Final Preparer Understatement Penalty Regs Released

 [4830-01]

 ACTION: Final Regulations.

 SUMMARY: This document contains final regulations concerning a penalty for understatement of a taxpayer's liability and relates to persons who prepare for compensation income tax returns and claims for refund. Changes to the applicable tax law were made by the Omnibus Budget Reconciliation Act of 1989. The regulations provide guidance necessary to comply with these changes.

 EFFECTIVE DATE: Except for section 1.6694-3(c)(3), sections 1.6694-1 through 1.6694-3 are effective for documents prepared and advice given after December 31, 1991. Section 1.6694-3(c)(3) is effective for documents prepared and advice given after December 31, 1989. Section 1.6694-4 is effective as of December 19, 1989. Section 1.6694-0 is effective December 31, 1991.

 FOR FURTHER INFORMATION CONTACT: Lisa J. Byun of the Office of Assistant Chief Counsel (Income Tax & Accounting), Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (Attention: CC:IT&A:4) or telephone 202-566-5985 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1231. The estimated annual burden per respondent is .5 hours.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents may require greater or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attn: IRS Reports Clearance Officer T:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

On March 4, 1991, the Federal Register (56 FR 8959) published a notice of proposed rulemaking to provide guidance under section 6694 of the Internal Revenue Code as revised by sections 7732 and 7737 of the Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239 (OBPA 1989). The Internal Revenue Service received public comments on the proposed regulations and held a public hearing on June 3, 1991. After consideration of the public comments regarding the proposed regulations, the regulations are adopted as revised by this Treasury decision. Descriptions of the revisions to the proposed regulations are included in the discussion of the public comments below.

EXPLANATION OF STATUTORY PROVISIONS

 As amended by OBRA 1989, section 6694(a) provides that a $250 penalty will be imposed on an income tax return preparer ("preparer") who understates a taxpayer's tax liability on an income tax return or claim for refund if the understatement is due to a position for which there was not a realistic possibility of being sustained on its merits and the preparer knew or reasonably should have known of such position. The penalty does not apply, however, if the position is not frivolous and is adequately disclosed, or if there was reasonable cause for the position taken and the preparer acted in good faith.

 As amended, section 6694(b) provides that a $1,000 penalty will be imposed on a preparer who understates a taxpayer's tax liability on an income tax return or claim for refund if the understatement is due to the preparer's willful attempt to understate tax liability or the preparer's reckless or intentional disregard of rules or regulations. There is no statutory disclosure exception to this penalty. However, the legislative history indicates that the penalty for disregarding rules or regulations should not be imposed if proper disclosure is made.

 OBRA 1989 also amended section 6694(c) to expressly permit the Internal Revenue Service ("Service") to counterclaim in a refund proceeding for any portion of the section 6694 penalty that was not paid by the preparer prior to commencing the proceeding.

PUBLIC COMMENTS

GENERAL PROVISIONS

1. ONE-PREPARER-PER-FIRM RULE

a. SOLE PROPRIETORSHIPS

The proposed regulations provide that no more than one individual associated with a firm (for example, as a partner or employee) is treated as a preparer with respect to the same return or claim for refund. Prop. Reg. section 1.6694-1(b)(1). One commentator commented that this rule would prevent the Service from penalizing a sole proprietorship and an employee of the firm who was not the sole proprietor, on the ground that, in such a case, a preparer penalty would be imposed on two individuals associated with the same firm. The proposed regulations do not prevent the Service from imposing two preparer penalties in this context because the sole proprietor would be penalized in his capacity as the firm, not in his capacity as an individual "associated with" the firm. Nevertheless, to eliminate any confusion, the final regulations note that a firm includes a sole proprietorship.

b. SIGNING PREPARER

 In the case of a signing preparer who is associated with a firm, the proposed regulations provide that only the signing preparer and no other individual associated with the firm is a preparer with respect to the return or claim. Prop. Reg. section 1.6694-1(b)(1). A corollary of this rule is that the signing preparer cannot avoid the penalty under section 6694(a) by relying on the advice of another individual in the same firm. Several commentators stated that a signing preparer should not be subject to a penalty if the signing preparer relied on the advice of another individual within the same firm.

 The commentators did not object to the one-preparer-per-firm rule, but argued that the signing preparer should not be required to bear the penalty if he or she relied on advice of another individual in the firm. Such a rule would impose a heavy administrative burden on the Service because it would have to establish which individual within a firm was ultimately responsible for the position for which the penalty was imposed. This would require the imposition of standards for intrafirm advice and disclosure, and would burden practitioners with documenting intrafirm communications in order to comply with the disclosure requirements of the preparer regulations and to establish justifiable reliance on the advice of others. These were the concerns that influenced the initial formulation of the one- preparer-per-firm rule.

 After careful consideration of the comments, the Service has determined that the approach taken in the proposed regulations -- limiting the penalty to one individual per firm but designating that individual on the basis of objective criteria -- reasonably balances the interests of the Government and practitioners. Accordingly, the final regulations adopt the rule of the proposed regulations without change.

c. NONSIGNING PREPARER

 In the case of a nonsigning preparer who is associated with a firm, the proposed regulations provide that, ordinarily, the individual who is a preparer for purposes of section 6694 is the individual with direct supervisory responsibility for the matter. Prop. Reg. section 1.6694-1(b)(1). One commentator found this provision confusing, because more than one individual in a firm may have direct supervisory responsibility for matters relating to the same return or claim. The final regulations clarify this point by providing that the nonsigning preparer in such a case ordinarily is the individual with overall supervisory responsibility for the advice given by the firm with respect to the return or claim.

2. MAXIMUM PENALTY ON PREPARER OF PARTNERSHIP RETURN

Under the definition of an income tax return preparer in Treas. Reg. section 301.7701-15(b)(3), a preparer of a partnership return is considered a preparer of a partner's return if the entries on the partnership return that are reportable on the partner's return constitute a substantial portion of the partner's return. Given the increase in the section 6694 penalty amounts and the large size of some partnerships, one commentator asked that the Service limit the amount (e.g., at $5,000 or $10,000) that a preparer of a partnership return can be penalized for returns of partners in the partnership. Because the Service does not have the authority to set limits on the section 6694 penalty amounts, the final regulations do not adopt the commentator's suggestion.

3. PROCEDURAL MATTERS

One commentator commented that the deficiency procedures available to preparers offer little recourse to small practitioners. Therefore, the commentator asked that additional consideration be given to providing administrative recourse (e.g., a review by Appeals) before a preparer is required to contest the penalty assessment in district court. Another commentator requested clarification as to the office of the Service in which a final administrative determination will ordinarily be made.

 The proposed regulations provide that unless the period of limitations may expire without adequate opportunity for assessment, the Service will also send, before assessment of either penalty, a 30-day letter to the preparer notifying him of the proposed penalty or penalties and offering an opportunity to the preparer to request further administrative consideration and a final administrative determination by the Service concerning the assessment. If the preparer then makes a timely request, assessment may not be made until the Service makes a final administrative determination adverse to the preparer. Prop. Reg. section 1.6694-4(a)(1). The final administrative determination is generally made by Appeals. Specific instructions on how and where to administratively appeal the proposed penalty assessment are contained in the letter issued to the preparer. Therefore, the Service believes further clarification or elaboration on the administrative appeals process is not necessary in the final regulations.

4. EFFECTIVE DATES

The proposed regulations provide that, in the case of a position contrary to a revenue ruling, a preparer will not be considered to have recklessly or intentionally disregarded the ruling if the contrary position has a realistic possibility of being sustained on its merits. Prop. Reg. section 1.6694-3(c)(3). This provision was proposed to be effective with respect to documents prepared and advice given after December 31, 1991. A similar rule for taxpayers under the proposed section 6662 regulations (relating to the penalty for negligence or disregard of rules or regulations) was proposed to be effective with respect to returns due after December 31, 1989.

