as: a. Section 6694 (Understatement of a Taxpayer's Liability) b. Section 7201 (Criminal Attempt to Evade or Defeat Tax) c. Section 7206 (Criminal Fraud and Making False Statements) Because §7525 applies to neither criminal proceedings nor written advice in connection with tax shelters, this is the best answer. Two recognized exceptions to the confidentiality requirement are disclosure to other firm members on a need-to-know basis and disclosure during an ethics examination. Accountants are charged with keeping their clients' confidences, but there are several exceptions. Accountants cannot be forced to face clients in litigation with "one arm tied behind their backs." Therefore, in litigation, arbitration, ethics investigations, or other official proceedings relating to the client, accountants must have the ability to disclose confidential information where necessary to establish, for example, that they acted professionally when working for the client. Generally, the mere name of clients is not confidential information. Therefore, unless the accountant knows (or has reason to know, given the circumstances) that the client wishes to keep its identity as a client confidential, this information may be disclosed. An accountant would have reason to know there was a problem if disclosure of the client's name informed the world that the client was experiencing financial difficulties.

Common Law Duties and Liabilities to Clients and Third Parties

A. Many malpractice lawsuits against accountants are based on various "common law" causes of action created by the courts over the years and often modified by legislatures. A high percentage of malpractice lawsuits against CPAs involve tax errors. B. The most significant common law theories that will be covered in this lesson are: 1. Breach of contract 2. Negligence 3. Fraud Note that a breach of contract action is based on breach of an agreement between two parties, whereas tort actions (such as negligence and fraud) are based on a duty (not to be careless and not to mislead) that the courts have imposed on accountants as a matter of public policy. Breach of Contract A. Although client malpractice actions against tax accountants usually are brought in tort as negligence (and occasionally fraud) claims, breach of contract claims are common as well. B. Many courts, in an attempt to reduce the amount of litigation by eliminating duplicative theories, hold that: 1. If the accountant did not do the job at all (e.g., Sam took the client's fee but never prepared or filed the tax return), he should be sued for breach of contract. 2. But if the accountant did the job but did it carelessly (e.g., CPA May miscalculated the taxes, causing the client to pay a large tax penalty), she should be sued in negligence rather than for breach of contract. C. Other courts allow a breach of contract action in either case (after all, May also breached the contract by not performing satisfactorily). This distinction can be important, because there are differences in the two theories. For example: 1. A breach of contract (BOK) theory often has a longer statute of limitations (four or even six years) than does a negligence cause of action (two years, typically). 2. Comparative negligence ("Hey, the plaintiff was careless also and therefore should not recover from me for my carelessness or at least should have his recovery reduced") is typically not a defense in a BOK suit, as it is in a negligence suit. D. Elements of a Breach of Contract Suit—To win a breach of contract lawsuit, a plaintiff must prove the following four elements: 1. Existence of an enforceable contract; a. While some agreements must be in writing to be enforceable, most do not, so breach of an oral contract is typically actionable. b. Obligations may be expressly spelled out (orally or in writing) but may also be implied. The law reads into professional contracts the obligation to perform to a professional standard. 2. Plaintiff client complied with contractual obligations; a. If the client, for example, promised to pay 50% of the agreed-upon fee in advance but then failed to do so, it would be unreasonable to require the accountant to do the taxes for free. 3. Defendant accountant breached the contract; and a. The breach may be intentional but need not be for this element to be satisfied. b. Examples of breach: i. Accountant failed to complete the tax return as promised. ii. Accountant filed the tax return late. iii. Accountant filed the tax return filled with errors. iv. Accountant gave faulty tax planning advice to client. 4. Damages were caused by the breach. a. Plaintiffs may recover "compensatory" damages to compensate them for losses they sustained because of the breach. Such damages usually are not recoverable unless they were reasonably foreseeable at the time the contract was made. b. Punitive damages are not recoverable in BOK claims. E. Burden of Proof 1. The burden of proof in most civil cases, including breach of contract and negligence cases, is the "preponderance of the evidence" standard, meaning that plaintiff need only establish that alleged facts are more likely true than not true (>50%). F. Defenses to Breach of Contract Claims 1. Statute of limitations a. To prevent the uncertainty caused by memories fading and documents being lost, the law requires lawsuits to be filed reasonably promptly. b. Although there is considerable variation from state to state, in many states the statute of limitations is: i. Oral contract: two years from breach; or ii. Written contract: four years from breach. 2. Justifiable breach a. Sometimes a client's misconduct justifies an accountant's breach, precluding liability. b. Examples: i. Client refuses to provide accountant with the documents necessary to complete the tax return. ii. Client provides accountant with incomplete, inaccurate, or misleading information. iii. Client informs accountant that it will not pay her bill as promised. iv. Client's CFO was incompetent, undermining the reliability of the client's financial information. Accountant agreed to do the following year's tax return only on condition that the CFO be replaced. The client promised to do so but then did not. The accountant would be justified in refusing to complete the tax return. 3. Substantial performance—If an accountant's breach of contract is major, she is not entitled to recover her fee and will be liable for damages. But if the breach is minor, she will be entitled to recover her fee, but minus damages to plaintiff caused by the breach. Negligence A. Elements of a Cause of Action for Professional Negligence—In order to win a negligence malpractice case, a plaintiff must prove the following four elements by a preponderance of the evidence: 1. Defendant accountant owed a duty of care to the client plaintiff. a. A contract between an accountant and a client typically includes a promise by the accountant to fulfill all professional responsibilities in a careful manner, but the law implies such a duty even if it is not spelled out in the engagement letter. 2. Defendant breached the standard of care. a. The essence of a negligence claim is carelessness, not intentional wrongdoing. b. Accountants are not expected to be perfect but are expected to meet the standards of their profession in the relevant field—audit, tax, consulting, and so on. Auditors, for example, cannot detect all frauds but should catch those that a reasonably competent auditor would detect. Courts often say that accountants should act with the "skill and knowledge normally possessed by accountants in good standing in similar communities." c. The standard of care can be raised above that of the "reasonable" accountant by: i. An accountant being a specialist; ii. An accountant holding self out has having special expertise; or iii. A contractual provision in which the accountant promises a higher duty of care. d. Remember that in many jurisdictions, failure to do the job at all is remediable by a breach of contract action while doing a bad job is remediable only by a negligence action. Other jurisdictions allow both a breach of contract and a negligence lawsuit in a case where the accountant did the job but did it carelessly. e. Examples of negligent breach i. D carelessly neglects to file tax return on time. ii. D carelessly fails to file documentation needed to support a tax position. iii. D carelessly researches a tax issue and therefore erroneously advises the client to take a position that results in a substantial penalty. iv. D carelessly fails to consider tax return options that would save the client substantial tax liability. v. D carelessly advises a client to sell a business at a loss, but the transaction does not generate the tax savings promised. 