Is State Regulation of Tax Preparers the Solution?

New York Coordinates Its Efforts with the 1RS

Things have been looking up for the New York State Department of Tax and Finance (DTF). In 2011, it received the Gartner Business Process Management Excellence Award for an initiative that enabled an increase in the average daily processing of tax returns from 60,000 to 600,000; the initiative also resulted in a 60% reduction in the time needed to resolve missing information and errors in tax returns and other documents, a significant decrease in payments in questionable returns, and a significant increase in collections (http://www.tax. ny.gov/press/rel/201 l/gartner05251 l.htm).

Furthermore, the department's audit division director, Nonie Manion, received the 2012 Federation of Tax Administrators (FIA) Leadership Award 'Tor her high-profile work and success in using advanced technology and third-party data to greatly improve the agency's return on investment and overall efficiency" (http://www.tax.ny.gov/press/ rel/2012/manion062012.htm). In 2013, the DTF received the 2013 FTA Award for Outstanding Management Program, due to its "enterprise-wide approach to risk management" (http ://www. taxadmin. org/fta/ awards/2013_management.pdf).

In addition to improving process and efficiency, the department has been focusing- with the statutory blessing of the New York State Legislature-on developing a comprehensive regulatory scheme to improve the professionalism and competency of the tax preparation industry, with the goal of taxpayer protection very much in mind.

Ibis success should be compared with the IRS's recent experience. On January 18, 2013, the U.S. District Court for the District of Columbia issued an order that permanently enjoined the 1RS from enforcing its new regulatory scheme for registered tax return preparers. The court held that the 1RS lacked the statutory authority to promulgate and enforce the new regulations, which would require preparers who are not attorneys, CPAs, or enrolled agents to pass a qualifying exam, pay an annual application fee, and take 15 hours of continuing professional education (CPE) courses each year. In a memorandum opinion and order issued February 1, 2013, however, the court clarified that the 1RS may still require tax return preparers-including CPAs, attorneys, and enrolled agents-to obtain a preparer tax identification number (PTIN), as specifically authorized by Internal Revenue Code (IRC) section 6109(a)(4). The case is currently on appeal, and arguments were heard on an expedited basis on September 24,2013.

In the wake of the decision, the Taxpayer Protection and Preparer Fraud Prevention Act of 2013 (HR 1570 section 2[a]) was introduced in the House of Representatives on April 15,2013. If enacted, this bill would grant the Secretary of file Treasury statutory authority to regulate the tax preparation industry. But considering that it is the ninth such bill introduced since 2005 and that all prior bills have failed, it seems unlikely that Congress will extend the IRS's regulatory powers-especially at a time when the agency's integrity has been called into question and doubt is being cast on its ability to oversee compliance with the Patient Protection and Affordable Care Act of 2010 (ACA).

This repeated failure by lawmakers might explain why the 1RS finally took matters into its own hands, asserting for the first time that it already has the statutory authority to regulate tax return preparers because they are among those "representatives" who "practice" before the 1RS; preparers are subject to the rules and regulations set forth in Circular 230, "Relations Governing Practice before the Internal Revenue Service." It might also explain why the 1RS is pursuing its appeal so aggressively. If it does not win on file issue now, when will it gain the regulatory control it seeks?

A Solution in Search of a Problem?

The challenge to the IRS's new regulatory scheme was brought before the U.S. District Court for the District of Columbia by three independent tax return preparers (Sabina Loving, Elmer Kilian, and John Gambino), represented by counsel retained through the Institute for Justice. On its website, the Institute for Justice describes the IRS's new regulatory scheme as "an unlawful power grab" and "typical government protectionism" that places the heaviest burden upon independent tax return preparers and small businesses, which have fewer resources to pay the costs associated with certification and CPE. It also contends that taxpayers will bear these costs through higher tax preparation fees (http://www.ij.org/irs-tax-preparersbackgrounder-2).

The Institute for Justice calls the new regulatory scheme a "solution in search of a problem." It claims that "the vast majority of U.S. taxpayers report confidence in their paid tax return preparer and 87 percent would use a paid preparer in the future." It also claims that, under the current tax return preparer penalties that are in place, "the rate of violations is predictably low," and "tax preparers have a right to earn an honest living without getting permission from the 1RS. And taxpayers-not the 1RS-should be the ones who decide who prepares their taxes" (http://www.ij.org/irs-tax-preparers-backgrounder-2).