 Several commentators urged that the December 31, 1989 effective date under section 6662 be adopted for the section 6694 provision as well. To respond to this concern, the final preparer penalty regulations adopt the effective date of the accuracy-related penalty regulations on this point. Thus, the provision in the preparer regulations which provides that a preparer is not considered to have recklessly or intentionally disregarded a revenue ruling if the position contrary to the ruling has a realistic possibility of being sustained on its merits is effective for documents prepared and advice given after December 31, 1989. The final preparer regulations contain a similar rule, which is also effective for documents prepared and advice given after December 31, 1989, regarding positions contrary to certain notices issued by the Service.

SECTION 6694(a) PROVISIONS

1."ONE-IN-THREE" DEFINITION OF THE REALISTIC POSSIBILITY STANDARD

The proposed regulations provide that a position will be considered to have satisfied the realistic possibility standard if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits. Prop. Reg. section 1.6694-2(b)(1). Many commentators asked that the "one-in-three" definition be eliminated because it is difficult to assess the likelihood of a position being sustained on its merits. The final regulations retain the one-in- three definition, however, because a numerical benchmark helps prevent erosion of the standard and because other definitions suggested by commentators would not provide any more meaningful guidance.

2. AUTHORITIES

The proposed regulations provide that, in determining whether a position satisfies the realistic possibility standard, only the "authorities" listed in section 1.6662-4(d)(3)(iii) of the proposed regulations (relating to the authorities for determining substantial authority) are to be considered. Prop. Reg. section 1.6694-2(b)(2). Section 1.6662-4(d)(3)(iii) provides that the term "authorities" does not include conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by other tax professionals but that the authorities underlying such expressions of opinion may give rise to substantial authority. Several commentators argued that "authorities" should include additional sources such as well-reasoned treatises, articles in recognized professional tax publications, and other reference tools and sources of tax analyses commonly used by tax advisers and return preparers.

 The commentators' suggestion was not adopted in the final regulations because (1) it would be too difficult to administratively determine which of these secondary sources were well-reasoned or were otherwise accurate expressions of the tax law, and (2) the regulations provide sufficient protection to preparers by allowing them to rely on the authorities underlying the conclusions in the secondary sources.

3. WHEN REALISTIC POSSIBILITY DETERMINED

The proposed regulations provide generally that, in the case of a signing preparer, the relevant date for determining whether a position satisfies the realistic possibility standard is the date the preparer signs and dates the return or claim. In the case of a nonsigning preparer, the relevant date is the date the preparer provides the advice. Prop. Reg. section 1.6694-2(b)(5).

 One commentator stated that the dates for determining whether a position satisfies the realistic possibility standard should conform to the dates for determining whether a position satisfies the substantial authority standard. Under this approach, the realistic possibility standard could be satisfied either on the last day of the taxable year covered by a return or on the date the return was signed (or the advice was given). The commentator was concerned that the difference in determination dates creates a potential for conflict between preparers and taxpayers where an adverse technical development occurs after the end of the taxable year but before the return is signed (or the advice is given).

 The commentator's suggestion was not adopted in the final regulations because a preparer should not be permitted to ignore developments in the law occurring after the taxable year covered by the return and before the preparer signs the return (or provides the advice).

4. REALISTIC POSSIBILITY EXAMPLES 1.6694-2(b)(3))

a. EXAMPLE 2

One commentator suggested expanding this example (which concerns a statutory change that adversely affects a taxpayer) to provide that if the committee reports can be read to provide some evidence or authority to support the taxpayer's position (although the committee reports do not specifically address the situation), the position is not frivolous and, therefore, may be taken if adequately disclosed. The commentator's suggestion was not adopted in the final regulations because the proposed modification to the example does not provide sufficient information to determine whether the position is frivolous.

b. EXAMPLE 3

 Several commentators stated that this example (which concerns a conflict between the statutory language and the legislative history) should be revised to conclude that a position consistent with either the statute or the committee reports satisfies the realistic possibility standard. The final regulations adopt this suggestion but add that a position consistent with the committee reports but contrary to the statute constitutes a disregard of a rule or regulation and, therefore, must be adequately disclosed in order to avoid the section 6694(b) penalty.

c. EXAMPLE 4

 A commentator asked that this example (which concerns an inconsistency between a regulation and instructions on a tax form) be revised to further provide that a position consistent with the incorrect tax form instructions is frivolous if the preparer knew of the Service's announcement acknowledging the error. The commentator's recommendation was not adopted in the final regulations because "frivolous" is an objective standard and, therefore, the preparer's knowledge of the announcement is not relevant to a determination of whether the position is frivolous. Knowledge of the announcement would, however, be relevant to a determination of whether the preparer intentionally disregarded the regulation.

d. EXAMPLE 5

 Several commentators contended that the issuance of proposed regulations which are contrary to previously issued private letter rulings should not cause the earlier private letter rulings to cease being authorities; it should only diminish the weight of the private letter rulings. The commentators' suggestion was not adopted because proposed regulations are subject to a higher level of review than private letter rulings and it is not appropriate to retain as an authority a document that does not accurately reflect the current status of the law and position of the Service.

e. EXAMPLE 8

 Two commentators contended that a taxpayer should be treated as having a realistic possibility of success with respect to a position involving a statutory phrase if there is a favorable interpretation of identical language appearing in another place in the Internal Revenue Code. The example provides that interpretations of identical language are relevant, but that the context in which the identical language arises also must be taken into account in applying the realistic possibility standard. Because the context in which the identical language arises is important, the final regulations retain this example without any revisions.

5. EMPLOYER/PARTNERSHIP LIABILITY

The proposed regulations provide that an employer or partnership of a preparer subject to the section 6694(a) penalty is also subject to the penalty if the employer or partnership (or one or more of its principal officers or general partners) also knew or reasonably should have known of the position. Prop. Reg. section 1.6694-2(a). Several commentators expressed concern that the "also knew or reasonably should have known" language could result in automatic assertion of a penalty against a firm if an employee or partner of the firm were penalized. This was not the intent of the proposed regulations.

 In response to this concern, the final regulations clarify the circumstances under which a firm will be subject to penalty under section 6694. The final regulations provide that an employer or partnership of a preparer subject to penalty under section 6694(a) is also subject to penalty only if (1) one or more members of the principal management (or principal officers) of the firm or a branch office participated in or knew of the conduct proscribed by section 6694(a), (2) the employer or partnership failed to provide reasonable and appropriate procedures for review of the position for which the penalty is imposed, or (3) such review procedures were disregarded in the formulation of the advice, or the preparation of the return or claim for refund, that included the position for which the penalty is imposed. A mid-level manager is not ordinarily considered a member of principal management for purposes of this provision; however, the principal managers of a branch office are considered members of principal management even if they are not principal managers of the firm as a whole. (Similar rules apply for purposes of section 6694(b).)

6. DEFINITION OF "FRIVOLOUS"

The proposed regulations define a "frivolous" position as one that is "patently improper." Prop. Reg. section 1.6694-2(c)(2). Commentators recommended that this definition be changed, for example, to require that the position be both patently improper and knowingly advanced in bad faith, or that a frivolous position be defined as one that is "not litigable."

 The "patently improper" definition was included in the proposed regulations because it represents an objective standard. Thus, neither the good nor the bad intentions of a person taking a position are relevant to a determination of whether that position is frivolous within the meaning of the regulations. The Service continues to believe that an objective standard is appropriate. The recommendation that a frivolous position be defined as one that is not litigable would place preparers who are not attorneys at a disadvantage in assessing the effectiveness of disclosure in relation to preparers who are. Accordingly, the final regulations retain the definition of a frivolous position as one that is patently improper.

