Congress saw fit last year to change the rules that relate to potential penalties imposed on preparers of tax returns. These rules, codified in Internal Revenue Code Section 6694, have always imposed penalties on preparers of income tax returns if they knew or should have known the position taken would understate income tax liability.
Tax-exempt organizations take many tax positions, including that they are actually exempt from income taxes, certain revenue streams are not taxable as unrelated business income, and that expenses are properly deductible from any revenue identified as unrelated business income.
Congress changed these rules by passing the Small Business and Work Opportunity Act last year. Now, Section 6694 applies to any tax return preparer. The expanded definition brings preparers of estate and gift tax, excise tax, employment tax and information returns within its scope. This will include preparers of Form 990, as well as 990-T.
The higher standard now imposed on preparers requires that the preparer have a reasonable belief that each return position will more likely than not (MLTN) be sustained on the merits if challenged by the Internal Revenue Service (IRS). This standard requires more than a 50 percent confidence level. Alternatively, if the position has a reasonable basis, penalties can be avoided by disclosure on a Form 8275, Disclosure Statement. The penalties were also significantly changed, from $250 to the greater of $1,000 or 50 percent of the income derived by the preparer from the preparation of the return.
The standard imposed on taxpayers for positions taken on their return requires that there be at least substantial authority for the position (which is approximately a greater than 40 percent confidence level), or a reasonable basis plus disclosure. Consequently, the standards are currently higher on return preparers than on their clients.
The differing standards present a potential for a conflict between a preparer and a taxpayer/client. This could arise if a return were to contain a position that satisfies the taxpayer standard (substantial authority) under Section 6662(d), but not the higher preparer standard (MLTN) under Section 6694. In such a situation, the taxpayer would not be required to disclose the position to avoid a penalty. The preparer, however, would be protected from the Section 6694 penalty only if the taxpayer were to make the disclosure.
Early in 2008, however, the IRS issued guidance that might prevent otherwise required disclosures in certain cases if the preparer advised taxpayers about the differing standards and documented the discussions. Therefore, your return preparer may discuss certain tax positions with you before completing your returns.
Individuals who will be the tax return preparer of a tax-exempt organization’s Form 990 or Form 990-PF that is due after December 31, 2007 are now faced with a significant challenge. As a result of the changes, tax return preparers must now work more closely with tax-exempt organizations to ensure that both the organization and the preparer are in compliance with IRC Section 6694.
The change became effective May 25, 2007 and applies to all individuals who fit the IRS definition of “return preparer,” defined as “any person who prepares for compensation or who employs one or more persons to prepare for compensation, all or a substantial portion of a return.” Employees of the filing organization that work on the return are excluded from this definition.
To determine whether a substantial portion of a return is prepared the complexity and size of the organization’s Form 990 and the amount of unrelated business income tax shown on Form 990-T is considered. Therefore, every return prepared should be analyzed separately to determine if substantiality is met. This is also referred to as a facts and circumstances test. Individuals who only give tax advice can also be subject to Section 6694 and the penalties it imposes. An advisor is a preparer if the advice is directly relevant to the position taken and the underlying events have already occurred. It is not necessary that the advisor see nor discuss the return. Once again, the facts and circumstances test is used. For instance, it needs to be determined whether or not the advice is directly relevant to the information disclosed on a return and if the advice pertains to a substantial portion of the return.
A person who advises on specific issues of tax law is not considered a preparer if the advice is given with respect to contemplated actions and the advice is not directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim. As a result of the recently amended Section 6694, tax return preparers must now concentrate their efforts on carefully analyzing the various revenue streams that a tax-exempt organization discloses on its Form 990. For example, if a tax-exempt organization has sponsorship revenue it should also have copies of the corporate sponsorship agreements readily available for interested parties, such as the tax return preparer, to review. In addition, the tax return preparer should be able to determine from the sponsorship agreements what the sponsors get in return for their sponsorship payments.
This will determine whether or not the sponsorship payments are qualified (Section 513(i)). Thus, unrelated business taxable income may result if it is decided that the sponsorship payments are not qualified.
One example of a qualified sponsorship payment is when the sponsor has its name or logo shown on items at a fundraising event held by the tax-exempt organization. If there is qualitative advertising of the sponsor’s business this will disqualify the sponsorship payment. If your organization receives royalties or mailing list revenue it should also have agreements in place related to these revenue streams. The agreements should describe that the payments received are for the right to use the tax-exempt organizations intangible property rights (Section 512(b)(2)). In addition, it is helpful if the agreement is actually called “royalty agreement” and avoids language mentioning a joint venture or partnership.
The organization should avoid providing services in return for the payments treated as royalties or mailing list revenue and should base the royalty fees on the gross revenue (not profits) of the activities involved. After reviewing the agreements, the preparer must believe it is more likely than not that the revenue qualifies as royalty income to avoid reporting unrelated business income on your return.
Another revenue stream that might or might not be treated as unrelated business taxable income is management fees. To determine whether management fees should be included on Form 990-T as unrelated business taxable income the tax return preparer should determine whether or not a profit is generally recognized after considering the costs associated with the management fee revenue.
Additional analysis might be necessary such as determining whether the same fee is charged each year or whether the fee increases each year. After sufficient analysis, if it is determined that there is generally a loss after netting the costs with the revenue the management fees would “more likely than not” be considered tax-exempt income reportable on Form 990. However, if a profit generally results, additional analysis would need to be made.
Issues regarding return positions can also arise if your tax-exempt organization shares revenues and expenses with another entity, whether it is a tax-exempt organization or taxable entity. You must provide your preparer with the agreement documenting how revenues and expenses are shared with another entity so that the person can review it to determine that the transactions are properly reflected in the return. For the income derived from the agreement to be tax-exempt, the agreement should clearly indicate that profits are not shared. If profits are shared, then a partnership exists and the income derived from the agreement may be subject to unrelated business income tax.
If you file Form 990-T to reflect unrelated business taxable income you should be able to explain how you are determining deductible expenses shown on the return. For example, salaries and wages shown on Form 990-T should be based on time entered on timesheets, not allocated based on an estimate. Therefore, all deductible expenses shown on Form 990-T should be directly related to the revenue shown on the return. Again, your preparer will have to evaluate the allocations to determine if they meet the more likely than not standard of Section 6694.
To make the transition in complying with Section 6694 tax return preparers and tax-exempt organizations will become more involved in the tax preparation process and in the underlying details of the amounts reflected. As a result of the changes, tax return preparers will be requesting information from tax-exempt organizations that they haven’t requested in the past. You should probably prepare to spend more time amassing the information used by your preparer in the return process.
The IRS has indicated that proposed regulations under Section 6694 will be issued in the near future. The proposals might clarify some of the uncertainty that currently exists. Additionally, some organizations are lobbying Congress to make the preparer and taxpayer standards the same and legislation has been introduced. We will see whether this results in an increase in the standards applicable to taxpayers or a lowering of the preparer standards. For now, we can all expect the amount of work to increase. NPT
Harvey Berger is a retired tax partner with Grant Thornton and currently serves as a consultant on nonprofit tax issues. His email is firstname.lastname@example.org. Greg Goller is Grant Thornton’s national partner-in-charge of Not-for-Profit Tax Services and is based in the Washington, D.C. area office. His email is email@example.com. William Winter is a senior associate in the not-for-profit tax practice in Grant Thornton’s Washington Area Office. His email is firstname.lastname@example.org