3. The breach proximately causes an injury. a. Proximate causation has two parts: i. Factual ("but for") causation, meaning that the courts can say that "but for" the accountant's breach of the duty of due care, the loss would not have occurred; and ii. Legal ("proximate") causation, meaning that the injury was a reasonably foresee result of the breach. b. Proximate cause can be disrupted by an act or event that was beyond the control of and unforeseeable to the defendant (an "independent intervening cause"). 4. Plaintiff client suffers damages. a. Plaintiffs are entitled to recover "compensatory damages" to compensate them for losses caused by the accountant's carelessness. b. But no "punitive damages" are allowed in negligence cases as they sometimes are in cases of intentional torts in order to punish defendants for intentional wrongdoing. B. Defenses 1. Statute of limitations a. The SOL in most jurisdictions is two years from when the plaintiff knew or should have known of the right to sue. If the lawsuit is filed after that deadline, it will be dismissed. 2. Comparative negligence a. If the plaintiff was also careless and that carelessness contributed causally to the loss, the plaintiff's recovery will generally be reduced and perhaps even barred altogether (if plaintiff's carelessness exceeds 50%). C. Negligent Misrepresentation 1. In many jurisdictions, courts recognize causes of action for both negligence and negligent misrepresentation. Because many negligence lawsuits against accountants are based on statements they have made while giving tax advice or rendering audit opinions, negligent misrepresentation lawsuits are commonly brought against accountants. 2. Elements of a cause of action. The elements of a negligent misrepresentation claim are very similar to those of a straight negligence claim and typically lead to the same results. One common formulation requires the plaintiff to prove all of the following elements: a. Defendant is in the business or profession of supplying information. i. Accountants are, of course, in such a profession. b. Defendants provided false information for the guidance of others in their business transactions. i. CPAs working as tax advisers or TRPs, as auditors, or as consultants might do this. c. Plaintiff relies on the information. i. If there is one significant difference between the typical negligence cause of action and the negligent misrepresentation cause of action, it is this requirement of reliance. d. Proximate causation; and i. As with regular negligence, this requires proof of both factual and legal causation. e. Damage to plaintiff. Fraud A. The essence of fraud is intentional (or at least reckless) wrongdoing, as contrasted to mere carelessness, which is the essence of a negligence claim. B. The basic elements of a fraud claim are the same everywhere, but they are often packaged in different ways. A common formulation of the elements requires the plaintiff to prove: 1. Defendant accountant made a false representation of fact (or omitted to state a fact in the face of a duty to do so). a. Opinions are not facts, so a false statement of opinion is not generally a basis for a fraud claim, even if intentionally made. b. However, a false statement of expert opinion is deemed tantamount to a representation of fact. 2. The misrepresented (or omitted) fact was material. a. A minor error is often not actionable, even if the result of an intentional misstatement. 3. The defendant accountant knew or recklessly disregarded the falsity. a. Knowledge (scienter) = actual fraud. b. Reckless disregard or gross negligence = constructive fraud. 4. The defendant accountant intended to and did induce plaintiff's reasonable reliance on the misstatement or omission; and 5. The false statement (or omission) proximately caused damages to the plaintiff. a. Plaintiffs who can prove fraud can recover both: i. Compensatory damages, and ii. Punitive damages, which are rendered to both to punish the defendant for intentional wrongdoing and to deter the defendant and others from acting fraudulently in the future. C. Whereas the burden of proof in most civil lawsuits, including those for breach of contract and negligence, is the preponderance of the evidence standard, it is a serious thing to accuse others of fraud. In most states, the burden of proof is raised slightly, requiring plaintiffs to prove their claims by "clear and convincing evidence," often defined as evidence that is substantially more probable to be true than not and that gives rise to a firm belief as to its factuality in the mind of the trier of fact." D. Defenses—Because a plaintiff's carelessness is not nearly as bad as a defendant's intentional fraud, there is no comparative negligence or comparative fault defense to a fraud claim. However, there is at least one significant defense: 1. Statute of limitations a. The statute of limitations for fraud claims varies from state to state, but it is common to require plaintiffs to sue within four years of when they did or should have discovered the fraud. E. Fraud, unlike mere negligence and breach of contract, often also constitutes a crime and is punishable under a wide array of state and federal statutes forbidding tax fraud, securities fraud, bank fraud, and so on. Part Two: Liability to Third Parties Breach of Contract A. Normally only the parties to a contract are allowed to sue for its breach. B. However, third parties sometimes may sue if they were intended beneficiaries of the contract. C. Types of Beneficiaries 1. Intended beneficiaries (can sue) a. Creditor beneficiaries b. Donee beneficiaries 2. Incidental beneficiaries (cannot sue) Audit Cases 1. When auditors breach their engagement letter by erroneously certifying financial statements indicating that a company is in good financial shape when it is not, creditors and investors often lose money. When these third parties attempt to sue for damages they sustained because of the breach, the issue of whether they are intended beneficiaries of the engagement letter arises. 2. In general, unless the engagement letter specifically states that a particular creditor or investor is to receive a copy of the audit report (or there is some other written acknowledgment by the auditor of the third party's legitimate reliance on the report), such third parties will not be allowed to sue as third-party beneficiaries. Negligence A. When accountants are careless in providing tax, audit, consulting, or other services, they generally will be held liable to one or a limited class of nonclients where the accountant knows: 1. The information being supplied to the client will be given to, or is for the benefit and guidance of, this limited class of third persons, and 2. The information will influence those third parties in a specific transaction or type of transaction. 3. Liability to Third Parties a. Intended beneficiary (merger/acquisition/will beneficiary) (Ultramares) b. Knowledge of distribution to limited third parties c. Reasonably foreseeable d. Privity (Ultramares) B. Audit Cases—The case law in this area has developed primarily in the context of audit cases where third-party investors or creditors sued auditors who had carelessly certified their clients' inaccurate financial statements. Fraud A. Because fraud, being intentional or at least reckless, is more blameworthy than mere carelessness, courts tend to allow a wider range of third parties to recover from accountants who have acted fraudulently than from accountants who have been merely negligent. B. The traditional rule has been that fraudsters are liable not just to clients but to everyone they can reasonably foresee will rely on their fraudulent acts or statements. However, some courts are uncomfortable with the potentially broad scope of the "reasonable foreseeability" standard and allow recovery only if there was some special reason for the defendant to believe that the particular plaintiff would rely on the false representations or omissions. Examples: Although the AICPA lists this as the correct answer, it is poorly worded. The majority view is the Restatement "limited class" approach, which generally allows recovery by third parties where the CPA had prior knowledge of the existence of a limited class of potential users (but not necessarily of their individual identities) and of the general purpose of their use of the audit. Prior knowledge is the key, so mere foreseeability is not enough, although this answer implies the contrary.