7. ADEQUATE DISCLOSURE

a. METHOD OF MAKING ADEQUATE DISCLOSURE

The proposed regulations provide that disclosure by a signing preparer is adequate for purposes of section 6694(a) if made on a Form 8275 or on the return in accordance with an annual revenue procedure. Prop. Reg. section 1.6694-2(c)(3)(i). Several commentators stated that the method for making adequate disclosure should not be so limited.

 It is in the interest of both preparers and the Service to have a relatively uniform disclosure regime that provides certainty as to whether adequate disclosure has been made. Thus, the final regulations do not relax the requirements for making adequate disclosure for purposes of this penalty. The final regulations also add a special disclosure rule for positions contrary to regulations (see the "Adequate Disclosure" section below in the portion of this preamble that discusses the provisions under section 6694(b)).

b. TENSION BETWEEN ACCURACY-RELATED PENALTIES AND THE PREPARER PENALTIES

One commentator noted that tension can exist between a taxpayer and a signing preparer with respect to disclosure of a position that (1) results in an understatement that is too small to be considered substantial, and (2) lacks a realistic possibility of being sustained on its merits. In such a case, the signing preparer would have to disclose the position to avoid a preparer penalty, but a taxpayer would not have to disclose to avoid the substantial understatement penalty. The different standards for taxpayers and preparers are established by statute and cannot be changed by regulation. Therefore, the final regulations adopt the position of the proposed regulations without change.

8. "RARE CASE" PROVISION

The proposed regulations provide disclosure rules for nonsigning preparers in the "rare cases" in which a position has substantial authority but does not satisfy the realistic possibility standard. Prop. Reg. section 1.6694-2(c)(3)(ii)(A)(2). Because many commentators criticized this provision as unnecessary and confusing, it has been eliminated.

9. REASONABLE CAUSE AND GOOD FAITH

a. FREQUENCY OF ERRORS

The proposed regulations provide that in determining whether the reasonable cause and good faith exception applies, one factor to consider is whether the understatement is due to an isolated error rather than a number of errors. Although the exception generally applies to an isolated error, the exception does not apply if the error is sufficiently obvious, flagrant or material. Prop. Reg. section 1.6694-2(d)(2). One commentator argued that the materiality of an error should not enter into this determination. The final regulations respond to this suggestion by clarifying that the materiality of an error is relevant to whether the error should have been discovered during a review of the return or claim.

b. PREPARER'S NORMAL OFFICE PRACTICE

 Under the proposed regulations, a preparer's normal office practice is one of the factors considered in making the reasonable cause and good faith determination. The proposed regulations provide that a normal office practice "generally must involve, at a minimum" certain procedures enumerated in the regulations. Prop. Reg. section 1.6694-2(d)(4). One commentator questioned whether the Service should mandate minimum standards for office procedures. In response to this comment, the final regulations eliminate the minimum office procedure requirement, but list these procedures as factors to consider in determining whether a practitioner's normal office practice promotes accuracy and consistency in the preparation of returns and claims for refund. Stylistic changes were also made to this provision.

c. RELIANCE ON ADVICE OF ANOTHER PREPARER

 The proposed regulations generally provide that the reasonable cause and good faith exception applies if the preparer relied in good faith on the advice of another preparer (or a person who would be considered a preparer had the advice constituted preparation of a substantial portion of the return or claim for refund). Prop. Reg. section 1.6694-2(d)(5). One commentator suggested clarifying this provision to expressly provide that the exception only applies if the preparer being relied on is a paid preparer.

 The proposed regulations define an "income tax return preparer" as any person who is an income tax return preparer within the meaning of section 7701(a)(36) and the regulations thereunder. Under section 7701(a)(36), a person is not an income tax return preparer unless such person is compensated for preparing a return or claim. Because a preparer, by definition, must have been compensated, no further clarification is necessary.

 Another commentator stated that this provision should cover the situation where a preparer, in preparing a taxpayer's return, relies on a Schedule K-1 that has been prepared by another preparer. No change is necessary to permit reliance on a Schedule K-1 prepared by another preparer as the proposed and final regulations both permit a preparer to rely on "the advice of, or schedules prepared by" another preparer (or by a person who would be considered a preparer had the advice or schedules constituted preparation of a substantial portion of the return or claim for refund).

SECTION 6694(b) PROVISIONS

1. RECKLESSNESS

The proposed regulations provide that a preparer is reckless in not knowing of a rule or regulation if the preparer makes little or no effort to determine whether a rule or regulation exists, under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable preparer would observe in the situation. Prop. Reg. section 1.6694-3(c)(1). One commentator asked that the term "reasonable preparer" either be defined or changed to "reasonably diligent preparer." This suggestion was not adopted because diligence is implicit in the standard contained in the proposed regulations.

2. RULES OR REGULATIONS

The proposed regulations define the term "rules or regulations" to include the provisions of the Internal Revenue Code, temporary or final Treasury regulations, and revenue rulings issued by the Service. Prop. Reg. section 1.6694-3(f). One commentator requested that we clarify the meaning of this term. Another commentator stated that a revenue ruling should not be treated as a "rule" because (1) a revenue ruling does not constitute a rule under the Administrative Procedure Act (5 U.S.C. sections 500, et seq.) and (2) a revenue ruling is only the contention of one party and is not subjected to the give and take of a public comment process.

 The legislative history to the Tax Reform Act of 1976 (which enacted section 6694) expressly provides that rules and regulations include regulations and "IRS rulings." See S. Rep. No. 938, 94th Cong., 2d Sess. 355 (1976). Moreover, revenue rulings were expressly listed as "rules" under former section 1.6694-1(a)(3). Therefore, the final preparer penalty regulations, in providing that revenue rulings are "rules," merely reflect a continuation of prior law.

 Notices published in the Internal Revenue Bulletin by the Service also contain substantive interpretations of Federal tax law. In addition, these notices generally are subject to a level of review that is the same or higher than that accorded revenue rulings. Accordingly, the final regulations also provide that the term "rules or regulations" includes notices (other than notices of proposed rulemaking) that are issued by the Service and published in the Internal Revenue Bulletin. (Revenue procedures are not listed, as they may or may not be treated as "rules or regulations" depending on all facts and circumstances.) A corresponding provision is contained in the final regulations providing that a preparer is not considered to have recklessly or intentionally disregarded such a notice if the position contrary to the notice has a realistic possibility of being sustained on its merits.

3. ADEQUATE DISCLOSURE

The proposed regulations provide that a preparer will not be considered to have recklessly or intentionally disregarded a regulation if the position contrary to the regulation is not frivolous and is adequately disclosed. Prop. Reg. section 1.6694-3(c)(2). Commentators stated that a preparer should be permitted to take a position contrary to a regulation without disclosure if (1) the position has a realistic possibility of being sustained on its merits, or (2) the regulation was invalidated by a court. Another commentator stated that the legislative history to OBRA 1989 suggests only that disclosure should be a safe harbor and not the sole means of avoiding a penalty for reckless or intentional disregard of a regulation.

 There is no indication in the legislative history of OBRA 1989 that Congress intended to permit the taking of positions contrary to regulations without disclosure in the circumstances described above or, more generally, that Congress intended disclosure to be only a safe harbor. The taking of a position contrary to a regulation is of sufficient importance to the self-assessment nature of the Federal tax system that it is appropriate to require that the Service be notified of such positions. Therefore, the final regulations adopt the rule of the proposed regulations requiring adequate disclosure of a position contrary to a regulation.

