AICPA Submits Statement on Closing Tax Gap

The AICPA is the national, professional organization of certified public accountants comprised of approximately 330,000 members. Our members advise clients on federal, state, and international tax matters and prepare income and other tax returns for millions of Americans. They provide services to individuals, not-for-profit organizations, and small and medium-sized businesses, as well as America's largest businesses.

The AICPA notes the Senate Finance Committee's significant work on tax administration and tax gap initiatives, particularly the measures contained in last year's committee bill (S. 1321), the Telephone Excise Tax Repeal and Taxpayer Protection and Assistance Act of 2006. And, we acknowledge that the Finance Committee has continued these efforts in 2007 through hearings and legislation, including (H.R. 2) the Small Business and Work Opportunity Act.¹

The AICPA would be pleased to share our views with the Finance Committee at any time on any of the tax administration provisions contained in S. 1321 or in bills currently pending in the Senate (like H.R. 2). At this time, we are providing comments on 5 provisions contained in S. 1321: (1) the understatement of taxpayer's liability by tax return preparers; (2) the penalty for aiding and abetting the understatement of tax liability; (3) the doubling of certain penalties, fines, and interest on underpayments relating to certain offshore financial arrangements; and (4) two proposals involving Internal Revenue Code sections 6713 and 7216.

Tax Penalties and the Tax Gap

A number of legislative proposals involving tax penalties are being raised in 2007 under the guise of closing the tax gap. Similarly, numerous proposals contained in S. 1321 involve tax penalties; and such proposals are beginning to resurface as tax gap initiatives. In this context, we are concerned that many of these penalty proposals are being raised by Congress and the Administration in a narrow, rifle-shot perspective. Instead, we believe greater levels of tax compliance could be achieved among the public if Congress established a legislative oversight process similar to that which was used to enact the Improved Penalty Administration and Compliance Tax Act, which ultimately became law as part of the Omnibus Budget and Reconciliation Act of 1989. The fundamental purpose of the 1989 penalty reform was to overcome the piecemeal approach to legislating penalty changes.

In our opinion, establishing a broad legislative oversight (penalty) review process would not only achieve higher levels of tax compliance, but should also result in greater numbers of taxpayers believing that tax fairness has been achieved. This is consistent with a 2006 statement by J. Russell George, Treasury Inspector General for Tax Administration (TIGTA), that ". . . it is often difficult to ascertain whether a taxpayer has intentionally evaded taxes, or whether there was an honest misunderstanding. Therefore, the IRS use of punitive penalties must be tempered to ensure taxpayers are not penalized for honest misunderstandings." ²

Prior to the passage of the 1989 tax penalty reforms, penalties were seen by taxpayers and tax professionals as (1) an IRS tool for punishing taxpayers and a bargaining chip in examinations and (2) a means of raising revenues for the U.S. Treasury. Before 1989, penalties were also viewed as being applied unevenly in differing regions of the U.S., as well as lacking in coordination and overlapping in application.³ Representative J.J. Pickle, one of the main proponents of penalty reform at the time, viewed the 1989 reform measures as fairer and less complex than the current penalty regime, and an inherent extension of tax reform and simplification.⁴

1. Understatement of Taxpayer's Liability by Tax Return Preparers (S. 1321, Section 407)

The bill makes a number of modifications to the tax return preparer penalties under sections 6694 and 6695 of the Internal Revenue Code. Under this proposal, the scope of present law preparer penalties are broadened to cover the preparation of estate and gift tax, employment tax, excise tax, and exempt organization returns. The AICPA supports this extension in the scope of the preparer penalties and believes such penalty expansions should increase tax compliance.

The standards of conduct for avoiding imposition of the penalties for preparing a return with respect to an understatement of tax are also altered under the proposal. First, the current law realistic possibility standard for undisclosed positions is replaced with a requirement that the preparer have a reasonable belief that a potential position to be taken on a return is more likely than not the proper treatment. For disclosed positions, the provision replaces the non-frivolous standard with the requirement that there be a reasonable basis for the tax treatment of the position. Further the bill imposes a penalty on a tax return preparer for the portion of a claim for refund or credit that is disallowed if there is no reasonable basis for the disallowed portion of such claim for refund or credit.

