Ethical Considerations for Tax Professionals: Standards and Penalties for Tax Positions

When tax professionals prepare a tax return, they are typically aiming for the return to be correct “beyond a reasonable doubt.” However, this is hardly a black-and-white matter. In the eyes of tax law, the reality is that almost nothing can be dubbed “always correct” or “always incorrect.” Rather, tax professionals must learn to navigate a world of gray. One illustrative example is a court case that determined 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 somewhere.

For guidance on ethical practice before the IRS, tax professionals can refer to Circular 230, which is generally applicable to attorneys, CPAs, and enrolled agents. Circular 230 says that all positions on tax returns must have a reasonable basis in the law and be disclosed adequately. This is actually a lower standard than some may assume. Within the hierarchy of standards, there are five different levels:

  1. More likely than not
  2. Substantial authority
  3. Reasonable basis
  4. Not frivolous
  5. Frivolous

In a tax court, a position has to qualify at the highest level of “more likely than not” to win in most court cases. “More likely than not” ties into the concept of “preponderance of evidence,” which requires that your position have a more than 50% likelihood of being true based on authoritative evidence.

The next highest level is “substantial authority,” which is outlined in this official definition: “The weight of the authorities supporting the position you took is substantial in relation to the weight of the authority supporting contrary treatment.” 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 more than merely arguable. Rather, your position must 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

The authorities included on this list are still expanding. For example, the IRS has been increasing its use of website “Frequently Asked Questions” (FAQs) related to new tax laws. Previously, FAQs did not constitute authority for penalty protection. However, the IRS recently announced that all FAQs of significance posted on the IRS 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.

Notably, 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 still met your ethical obligation and are unlikely to be subject to a penalty. This is true for both the taxpayer and the tax preparer.

If your position is submitted to the IRS, the standard is that it cannot be deemed “frivolous.” A tax practitioner cannot advise a client to 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. Tax professionals will therefore want to ensure any positions taken on a return have a reasonable basis and are disclosed adequately.

To sharpen your knowledge of standards and penalties for tax positions, enroll now to become a Certified Tax Planner.

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