 In addition, because of the importance to the self-assessment system of disclosing positions contrary to regulations, the final regulations make two changes to the rules concerning positions contrary to regulations. First, the final regulations provide that disclosure of such positions is adequate only if the disclosure is separately made on a Form 8275-R. Until Form 8275-R is available, preparers must disclose positions contrary to regulations on a separate Form 8275 with the caption "REGULATIONS" appearing in the upper right corner of the form. (A similar disclosure rule is provided in the final accuracy-related penalty regulations for the penalty for negligence or disregard of rules or regulations.) Second, because the legislative history of OBRA 1989 indicates that the penalty for reckless or intentional disregard of a regulation may be avoided through disclosure only if the position represents a good faith challenge to the validity of the regulation, the final regulations incorporate this standard. See H.R. Rep. No. 247, 101st Cong., 1st Sess. 1393, 1396-97 (1989).

4. EXAMPLES (SECTION 1.6694-3(d))

EXAMPLE 3

Two commentators argued that the statement in the example that five different courts had arrived at the same position on an issue and that this position satisfies the realistic possibility standard created a negative inference that a position supported by fewer than five courts would not satisfy the standard. No such inference was intended. Accordingly, the inference has been eliminated by replacing "five" with "several" in the final regulations.

5. BURDEN OF PROOF

The proposed regulations provide that the Government bears the burden of proof on the issue of whether a preparer willfully attempted to understate tax liability, but that the preparer bears the burden of proof on such other issues as whether the preparer recklessly or intentionally disregarded a rule or regulation or whether disclosure was adequately made. Prop. Reg. section 1.6694-3(h). One commentator stated that the Government should also bear the burden of proof on the issue of whether the preparer recklessly or intentionally disregarded a rule or regulation.

 Section 7427 of the Code expressly provides that the burden of proof on the issue of whether a preparer willfully attempted to understate tax liability (within the meaning of section 6694(b)) is on the Government. Although OBRA 1989 added reckless disregard of rules or regulations as a basis for imposing the section 6694(b) penalty and made intentional disregard of rules or regulations subject to section 6694(b) rather than 6694(a), OBRA 1989 did not amend section 7427 to place the burden of proving reckless or intentional disregard on the Government. Furthermore, the regulations under former section 6694(a) (consistent with the legislative history of the Tax Reform Act of 1976) placed the burden of proof on the issue of whether a preparer intentionally disregarded a rule or regulation on the preparer. For these reasons, the commentator's suggestion was not adopted in the final regulations and the burden of proof on the issue of whether a position contrary to a regulation represents a good faith challenge to the validity of the regulation also is placed on the preparer.

SPECIAL ANALYSES

 It has been determined that these regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Lisa J. Byun, Office of the Assistant Chief Counsel (Income Tax & Accounting), Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR 1.6654-1 through 1.6709-IT

 Income taxes, Penalties, Reporting and recordkeeping requirements.

26 CFR Part 602

 Reporting and recordkeeping requirements.

Treasury Decision 8382

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 continues to read in part:

Authority: Sec. 7805, 68A Stat. 917; sec. 26 U.S.C. 7805, 26 U.S.C. 7805 * * *

Par. 2. Sections 1.6694-1 and 1.6694-2 are revised and new sections 1.6694-0, -3, and -4 are added to read as follows.

SECTION 1.6694-0 TABLE OF CONTENTS.

This section lists the captions that appear in sections 1.6694-1 through 1.6694-4.

1.6694-1 Section 6694 penalties applicable to income tax return preparer.

 (a) Overview.

(a) OVERVIEW. Section 6694(a) and section 6694(b) impose penalties on income tax return preparers for certain understatements of liability on a return or claim for refund. The section 6694(a) penalty is imposed for an understatement of liability with respect to tax imposed by subtitle A of the Internal Revenue Code that is due to a position for which there was not a realistic possibility of being sustained on its merits. The section 6694(b) penalty is imposed for an understatement of liability with respect to tax imposed by subtitle A of the Internal Revenue Code that is due to a willful attempt to understate tax liability or that is due to reckless or intentional disregard of rules or regulations. See section 1.6694-2 for rules relating to the penalty under section 6694(a). See section 1.6694-3 for rules relating to the penalty under section 6694(b).

(b) INCOME TAX RETURN PREPARER -- (1) IN GENERAL. Solely for purposes of the regulations under section 6694, the term "income tax return preparer" ("preparer") means any person who is an income tax return preparer within the meaning of section 7701(a)(36) and section 301.7701-15 of this Chapter, except that no more than one individual associated with a firm (for example, as a partner or employee) is treated as a preparer with respect to the same return or claim for refund. If a signing preparer is associated with a firm, that individual, and no other individual associated with the firm, is a preparer with respect to the return or claim for purposes of section 6694. If two or more individuals associated with a firm are income tax return preparers with respect to a return or claim for refund, within the meaning of section 7701(a)(36) and section 301.7701-15 of this Chapter, and none of them is the signing preparer, only one of the individuals is a preparer (i.e., nonsigning preparer) with respect to that return or claim for purposes of section 6694. In such a case, ordinarily, the individual who is a preparer for purposes of section 6694 is the individual with overall supervisory responsibility for the advice given by the firm with respect to the return or claim. To the extent provided in section 1.6694-2(a)(2) and section 1.6694-3(a)(2), an individual and the firm with which the individual is associated may both be subject to penalty under section 6694 with respect to the same return or claim for refund. If an individual (other than the sole proprietor) who is associated with a sole proprietorship is subject to penalty under section 6694, the sole proprietorship is considered a "firm" for purposes of this paragraph.

(2) SIGNING AND NONSIGNING PREPARERS. A "signing preparer" is any preparer who signs a return of tax or claim for refund as a preparer. A "nonsigning preparer" is any preparer who is not a signing preparer. Examples of nonsigning preparers are preparers who provide advice (written or oral) to a taxpayer or to a preparer who is not associated with the same firm as the preparer who provides the advice.

(3) EXAMPLE. The provisions of paragraph (b) of this section are illustrated by the following example:

EXAMPLE. Attorney A provides advice to Client C concerning the proper treatment of a significant item on C's income tax return. The advice constitutes preparation of a substantial portion of the return. In preparation for providing that advice, A discusses the matter with Attorney B, who is associated with the same firm as A, but A is the attorney with overall supervisory responsibility for the advice. Neither Attorney A nor any other attorney associated with A's firm signs C's return as a preparer. For purposes of the regulations under section 6694, A is a preparer with respect to C's return and is subject to penalty under section 6694 with respect to C's return. B is not a preparer with respect to C's return and, therefore, is not subject to penalty under section 6694 with respect to a position taken on C's return. This would be true even if B recommends that A advise C to take an undisclosed position that did not satisfy the realistic possibility standard. In addition, since B is not a preparer for purposes of the regulations under section 6694, A may not avoid a penalty under section 6694 with respect to C's return by claiming he relied on the advice of B. See section 1.6694-2(d)(5).

(c) UNDERSTATEMENT OF LIABILITY. For purposes of the regulations under section 6694, an "understatement of liability" exists if, viewing the return or claim for refund as a whole, there is an understatement of the net amount payable with respect to any tax imposed by subtitle A of the Internal Revenue Code, or an overstatement of the net amount creditable or refundable with respect to any tax imposed by subtitle A of the Internal Revenue Code. The net amount payable in a taxable year with respect to the return for which the preparer engaged in conduct proscribed by section 6694 is not reduced by any carryback. Tax imposed by subtitle A of the Internal Revenue Code does not include additions to the tax provided by section 6654 and section 6655 (relating to underpayments of estimated tax). Except as provided in paragraph (d) of this section, the determination of whether an understatement of liability exists may be made in a proceeding involving the preparer apart from any proceeding involving the taxpayer.