We think this shift in the standards of conduct is unwise and thus, we do not support the shift. For an undisclosed position on a return, the AIPCA believes that the tax return preparer should have a good faith belief that the tax return position being recommended has a realistic possibility of being sustained administratively or judicially on its merits, rather than the higher "more likely than not" standard. In general, under this standard, the preparer should have a good faith belief that the taxpayer's position is warranted by existing law or can be supported by a good faith argument.

The AICPA is concerned that elevating the reporting standard for tax return preparers on all return items to the very highest standard that now is imposed only on tax shelter items -- the "more likely than not" standard -- would ultimately become an unworkable burden for the entire tax system. This elevation would not necessarily create the desired result of weeding out abuses in the system but would create the unintended consequence of encouraging tax return preparers to recommend that taxpayers consider filing disclosures on virtually any return item on which there is the slightest question of uncertainty in the ultimate tax result. Clearly, this is not a desired outcome, nor is it likely to focus attention on potentially abusive tax avoidance transactions. The IRS would be swamped with paper; e-filing would be undermined; important disclosures would be overlooked; and a large percent of these voluminous disclosures would be meaningless.⁵

We do not believe that a change in the preparer standard for routine transactions is warranted. In a self-assessment system such as ours, taxpayers are expected to report their transactions in accordance with the rules prescribed by the income tax laws. However, given the complexity of our tax laws and the many issues awaiting administrative guidance from the Treasury Department and the IRS, Congress has wisely built flexibility into the system to allow for reasonable interpretations of the law's many gray areas without the threat of having penalties imposed where such interpretations are challenged by the IRS and tax deficiencies assessed.

The current notion that the taxpayer should bear ultimate responsibility for the contents of the tax return is the proper rule, since we believe the preparer is generally not in the position to determine the correctness or completeness of all information being placed on the return. This is consistent with Circular 230, section 10.34(c) which states "A practitioner advising a client to take a position on a return, or preparing or signing a tax return as a preparer, generally may rely in good faith without verification upon information furnished by the client." [Emphasis added.]

The AICPA also has serious concerns about replacing the current non-frivolous standard for a disclosed position on a return with the requirement that there be a reasonable basis for the tax position. As long as a position is not advanced in bad faith or improper, i.e. the position is not frivolous, a preparer should generally be able to prepare and sign a return as long as the position is appropriately disclosed on the return.

The Federal tax law is always changing and as a result, there is often limited or no authority or guidance for a particular return position at the time the return is filed. Even if there is some authority, it may be extremely difficult for taxpayers and preparers to know the probable correctness of many return positions given the exceedingly complex and dynamic nature of the tax law.

It is not only unrealistic, but in many cases impossible, to ensure the high degree of accuracy required should Congress pass legislation imposing a "more likely than not standard" on preparers in the case of undisclosed positions or even a "realistic possibility of success" standard for disclosed positions. We believe that the unfortunate result will be that taxpayers will be forced to avoid otherwise meritorious positions on their returns or make voluminous boilerplate disclosures that will not improve the overall compliance process.

We would also like to point out a troubling anomaly under the proposal. If these changes are enacted, the tax return preparer's reporting standard would exceed the taxpayer's reporting standard (substantial authority) for most transactions. As a result, a tax return preparer could be subject to a section 6694 penalty even though the taxpayer was not penalized. Historically, the preparer standard has been below that of the taxpayer in order to provide an environment where taxpayers have access to the full range of competent, professional advice necessary to navigate through a very complicated tax system. Elevating the preparer standard above the taxpayer standard, particularly for routine transactions, is quite troubling in that the preparer could not sign a tax return reflecting a position that would be proper if the taxpayer prepared the tax return without professional assistance.

