The Small Business and Work Opportunity

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1 July Augus 2007 Curren Developmens and Planning Ideas By Peer J. Melcher Reurn Preparers and Reurn Advisors Beware The Small Business and Work Opporuniy Tax Ac of 2007, recenly signed ino law by Presiden Bush, is he laes in a series of seps by Congress and he IRS o discourage aggressive ax planning. The Ac broadens he scope of reurn preparer penalies, raises he confidence levels necessary o avoid penalies, increases he amoun of he penalies ha can be imposed and creaes a new penaly for erroneous refund claims. Scope of Penalies Hisorically, he ax reurn preparer penalies of Code Sec applied only o income ax reurns. 1 The penalies now apply o preparers of all ax reurns, including esae, gif, excise ax, employmen ax and exemp organizaion reurns. 2 Increased Confidence Level Peer J. Melcher, J.D., LL.M., M.B.A. is a family wealh planning manager a Gran Thornon in Milwaukee, Wisconsin. You may reach Mr. Melcher a Code Sec generally imposed penalies on income ax reurn preparers for undersaemens of ax if (1) any par of he undersaemen was due o a posiion aken on he reurn ha did no have a realisic possibiliy (a leas one chance in hree) of being susained on he meris and (2) he preparer knew or reasonably should have known abou he posiion. 3 If he preparer disclosed he ax posiion on he reurn, however, he sandard was lower. Penalies JOURNAL OF RETIREMENT PLANNING 2007 CCH. All Righs Reserved. 15

2 Curren Developmens and Planning Ideas could be avoided if he posiion was no frivolous, 4 defined in he applicable regulaions o mean no paenly improper. 5 The no frivolous sandard is generally hough of as a 10 o 15 percen chance of success on he meris. Proper disclosure was made on a Form 8275 (for a posiion no conrary o a regulaion), on a Form 8275-R (for a posiion ha was conrary o a regulaion) or on a reurn or qualified amended reurn if permied by he IRS under a revenue procedure. 6 Preparers could also avoid he penaly if hey had reasonable cause for he undersaemen and aced in good faih. 7 The deerminaion of wheher his excepion applied was made on he basis of all relevan facs and circumsances. 8. The Code Sec penalies can now be avoided only if (1) he preparer reasonably believed ha he posiion in quesion was more likely han no correc or (2) he posiion was disclosed on he reurn and had a reasonable basis. 9 These changes represen subsanial increases in he required confidence levels. In he case of non-disclosed posiions, he increase is from one chance in hree o more han 50 percen. In he case of disclosed posiions, he increase is from a confidence level of approximaely 10 o 15 percen (no frivolous sandard) o a confidence ce level of approximaely p percen (reasonable able basis sandard). Increased Penalies Old Code Sec imposed a $250 penaly. The penaly increased o $1,000 where he undersaemen eme of ax was due o willful or reckless conduc. 10 New Code Sec increases he firs ier penaly o he greaer of $1,000 or 50 percen of he income derived (or o be derived) by he ax reurn preparer from he preparaion of he reurn or claim wih respec o which he penaly is imposed. 11 The penaly for willful or reckless conduc is increased o he greaer of $5,000 or 50 percen of he income derived (or o be derived). 12 Refund Claims Prior o enacmen of he Ac here was no penaly for filing an erroneous refund claim. New Code Sec provides ha if a claim for refund or credi of income ax is made in an excessive amoun, he person making he claim is liable for a penaly equal o 20 percen of he excess unless here was a reasonable basis for he claim. 13 Effecive Dae and Transiional Relief Alhough he Ac made he effecive dae for he changes May 25, 2007, he IRS subsequenly issued Noice , providing ransiional relief o give ax praciioners ime o implemen he new sandards. 14 The duraion and naure of he ransiional relief varies depending on he ype of reurn, amended reurn or refund claim involved. Reurns Qualifying for Relief Transiional relief applies o (1) all reurns, amended reurns, and refund claims due before 2008 (deermined wih regard o any exension of ime for filing); (2) 2007 esimaed ax reurns due on or before January 15, 2008; and (3) 2007 employmen and excise ax reurns due on or before January 31, Naure of Relief The reasonable basis/no frivolous sandard will coninue o apply o income ax reurns, amended reurns and refund claims during he ransiion period. Thus, he relief provisions will pospone he increased confidence e levels els for income ax reurns. For all oher reurns, including i esae, e, gif and dgstt reurns, employmen ax reurns, and excise ax reurns, he reasonable basis sandard will apply regardless of wheher disclosure is made. Planning Implicaions Serious Exposure for Esae Planners Many esae planners may have lile concern abou he new preparer penalies because heir role is limied o planning. Unforunaely, esae planners could be subjec o penalies even if hey never see any ax reurns. Under Code Sec. 7701(a)(36) and he Code Sec regulaions, accounans, aorneys and oher ax advisors can be reaed as non-signing reurn preparers if hey give advice o a axpayer or o he professional who prepares he axpayer s reurn. 15 The non-signing preparer rule applies o any CCH. All Righs Reserved.