(d) ABATEMENT OF PENALTY WHERE TAXPAYER'S LIABILITY NOT UNDERSTATED. If a penalty under section 6694(a) or section 6694(b) concerning a return or claim for refund has been assessed against one or more preparers, and if it is established at any time in a final administrative determination or a final judicial decision that there was no understatement of liability relating to the return or claim for refund, then --

(1) The assessment must be abated; and

(2) If any amount of the penalty was paid, that amount must be refunded to the person or persons who so paid, as if the payment were an overpayment of tax, without consideration of any period of limitations.

(e) VERIFICATION OF INFORMATION FURNISHED BY TAXPAYER -- (1) IN GENERAL. For purposes of section 6694(a) and section 6694(b), the preparer generally may rely in good faith without verification upon information furnished by the taxpayer. Thus, the preparer is not required to audit, examine or review books and records, business operations, or documents or other evidence in order to verify independently the taxpayer's information. However, the preparer may not ignore the implications of information furnished to the preparer or actually known by the preparer. The preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. Additionally, some provisions of the Code or regulations require that specific facts and circumstances exist -- for example, that the taxpayer maintain specific documents, before a deduction may be claimed. The preparer must make appropriate inquiries to determine the existence of facts and circumstances required by a Code section or regulation as a condition to the claiming of a deduction.

(2) EXAMPLE. The provisions of paragraph (e) of this section are illustrated by the following example:

EXAMPLE. A taxpayer, during an interview conducted by the preparer, stated that he had paid $6,500 in doctor bills and $5,000 in deductible travel and entertainment expenses during the tax year, when in fact he had paid smaller amounts. On the basis of this information, the preparer properly calculated deductions for medical expenses and for travel and entertainment expenses which resulted in an understatement of liability for tax. The preparer had no reason to believe that the medical expense and travel and entertainment expense information presented was incorrect or incomplete. The preparer did not ask for underlying documentation of the medical expenses but inquired about the existence of travel and entertainment expense records. The preparer was reasonably satisfied by the taxpayer's representations that the taxpayer had adequate records (or other sufficient corroborative evidence) for the deduction of $5,000 for travel and entertainment expenses. The preparer is not subject to a penalty under section 6694.

(f) EFFECTIVE DATE. Sections 1.6694-1 through 1.6694-3 are generally effective for documents prepared and advice given after December 31, 1991. However, section 1.6694-3(c)(3) (which provides that a preparer is not considered to have recklessly or intentionally disregarded a revenue ruling or notice if the position contrary to the ruling or notice has a realistic possibility of being sustained on its merits) is effective for documents prepared and advice given after December 31, 1989. Except as provided in the preceding sentence, section 6694 and the existing rules and regulations thereunder (to the extent not inconsistent with the statute as amended by the Omnibus Budget Reconciliation Act of 1989), and Notice 90-20, 1990-1 C.B. 328, apply to documents prepared and advice given on or before December 31, 1991. For the effective date of section 1.6694-4, see section 1.6694-4(d).

SECTION 1.6694-2 PENALTY FOR UNDERSTATEMENT DUE TO AN UNREALISTIC POSITION.

(a) IN GENERAL -- (1) PROSCRIBED CONDUCT. Except as otherwise provided in this section, if any part of an understatement of liability relating to a return of tax under subtitle A of the Internal Revenue Code or claim for refund of tax under subtitle A of the Internal Revenue Code is due to a position for which there was not a realistic possibility of being sustained on its merits, any person who is a preparer with respect to such return or claim for refund who knew or reasonably should have known of such position is subject to a penalty of $250 with respect to such return or claim for refund.

(2) SPECIAL RULE FOR EMPLOYERS AND PARTNERSHIPS. An employer or partnership of a preparer subject to penalty under section 6694(a) is also subject to penalty only if --

(i) One or more members of the principal management (or principal officers) of the firm or a branch office participated in or knew of the conduct proscribed by section 6694(a);

(ii) The employer or partnership failed to provide reasonable and appropriate procedures for review of the position for which the penalty is imposed; or

(iii) Such review procedures were disregarded in the formulation of the advice, or the preparation of the return or claim for refund, that included the position for which the penalty is imposed.

(b) REALISTIC POSSIBILITY OF BEING SUSTAINED ON ITS MERITS -- (1) IN GENERAL. A position is considered to have a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits (realistic possibility standard). In making this determination, the possibility that the position will not be challenged by the Internal Revenue Service (e.g., because the taxpayer's return may not be audited or because the issue may not be raised on audit) is not to be taken into account. The analysis prescribed by section 1.6662-4(d)(3)(ii) for purposes of determining whether substantial authority is present applies for purposes of determining whether the realistic possibility standard is satisfied.

(2) AUTHORITIES. The authorities considered in determining whether a position satisfies the realistic possibility standard are those authorities provided in section 1.6662-4(d)(3)(iii).

(3) EXAMPLES. The provisions of paragraphs (b)(1) and (b)(2) of this section are illustrated by the following examples:

EXAMPLE 1. A new statute is unclear as to whether a certain transaction that a taxpayer has engaged in will result in favorable tax treatment. Prior law, however, supported the taxpayer's position. There are no regulations under the new statute and no authority other than the statutory language and committee reports. The committee reports state that the intent was not to adversely affect transactions similar to the taxpayer's transaction. The taxpayer's position satisfies the realistic possibility standard.

EXAMPLE 2. A taxpayer has engaged in a transaction that is adversely affected by a new statutory provision. Prior law supported a position favorable to the taxpayer. The preparer believes that the new statute is inequitable as applied to the taxpayer's situation. The statutory language is unambiguous as it applies to the transaction (e.g., it applies to all manufacturers and the taxpayer is a manufacturer of widgets). The committee reports do not specifically address the taxpayer's situation. A position contrary to the statute does not satisfy the realistic possibility standard.

EXAMPLE 3. The facts are the same as in Example 2, except the committee reports indicate that Congress did not intend to apply the new statutory provision to the taxpayer's transaction (e.g., to a manufacturer of widgets). Thus, there is a conflict between the general language of the statute, which adversely affects the taxpayer's transaction, and a specific statement in the committee reports that transactions such as the taxpayer's are not adversely affected. A position consistent with either the statute or the committee reports satisfies the realistic possibility standard. However, a position consistent with the committee reports constitutes a disregard of a rule or regulation and, therefore, must be adequately disclosed in order to avoid the section 6694(b) penalty.

EXAMPLE 4. The instructions to an item on a tax form published by the Internal Revenue Service are incorrect and are clearly contrary to the regulations. Before the return is prepared, the Internal Revenue Service publishes an announcement acknowledging the error and providing the correct instruction. Under these facts, a position taken on a return which is consistent with the regulations satisfies the realistic possibility standard. On the other hand, a position taken on a return which is consistent with the incorrect instructions does not satisfy the realistic possibility standard. However, if the preparer relied on the incorrect instructions and was not aware of the announcement or the regulations, the reasonable cause and good faith exception may apply depending on all facts and circumstances. See section 1.6694-2(d).

EXAMPLE 5. A statute is silent as to whether a taxpayer may take a certain position on the taxpayer's 1991 Federal income tax return. Three private letter rulings issued to other taxpayers in 1987 and 1988 support the taxpayer's position. However, proposed regulations issued in 1990 are clearly contrary to the taxpayer's position. After the issuance of the proposed regulations, the earlier private letter rulings cease to be authorities and are not taken into account in determining whether the taxpayer's position satisfies the realistic possibility standard. See section 1.6694-2(b)(2) and section 1.6662-4(d)(3)(iii). The taxpayer's position may or may not satisfy the realistic possibility standard, depending on an analysis of all the relevant authorities.

