A CPA is preparing a tax return for a client who operates a cash-intensive business. The client provides summary financial data but lacks detailed underlying records for certain expenses. The CPA makes reasonable inquiries and obtains substantiation for some expenses, but others remain unsubstantiated. The CPA believes, based on professional judgment and industry averages, that the unsubstantiated expenses are legitimate but cannot be fully proven. Under the 'reasonable basis' standard, what is the CPA's MOST appropriate course of action to avoid preparer penalties for an undisclosed position?
- AAdvise the client to reconstruct detailed records for all unsubstantiated expenses before filing the return.
- BInclude the unsubstantiated expenses on the return and attach Form 8275, 'Disclosure Statement,' to disclose the position.
- CExclude all unsubstantiated expenses from the return, as they cannot be fully proven.
- DInclude the unsubstantiated expenses on the return without disclosure, relying on professional judgment.
Show answer & explanationAnswer & explanation
Correct answer: B. Include the unsubstantiated expenses on the return and attach Form 8275, 'Disclosure Statement,' to disclose the position.
If a tax position has a 'reasonable basis' (meaning it has a realistic possibility of being sustained, generally >20% likelihood) but does not meet the 'substantial authority' standard (>33% likelihood), the position must be disclosed on Form 8275 (or 8275-R for regulatory positions) to avoid preparer penalties under IRC Sec. 6694(a). This scenario describes a position with a reasonable basis but insufficient substantiation for a higher standard, thus requiring disclosure.
Why the other options are wrong
- A. While ideal, reconstructing records may not always be possible or practical. The question asks for the appropriate action under current circumstances and a 'reasonable basis' standard.
- C. Excluding potentially legitimate expenses may be overly cautious and disadvantageous to the client if there's a reasonable basis for them.
- D. Including unsubstantiated expenses without disclosure, relying only on 'reasonable basis,' would expose the preparer to penalties under IRC Sec. 6694(a).
Reasonable Basis & Disclosure
A tax position with a 'reasonable basis' (realistic possibility of being sustained) but lacking 'substantial authority' requires disclosure on the tax return to avoid preparer penalties.
- Reasonable basis generally means a >20% chance of success.
- Substantial authority generally means >33% but <50% chance of success.
- If only 'reasonable basis' is met, disclosure on Form 8275 is mandatory for preparers to avoid penalties.
- Disclosure alerts the IRS to the position and potential for controversy.
Memory trick: Reasonable basis, disclose with grace, or penalty you'll face.