Taxpayer Penalties

A. The Internal Revenue Code (IRC) has several provisions that punish taxpayers for negligence, noncompliance, and even intentional fraud. B. The penalties are both civil (burden of proof = preponderance of the evidence) and criminal (burden of proof = beyond a reasonable doubt). C. The tax code recognizes that tax law is very complicated and therefore is not aimed at punishing taxpayers who have made diligent, good faith efforts to comply with the law. II. Late Filing Penalties—The IRC (Section 6651) imposes penalties for late filing or failure to file as well as late payment of tax. A. Late Filing or Failure to File 1. Penalty is 5% of the net tax due per month (up to 25% of unpaid taxes is the most a taxpayer will have to pay of their owed taxes). 2. If the failure to file is fraudulent, the penalty becomes 15% per month (up to 75% of unpaid taxes). B. Late Payment of Tax 1. Penalty is 0.5% of the net tax due per month (up to 25%). 1. The failure to file penalty is 10 times the size of the failure to pay penalty in order to encourage taxpayers to file, even if they are financially strapped. 2. For any month to which both the late filing and late payment penalties apply, the late filing penalty is reduced by the late payment penalty so that the maximum is 5% per month (up to 25%). 3. For returns filed more than 60 days after the due date (taking into account extensions granted), the minimum penalty for returns filed after 12/31/19 is the lesser of $435 or 100% of the unpaid tax. This amount is frequently inflation-adjusted upwards. 4. Taxpayers who have requested an extension by the due date and paid at least 90% of taxes owed will not face a failure-to-pay penalty. 5. A "reasonable cause" defense applies (example: serious illness strikes on the eve of the filing deadline). Understatement Penalties—The key statute (26 U.S.C. 6662) imposes an accuracy-related 20% penalty on taxpayers for the following underpayments: A. Underpayments attributable to negligence or disregard of rules or regulations. 1. "Negligence" is "any failure to make a reasonable attempt to comply with" the rules. a. Negligence may include, among many other things: failure to keep adequate books and records and to otherwise substantiate items that gave rise to the understatement. b. The statute focuses on two interrelated aspects: i. Taxpayer conduct—Did the taxpayer make reasonable attempts to get it right? Sophisticated taxpayers may be held to a higher standard, but even unsophisticated taxpayers may be viewed as negligent if they failed to consult a tax professional. ii. Taxpayer positions—A taxpayer position that lacks a "reasonable basis" may be attributed to negligence. c. A reasonable cause/good faith defense exists under Section 6664 and is discussed below. d. Disclosure of a position that is negligently taken is not a defense. 2. "Disregard" may be negligent, reckless, or intentional. a. Negligent and reckless disregard largely overlap with the "negligence" provision of the statute. b. Intentional disregard may be problematic but is not necessarily wrongful just because the taxpayer takes a tax position that is ultimately found to be erroneous. A "good-faith" mistake of law provides a defense. c. Disclosure of a position on a Form 8275 or 8275-R may provide a defense to any penalty for intentional disregard if the position has a reasonable basis and the taxpayer has kept adequate books and records to properly substantiate necessary items. B. Any Substantial Understatement of Income Tax 1. For individuals, a "substantial understatement" is one that exceeds the greater of: a. 10% of the tax, or b. $5,000. c. The underpayment would subject the person to 20% penalty on the amount owed 2. For non-Subchapter S corporations, a "substantial understatement" is one that exceeds the lesser of: a. 10% of the tax (or, if greater, $10,000), or b. $10 million. c. The underpayment would subject the person to 20% penalty on the amount owed 3. An "understatement" is reduced by the amount attributable to either: a. Any item for which there is or was "substantial authority" for the claimed tax treatment. i. "Substantial authority" is an objective standard requiring that the weight of authorities supporting the claimed position is substantial in relation to the weight of authorities opposing it. ii. Tax practitioners tend to think of "no substantial authority" as there being <40% chance of the position being sustained if challenged before the IRS. iii. Authorities that count include, among others, the IRC, regulations, revenue rulings and procedures, court cases, and congressional intent as reflected in committee reports. b. Any item if: i. The relevant facts affecting the tax treatment are adequately disclosed (typically on a Form 8275 or 8275R); and ii. There is a "reasonable basis" for the tax treatment. a. Because disclosure calls the IRS's attention to the position and makes it clear that the taxpayer is not trying to sneak it by, a more lenient standard is applied in determining "unreasonableness." b. Tax practitioners tend to think of a position as having "no reasonable basis" if there is <20% chance of it being sustained if challenged. 4. However, an understatement is not reduced under these rules if the transaction involved is a "tax shelter," defined as: a. A partnership or other entity, b. Any investment plan or arrangement, or c. Any other plan or arrangement, if a significant purpose of the partnership, entity, plan, or arrangement is the "avoidance or evasion" of income tax. i. Note: However, Section 6664 does provide a reasonable cause/good-faith exception that applies even to tax shelters. ii. The defense applies to tax shelters only if there is authority giving rise to a good faith believe that it is "more likely than not" (MLTN) (>50% likelihood) that the position taken will be sustained. C. There are also penalties for other wrongs that are litigated much less frequently, including: for substantial valuation misstatements, for substantial estate or gift tax valuation understatements, for claimed tax benefits by reason of a transaction lacking economic substance, and others. For some of these categories, the penalty is 40% of the underpayment, rather than merely 20%. IV. Reasonable Cause and Good Faith Defense (Section 6664) A. No Section 6662 penalty is imposed if (a) there was "reasonable cause" for the underpayment and (b) the taxpayer acted with "good faith." 1. Negligence or disregard—Although the reasonable cause/good-faith defense apparently applies to understatements due to negligence or careless disregard of the rules, if the taxpayer was not negligent, she will not usually need the defense; if she was negligent, the defense usually will not succeed. 2. Substantial understatement—Therefore, the defense applies primarily in cases of substantial understatements where it largely overlaps with the provision of Section 6662 providing that any understatement is reduced by amounts for which there was "substantial authority" or disclosed positions for which there was a "reasonable basis." B. Reasonable Cause 1. Definition—The exercise of ordinary business care and prudence 2. Judged objectively 3. Examples of reasonable cause: a. Reliance on tax adviser b. Reliance on advice of IRS employee c. Death or illness of taxpayer or close family member d. Unavoidable destruction of records or place of business 4. Belief requirement for reasonable cause related to tax positions: a. Undisclosed position—"Substantial authority" (≥40% chance) b. Disclosed position—"Reasonable basis" (≥ 20% chance) c. Tax shelter position—"More likely than not" (>50% chance) C. Good Faith 1. Definition—Honesty of purpose. 