But New York State sees a problem and is making the case for regulation. The New York State DTF began an undercover investigation in 2007 to determine if preparers were assisting clients in committing fraud. It found that "51 out of 170 preparers visited over an almost three-year period-some 30 percent-actively offered to coach their clients in tax fraud efforts"; worse still, it observed this criminal behavior "in all manner of tax return preparers, ranging from unenrolled preparers to licensed CPAs" (http://www.tax.ny.gov/ pdf/documents/task_force_report_reg_ preparers.pdf, p. 4).

New Yoik's budget for 2009 included several provisions related to the regulation of tax return preparers. It established a system for preparer registration, codified as section 32 of the N.Y. Tax. Law, and it enhanced consumer protections with respect to refund anticipation loans (RAL) and refund anticipation checks (RAC), codified in Article 24-C of the N.Y. General Business Law. It mandated that the commissioner of taxation and finance convene a task force to prepare a report addressing specific issues, including the appropriate scope for regulating preparers, appropriate qualifications and CPE requirements, and an examination of the issues and abuses involving RALs and RACs. The mandate also instructed the task force to consider other matters it deemed necessary or appropriate. The task force issued the "Report of the Task Force on Regulation of Tax Return Preparers" on September 28,2011, six months ahead of schedule.

In its report, the task force stated-

The case for regulation is compelling. We are persuaded that the adoption of a strong, fair and efficient regulatory scheme is essential to advance tax administration, to elevate the professionalism of the tax return preparation industry, and to protect New York taxpayers. Tax return preparers perform a vital service for taxpayers and play a key role in our system of tax administration. It is time for the State to recognize that preparers ought to meet minimum qualifications to help ensure the sound performance of that critical function. So too, we believe taxpayers are entitled to the services of a preparer who is required to conform to a code of conduct designed to ensure the preparer's integrity and competence. (http://www.tax.ny.gov/pdf/documents/ task force report reg preparers.pdf, p. 2)

The task force cited problems in the tax preparation industry, ranging from "deficiencies in the general quality of tax preparation services" to "outright fraudulent conduct by a limited number of bad actors" (p. 3). It also reported consumers' lack of confidence in the quality of tax preparation services and asserted that with "the vast numbers of taxpayers who utilize the services of tax return preparers, even a small proportion of poorly prepared returns can have serious consequences" (p. 3).

Viewed in the light of the task force's report, the arguments made by the Institute for Justice, citing both taxpayer confidence in paid preparers and the paid preparers' "right to earn an honest living," seem suspect; in any event, they sidestep the real issue of harm caused to the public by unscrupulous and incompetent preparers. The Institute for Justice also avoids the issue of fiscal harm caused to the federal Treasury and to the various state departments of revenue. And although the 1RS is authorized to seek injunctive relief to prevent the unscrupulous from preparing returns and to seek penalties for the preparation of false returns, both "remedies" occur after the fact and involve the courts-a lengthy process compared to the IRS's desired ability to handle such matters internally and preemptively.

The time and effort involved in identifying and taking a "bad actor" to court after harm has been done might explain the Institute for Justice's claim that "the rate of violations is predictably low" (http://www.ij.org/irs-tax-preparersbackgrounder-2). Perhaps it is only the rate at which violations make their way through the court system that is predictably low. The IRS wants to stop the harm before it happens, preferring instead to invest its time, energy, and money in registration, training, and certification efforts. It also wants to restore the public's trust in the tax preparation industry and, ultimately, in a system that relies so heavily on the selfreporting of taxes.

Although the problems posed by an unregulated tax preparation industry are real, the IRS might be unable to exert any real regulatory control. This is where New York and several other states have stepped in.

State Action and Regulation

The mandate for the DTF task force contained a short but powerful provision: the "commissioner of taxation and finance may promulgate regulations to implement any of tiie recommendations made by the task force" (Laws of 2009, ch. 59, part W, section 4). It provides clear statutory authority for the DTF to regulate the tax preparation industry.

