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The IRS Has A New Weapon: Your Tax Pro

The IRS Has A New Weapon: Your Tax Pro

As a result, some taxpayers who try to get their preparer to sign a return may need to provide more documentation than in the past to support aggressive tax positions. In some cases, fees could go up as preparers need to do more research on complex or blurry tax rules. And some accountants expect a few clients will shop around for a more amenable tax pro willing to agree to what the client wants.

Paid preparers -- from certified public accountants and lawyers to storefront operations -- handle more than half of all individual income-tax returns, and an even greater percentage of those filed by high-income taxpayers. Fees can range from a couple of hundred dollars for a simple return, to thousands of dollars for complex cases.

The new law, enacted in May as part of wide-ranging legislation that included funding for the Iraq war, reflects efforts by Congress to narrow the nation's tax gap, or the amount of taxes believed to go unpaid each year. IRS researchers have estimated the tax gap at about $290 billion. The basic idea for the new law came from Congress, and senior IRS officials were surprised by its enactment. An IRS spokesman in Washington declined to comment on the new law.

"It's politically unacceptable to put more agents on the street or increase the IRS's budget," says Cono Namorato, a former IRS official and now a Washington lawyer at Caplin & Drysdale. Thus, the new law represents "an attempt to deputize" more tax practitioners by "holding them to a higher standard."

Tax preparers have long faced possible penalties for signing questionable returns without specifically disclosing the tax positions in question. But the new law raises the standards considerably, and sharply boosts penalties to $1,000, or half the preparer's total fee, whichever is larger. Fines for preparers showing "willful or reckless conduct" are much higher still.

Tax preparers can sign returns with questionable tax positions if those positions are disclosed, typically using IRS Form 8275. But some clients may object to filing the form, fearing it could raise red flags at the IRS. "We will be using far more Form 8275 disclosures with returns, and I'm not sure how clients will react," says Claudia Hill, the owner of Tax Mam, a tax-services firm in Cupertino, Calif.

Many accountants claim the new law is unfair since it applies higher standards to return preparers than to taxpayers. This could put the two parties at odds.

Ms. Hill says she recently spent three hours with a new client who had asked her to review two years of returns he had prepared for himself. "There were three obvious issues he had taken" that could raise questions, Ms. Hill says. When she explained the new law, "he quickly figured out that I could not prepare his returns taking those aggressive positions without full disclosure," but that he could do so on his own.

Ms. Hill says she is now considering the client's request to engage her merely to "consult" on his returns, not to prepare them. "I have to figure out at what point advice I give about a return becomes 'return preparation,'" she says.

Congress made the law effective in May. But the IRS recently said the new standards typically will apply to returns filed starting next year, thus effectively exempting 2006 returns that have received filing extensions. Still, the new law generally is in effect for advice that preparers give today to clients for returns filed next year.

Tax advisers are particularly concerned about conversations with clients over gray areas of the law, such as issues where federal courts have issued contradictory rulings on the same subject. For example, can a trust or estate fully deduct investment advisory fees? One federal appeals court has said yes. Three others have said no.

Under the old law, a preparer in a court circuit that hasn't yet issued a ruling on the subject could have argued there was a "realistic possibility" of success -- the previous standard for a preparer to sign off on a tax return -- since one federal appeals court had ruled that way. But can that same preparer do so under the new law, which requires a preparer to have a "reasonable belief" that an undisclosed tax position was "more likely than not" to be the correct treatment?

No, several tax advisers say. Mr. Namorato says that if a client came to him seeking advice on that issue, "I would advise him not to take the position without disclosure." The U.S. Supreme Court recently agreed to hear a case on this subject, a very important issue in the high-stakes world of estate and gift taxation.

Researching whether arcane tax strategies meet the higher standard will likely push up some tax-return preparation fees next year, especially for thorny questions on which the IRS hasn't published any guidance, accountants say. "Fees in many cases will increase, particularly where you have the more complex situations and complex transactions," says Stephen R. Buschel, a certified public accountant and tax partner at BDO Seidman LLP in New York City. He says the law is too new to estimate how much fees might go up.

Preparers will have to "exercise more care in evaluating issues to ensure they are accurate in amount and technical merit before they report it on a tax return," says an aide to Senate Finance Committee Chairman Max Baucus (D., Mont.). "Preparers are tax professionals, and it is reasonable to expect that they believe an item they place on a taxpayer's tax return has at least 50% odds of being correct," he says.

Another highly complex issue that taxpayers might find themselves questioned about is whether a family limited partnership has been set up correctly, based on IRS rules and a long series of court decisions. These partnerships are a popular technique used to slash estate and gift taxes. Typically, they involve transferring assets into a partnership that includes someone's heirs. The IRS has attacked what it considers misuses of the strategy.

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