2. Judged subjectively. 3. Examples: a. Reliance on erroneous W-2, with no red flags to indicate its inaccuracy. b. Reliance on erroneous advice of tax adviser where: i. Adviser was given all facts and circumstances; ii. Advice was not based on unreasonable assumptions; and iii. If the advice was that a regulation was invalid, the position was adequately disclosed. V. Disclosure and Substantiation—As noted in the previous lesson, disclosure and substantiation of positions taken can help establish the reasonable cause/good faith defense. VI. Obviously there is no reasonable cause or good-faith defense when a taxpayer attempts to commit fraud. A 75% (of the portion of underpayment) civil penalty applies to fraudulent underpayments (26 U.S.C. 6663). A. When the underpayment is allegedly fraudulent, the 75% penalty applies to the return's entire understatement, unless the taxpayer can establish that parts of it were not attributable to fraud. VII. Criminal Tax Culpability—Taxpayers who willfully attempt to avoid paying taxes that they rightfully owe are subject to criminal punishment under the following provisions, among others: A. Tax Evasion—26 U.S.C. Section 7201 punishes tax evasion and is applied very broadly. 1. This provision has been used to prosecute, among other wrongs: a. Failure to file a return b. Falsifying income c. Falsifying amounts that reduce taxable income 2. To secure a conviction, the government must prove: a. An affirmative act constituting an attempt to evade or defeat payment of a tax; b. Willfulness; and c. Existence of a tax deficiency. 3. Maximum punishment for individuals: fine of $100,000 and/or 5 years in jail. B. Tax Fraud—26 U.S.C. Section 7206 punishes fraud and false statements by taxpayers and others, criminalizing (among other wrongs): 1. Willfully making and subscribing to any document made under penalty of perjury that the taxpayer does not believe to be true as to every material matter 2. Willfully aiding the preparation of any tax-related matter that is fraudulent as to any material matter 3. Removing or concealing property with intent to defeat taxes

Substantiation and Disclosure of Tax Positions

A. The Internal Revenue Code is lengthy and complex, so it is unsurprising that even when acting in good faith, taxpayers may find themselves in situations where they clash with the IRS regarding whether certain income is taxable, certain deductions are allowed, and the like. B. Therefore, the IRC has provisions that attempt to punish unreasonable actions by taxpayers and to protect good faith attempts at compliance with federal tax law. The Supreme Court once wrote that "the [tax] law is complicated, accounting treatment of various items raises problems of great complexity, and innocent errors are numerous. . . . It is not the purpose of the law to penalize frank differences of opinion or innocent errors made despite the exercise of reasonable care." [Spies v. U.S. (1943)] C. Requiring disclosure and substantiation of various positions is one important aspect of the IRS approach. II. The IRC imposes (in Section 6662) a 20% penalty on various types of underpayments, including: A. Underpayments attributable to negligence or disregard of rules or regulations. B. Any substantial understatement of income tax. 1. An "understatement" in this category is reduced by the amount attributable to any item where: a. The relevant facts affecting the tax treatment are adequately disclosed (typically on a Form 8275 or 8275R), and b. There is a "reasonable basis" (≥20% chance of being sustained) for the tax treatment. 2. Disclosure is important here because an undisclosed position must be supported by "substantial authority," which requires a ≥40% chance of being sustained. III. Reasonable Cause and Good Faith Defense (Section 6664)—No Section 6662 penalty is imposed if (a) there was "reasonable cause" for the underpayment and (b) the taxpayer acted with "good faith." (This defense obviously overlaps with the provision in Section 6662 that reduces an understatement where facts are disclosed and there is a reasonable basis for the tax treatment.) A. Reasonable Cause 1. Definition—The exercise of ordinary care 2. Judged objectively 3. Examples of reasonable cause: a. Reliance on tax adviser and/or b.Reliance on advice of IRS employee. 4. Standards of belief: a. Undisclosed position—"Substantial authority" (≥40% chance of being sustained) b. Disclosed position—"Reasonable basis" (≥20% chance of being sustained) B. Good Faith 1. Definition—Honesty of purpose 2. Judged subjectively 3. Examples: a. Reliance on erroneous W-2, with no red flags to indicate its inaccuracy. b. Reliance on erroneous advice of tax adviser where: i. Adviser was given all facts and circumstances; ii. Advice was not based on unreasonable assumptions; and iii. If the advice was that a regulation was invalid, the position was adequately disclosed. IV. Disclosure and Substantiation A. Introduction—Taxpayers have to pay penalties under Section 6662 because of their negligent conduct or because they have taken positions that are inappropriate. 1. Disclosure can help avoid liability by demonstrating that the taxpayer was acting in good faith and not trying to pull a fast one or otherwise sneak a position past the IRS. 2. Substantiation can help avoid liability by establishing entitlement to a claimed position and also indicating good faith by a taxpayer who is trying to get things right. B. Disclosure—When a taxpayer takes a position contrary to an IRS regulation, the underpayment penalty does not apply, according to Treasury Regulation 1.6662-3, if: 1. The position is disclosed on "a properly completed and filed Form 8275-R"; 2. The position represents a "good-faith challenge" to the validity of the regulation; and 3. The taxpayer has: a. A "reasonable basis" (≥ 20% chance of being sustained) for the position, and b. Kept adequate books and records or otherwise substantiated items properly. C. Substantiation—As noted, accuracy-related penalties may be imposed for underpayments caused by negligence, which include: 1. Failure to keep adequate books and records. a. In general, the law does not require any specific type of record; taxpayers may choose any suitable system that clearly establishes the necessary facts. b. Deductions that are often questioned include: i. Home office deductions ii. Vehicle mileage iii. Gifts to clients iv. Food and entertainment c. Records that should be retained: i. All tax returns for the previous seven years ii. All records that pertain to a return for the previous three years iii. Other records, no matter how old, that would be needed to support a tax position on a subsequent return 2. Failure to substantiate items that gave rise to the underpayment. a. Among others, taxpayers are required to substantiate: i. Charitable contributions—The taxpayer must have a receipt for large donations to a charitable organization. Donations ≥ $250 must be documented with a receipt. Donations > $5,000 generally require a qualified appraisal. ii. Business use of an automobile—The taxpayer must track the miles driven for business use in a timely kept log. 3. Good faith provides a defense to even a failed effort.