But New York State is not the first to regulate this industry; California and Oregon have been doing so since the 1970s, and Maryland acted to do so about tiie same time New York did. The questions are: to what extent will various states take control and oversee the tax preparation industry-and to what extent will they oversee a tax preparer's integrity and competency to prepare a federal income tax return? While the question of federal regulation is being decided, four states-California, Oregon, New York, and Maryland-have enacted express legislative authority to regulate tax return preparers.

California. This state has implemented one of the longest running and most comprehensive regulatory schemes. It addresses registration, examination, and CPE requirements, and it requires those individuals who are paid to prepare or assist in the preparation of state or federal income tax returns (as well as state bank and corporate franchise tax returns) to register with tiie state. CPAs licensed by the California Board of Accountancy, attorneys who are active members of the State Bar of California, enrolled agents, and employees who are supervised by any of the foregoing in the preparation of tax returns (and do not sign the returns) all remain exempt from the registration requirements (http:// www.ctec.org/).

Oregon. This state requires a license for income tax preparation businesses, as well as for individuals who are paid to prepare, advise, or assist in the preparation of personal income tax returns. Oregon exempts from registration CPAs and public accountants licensed by or registered with the Oregon Board of Accountancy, attorneys who are members of the Oregon State Bar, and their supervised employees. The licensing requirements include passing a qualifying exam and completing annual CPE coursework (http://www.oregon.gov/OBTP/docs/form/ gen_info.pdf).

Maryland. Like New York, Maryland enacted tax preparer legislation in 2009 (Maryland Code Annotated, Business Occupations & Professions section 21-501, West 2009); however, although Maryland's regulation was designed to take effect June 1,2010, it is contingent upon the governor's appointment of a board of individual tax return preparers and the appropriation of funds by the legislature, neither of which has occurred. Once implemented, the law would require registration for anyone offering individual income tax preparation services. It would exempt from registration CPAs licensed in any state, attorneys admitted to the practice of law in any state, individuals employed by a local or state government or by the federal government (but only in the performance of their official duties), enrolled agents subject to the IRS's regulations under Circular 230, and the employees or assistants of any of the foregoing who are performing duties on their behalf.

New York. The variance in registration requirements for tax return preparers in California, Oregon, and Maryland-particularly in terms of exemption-is striking. New York requires individuals to register if they prepare a substantial portion of any return for compensation. CPAs and public accountants licensed or registered in New York, attorneys licensed in New York, and the employees supervised by any of the foregoing in the preparation of returns were originally exempt; however, the legislature later broadened the exemption to include enrolled agents, as well as attorneys, public accountants, and CPAs registered or licensed in any U.S. state. This aligned New York's registration requirements more closely with those of Maryland rather than California or Oregon. New York also requires registration for all RAL and RAC facilitators, and no one is exempt from this requirement, even if otherwise exempt from registration as a tax return preparer.

In its report, the DTF task force recommended that the New York State Legislature consider ending the registration exemption for attorneys, CPAs, public accountants, enrolled agents, and the employees they supervise in the preparation of a return; the report cited the incidence of fraud even among CPAs as a reason for requiring registration (pp. 14-15).

The task force further stated that eliminating the registration exemption would serve tiie overall purposes of the program and be more consistent with the IRS's registration requirements, which require all compensated preparers to register, even if they are members of a group that would otherwise be exempt from passing a qualifying exam and completing CPE coursework. The task force also recommended that the DTF, the 1RS, and other state regulators share tax preparer information and identification numbers, to the extent possible, in order to achieve "a single, seamless registration system" in tiie future (p. 15).

Notwithstanding, the New York State DTF published proposed regulations in August 2013, which do not change New York State's registration exemption for CPAs, public accountants, attorneys, enrolled agents, and their supervised employees (N.Y. Comp. Codes R & Regs., Title 20, proposed Part 2600). The proposed regulations do respond, however, to the task force's recommendations for an otherwise comprehensive regulatory scheme for tax return preparers, including the requirement that commercial tax return preparers pass a qualifying exam and complete CPE.

This proposal also reflects New York's attempt to coordinate its initiative with that of the 1RS. The task force specifically recommended that New York's regulatoiy scheme "build on and complement the 1RS initiative to regulate tax preparers. Duplicative requirements should be avoided" (p. 14). But should New York change its approach if the 1RS is permanently enjoined from promulgating and enforcing its new regulations?