Additionally, the bill increases the section 6694(a) penalty (understatements due to unrealistic positions) from $250 to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer from the preparation of a return or claim with respect to which the penalty is imposed. Moreover, the legislation increases the section 6694(b) penalty (willful and reckless conduct) from $1,000 to the greater of $5,000 or 50 percent of the income derived (or to be derived) by the tax preparer. Based on the lack of empirical evidence indicating that the current flat-dollar penalty is not effective, we do not support the proposed increases in these two section 6694 preparer penalties. Rather we support retaining the two-tier, flat dollar penalty under current law. We believe that deterrence for preparers results, not from a dollar penalty, but from the possible adverse impact on the ability to practice and on their reputation for integrity and ethical behavior.

2. Penalty for Aiding and Abetting the Understatement of Tax Liability (S. 1321, Section 408)

This proposal expands the scope of the section 6701 "aiding and abetting" penalty. In general, the proposal applies the penalty: (1) to aiding and abetting that occurs with respect to a tax liability reflected in a tax return and (2) for each instance of aiding and abetting; and (3) it increases the amount of the penalty to a maximum of 100 percent of the gross income derived (or to be derived) from the aiding and abetting. The AICPA is not opposed to these modifications in the penalty as we believe the modifications should encourage an increase in tax compliance and will likely act as an economic deterrence for persons susceptible to wrong-doing.

The provision also states that if more than one person is liable for the penalty, all such persons will be jointly and severally liable for the penalty. As a general proposition, we do not have a problem with the imposition of joint and several liability on persons subject to the section 6701 penalty. However, we believe the legislative language should be clarified with respect to the impact of joint and several liability on members of professional firms that are organized as a limited liability company, S corporation, or a partnership. As currently drafted, the language is not clear as to whether (under certain circumstances) all members of a professional firm could be determined to be liable for the penalty without regard to their actual conduct or knowledge. We recommend that the legislation clarify that: (1) the members of a firm who have little or no knowledge of the advice or transactions in question are not subject to joint and several liability under the penalty and (2) the penalty should not be treated as a simple firm (entity) debt such that all members of the firm would be liable for the debt.

3. Doubling of Certain Penalties, Fines, and Interest on Underpayments Related to Certain Offshore Financial Arrangements (S. 1321, Section 410)

This proposal is intended to stem the promotion of, and participation in, certain abusive offshore financial arrangements by both individuals and corporations. The provision doubles the amount of civil penalties, interest, and fines related to a taxpayer's underpayment of U.S. income tax liability through the direct or indirect use of certain offshore financial arrangements.

The AICPA is very supportive of legislative efforts to stem the use of abusive tax schemes and the imposition of sanctions to encourage and accomplish this goal. However, we offer the following comments with regard to this proposal; a provision that is also found in section 208 of S. 349, the Small Business and Work Opportunity Act of 2007.

This proposal provides that penalties arising from these transactions shall be imposed without regard to the reasonable cause relief provisions under current Code section 6664. In effect, the provision imposes a strict and absolute penalty. An exception to this strict liability concept is available if it is determined that the use of such offshore payment mechanisms is incidental to the transaction and, in addition, in the case of a trade or business, such use is conducted in the ordinary course of the type of trade or business of the taxpayer.

As a fundamental principle, the AICPA is opposed to strict liability penalties because such penalties are unduly harsh and don't allow for an abatement due to reasonable cause (such as to reflect a taxpayer's inadvertent actions). We believe that taxpayers may become involved in transactions that they do not envision as abusive. At the same time, the IRS may determine that these same transactions fall outside of the taxpayer's "ordinary course" of business and are considered abusive. In such situations, the imposition of a strict liability penalty may not necessarily result in the desired outcome of stemming the participation in abusive schemes. We believe that fairness and effective tax administration require the IRS to retain discretion in assessing this penalty. This discretion should provide for a more reasonable and effective implementation of the proposal and protect taxpayers who may have made an inadvertent error.