Sources of Tax Authority and Research

A. There are two types of authority: primary and secondary. Primary authority consists of the original sources of the law, whereas secondary authority is commentary on tax law such as treatises, journals, and commentaries provided by editorial services. B. Primary authority comes from each of the three branches of the federal government. 1. Legislative authority 2. Administrative authority 3. Judicial authority Legislative Authority—Authority from Congress A. Sources of statutory authority include: 1. The Constitution, as all tax laws must be consistent with the provisions of the Constitution such as the 16th Amendment authorizing an income tax 2. Internal Revenue Code Statutes (cited as IRC §351) 3. Treaties 4. Committee Reports of the House Ways and Means Committee, Senate Finance Committee, and the Joint Conference Committee B. The Internal Revenue Code (IRC) is the codification of the tax laws promulgated by Congress. For a tax law to be passed by Congress, it must pass through the following steps: 1. All tax bills must originate in the House Ways and Means Committee. 2. The bill, then, must be passed by the House of Representatives. 3. Afterwards, the House bill moves to the Senate Finance Committee. Note that this committee is free to do as it wills with the House bill, even striking the entire bill and starting anew. However, the Senate Finance Committee can take no action without receiving a bill from the House. 4. The Senate debates the bill and passes its own version. 5. The House bill and Senate bill usually differ, so a Joint Conference Committee is created to craft a compromise bill. 6. Once the Joint Conference Committee passes its bill, this bill must return to the House and Senate for another vote (assuming the compromise bill differs from the original bills). 7. The President either signs or vetoes the bill. 8. If vetoed Congress can override a veto with a two-thirds vote. Administrative Authority—Authority from the Treasury Department and Internal Revenue Service. While there are many types of pronouncements issued by the Internal Revenue Service, the most significant are as follows. (Examples are provided for how each authority is cited.) A. Treasury Regulations—(Treas. Reg. §1.351-1). Regulations are published in the Federal Register and later in the Internal Revenue Bulletin. 1. Regulations are organized in a sequential system with numbers preceding and following a decimal point. The numbers preceding the decimal point indicate the type of regulation or applicable area of tax law to which they pertain, while the numbers immediately following a decimal point indicate the Internal Revenue Code section being interpreted. Some of the more common prefixes include: 1=Income Tax 20=Estate Tax 25=Gift Tax 301=Administrative and Procedural matters 601=Procedural rules 2. Regulations can be classified as: a. Legislative—These regulations have almost as much weight as the statute (IRC), since Congress has authorized the Treasury to develop regulations dealing with a specific issue. b. Interpretative—These regulations are written under the general mandate given to Treasury to develop regulations to interpret the laws legislated by Congress. c. Procedural—These regulations apply to procedural issues such as the information required to be submitted, the process for submission, etc. 3. Regulations can also be classified as: a. Proposed—Regulations must be issued as proposed regulations for at least 30 days before becoming final, although they may exist in a proposed form for many years. Proposed regulations do not have the effect of law, but they do provide an indication of the IRS's view on a tax issue.Temporary—These regulations do have the effect of law but only for three years. b. Temporary regulations are usually issued when taxpayers need immediate guidance on a substantive matter of the law. c. Final regulations—Proposed or temporary regulations can later be issued as final regulations which have the effect of law until revoked. Revenue Rulings—(Rev. Rul. 2009-12) 1. Do not have as much weight as regulations 2. Are limited to a given set of facts 3. Deal with more specific issues than regulations Private Letter Rulings—(PLR 200948009) 1. Request by the taxpayer for the IRS to provide the tax consequences on a specific set of facts 2. Transaction cannot have been completed by the taxpayer for the request to be made. 3. Precedent applies only to the taxpayer making the request. However, PLRs can be used by other taxpayers to establish "substantial authority" for penalty purposes. 4. IRS does not have to provide a ruling on the request. Revenue Procedures (Rev. Proc. 2008-23)—These provide internal management practices of the IRS. Technical Advice Memoranda—(TAM 201003016)—These are requested by the IRS field agents during an audit. They apply only to the affected taxpayer. Other sources of authority include notices, announcements, and general council memoranda. Judicial Authority A. Courts of Original Jurisdiction—Any tax dispute not resolved between the taxpayer and the IRS that goes to court must begin in a court of original jurisdiction. 1. U.S. Tax Court a. Hears only tax cases b. One court, but the 19 judges travel in smaller groups throughout the country to hear cases. For certain issues all judges may hear the case. c. Taxpayer does not have to pay deficiency before trial as long as a petition is filed in a timely manner. d. Jury trial is not available. e. The IRS has adopted an acquiescence policy for regular Tax Court decisions that it loses. Acquiescence indicates that the IRS will follow the decision in future situations, involving similar facts and issues. Nonacquiescence indicates that the IRS will not follow the decision and can be expected to litigate in situations involving similar facts and issues. f. Decisions of the Tax Court are appealed to U.S. Court of Appeals. As a matter of policy known as the Golsen Rule, the Tax Court will follow the law of the circuit to which a case is appealable. 2. U.S. District Courts a. Jury trial is possible. b. Must pay deficiency first and then sue the IRS for a refund c. Judges are not tax specialists since all types of legal matters are tried. d. Many different district courts throughout the country 3. U.S. Court of Federal Claims a. There is only one court in Washington, D.C. b. Must pay deficiency first and then sue the IRS for a refund c. 16 judges, who are not tax specialists, since all types of legal matters are tried d. Jury trial is not available. 4. U.S. Tax Court—Small Cases Division a. $50,000 or less b. No appeal B. Appellate Courts 1. U.S. Court of Appeals a. Hears appeals from Tax Court and District Court b. 11 circuits plus the District of Columbia Circuit c. District court must follow the decision/precedent of the Circuit Court of Appeals for the circuit in which the District Court is located d. Tax Court will follow previous decisions in the Circuit that will have jurisdiction on appeal (Golsen rule). Definition Precedent: The courts must follow previous decisions for future cases with the same controlling set of facts. 2. U.S. Court of Appeals for the Federal Circuit—Hears appeals from the U.S. Court of Federal Claims.U.S. C. Supreme Court 1. Hears very few tax cases 2. Highest court in the United States Weighting of Authority A. Legislative authority is weighted in the following order. Barring certain exceptions (e.g., constitutional issues), Congress has the last word on what the Federal tax law should be. 1. The highest source of tax authority is the U.S. Constitution 2. The next highest source is the Internal Revenue Code 3. If a treaty exists with a foreign country, the provisions of the treaty control the tax consequences of a transaction B. Administrative Authority 1. Legislative regulations have almost as much weight as the IRC itself. 2. Other types of regulations have very significant authority within the context of administrative authority. 3. Revenue Rulings are the next highest source of authority. 4. Private Letter Rulings apply only to the taxpayer who requested the ruling. C. Judicial Authority—The weighting of a judicial decision depends on: 1. Level of court 2. Legal residence of the taxpayer 3. Whether the IRS has acquiesced to the decision (meaning that the IRS has indicated that it will follow the decision in the future) 4. The date of the decision 5. Whether later decisions have concurred with opinion Research Process—The following steps should be followed when researching a tax issue: A. Identify all relevant facts. B. Clearly state problem to be solved. C. Locate applicable tax authority. D. Evaluate the relevance of the authorities. E. Determine alternative solutions. F. Determine most appropriate solution. G. Communicate results. Communicating Research—A research memorandum should include the following key procedures: A. Document all relevant facts. B. Clearly describe the issue investigated. C. Report conclusions. D. Summarize rationale and authorities that support conclusions. E. Summarize key authorities used in research.