How to Proceed with State Regulation

In addition to synchronizing its tax preparer registration requirements with those of the 1RS, New York State is seeking to coordinate other potential requirements. Specifically, the task force recommended that commercial tax return preparers in New York be required to pass a New York State income tax competency exam, in addition to the competency exam that would be required by the 1RS. It has also recommended that commercial tax return preparers be required to complete four hours of CPE in New York personal income tax topics, in addition to the CPE required by the 1RS.

The proposed regulations issued by the DTF are in line with the task force's recommendations (except that they require tax return preparers with less than three years of experience preparing New York State tax returns to complete 16 hours of CPE coursework). Specifically, they allow the commissioner to deny registration to an applicant who has not satisfied the IRS's requirements (section 2600-2. l[h]). The regulations also explicitly require tax return preparers to "pass the Internal Revenue Service registered tax return preparers competency examination, if required for federal purposes" (section 2600-2.3[a][l]).

Whereas New York State has been working to coordinate its efforts with the IRS's new regulatory scheme, California and Oregon have been regulating tax return preparers since long before the 1RS started implementing its new requirements. Both states have required tax return preparers to possess at least a basic knowledge of federal personal income tax in order to be registered or licensed in their states. In other words, both states have already been regulating tax return preparers with respect to the preparation of federal income tax returns.

For example, the California Tax Education Council oversees California's registration requirements. Tax return preparers must generally complete at least 60 hours of basic personal income tax education-including 45 hours of federal income taxation-in order to be registered in the state. And in order to renew registration, a tax return preparer must complete at least 20 hours of CPE annually, including 10 hours of federal tax law, 3 hours of federal tax updates, 2 hours of ethics, and 5 hours of California state tax (http://www.ctec.org/).

The Oregon Board of Tax Practitioners, on the other hand, oversees licensing of tax practitioners in Oregon and issues two different licenses to qualified applicants: a tax preparer license and a tax consultant license. Among other requirements, a licensed tax preparer must be supervised by a licensed tax consultant or other qualified person, complete at least 80 hours of basic income tax law education, and pass Oregon's tax preparer exam. The requirements to be a licensed tax consultant include working as a tax preparer for a minimum of 780 hours during two of the last five years and passing Oregon's tax consultant examination. For either license, the applicant must pass the qualifying exam with a score of at least 75% (75% of the questions relate to federal tax law). Oregon also requires registrants to earn a minimum of 30 hours of CPE each year and renew their licenses annually (http://www.oregon.gov/OBTP/docs/form/ gen_info.pdf).

Likewise, New York State is in a position to incorporate federal income taxation as a significant component of any required competency exam and CPE, especially if federal regulation is impaired. To the extent that New York State aims to ensure the competency and integrity of tax return preparers, decrease fraud, and increase consumer confidence in the tax preparation services they receive, it must ensure that preparers are competent in preparing-at the very least-a basic federal income tax return. It is apparent that New York State recognizes this, given the task force's recommendation that tax return preparers be required to meet not only New York State's examination and CPE requirements, but also those established by the 1RS. A New York State return begins with the completion of a federal return, and, almost invariably, consumers expect that the two will be prepared together and by the same individual.

Like the California Tax Education Council and the Oregon Board of Tax Practitioners, the New York State DTF would also be in a position to handle disciplinary matters internally, obviating the need to rely on the court system. This is quite powerful, considering that it could potentially rescind a tax preparer's license in New York to prepare both a New York State income tax return and a federal return.

What's Next?

It is uncertain what the future holds in terms of federal regulation. With respect to state regulation, one issue has become quite clear: the regulation of tax return preparers will take place on a state-by-state basis- with each state taking a somewhat varied approach-unless and until federal regulation is successfully implemented as an overarching scheme. In the meantime, taxpayers in California, Oregon, and New York might rest a little easier knowing that their states are addressing the need for regulation-and tax preparers in these states should be prepared to meet their state's regulatory requirements.

The IRS might be unable to exert any real regulatory control. This is where New York and several other states have stepped in.

Kari A. Smoker, JD, is an assistant professor of accounting in the school of business administration and economics, SUNY-The College at Brockport.