Consider that you have prepared a MSA that includes payments from husband to wife that are to be reduced when one of the minor children attains majority. The MSA does not state that any part of the payment shall be non-taxable to the wife and non-deductible to the husband. The client calls you one April afternoon and asks if under the MSA you drafted for him, he may deduct the all of the payments he has made to the wife in the previous year. You tell him – yes – since the agreement did not expressly make the payments non-taxable or non-deductible. The client deducts all of the payments, is audited and the amount of alimony reduction keyed to the child reaching majority is disallowed as being disguised child support. The client tells the agent that “my divorce lawyer advised me that I could deduct all of the payments.”
Surprise, surprise, surprise! Under amended Section 6694 of the Internal Revenue Code, you literally could be considered a tax return preparer if the amount of alimony deducted represents a substantial portion of the tax return. Section 6694 imposes penalties on those deemed tax return preparers unless the position in the return on which they advised is more likely than not (better than 50 percent likelihood) to be sustained in litigation on the merits. It is not necessary for you to sign the tax return or even see the return or specifically discuss it for you to be considered a tax return preparer. It is only necessary that you are compensated and render advice which is directly relevant to an entry in the return deemed substantial when the underlying events have already occurred. Substantiality is determined by looking at the amount of tax involved in the item and the length and complexity of the item. If the position has less than a 51% likelihood of success the penalty may be avoided with respect to positions having a reasonable basis (something more than merely not frivolous) if the return preparer who was not required to sign the return advises the client to fully disclose the position in the tax return.
The penalty imposed by Section 6694 is the greater of $1,000 ($5,000 if willful or reckless) or 50% of the fee derived from advising the client. It is yet unclear what portion of a lawyer’s fee might be deemed related to having given tax advice. The amendments to section 6694 were made in Section 8246 of the Small Business and Work Opportunity Act of 2007 and have not been fully explained in Treasury Regulations although IRS has issued Notice 2007-54 providing interim guidance and transitional rules. There is also Treasury Regulation Sec. 1.6694-1 which interprets certain aspects of the pre-amendment version of Section 6694.
The bottom line: Don’t give tax advice. That may be easier said than done, however, because tax issues permeate every aspect of equitable distribution as well as alimony issues. Essentially, you cannot tell your client the real value of assets he or she will be receiving, without considering whether and to what extent those assets will be diminished through taxation. That discussion must invariably consider tax basis, capital gains and non-taxable income versus income taxed at higher rates. It is not always possible to have a CPA or tax lawyer present at every meeting. What you can do is offer a conditional opinion with these admonitions: You are not a tax lawyer; tax rules are complex and fact centered; and, therefore, a tax advisor with greater expertise should be consulted before reliance. And most importantly, never give tax advice about events that have already occurred.
This newsletter was prepared solely for general informational and discussion purposes. The comments contained herein are not intended nor should they be construed as constituting an opinion of legal or tax advice by the author with regard to a specific case or transaction.