Tax Practice and Procedure

Audit Process A. The audit process begins with a review of returns for error and matching information from W- 2s, 1099s, and so on. This review is applied to all tax returns. B. All returns are classified by type such as individual, corporation, partnership, fiduciary, and so on. C. Each return is given a score from formulas that are part of the Discriminate Function System (DIF). The DIF score is used to determine which returns to review for possible audit. D. The IRS often handles simple audits through written correspondence. The IRS can also conduct audits in its offices (called office examinations) or in the field (called field examinations). An office examination occurs at the local district office of the IRS. The IRS notifies the taxpayer by letter of the date and time of exam as well as the items being questioned. Taxpayers can represent themselves at an office examination. A field examination is conducted at the taxpayer's place of business and is more complex and extensive than an office examination. Taxpayers may appoint a qualified individual to represent them before the IRS, usually a CPA, attorney, or enrolled agent. The IRS has the power to summon the taxpayer's records and witnesses to testify. E. A taxpayer may appoint qualified individuals to represent him or her before the IRS, usually a CPA, attorney, or enrolled agent. F. The IRS reports its findings from the audit on Form 4549, Income Tax Examination Changes, which is sent to the taxpayer. The Revenue Agent's Report (RAR) that accompanies Form 4549 should provide the information necessary to explain the adjustments and demonstrate how the IRS computed the tax liability. The RAR is a proposed agreement that the IRS offers the taxpayer. G. IRS reports its findings from the audit on Form 4549, Income Tax Examination Changes, which is sent to the taxpayer. The Revenue Agent's Report (RAR) that accompanies Form 4549 should provide the information necessary to explain the adjustments and demonstrate how the IRS computed the tax liability. The RAR is a proposed agreement that the IRS offers the taxpayer. H. Disagreements between the taxpayer and the IRS may arise from questions of fact or from questions of law. I. The IRS will take positions consistent with its administrative sources of the tax law. J. The taxpayer and the IRS can negotiate until the issues are resolved. K. If the taxpayer agrees to the audit changes proposed in the Revenue Agent's Report (RAR), he or she cannot pursue tax relief through the appeals process or through the Tax Court. However, note that a signed agreement binds the IRS and taxpayer with regard to only items in the agreement. L. Nevertheless, once the deficiency is paid, the taxpayer can later pursue a claim for refund through the U.S. District Court or U.S. Claims Court. M. If agreement is not reached through the audit process, the taxpayer will receive a copy of the RAR and a 30-day letter. N. The IRS encourages the taxpayer to agree to the RAR or request an appellate conference. However, the taxpayer is not required to respond. O. If the IRS issues a no change report after an audit, the IRS generally cannot reopen the examination unless fraud or other similar misrepresentation is involved. Appeals Process A. To appeal, a written protest must be filed with the request for an appellate conference. B. The protest must explain the taxpayer's position for each issue and provide the support on which the taxpayer is relying for questions of law. C. The IRS is not required to grant an appeal in all cases. D. In general, new issues may not be raised by the IRS during the appeal. E. The appellate conference itself is informal when contrasted to a judicial proceeding. F. If the case is settled, a Form 870-AD is signed, which means that the case will not be reopened unless there is a significant mathematical error or fraud. G. If a taxpayer does not respond to the 30-day letter or does not reach agreement in the appeals process, a 90-day letter is issued. H. The 90-day letter is significant in that this is the time that the taxpayer has to file a petition with the Tax Court. If the petition is not filed in a timely manner, the taxpayer's only judicial recourse is through a U.S. District Court or a U.S. Claims Court, both of which require the deficiency to be paid before the judicial process can begin. I. Once a petition has been filed with the Tax Court, the IRS cannot issue a notice of deficiency until the court's decision in the matter has been finalized. Other Practice Issues A. An offer in compromise may be agreed to by the IRS, which allows a taxpayer to settle a tax liability for less than the actual amount owed. B. The IRS may request the taxpayer to extend the statute of limitations period. While not required to do so, a refusal to extend usually will lead the IRS to assess a tax deficiency. C. Any communication that would be privileged between a taxpayer and an attorney is also privileged between a taxpayer and any person who is authorized to practice before the IRS. D. This privilege does not apply to criminal tax matters or to corporate tax shelters. Signing a Return A. A taxpayer must sign a tax return for it to be complete. Both spouses must sign a joint return. This creates joint and several liability for each spouse, which means that the IRS can collect the entire tax liability from either spouse. B. A refund cannot be issued unless the return is signed. C. A taxpayer can use an electronic signature to sign a return that is e-filed. 1 . The taxpayer needs a personal identification number (PIN) to file electronically. 2. For a married filing jointly return, both spouses need PINs. 3. A taxpayer can self-select/enter a PIN or have the tax practitioner generate/enter a PIN for him/her. 4. Note that if a return is filed electronically, no forms or paper need to be mailed to the IRS, not even W-2s. D. A parent or guardian can sign a child's return as the child's representative. E. A tax return is signed under the penalty of perjury. If a taxpayer knowingly signs a false tax return, the taxpayer can be subject to civil and/or criminal penalties. See the "Compliance Responsibilities" lesson for more detail. F. The tax preparer must also sign the tax return and provide a PIN. Failure to do so results in a $50 penalty to the tax preparer for each failure (maximum of $25,000 in any calendar year). The penalty applies separately to the failure to sign and failure to provide a PIN. Standards of Practice A. Circular 230 describes the rules that one must meet to be eligible to practice before the IRS. The term "practice" in this case relates to representing a client before the IRS. It does not include the preparation of tax returns. B. In general, only CPAs, attorneys, and enrolled agents can practice before the IRS. Exceptions to this rule include individuals who are employees or officers of an entity. Limited exceptions are also made for registered tax return preparers. C. Circular 230 provides numerous rules for the standard of conduct that must be met by those who practice before the IRS, including that an individual must: 1. Advise a client of any noncompliance 2. Exercise due diligence in representations 3. Not charge an unconscionable fee 4. Submit requested records to the IRS D. CPAs are also subject to: 1. AICPA's Code of Professional Conduct. 2. AICPA's Statements on Standards for Tax Services. Rules Governing Authority to Practice under Circular 230 A. Who May Practice before the IRS—(Individuals may not be under suspension or disbarment.) 1. Attorneys 2. CPAs 3. Enrolled agents 4. Enrolled actuaries enrolled by the Joint Board for the Enrollment of Actuaries. However, practice is generally limited to issues related to qualified retirement plans. 5. Enrolled retirement plan agents. However, practice is limited to issues related to employee plans and to IRS forms in the 5300 and 5500 series. B. Practice before the IRS 1. Practice before the IRS includes all matters connected with a presentation to the IRS or any of its officers or employees related to a taxpayer's rights, privileges, or liabilities under laws or regulations administered by the IRS. 2. These presentations include but are not limited to: a. Preparing documents b. Filing documents c. Corresponding and communicating with the IRS d. Rendering written advice with regard to transactions having a potential for tax avoidance or evasion e. Representing a client at conferences, hearings, and meetings 3. A power of attorney (Form 2848, Power of Attorney and Declaration of Representative) is required for an individual to represent a taxpayer before the IRS. Taxpayer First Act A. Congress passed the Taxpayer First Act in 2019 with the goal to expand taxpayer rights. Key provisions include the following. B. The IRS Office of Appeals is renamed the IRS Independent Office of Appeals. The Independent Office of Appeals is required to make its referred case files available to: -Individuals with adjusted gross incomes of $400,000 or less for the tax year to which the dispute relates; and -Entities with gross receipts of $5 million or less for the tax year to which the dispute relates. C. The Act provides a new way for low-income taxpayers to waive the application fee for an Offer-in-Compromise (OIC). A taxpayer qualifies to waive the fee if their adjusted gross income (AGI) from the taxpayer's most recent tax return is at or below 250% of the federal poverty level. D. Previous law said the IRS may not contact anyone other than the taxpayer to determine or collect taxes without providing reasonable notice. The Act now requires 45 days' notice before the beginning of the period of contact. E. The Act allows IRS to exchange information with whistleblowers when doing so would be helpful to an investigation. It requires IRS to notify whistleblowers of the status of their claims at certain points in the review process. F. The Act enables IRS to directly accept credit, debit, or charge cards for the payment of income taxes provided that the fee is paid by the taxpayer. The statutory notice of deficiency is also known as 90-day letter. It is significant in that this is the time that the taxpayer has to file a petition with the Tax Court. If the petition is not filed in a timely manner, the taxpayer's only judicial recourse is through a U.S. District Court or a U.S. Claims Court, both of which require the deficiency to be paid before the judicial process can begin. The taxpayer is not required to respond to a 30-day letter, although if there is no response the IRS will follow with a 90-day letter.