3 July Augus 2007 ax professional who renders advice ha is direcly relevan o he deerminaion of he exisence, characerizaion, or amoun of an enry on a reurn or claim for refund if ha enry is a subsanial porion of he reurn or claim. Dispariy in Reporing Sandards beween Preparers and Taxpayers Hisorically, reporing sandards for axpayers were more sringen han hose for reurn preparers. Taxpayers needed o have subsanial auhoriy for a posiion o avoid ax penalies (roughly a percen chance of success), 16 while reurn preparers needed only a realisic possibiliy of success (33 and 1/3 percen chance of success). This was a desirable siuaion because i encouraged axpayers o hire compeen professionals o deermine heir ax liabiliy. Under he new rules, however, reurn preparers mus mee a higher sandard han axpayers (more likely han no). If he probabiliy of success for an imporan reurn posiion is beween 40 and 50 percen, he axpayer would have an incenive o prepare he reurn herself. The lower sandard for axpayers may also pu non-signing ng preparers in a difficul siuaion. Under prior law, a ax professional could be held dli liable efo for rp preparer penalies by advising a axpayer o ake a posiion ha lacked a realisic possibiliy iliy of success ss even hough he axpayer and no he advisor signed he reurn. r The penaly could be avoided, however, if he professional included in he advice a disclosure saing ha he posiion lacked subsanial al auhoriy y and ha aking he posiion on he reurn could subjec he axpayer o he subsanial undersaemen penaly if no disclosed. If he advice was in wriing he disclosure also had o be in wriing, bu if he advice was oral he disclaimer could also be oral. When he ax advice was given o anoher preparer, he non-signing preparer could avoid penalies by informing he oher preparer ha he posiion had o be adequaely disclosed on he reurn. Noe ha he preparer penaly could only apply if (1) i relaed o a compleed ransacion and (2) i was direcly relaed o he amoun or characerizaion of an amoun on a ax reurn. Thus, for example, an esae planning aorney who gave ax advice while a ransacion was being planned or while i was being pu ino effec was no subjec o penalies. 17 These rules worked well because he realisic possibiliy of success sandard was lower han he subsanial auhoriy sandard. If a posiion lacked a realisic possibiliy of success (33.33 percen chance of success), i also lacked subsanial auhoriy (40 percen chance of success) and he axpayer had a srong incenive o disclose o avoid penalies. Now, however, non-signing preparers mus advise disclosure unless he posiion aken is more likely han no correc. Thus, if a posiion has a 40 percen o 50 percen possibiliy of success, he non-signing preparer mus advise disclosure, bu disclosure would no be in he bes ineress of he axpayer. Leimberg Informaion Services, ciing o a presenaion by Diana Wolmann of Sullivan & Cromwell poins ou ha he nonsigning preparer s fae may be in he axpayer s hands in his siuaion because he can conrol wheher he axpayer discloses. 18 Ed Zollars of he CPA firm of Thomas & Zollars in Phoenix noes, however, ha if he non-signing preparer advises disclosure bu he axpayer does no disclose, a good faih defense may be available. This defense may be problemaic, however, because i migh be difficul o convince he IRS and he cours ha he advice o he axpayer was no given wih a wink. The IRS is well aware of his problem, specifically acknowledging in Noice ha addiional guidance will be necessary o resolve he non-signing preparer issue. 19 MLTN/Reasonable Basis Liss Law and accouning ng firms may wan o develop elo liss of esae planning n posiions hey believe eve are more likely han no, posiions hey believe would require disclosure and posiions ha could no be aken even wih disclosure in oher words, lising posiions wih more han a 50 percen chance of being upheld, posiions wih a 20 percen o 50 percen chance of being upheld and posiions wih less han a 20 percen chance of being upheld. Making hese deerminaions in advance should faciliae reurn preparaion and help avoid errors. While many posiions could no be caegorized because hey would be fac specific, ohers would lend hemselves o his approach. Some possible issues are wheher: various Code Sec powers included in a rus creae granor rus saus; such powers cause esae inclusion; such powers cause a ransfer o he rus o be JOURNAL OF RETIREMENT PLANNING 17