Section 410(a)(2)(A)(i)(II) defines transactions as including "any offshore financial arrangement (including any arrangement with foreign banks, financial institutions, corporations, partnerships, trusts, or other entities)." The breath of this language appears to reach beyond the identified abuse of unreported income in offshore financial accounts accessed through credit or debit cards or other financial arrangements in order to avoid or evade Federal income tax. Accordingly, the definition of "offshore financial arrangement" is a critical issue under the proposal; and thus, the term should be further clarified so as not to be overly broad. The breadth of the current language ought to make Congress very reluctant to prescribe a "strict liability" penalty regime which eliminates a taxpayer's right, in the context of a reasonable cause showing, to demonstrate that its conduct and/or the transaction was not abusive.

4. Internal Revenue Code Sections 6713 and 7216

Background

The legislative proposals addressed below are in some significant respects more restrictive and potentially problematic than those contained in the proposed IRS regulations.⁶ The AICPA submitted extensive comments on the proposed regulations on March 8, 2006 and urged the IRS to further engage the professional tax advisor community before finalizing the regulations. We similarly urge Congress to seek input from advisors and taxpayers alike on the practical impacts and, in many cases, impediments associated with the legislative proposals in S. 1321.

In particular we encourage Congress to carefully evaluate the wisdom of regulating the disclosure arena through the vehicle of criminal sanctions. In our view a civil penalty regime is a more effective way to encourage compliance and influence behavior. Civil penalties provide the IRS with an opportunity to modulate its reaction to account for inadvertent, and/or isolated incidents of noncompliance. One possible alternative would be to look to Internal Revenue Code section 6713 as the home for the general rules in this area while reserving Code section 7216 to address preparer behavior that would satisfy the "knowing or reckless" standards that are required to justify criminal sanctions.

a. Expanded Definition of Return Preparer for Purposes of Sections 6713 and 7216 (S. 1321, Section 511)

For purposes of sections 6713 and 7216, the provision replaces the current definition of tax return preparer with a broader definition. First, the definition is expanded to generally include the preparation of all types of tax returns, instead of to just income tax returns. Second, the definition is expanded to include any person who assists in preparing tax returns for compensation or holds himself out as preparing or assisting in the preparation of returns, regardless of whether preparation is the person's sole business activity or whether a fee is charged for the return preparation. Third, the provision expands the definition of tax return preparer to include (among others): (1) persons who develop tax software; (2) electronic return originators (EROs); and (3) contractors who perform services in connection with return preparation.

The AICPA agrees that it is appropriate to bring all types of federal tax returns within the scope of the return preparation definition. We also agree that it is appropriate for the return preparation definitions to acknowledge and encompass the roles played by those associated with tax return software development and deployment as well as other third party service providers who are associated with return preparation. Thus, we believe the expanded definitions are appropriate. We are concerned, however, that an expanded definition of the term "tax return preparer" for purposes sections 6713 and 7216 might cause confusion with definition of tax return preparer under other Tax Code sections. Accordingly, we suggest that the drafters of the legislation consider using a different term for parties subject to the disclosure rules of sections 6713 and 7216.

b. Restrict the Use and Disclosure of Taxpayer Information by Return Preparers for Non-Tax Purposes and Offshore Disclosures (S. 1321, Section 512)

Overall, we believe this provision introduces unnecessary burden and complexity that is at odds with well established modern business practices. Furthermore, we are concerned the proposal has the potential to actually undermine the range and quality of professional tax services available to many taxpayers. We understand the Congressional concerns that emanate from instances in which unscrupulous or unethical return preparers have abused their access to tax return information and the AICPA remains resolute in its commitment to the privacy of taxpayers' return information. However, if this proposal were to pass in its current form, it would reverberate well beyond the offensive conduct at which it is aimed and negatively impact the fundamental relationships between taxpayers and their chosen professional advisors.