Licensing and Disciplinary Systems

Authority—State boards of accountancy license CPAs and can prohibit non-CPAs from performing attest functions. State boards also license (and punish) CPA firms. 1. It is only state boards that can grant CPA licenses and only state boards that can take them away. 2. While the AICPA and state societies of CPAs cannot grant or take away CPA licenses, they can grant membership, take away membership, and punish members by suspensions, etc. The AICPA's authority in this regard is covered in the AUD materials. 3. The AICPA has developed the Uniform Accountancy Act (UAA) to provide states with a model to regulate CPAs. Most states have adopted some or all of the UAA, ensuring that most state rules for CPAs are identical or at least similar to AICPA rules. The rules of state societies of CPAs also, naturally, substantially follow AICPA rules. Licensing—To qualify to be licensed as a "certified public accountant," one must meet several requirements. In most states, three steps are the key and may be accomplished in any order: 1. Education a. "BA + 30" (150 hours of college education, including a bachelor's degree); b. Professional ethics course (required by many states); and c. Continuing professional education—Once certification is gained, there are also continuing professional education requirements. 2. Examination a. Pass the Uniform CPA Exam. 3. Experience a. How long? One year of professional experience (but at least 2,000 hours). b. In what areas? In accounting, attest, management advisory, financial advisory, tax or consulting areas and may be while working for any employer (accounting firm, corporation, government agency, etc.). Nonattest Services 1. One does not need a CPA license to perform such nonattest services as: a. Preparation of tax returns b. Management advisory services (consulting) c. Preparing financial statements without issuing a report thereon attest services-need cpa license Discipline—State boards may revoke CPA licenses and impose other penalties (such as fines) for such acts as: 1. Fraud or deceit in obtaining a certificate 2. Cancellation of a certificate in any other state for disciplinary reasons 3. Failure to comply with requirements for renewal 4. Revocation of the right to practice before any state or federal agency, including the PCAOB 5. Dishonesty, fraud, or gross negligence in performance of services or failure to file one's own income tax returns 6. Violation of professional standards 7. Conviction of a felony or any crime involving fraud or dishonesty Reciprocity—Most states are now an active part of the "UAA Mobility" project supported by the AICPA and the National Association of State Boards of Accountancy (NASBA). When fully implemented, accountants from one state will be able to represent clients in another state without obtaining a license from or paying a fee to the latter state's accountancy board. Role of AICPA A. Professional Ethics Division 1. Investigates violations of AICPA Code and sanctions minor cases B. Joint Trial Board 1. Hears more serious cases 2. Has power to acquit, admonish, suspend, or expel 3. Initial decisions are made by a panel whose actions are reviewable by the full trial board, whose decisions are conclusive C. Automatic expulsion from the AICPA without a hearing results when a member has been convicted or received an adverse judgment for: 1. Committing a felony; 2. Willfully failing to file a tax return; 3. Filing a fraudulent tax return on own or client's behalf; or 4. Aiding in preparing a fraudulent tax return for a client. D. Revocation of certificate by a state board of accountancy also leads to automatic expulsion. Joint Ethics Enforcement Program (JEEP) 1. The AICPA and most state CPA societies have agreements to split the handling of ethics complaints. The JEEP can handle violations across state lines with a single investigation, hearing, and punishment. 2. Typically, the AICPA handles: a. Matters of national concern b. Matters involving more than one state c. Matters in litigation 3. The individual states handle the rest.