4 Curren Developmens and Planning Ideas incomplee for gif ax purposes; a sale of a GRAT remainder ineres o a GST rus resuls in a axable erminaion; he lead beneficiary of a QTIP rus can purchase he remainder ineres wihou riggering applicaion of Code Sec. 2519; a privae annuiy sale can have an increasing payou feaure; a CLAT can have an increasing payou feaure; a spousal power of appoinmen rus can be used o achieve poorer spouse funding (i.e., wheher i can be used o include boh spouses propery in deceden spouse s esae o ake advanage of boh unified credis; a spousal power of appoinmen rus can be used o achieve a basis sep up for he asses of boh spouses in a non-communiy propery sae he life of a person oher han he seller can be used in a privae annuiy sale o ake advanage of a shorer han average life expecancy; Wheher he one-year and 18-monh rules of Reg (b)(3) apply o a SCIN; gain recogniion on an IDGT sale is acceleraed a he seller s deah; IDGT insallmen noes receive a basis sep up a he seller s er s deah; a GRAT can be compleely zeroed ou; aw wo-year GRAT is permissible; a 366-day GRAT is permissible; a ransfer o a domesic asse proecion on rus (DAPT) is complee for gif ax purposes; asses ransferred o a DAPT are included in he seller s esae under Code Sec. 2036(a) a deah; a rus sius may be moved for sae income ax purposes from a sae basing axaion on he residence of he granor a he ime he rus was creaed o a sae having a more favorable ax regime; and valuaion discouns can be aken for buil-in gains in a closely-held corporaion. Relaionship o Circular 230 Finally, he relaionship beween he changes in Code Sec and Circular 230 should be noed. Recall ha Circular 230 provides he Treasury Deparmen s rules for pracice before he IRS and imposes penalies on accounans, aorneys and enrolled agens who violae hem. These penalies include fines, censure, suspension or even being barred for life from pracicing before he IRS. Secion 10.34(a) of Circular 230 provides ha: A praciioner may no sign a ax reurn as a preparer if he praciioner deermines ha he ax reurn conains a posiion ha does no have a realisic possibiliy of being susained on is meris (he realisic possibiliy sandard) unless he posiion is no frivolous and is adequaely disclosed o he Inernal Revenue Service. The Ac did no amend Secion 10.34(a), leaving he realisic possibiliy of success sandard in place and making i easier o avoid penalies under Circular 230 han under new Code Sec Some commenaors expec ha he more sringen confidence levels incorporaed ino new Code Sec will evenually be applied o Circular 230. Confidence Level Char The various reurn preparer sandards are summarized below. Char 1 Sandard d Confidence e Level No Frivolous 10% - 15% Reasonable basis 20% - 25% Realisic Possibiliy 33 1/3 % Subsanial Auhoriy 35% - 40% MLTN > 50% 1 Code Secs and 7701(a)(36). 2 Ac 8246(a). 3 Code Sec. 6694(a)(1) and Reg (b)(1). 4 Code Sec. 6694(a)(2). 5 Reg (c)(2). 6 Reg (f)(1) and (f)(2). 7 Code Sec. 6694(a)(3) and Reg (d). 8 See Reg for a deailed explanaion and examples. ENDNOTES 9 Code Sec. 6694(a)(2), as amended. 10 Code Secs. 6694(a) and 6694(b). 11 Code Sec. 6694((b)(1), as amended. 12 Code Sec. 6694(b)(2), as amended. For purposes of his second ier penaly, he amended saue defines willful or reckless conduc as (A) a willful aemp in any manner o undersae he ax liabiliy for ax on he reurn or claim, or (B) a reckless or inenional disregard of rules or regulaions. 13 Code Sec. 6676(a). The Code Sec penaly is reduced by he amoun of any penalies imposed under Code Secs (accuracyrelaed penaly) or 6663 (civil fraud penaly) IRB, June 11, Code Sec. 7701(a)(36) and Reg (b)(1). This rule applies o advice which is direcly relevan o he deerminaion of he exisence, characerizaion, or amoun of an enry on a reurn or claim for refund CCH. All Righs Reserved.

5 July Augus 2007 if ha enry is a subsanial porion of he reurn or claim. 16 This assumes ha he posiion did no relae o a ax sheler. A confidence level of more likely han no was always required for ax sheler iems. 17 Reg (a)(2). 18 Reurn Preparer Penalies Sharks in he Waer, Seve Leimberg s Esae planning Newsleer Archive Message # 1140, June 20, Zollars, Delay of Game IRS Grans Temporary Relief for Secion 6694(a) Changes, Podcas, Leimberg Informaion Services, June 17, 2007 and correspondence wih he auhor. This aricle is reprined wih he publisher s permission from he JOURNAL OF RETIREMENT PLANNING, a bi-monhly journal published by CCH, a Wolers Kluwer business. Copying or disribuion wihou he publisher s permission is prohibied. To subscribe o he JOUR- NAL OF RETIREMENT PLANNING or oher CCH Journals please call or visi www. CCHGroup.com. All views expressed in he aricles and columns are hose of he auhor and no necessarily hose of CCH. JOURNAL OF RETIREMENT PLANNING 19