1. © 2007 Cleary Gottlieb Steen & Hamilton LLP. All rights reserved. Developments in Tax Penalties: Help or Hinderence to Administribility? William McRae Monday, June 15, 2007

2. 2 I. Amendments to Preparer Penalties Section 6694  Amended under the “Small Business and Work Opportunity Act of 2007.”  Enacted on May 25, 2007, and effective for all tax returns prepared after the date of enactment, except that the IRS has granted transitional relief for 2007 (Notice 2007-54).  The Amendments change: The standards that apply for penalties The amount of fines The returns covered by section 6694 (no longer just income tax returns)

3. 3 II. Changes to General Standards  Pre-amendment, section 6694(a) applied to cases where: “any part of any understatement of liability with respect to any [income tax] return or claim for refund is due to a position for which there was not a realistic possibility of being sustained on its merits,” “any person who is an income tax return preparer with respect to such return or claim knew (or reasonably should have known) of such position”; and such position was not disclosed or was frivolous. exception where “reasonable cause” and “good faith.”

4. 4 III. Changes to General Standards  Post-amendment, section 6694(a) applies to any understatement resulting from an “unreasonable position” which is a position where: “the tax return preparer knew (or reasonably should have known) of the position”; “there was not a reasonable belief that the position would be more likely than not be sustained on its merits”; and the position was not disclosed or there was no reasonable basis for it. exception for “reasonable cause” and “good faith” remains.

5. 5 IV. Changes to Penalty Amounts  For violations under the general rule: Penalty was $250. Now penalty is the greater of $1000 or $50% of fees, or $5000 or 50% of fees in the case of willful or reckless conduct.

6. 6 V. Who is Affected by Section 6694?  “Tax return preparer” Any person who prepares for compensation, or who employs one or more persons to prepare for compensation,” any tax return, or a “substantial portion of a return of claim for refund.” Pre-amendment, applied only to income tax returns. Post-amendment, applies to employment tax returns, and excise tax returns; estate, gift, and generation-skipping transfer tax returns.

7. 7 VI. Transitional Relief Under Notice 2007-54  The changes to section 6694 seems to have caught the IRS and Treasury by surprise.  Notice 2007-54 provides transitional relief where Standards under previous law will be applied in determining whether the IRS would impose a penalty in respect of an income tax return where no willful or reckless conduct. The reasonable basis standard of section 6662 for all non-income tax returns where no willful or reckless conduct. In cases where willful or reckless conduct, no transitional relief available. Relief applies to all returns, amended returns, and return claims due on or before December 31, 2007 (without regard to extensions); to estimated tax returns due on or before January 1, 2008, and to employment and excise tax returns due on or before January 31, 2008.

8. 8 VII. Penalties Under Section 6707A  For failure to report a “reportable transaction.”  Proposed regulations have been issued that are expected to become final soon, and that would provide for six categories of reportable transactions: Listed transactions (substantially similar transactions) Confidential transactions Transactions with contractual protection for tax benefits Loss transactions “Transactions of Interest” (or substantially similar transactions) Brief-asset-holding-period transactions where tax-credits, other than foreign tax credits, claimed. (Current regulations would apply to foreign tax credits.) The proposed regulations would remove reference to transactions giving rise to a significant book-tax difference, because Schedule M-3 considered to address that concern.

9. 9 VIII. Penalties Under Section 6707A  For reportable transactions other than listed transactions: $10,000 for natural persons $50,000 otherwise  For listed transactions: $100,000 for natural persons $200,000 otherwise  The IRS has authority to rescind penalty if: The transaction in question is not a listed transaction; rescission would “promote compliance with the requirements” of the tax law and “effective tax administration.”  Any determination to rescind or not rescind a penalty may not be reviewed in any judicial proceeding. (Rev. Proc. 2007-21 gives criteria).  Penalty must be reported to the SEC for public companies. Failure to comply with the SEC disclosure requirements shall be treated as a failure to disclose a listed transaction.

10. 10 IX. Penalties Under Proposed “Economic Substance” Codification  General proposal for a new section 6662B to provide for a penalty equal to 40% of the amount of any “noneconomic substance transaction understatement.” Generally, a transaction that does not change the taxpayer’s economic position in a meaningful non-tax way, or is not a “reasonable means” of accomplishing a substantial nontax purpose.  Penalty would be reduced to 20% in cases where the “relevant facts affecting the tax treatment of the item are adequately disclosed in the return or a statement attached to the return.”  If a 30-day letter has been sent, then: “only the Commissioner of Internal Revenue may compromise all or any portion of such penalty”; and the Commissioner’s decision will not be subject to judicial review.