A tax return preparer is facing a penalty for an understatement of tax liability on a client's return. The understatement resulted from a position that did not have substantial authority but had a reasonable basis. The position was NOT disclosed on the return. Which of the following statements is correct regarding the preparer's liability under IRC §6694?

Answer options:

No penalty applies because the position had a reasonable basis.

No penalty applies because the substantial authority standard is only required for tax shelters.

A penalty applies because the position was not disclosed and lacked substantial authority.

A penalty applies only if the understatement was willful or reckless.

How to approach this question

Distinguish between the standards for disclosed vs. undisclosed positions.

Full Answer

C.A penalty applies because the position was not disclosed and lacked substantial authority.✓ Correct

Under IRC §6694(a), a penalty is imposed for an understatement due to an unreasonable position. A position is unreasonable unless: (1) there is substantial authority for the position (if undisclosed), or (2) there is a reasonable basis for the position AND it is adequately disclosed (e.g., Form 8275). Since this position had only a reasonable basis and was NOT disclosed, it is considered unreasonable, and the penalty applies.

Common mistakes

Confusing the 'Reasonable Basis' standard (requires disclosure) with 'Substantial Authority' (does not require disclosure).

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