EXAMPLE 6. In the course of researching whether a particular position has a realistic possibility of being sustained on its merits, a preparer discovers that a taxpayer took the same position on a return several years ago and that the return was audited by the Service. The taxpayer tells the preparer that the revenue agent who conducted the audit was aware of the position and decided that the treatment on the return was correct. The revenue agent's report, however, made no mention of the position. The determination by the revenue agent is not authority for purposes of the realistic possibility standard. However, the preparer's reliance on the revenue agent's determination in the audit may qualify for the reasonable cause and good faith exception depending on all facts and circumstances. See section 1.6694-2(d). Also see section 1.6694-2(b)(4) and section 1.6662-4(d)(3)(iv)(A) regarding affirmative statements in a revenue agent's report.

EXAMPLE 7. In the course of researching whether an interpretation of a phrase incorporated in the Internal Revenue Code has a realistic possibility of being sustained on its merits, a preparer discovers that identical language in the taxing statute of another jurisdiction (e.g., a state or foreign country) has been authoritatively construed by a court of that jurisdiction in a manner which would be favorable to the taxpayer, if the same interpretation were applied to the phrase applicable to the taxpayer's situation. The construction of the statute of the other jurisdiction is not authority for purposes of determining whether the position satisfies the realistic possibility standard. See section 1.6694-2(b)(2) and section 1.6662-4(d)(3)(iii). However, as in the case of conclusions reached in treatises and legal periodicals, the authorities underlying the court's opinion, if relevant to the taxpayer's situation, may give a position favorable to the taxpayer a realistic possibility of being sustained on its merits. See section 1.6694-2(b)(2) and section 1.6662-4(d)(3)(iii).

EXAMPLE 8. In the course of researching whether an interpretation of a statutory phrase has a realistic possibility of being sustained on its merits, a preparer discovers that identical language appearing in another place in the Internal Revenue Code has consistently been interpreted by the courts and by the Service in a manner which would be favorable to the taxpayer, if the same interpretation were applied to the phrase applicable to the taxpayer's situation. No authority has interpreted the phrase applicable to the taxpayer's situation. The interpretations of the identical language are relevant in arriving at a well reasoned construction of the language at issue, but the context in which the language arises also must be taken into account in determining whether the realistic possibility standard is satisfied.

EXAMPLE 9. A new statutory provision is silent on the tax treatment of an item under the provision. However, the committee reports explaining the provision direct the Treasury to issue regulations interpreting the provision in a specified way. No regulations have been issued at the time the preparer must recommend a position on the tax treatment of the item, and no other authorities exist. The position supported by the committee reports satisfies the realistic possibility standard.

(4) WRITTEN DETERMINATIONS. To the extent a position has substantial authority with respect to the taxpayer by virtue of a "written determination" as provided in section 1.6662-4(d)(3)(iv)(A), such position will be considered to satisfy the realistic possibility standard with respect to the taxpayer's preparer for purposes of section 6694(a).

(5) WHEN "REALISTIC POSSIBILITY" DETERMINED. For purposes of this section, the requirement that a position satisfy the realistic possibility standard must be satisfied on the date prescribed by paragraph (b)(5)(i) or (b)(5)(ii) of this section, whichever is applicable.

(i) SIGNING PREPARERS -- (A) In the case of a signing preparer, the relevant date is the date the preparer signs and dates the return or claim for refund.

(B) If the preparer did not date the return or claim for refund, the relevant date is the date the taxpayer signed and dated the return or claim for refund. If the taxpayer also did not date the return or claim for refund, the relevant date is the date the return or claim for refund was filed.

(ii) NONSIGNING PREPARERS. In the case of a nonsigning preparer, the relevant date is the date the preparer provides the advice. That date will be determined based on all the facts and circumstances.

(c) EXCEPTION FOR ADEQUATE DISCLOSURE OF NONFRIVOLOUS POSITIONS -- (1) IN GENERAL. The section 6694(a) penalty will not be imposed on a preparer if the position taken is not frivolous and is adequately disclosed. For an exception to the section 6694(a) penalty for reasonable cause and good faith, see paragraph (d) of this section.

(2) FRIVOLOUS. For purposes of this section, a "frivolous" position with respect to an item is one that is patently improper.

(3) ADEQUATE DISCLOSURE -- (i) SIGNING PREPARERS. In the case of a signing preparer, disclosure of a position that does not satisfy the realistic possibility standard is adequate only if the disclosure is made in accordance with section 1.6662-4(f) (which permits disclosure on a properly completed and filed Form 8275 or 8275-R, as appropriate, or on the return in accordance with an annual revenue procedure).

(ii) NONSINGING PREPARERS. In the case of a nonsigning preparer, disclosure of a position that does not satisfy the realistic possibility standard is adequate if the position is disclosed in accordance with section 1.6662-4(f) (which permits disclosure on a properly completed and filed Form 8275 or 8275-R, as appropriate, or on the return in accordance with an annual revenue procedure). In addition, disclosure of a position is adequate in the case of a nonsigning preparer if, with respect to that position, the preparer complies with the provisions of paragraph (c)(3)(ii)(A) or (B) of this section, whichever is applicable.

(A) ADVICE TO TAXPAYERS. If a nonsigning preparer provides advice to the taxpayer with respect to a position that does not satisfy the realistic possibility standard, disclosure of that position is adequate if the advice includes a statement that the position lacks substantial authority and, therefore, may be subject to penalty under section 6662(d) unless adequately disclosed in the manner provided in section 1.6662-4(f) (or in the case of a tax shelter item, that the position lacks substantial authority and, therefore, may be subject to penalty under section 6662(d) regardless of disclosure). If the advice with respect to the position is in writing, the statement concerning disclosure (or the statement regarding possible penalty under section 6662(d)) also must be in writing. If the advice with respect to the position is oral, advice to the taxpayer concerning the need to disclose (or the advice regarding possible penalty under section 6662(d)) also may be oral. The determination as to whether oral advice as to disclosure (or the oral advice regarding possible penalty under section 6662(d)) was in fact given is based on all facts and circumstances. Contemporaneously prepared documentation of the oral advice regarding disclosure (or the oral advice regarding possible penalty under section 6662(d)) generally is sufficient to establish that the advice was given to the taxpayer.

(B) ADVICE TO ANOTHER PREPARER. If a nonsigning preparer provides advice to another preparer with respect to a position that does not satisfy the realistic possibility standard, disclosure of that position is adequate if the advice includes a statement that disclosure under section 6694(a) is required. If the advice with respect to the position is in writing, the statement concerning disclosure also must be in writing. If the advice with respect to the position is oral, advice to the preparer concerning the need to disclose also may be oral. The determination as to whether oral advice as to disclosure was in fact given is based on all facts and circumstances. Contemporaneously prepared documentation of the oral advice regarding disclosure generally is sufficient to establish that the advice regarding disclosure was given to the other preparer.

(d) EXCEPTION FOR REASONABLE CAUSE AND GOOD FAITH. The penalty under section 6694(a) will not be imposed if considering all the facts and circumstances, it is determined that the understatement was due to reasonable cause and that the preparer acted in good faith. Factors to consider include:

(1) NATURE OF THE ERROR CAUSING THE UNDERSTATEMENT. Whether the error resulted from a provision that was so complex, uncommon, or highly technical that a competent preparer of returns or claims of the type at issue reasonably could have made the error. The reasonable cause and good faith exception does not apply to an error that would have been apparent from a general review of the return or claim for refund by the preparer.