Disclosure for Non-tax Purposes

Under the proposal, a taxpayer may not consent to have its tax advisor use or disclose return information for a purpose other than return preparation. This is a highly unusual, if not unprecedented, restraint on taxpayer judgment and choice. In the name of stamping out the potential for some range of abusive use or disclosure, the provision outlaws a wide spectrum of normal, informed and ethical practices that have long been at the heart of the professional relationships between many taxpayers and their tax advisors. Advisors are often engaged by clients precisely because of the breadth of skills and services they and their firms are capable of providing. Reg. section 301.7216-2(e)(1) generally permits the disclosure of use of tax return information by attorneys and accountants "without [the] formal consent of the taxpayer" when such information is disclosed to another member of the preparer's firm for purposes of rendering other legal or accounting services to the taxpayer; that is, services that are other than the preparation of the tax return. This regulation section also states that in "the normal course of rendering" legal or accounting services for the taxpayer, the attorney or accountant may make the tax return information available to third parties "with the express or implied consent of the taxpayer." For example, the tax return information may generally be provided by the tax preparer to another professional in the accounting firm or to a third party in order to (1) render estate planning, financial planning, or investment services to the client, (2) respond to requests from lenders to the client's family or business, or (3) to provide a client's stockholders or management with appropriate financial information.

This is a long established and well founded rule. We believe that taxpayers who select an attorney or accountant as a return preparer often do so because they expect the attorney or accountant to act upon the information obtained during return preparation to ensure that the client is properly advised with respect to specific return positions as well as other aspects of the client's tax planning and compliance needs, including the client's business and personal financial affairs. To legislate away a taxpayer's right to authorize a trusted advisor to use or disclose tax return information, regardless of the taxpayer's needs, desires and willingness to provide such informed consent, can result in the taxpayer being under-served by its current advisors or forced to go through the expense and inconvenience of engaging tax advisors who play no role in return preparation. Clearly this cannot be the public policy result that best serves either taxpayers or the tax system as a whole.

We suggest that the proposal be modified to acknowledge the reality that CPAs and attorneys are already subject to a higher level of ethical standards. As an example, the AICPA Statements on Standards of Tax Services (SSTS) lay out in explicit detail the obligations that are incumbent on the CPA/return preparer. We urge the committee to acknowledge the reality of the professional expectations and duties that underpin the relationships between taxpayers and their lawyers and accountants. In that context we believe taxpayers should not be denied the ability to consent to their advisors use and disclosure of tax return information.

Offshore Disclosure

The legislative proposal would preclude the disclosure or use of information to or by any tax return preparer located outside of the United States unless the taxpayer grants explicit consent to such disclosure. The proposal further specifies the type of consent required to authorize such a disclosure. This proposal tracks proposed IRS regulations insofar as it calls for taxpayers to be informed by an explicit consent that would employ conspicuous language which, among other things, informed clients their information will be disclosed/located outside the U.S. and that federal law may not protect the taxpayer from unauthorized use. This proposal would require taxpayers and advisors to employ the same consent regime regardless of the nature of the disclosure or use involved. As an example, it would treat disclosures and use among and between affiliated firms or to trusted international third parties the same as disclosures made to totally unknown or unrelated parties.

While the Institute recognizes the special issues and sensitivity that potentially accrue to the international movement of return information we do not believe the proposal adequately recognizes the world within which modern accounting and legal advice is rendered. Our clients operate and have employees and interests all over the world. Any regulation of the movement of tax information should acknowledge and be in step with the best global business practices of our clients and the tax advisory profession. At the very time in which the capital markets and policy makers call for additional transparency in financial reporting, a consent regime like that inherent in this proposal will unnecessarily complicate the process by which professionals and their multinational clients provide and receive crucial financial reporting advice.

The current proposal is significantly out of step with the roles that many accounting firms currently perform for their multinational business clients. Most business clients consciously choose advisors who are able to provide multinational services. It is very typical for a tax professional located in the U.S. working on the tax return of a U.S. or non-U.S. multinational company with offices in the United States and overseas, to consult with a tax professional located overseas in order to properly complete the company's tax return. In such a circumstance it would seem counterproductive to require specific consents --- complete with their warnings that information may not be able to be protected --- in order to essentially place the advisor in a position to do the job it was engaged to do. Given the additional interplay among and between audit and tax firms who are called upon to advise their clients in such areas as the implementation of FIN 48, any artificial wall built at the country's edge can only make it more difficult for firms to efficiently serve their multi-national clients.