Internal Revenue Code and Regulations Related to Tax Return Preparers

The Internal Revenue Code (IRC) has many provisions that relate solely or largely to tax return preparers (TRPs). Some also apply to tax advisors. This section surveys those provisions. Definition—A TRP, generally speaking, is "any person who prepares for compensation, or who employs one or more persons to prepare for compensation, all or a substantial portion of any return of tax or any claims for refund of tax" under the IRC. Coverage—This provision covers not only federal income tax returns but also federal estate and gift tax returns, employment tax returns, and excise tax returns. Requirements—People are TRPs if they: 1. Are paid 2. To prepare, or retain employees to prepare, 3. A substantial portion 4. Of any federal tax return or refund claim. Subtypes—Assume Smith is preparing an income tax return for a client and brings in his partner, Kahn, who is an expert whose advice Smith uses to complete a major portion of the return. Smith signs the return. He is a signing TRP. Although Kahn contributed substantially to completion of the return, he did not sign it and is therefore a nonsigning TRP. 1. Signing TRPs are individual TRPs who bear "primary responsibility" for the overall accuracy of the return or claim for refund (Smith in our example). 2. Nonsigning TRPs are those other than the signing TRP who prepare all or a substantial portion of a return or claim for refund (Kahn in our example). Substantial Portion—The signing TRP is always responsible for a substantial portion of the return. But what about nonsigning TRPs? If Kahn (to return to our example) evaluates a corporate taxpayer's just-completed transaction and concludes that it entitles the taxpayer to take a large deduction, he has prepared a "substantial portion" unless the deduction involves either: 1. Less than $10,000, or 2. Less than $400,000, which is also less than 20% of the gross income indicated on the return. Not a TRP—People are not TRPs merely because they: 1. Furnish typing, reproducing, or other mechanical assistance 2. Prepare as a fiduciary a return or claim for refund for any person 3. Prepare taxes as part of a Volunteer Income Tax Assistance (VITA) or a Low Income Tax Clinic (LITC) program, but only for returns prepared as part of that program 4. Prepare a return with no explicit or implicit agreement for compensation, even if the person receives an insubstantial gift, return service, or favor 5. Prepare a return or claim for refund of the employer (or of an officer or employee of the employer) by whom he or she is regularly and continuously employed Civil Penalties Imposed on TRPs A. Understatement of Taxpayer's Liability—Section 6694 of the IRC imposes civil penalties on TRPs for understatement of their clients' taxes. B. Subsection (a) punishes understatement due to unreasonable positions. 1. An undisclosed position is "unreasonable" if there is no substantial authority (<40% chance of being sustained) for the position. a. "Substantial authority" is an objective standard requiring that the weight of authorities supporting the claimed position is substantial in relation to the weight of authorities opposing it. b. Tax practitioners tend to think of "no substantial authority" as there being <40% chance of the position being sustained if challenged before the IRS. 2. If a position is disclosed, then it is "unreasonable" if there is no reasonable basis for the position a. Because disclosure calls the IRS's attention to the position and makes it clear that the taxpayer is not trying to "sneak" it by, a more lenient standard is applied in determining "unreasonableness." b. Tax practitioners tend to think of a position as having "no reasonable basis" if there is <20% chance of it being sustained if challenged. 3. If the position relates to a tax shelter, it is "unreasonable" unless it is more likely than not (MLTN) (>50% chance) that the position will be sustained. 4. The maximum civil fine per violation under Subsection (a) is the greater of $1,000 or 50% of the income derived by the TRP with respect to the return. 5. Reasonable cause defense—No penalty applies if the TRP had "reasonable cause" (an objective standard) for the position and acted in "good faith" (a subjective standard). C. Subsection (b) of 6694 imposes harsher punishments for willful or reckless understatements. 1. The penalty for a willful or reckless understatement is the greater of $5,000 or 75% of the income derived by the TRP with respect to the claim (per violation). 2. Example—TRP fabricates deductions or ignores information provided by taxpayer. 3. Good faith defense applies—For example, the taxpayer might provide false information to the TRP which appears to be genuine and accurate. D. Disclosure Provisions—Section 6695 punishes TRPs for, among other things: 1. Failure to furnish copy of return to taxpayer 2. Failure to sign return and show own identity 3. Failure to furnish identifying number to the IRS 4. Failure to keep a copy of the return 5. Failure to file correct information returns 6. Negotiation of check made out to the taxpayer (other than to deposit the full amount into the taxpayer's bank account) 7. Failure to be diligent in determining eligibility for the earned income tax credit and the child tax credit E. Abusive Tax Shelters—Section 6700 punishes TRPs and others who promote abusive tax shelters when they: 1. Organize or participate in the sale of a shelter; and 2. Either: a. Knowingly or recklessly make a materially false statement that affects tax liability, or b. Engage in a gross overvaluation (2X actual value) of property. F. Aiding and Abetting the Understatement of Tax Liabilities—TRPs and others can be liable under 26 U.S.C. 6701 for aiding and abetting an understatement of tax liability. 1. In order to be liable, the TRP must: a. Aid, assist, procure, or advise in preparation or presentation of any portion of any return or other document; b. Know or have reason to know that it will be used in matters arising under tax law; and c. Know that if the return or document is so used, an understatement of the tax liability of another person will result. 2. Liability can be imposed even if the taxpayer does not have knowledge of or consent to the understatement. 3. Merely furnishing typing, reproducing, or other mechanical assistance with respect to a document does not constitute having aided and abetted the preparation of that document. 4. A TRP may be liable for the understatement activities of a subordinate by (a) ordering the subordinate to do the act, or (b) knowing of, and not attempting to prevent, participation by a subordinate in the act. G. Confidentiality—Subject to obvious exceptions for court orders, peer reviews, and the like, 26 U.S.C. 6713 penalizes TRPs if they: 1. Disclose any information furnished to them in connection with preparation of a return, or 2. Use any such information for any purpose other than to prepare the return. H. Injunctions—In addition to civil fines, Section 7407 authorizes the IRS to enjoin TRPs from violating the Internal Revenue Code. 1. TRPs may be enjoined from: a. Violating Section 6694 (understatement of tax liability) and 6695 (disclosure requirements); b. Misrepresenting education or experience as a TRP, or eligibility to practice before the IRS; c. Guaranteeing payment of any tax refund or allowance of any tax credit; or d. Engaging in any other fraudulent or deceptive conduct that substantially interferes with the proper administration of tax laws. 2. These narrow injunctions for specific violations can pave the way for a broad injunction that bars people from serving as TRPs at all if they have continually or repeatedly violated these rules. 3. Section 7408 provides similar injunctive authority relating to wrongdoing in connection with tax shelters and reportable transactions. Criminal Provisions—The IRC also contains criminal provisions to punish TRPs and others for various tax-related wrongs. In a criminal case, the burden of proof is on the government to establish the crime beyond a reasonable doubt, whereas the burden of proof in civil cases is a mere preponderance of the evidence. A. Tax Evasion—26 U.S.C. Section 7201 punishes tax evasion and is applied very broadly. 1. This provision has been used to prosecute, among other wrongs: a. Failure to file a return b. Falsifying income c. Falsifying amounts that reduce taxable income 2. To secure a conviction, the government must prove: a. An affirmative act constituting an attempt to evade or defeat payment of a tax; b. Willfulness; and c. Existence of a tax deficiency. B. Tax Fraud—26 U.S.C. 7206 punishes fraud and false statements by TRPs and others, criminalizing (among other wrongs): 1. Willfully making and subscribing to any document made under penalty of perjury that the CPA does not believe to be true as to every material matter 2. Willfully aiding the preparation of any tax-related matter that is fraudulent as to any material matter 3. Removing or concealing a client's property with intent to defeat taxes C. Most criminal tax prosecutions are brought under Sections 7201 or 7206, but other criminal provisions include: 1. Willful failure to file a return, supply information, or pay a tax (Section 7203) 2. Willful failure to collect or pay over a tax (Section 7202) 3. Fraudulent returns, statements, or other documents (Section 7207) 4. Attempts to interfere with the administration of Internal Revenue laws, such as by threatening or misleading IRS agents (Section 7212) 5. Unauthorized disclosure of taxpayer information (with obvious exceptions for court orders, peer reviews, etc.) (Section 7213) 6. Willful disclosure or use of confidential information learned while preparing a tax return (Section 7216) 7. Conspiracy to commit any offense or fraud against the United States, including tax offenses (18 U.S.C. Section 371) 8. Aiding and abetting tax fraud (18 U.S.C. Section 2)