(2) FREQUENCY OF ERRORS. Whether the understatement was the result of an isolated error (such as an inadvertent mathematical or clerical error) rather than a number of errors. Although the reasonable cause and good faith exception generally applies to an isolated error, it does not apply if the isolated error is so obvious, flagrant or material that it should have been discovered during a review of the return or claim. Furthermore, the reasonable cause and good faith exception does not apply if there is a pattern of errors on a return or claim for refund even though any one error, in isolation, would have qualified for the reasonable cause and good faith exception.

(3) MATERIALITY OF ERRORS. Whether the understatement was material in relation to the correct tax liability. The reasonable cause and good faith exception generally applies if the understatement is of a relatively immaterial amount. Nevertheless, even an immaterial understatement may not qualify for the reasonable cause and good faith exception if the error or errors creating the understatement are sufficiently obvious or numerous.

(4) PREPARER'S NORMAL OFFICE PRACTICE. Whether the preparer's normal office practice, when considered together with other facts and circumstances such as the knowledge of the preparer, indicates that the error in question would rarely occur and the normal office practice was followed in preparing the return or claim in question. Such a normal office practice must be a system for promoting accuracy and consistency in the preparation of returns or claims and generally would include, in the case of a signing preparer, checklists, methods for obtaining necessary information from the taxpayer, a review of the prior year's return, and review procedures. Notwithstanding the above, the reasonable cause and good faith exception does not apply if there is a flagrant error on a return or claim for refund, a pattern of errors on a return or claim for refund, or a repetition of the same or similar errors on numerous returns or claims.

(5) RELIANCE ON ADVICE OF ANOTHER PREPARER. Whether the preparer relied on the advice of or schedules prepared by ("advice") another preparer as defined in section 1.6694-1(b). The reasonable cause and good faith exception applies if the preparer relied in good faith on the advice of another preparer (or a person who would be considered a preparer under section 1.6694-1(b) had the advice constituted preparation of a substantial portion of the return or claim for refund) who the preparer had reason to believe was competent to render such advice. A preparer is not considered to have relied in good faith if --

(i) The advice is unreasonable on its face;

(ii) The preparer knew or should have known that the other preparer was not aware of all relevant facts; or

(iii) The preparer knew or should have known (given the nature of the preparer's practice), at the time the return or claim for refund was prepared, that the advice was no longer reliable due to developments in the law since the time the advice was given.

The advice may be written or oral, but in either case the burden of establishing that the advice was received is on the preparer.

(e) BURDEN OF PROOF. In any proceeding with respect to the penalty imposed by section 6694(a), the issues on which the preparer bears the burden of proof include whether --

(1) The preparer knew or reasonably should have known that the questioned position was taken on the return;

(2) There is reasonable cause and good faith with respect to such position; and

(3) The position was disclosed adequately in accordance with paragraph (c) of this section.

SECTION 1.6654-3 PENALTY FOR UNDERSTATEMENT DUE TO WILLFUL, RECKLESS, OR INTENTIONAL CONDUCT.

(a) IN GENERAL -- (1) PROSCRIBED CONDUCT. If any part of an understatement of liability relating to a return of tax under subtitle A of the Internal Revenue Code or claim for refund of tax under subtitle A of the Internal Revenue Code is due to --

(i) A willful attempt in any manner to understate the liability for tax by a preparer of the return or claim for refund; or

(ii) Any reckless or intentional disregard of rules or regulations by any such person,

such preparer is subject to a penalty of $1,000 with respect to such return or claim for refund.

(2) SPECIAL RULE FOR EMPLOYERS AND PARTNERSHIPS. An employer or partnership of a preparer subject to penalty under section 6694(b) is also subject to penalty only if --

(i) one or more members of the principal management (or principal officers) of the firm or a branch office participated in or knew of the conduct proscribed by section 6694(b);

(ii) The employer or partnership failed to provide reasonable and appropriate procedures for review of the position for which the penalty is imposed; or

(iii) Such review procedures were disregarded in the formulation of the advice, or the preparation of the return or claim for refund, that included the position for which the penalty is imposed.

(b) WILLFUL ATTEMPT TO UNDERSTATE LIABILITY. A preparer is considered to have willfully attempted to understate liability if the preparer disregards, in an attempt wrongfully to reduce the tax liability of the taxpayer, information furnished by the taxpayer or other persons. For example, if a preparer disregards information concerning certain items of taxable income furnished by the taxpayer or other persons, the preparer is subject to the penalty. Similarly, if a taxpayer states to a preparer that the taxpayer has only two dependents, and the preparer reports six dependents on the return, the preparer is subject to the penalty.

(c) RECKLESS OR INTENTIONAL DISREGARD -- (1) Except as provided in paragraphs (c)(2) and (c)(3) of this section, a preparer is considered to have recklessly or intentionally disregarded a rule or regulation if the preparer takes a position on the return or claim for refund that is contrary to a rule or regulation (as defined in paragraph (f) of this section) and the preparer knows of, or is reckless in not knowing of, the rule or regulation in question. A preparer is reckless in not knowing of a rule or regulation if the preparer makes little or no effort to determine whether a rule or regulation exists, under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable preparer would observe in the situation.

(2) A preparer is not considered to have recklessly or intentionally disregarded a rule or regulation if the position contrary to the rule or regulation is not frivolous as defined in section 1.6694-2(c)(2), is adequately disclosed in accordance with paragraph (e) of this section and, in the case of a position contrary to a regulation, the position represents a good faith challenge to the validity of the regulation.

(3) In the case of a position contrary to a revenue ruling or notice (other than a notice of proposed rulemaking) published by the Service in the Internal Revenue Bulletin, a preparer also is not considered to have recklessly or intentionally disregarded the ruling or notice if the position has a realistic possibility of being sustained on its merits.

(d) EXAMPLES. The provisions of paragraphs (b) and (c) of this section are illustrated by the following examples:

EXAMPLE 1. A taxpayer provided a preparer with detailed check registers reflecting personal and business expenses. One of the expenses was for domestic help, and this expense was identified as personal on the check register. The preparer knowingly deducted the expenses of the taxpayer's domestic help as wages paid in the taxpayer's business. The preparer is subject to the penalty under section 6694(b).

EXAMPLE 2. A taxpayer provided a preparer with detailed check registers to compute the taxpayer's expenses. However, the preparer knowingly overstated the expenses on the return. After adjustments by the examiner, the tax liability increased significantly. Because the preparer disregarded information provided in the check registers, the preparer is subject to the penalty under section 6694(b).

EXAMPLE 3. A revenue ruling holds that certain expenses incurred in the purchase of a business must be capitalized. The Code is silent as to whether these expenses must be capitalized or may be deducted currently, but several cases from different courts hold that these particular expenses may be deducted currently. There is no other authority. Under these facts, a position taken contrary to the revenue ruling on a return or claim for refund is not a reckless or intentional disregard of a rule, since the position contrary to the revenue ruling has a realistic possibility of being sustained on its merits. Therefore, the preparer will not be subject to a penalty under section 6694(b) even though the position is not adequately disclosed.

EXAMPLE 4. Final regulations provide that certain expenses incurred in the purchase of a business must be capitalized. One Tax Court case has expressly invalidated that portion of the regulations. Under these facts, a position contrary to the regulation will subject the preparer to the section 6694(b) penalty even though the position may have a realistic possibility of being sustained on its merits. However, because the contrary position on these facts represents a good faith challenge to the validity of the regulations, the preparer will not be subject to the section 6694(b) penalty if the position is adequately disclosed in the manner provided in paragraph (e) of this section.

(e) ADEQUATE DISCLOSURE -- (1) SIGNING PREPARERS. In the case of a signing preparer, disclosure of a position that is contrary to a rule or regulation is adequate only if the disclosure is made in accordance with section 1.6662-4(f)(1), (3), (4) and (5) (which permit disclosure on a properly completed and filed Form 8275 or 8275-R, as appropriate). In addition, the disclosure of a position that is contrary to a rule or regulation must adequately identify the rule or regulation being challenged. The provisions of section 1.6662-4(f)(2) (which permit disclosure on the return in accordance with an annual revenue procedure) do not apply for purposes of this section.