The proposed legislation will also negatively impact on the processes by which the thousands of U.S. expatriates stationed around the world employed by U.S. and non-U.S. multinational companies, and an ever growing number of foreigners employed in the United States, are served. These taxpayers often have very complex tax filing requirements in their host countries and in the United States. To assist them in meeting their various tax filing obligations, multinational employers typically employ a U.S. based CPA firm to prepare tax returns for their employees for each jurisdiction. U.S. based firms are familiar with U.S. laws and regulations and are subject to the jurisdiction of the IRS and the U.S. courts. At the same time, U.S. based tax practitioners are generally not familiar with the preparation of foreign tax returns for their expatriate clients, and may frequently find themselves expected by their clients to ensure that the foreign firm has the necessary return information to ensure the employee files an accurate return.

There are two other aspects of the proposal that we believe are problematic and noteworthy. First, the limitations on disclosure -- including the proposed approaches to consent -- do not recognize or adequately reflect the various forms under which large accounting and legal firms are organized in today's global market. Second, that part of the proposal that relates to the form of the required consents for international disclosure creates a significant misimpression. The proposal would require that clients be warned in a way that could suggest the advisor has no responsibility or recourse for wrongful disclosures. In fact firms with global capabilities have adopted an entire range of sophisticated business protocols to ensure that they can enforce a broad spectrum of information security-related contractual obligations and duties.

The proposal appears more designed to address, at least in part, the concerns of those who want to prevent outsourcing of U.S. jobs. Even with respect to such concerns, it should be noted that, unlike other circumstances in which jobs are located abroad primarily to reduce labor costs, many accounting firms employ international resources because of staffing challenges in the U.S. The return preparation business has long been confronted by intense workload compression issues that derive from the peak-season nature of their business. A law that constructs artificial barriers to the use of international resources to augment domestic return preparation capabilities will make it difficult for some advisors to meet the needs of their current clients.

Alternative Approaches

For purposes of the disclosure or use of tax return information by tax preparers involving multinationals and employees on overseas assignments, we recommend that the tax preparer (or advisor) use an engagement letter that would: (a) explicitly identify the extent to which tax information may go offshore during the preparation/consultation process, (b) require some form of specific acknowledgement within the engagement letter that affirms the client's understanding that its information may leave the country, and (c) a statement on the part of the accountant as to its ethical and legal responsibility to reasonably ensure that no unauthorized disclosure occurs.

As a point of reference, the AICPA has adopted three ethics rulings which address a member's responsibilities when utilizing services of a third-party service provider. In general, a third-party service provider is defined as any entity that an AICPA member individually or collectively with his firm, does not control and any individual who is not employed by the CPA member or his firm. Accordingly, the AICPA standards apply to all independent contractors used by the firm; regardless of whether the contractor is situated within the United States or overseas.

Our ethics ruling under Rule 102, Integrity and Objectivity, of the AICPA Code of Professional Conduct requires that, prior to sharing confidential client information (such as a tax return) with a third-party service provider, the AICPA member must inform the client, preferably in writing, that he or she may be using a third-party service provider when providing professional services to the client. In addition, our ethics ruling under Rule 201, General Standards, and Rule 202, Compliance With Standards, states the AICPA's longstanding belief that members who use third-party service providers in providing professional services to clients remain responsible for the work performed by the service provider.

² Statement of the Honorable J. Russell George, Treasury Inspector General for Tax Administration, on "A Closer Look at the Size and Sources of the Tax Gap, Before the Senate Finance Committee, Subcommittee on Taxation and IRS Oversight, July 26, 2006; see document section entitled, "Reduce the Complexity of the Code."

³ "Tax Politics and a New Substantial Understatement Penalty," by Dennis J. Ventry, Jr., Tax Notes Today, October 3, 2006.

⁴ Ibid.

⁵ See "IRS Seeing Overdisclosure of Reportable Transactions, Officials Say," by Crystal Tandon, Tax Notes Today, October 12, 2006.

⁶ See proposed amendments to the regulations under Section 7216 of the Internal Revenue Code, Federal Register Volume 70, Number 235, December 8 , 2005, page 72954.