One of the many benefits of working with a tax professional is the guidance they provide in developing tax return positions that substantiate why certain income qualifies for tax-exemption or why you are eligible for a certain tax deduction. When tax professionals prepare a tax return, they are typically aiming for the return to be correct “beyond a reasonable doubt.” Taxpayers may assume this is a black-and-white matter—but when it comes to tax planning, almost nothing can be dubbed “always correct” or “always incorrect.
For example, one popularly-cited court case determined that the taxpayer’s clarinet lessons were deductible as a medical expense because the lessons were prescribed by a doctor to correct an overbite. While in the vast majority of cases, a tax advisor can confidently say clarinet lessons are not tax-deductible, this ruling goes to show that there is often an exception.
For guidance on ethical practice before the IRS, tax professionals turn to Circular 230. This publication by the Treasury Department is used by certified public accountants (CPAs), attorneys, and enrolled agents. The regulations outlined there provide tax professionals with information on what is considered a viable tax position and what is likely to incur a penalty.
Circular 230 states that all positions on tax returns need to have a reasonable basis in the law and be disclosed adequately. This is actually a lower standard than some may assume. In the tax law hierarchy of standards, there are five different levels:
- More likely than not
- Substantial authority
- Reasonable basis
- Not frivolous
- Frivolous
In tax court, a position has to qualify as “more likely than not” to win most cases. What this means is that your return position has a more than 50% likelihood of being true (also referred to as a “preponderance of evidence”).
The next highest level is “substantial authority.” If you imagine a scale, you would weigh the things in favor of your position on one side and weigh the things against your position on the other side. If the side in favor substantially outweighs the side against, you have substantial authority. This means that based on your research, your position appeared legitimate. Substantial authority is often estimated as a 40% or higher chance that your claim is true.
The required level of authority—reasonable basis—is even lower than this, often estimated at a 25% chance of being upheld. To have a reasonable basis, the law says that your return position needs to be “reasonably based” on one or more tax authorities such as:
- Internal Revenue Code
- Treasury Regulations
- Revenue Rulings and Procedures
- Tax Treaties
- Court Cases
- Congressional Intent via Committee Reports
- Private Letter Rulings
- Actions on Decisions and General Counsel Memorandum
- IRS announcements and notices
- IRS press releases
In addition to the above list, the IRS has been increasing its use of website “Frequently Asked Questions” (FAQs) related to new tax laws. Previously, FAQs were not considered authoritative enough to protect the taxpayer from penalties. However, the IRS recently announced that all FAQs of significance posted on their website will now be attached to an IRS press release as a fact sheet. Because IRS press releases count as a reasonable authority, the FAQs fact sheet can also be relied on as an authority for return positions.
Even if a tax court ultimately rules that your return position is not allowed, as long as your position has a reasonable basis in the law (or meets a higher standard), you have met your legal obligation and are unlikely to be subject to a penalty. If your position is submitted to the IRS, the standard is that it cannot be deemed “frivolous.” A taxpayer cannot submit a document simply to delay tax administration, that demonstrates intentional disregard of a rule, or that is otherwise frivolous and not based on guidance from a reasonable authority. If a position is deemed frivolous, both the taxpayer and the tax preparer can be penalized.
To receive expert guidance on developing substantial tax positions and avoiding penalties, enlist the help of a Certified Tax Planner today.