(2) NONSIGNING PREPARERS. In the case of a nonsigning preparer, disclosure of a position that is contrary to a rule or regulation is adequate if the position is disclosed in the manner provided in paragraph (e)(l) of this section. In addition, disclosure of a position is adequate in the case of a nonsigning preparer if, with respect to that position, the preparer complies with the provisions of paragraph (e)(2)(i) or (ii) of this section, whichever is applicable.

(i) ADVICE TO TAXPAYERS. In the case of a nonsigning preparer who provides advice to the taxpayer with respect to a position that is contrary to a rule or regulation, disclosure of that position is adequate if the advice includes a statement that --

(A) The position is contrary to a specified rule or regulation and, therefore, is subject to a penalty described in section 6662(c) unless adequately disclosed in the manner provided in section 1.6662-3(c)(2) (which permits disclosure on a properly completed and filed Form 8275 or 8275-R, as appropriate, and which requires adequate identification of any rule or regulation being challenged); and

(B) In the case of a position contrary to a regulation, the position must represent a good faith challenge to the validity of the regulation.

If the advice with respect to the position is in writing, the statement concerning disclosure also must be in writing. If the advice with respect to the position is oral, advice to the taxpayer concerning the need to disclose also may be oral. The determination as to whether oral advice as to disclosure was in fact given is based on all facts and circumstances. Contemporaneously prepared documentation of the oral advice regarding disclosure generally is sufficient to establish that the advice was given to the taxpayer.

(ii) ADVICE TO ANOTHER PREPARER. If a nonsigning preparer provides advice to another preparer with respect to a position that is contrary to a rule or regulation, disclosure of that position is considered adequate if the advice includes a statement that disclosure under section 6654(b) is required. If the advice with respect to the position is in writing, the statement concerning disclosure also must be in writing. If the advice with respect to the position is oral, advice to the preparer concerning the need to disclose also may be oral. The determination as to whether oral advice as to disclosure was in fact given is based on all facts and circumstances. Contemporaneously prepared documentation of the oral advice regarding disclosure generally is sufficient to establish that the advice was given to the other preparer.

(f) RULES OR REGULATIONS. The term "rules or regulations" includes the provisions of the Internal Revenue Code, temporary or final Treasury regulations issued under the Code, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin.

(g) SECTION 6694(B) PENALTY REDUCED BY SECTION 6694(A) PENALTY. The amount of any penalty to which a preparer may be subject under section 6694(b) for a return or claim for refund is $1,000 reduced by any amount assessed and collected against the preparer under section 6694(a) for the same return or claim.

(h) BURDEN OF PROOF. In any proceeding with respect to the penalty imposed by section 6694(b), the Government bears the burden of proof on the issue of whether the preparer willfully attempted to understate the liability for tax. See section 7427. The preparer bears the burden of proof on such other issues as whether --

(1) The preparer recklessly or intentionally disregarded a rule or regulation;

(2) A position contrary to a regulation represents a good faith challenge to the validity of the regulation; and

(3) Disclosure was adequately made in accordance with paragraph (e) of this section.

SECTION 1.6694-4 EXTENSION OF PERIOD OF COLLECTION WHERE PREPARER PAYS 15 PERCENT OF A PENALTY FOR UNDERSTATEMENT OF TAXPAYER'S LIABILITY AND CERTAIN OTHER PROCEDURAL MATTERS.

(a) IN GENERAL -- (1) The Internal Revenue Service will investigate the preparation by a preparer of a return of tax under subtitle A of the Internal Revenue Code or claim for refund of tax under subtitle A of the Internal Revenue Code and will send a report of the examination to the preparer before the assessment of either --

(i) A penalty for understating tax liability due to a position for which there was not a realistic possibility of being sustained on its merits under section 6694(a); or

(ii) A penalty for willful understatement of liability or reckless or intentional disregard of rules or regulations under section 6694(b).

Unless the period of limitations (if any) under section 6696(d) may expire without adequate opportunity for assessment, the Internal Revenue Service will also send, before assessment of either penalty, a 30-day letter to the preparer notifying him of the proposed penalty or penalties and offering an opportunity to the preparer to request further administrative consideration and a final administrative determination by the Internal Revenue Service concerning the assessment. If the preparer then makes a timely request, assessment may not be made until the Internal Revenue Service makes a final administrative determination adverse to the preparer.

(2) If the Internal Revenue Service assesses either of the two penalties described in section 6694(a) and section 6694(b), it will send to the preparer a statement of notice and demand, separate from any notice of a tax deficiency, for payment of the amount assessed.

(3) Within 30 days after the day on which notice and demand of either of the two penalties described in section 6694(a) and section 6694(b) is made against the preparer, the preparer must either --

(i) Pay the entire amount assessed (and may file a claim for refund of the amount paid at any time not later than 3 years after the date of payment); or

(ii) Pay an amount which is not less than 15 percent of the entire amount assessed with respect to each return or claim for refund and file a claim for refund of the amount paid.

(4) If the preparer pays an amount and files a claim for refund under paragraph (a)(3)(ii) of this section, the Internal Revenue Service may not make, begin, or prosecute a levy or proceeding in court for collection of the unpaid remainder of the amount assessed until the later of --

(i) A date which is more than 30 days after the earlier of --

(A) The day on which the preparer's claim for refund is denied; or

(B) The expiration of 6 months after the day on which the preparer filed the claim for refund; and

(ii) Final resolution of any proceeding begun as provided in paragraph (b) of this section.

However, the Internal Revenue Service may counterclaim in any proceeding begun as provided in paragraph (b) of this section for the unpaid remainder of the amount assessed. Final resolution of a proceeding includes any settlement between the Internal Revenue Service and the preparer, any final determination by a court (for which the period for appeal, if any, has expired) and, generally, the types of determinations provided under section 1313(a) (relating to taxpayer deficiencies). Notwithstanding section 7421(a) (relating to suits to restrain assessment or collection), the beginning of a levy or proceeding in court by the Internal Revenue Service in contravention of this paragraph (a)(4) may be enjoined by a proceeding in the proper court.

(b) PREPARER MUST BRING SUIT IN DISTRICT COURT TO DETERMINE LIABILITY FOR PENALTY. If, within 30 days after the earlier of --

(1) The day on which the preparer's claim for refund filed under paragraph (a)(3)(ii) of this section is denied; or

(2) The expiration of 6 months after the day on which the preparer filed the claim for refund,

the preparer fails to begin a proceeding for refund in the appropriate United States district court, the Internal Revenue Service may proceed with collection of the amount of the penalty not paid under paragraph (a)(3)(ii) of this section.

(c) SUSPENSION OF RUNNING OF PERIOD OF LIMITATIONS ON COLLECTION. The running of the period of limitations provided in section 6502 on the collection by levy or by a proceeding in court of the unpaid amount of a penalty or penalties described in section 6694(a) or section 6694(b) is suspended for the period during which the Internal Revenue Service, under paragraph (a)(4) of this section, may not collect the unpaid amount of the penalty or penalties by levy or a proceeding in court.

(d) EFFECTIVE DATE. The provisions of this section are effective as of December 19, 1989.

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority for part 602 continues to read as follows:

Authority: (26 U.S.C. 7805)

Par. 4. Sections 602.101(c) is amended by adding the following in the table:

Section 1.6694-2(c). . . . . . . 1545-1231

Section 1.6694-3(e). . . . . . . 1545-1231