Dealing with Shades of Gray: The Realistic Possibility Standard

Although finding an authoritative answer to a complicated tax question can be a challenge, resolving an issue for which there is no definitive answer is an even greater challenge. Before taking a tax position, CPAs must consider the technical provisions of the tax law, client interests, possible taxpayer and preparer penalties and the ethical application of professional standards--a process that's as clear-cut as distinguishing between shades of gray. In recent years much attention has been focused on ethics--and especially on how practitioners resolve matters requiring professional judgment. The American Institute of CPAS tax division's statements on responsibilities in tax practice (SRTPs), the American Bar Association's (ABA's) Formal Opinion 85-352 and Internal Revenue Code section 6694 all establish "realistic possibility" as the standard for resolving uncertainty in such situations. The three rules are summarized in exhibit 1, page 53. The realistic possibility standard supersedes the "reasonable basis" test that was thought to be an ineffective ethical guideline because it set such a low threshold. Reasonable basis exists if a position is arguable, even if it is likely to fail in the courts. In contrast, the realistic possibility standard requires a good faith belief a position has a realistic possibility of being sustained on its merits. According to a survey of AICPA tax division members on how they interpreted the realistic possibility standard, CPAs who were very familiar with the standard were less aggressive than those unfamiliar with it. With the current emphasis on ethics and with court cases resulting from tax negligence outnumbering those resulting from audits, it is important for CPAs to gain a clear understanding of the standard so they can comply with it. The purpose of this article is to provide CPAs with guidance on implementing this stricter ethical standard. DEVELOPING GUIDANCE In 1985 the ABA adopted Opinion 85-352, which says a lawyer may advise a reporting position on a tax return as long as "the lawyer has a good faith belief . [the position is! warranted under current law or can be supported by a good faith argument for an extension, modification or reversal of existing law . and that there is some realistic possibility of success if the matter is litigated. " The Report of the Special Task Force on Formal Opinion 85-352 says the realistic possibility standard is met if there is a one-in-three chance of success should the tax position under consideration be litigated. Since the report was issued before IRC section 6694 was enacted, it does not mention an exception for disclosed positions. Rather than prepare a return that does not meet the realistic possibility standard a lawyer must, under ABA model rule of professional conduct 1.16(a), withdraw from the engagement. The change was adopted because the existing reasonable basis standard was criticized as an ineffective ethical guideline by the tax bar, Internal Revenue Service officials and some members of Congress. The standard was quantified to improve the reliability of tax advice provided by lawyers and to provide an enforceable objective standard. The same concerns led the AICPA tax division and congress to adopt similar standards. In 1988, the AICPA tax division revised advisory SRTP no. 1, Tax Return Positions, to inform CPAs of the standard to follow when recommending tax return positions. The standard requires CPAs to have "a good faith belief . [a tax return] position has a realistic possibility of being sustained administratively or judicially on its merits if challenged. " The AICPA standard is substantially identical to IRC section 6694, which imposes a $250 penalty on tax return preparers if the tax liability on a return is understated because a tax position was taken that did not have a realistic possibility of being sustained on its merits. …