Under IRC §6694, a tax preparer who prepares a tax return or claim of refund that includes an understatement of liability due to an unreasonable position is liable for a penalty if he or she knew or reasonably should have known of the position. The penalty is the greater of $1,000 or 50% of the income the preparer earned in regard to the return or claim. The penalty increases to the greater of $5,000 or 50% of the income if the understatement or refund claim is due to willful or reckless conduct.
The Chief Counsel of the Internal Revenue Service (IRS) recently issued Chief Counsel Advice Memorandum (CCA) 201519029 to provide additional insight on when it’s appropriate to apply the understatement penalty in the presence of willful or reckless conduct. It’s important to remember that although CCAs are informative, they aren’t citable and don’t set a precedent.
DEFINITION OF TERMS
Before delving into the content of CCA 201519029, it’s important to understand the basic definitions of a tax preparer and willful or reckless conduct. A tax preparer is defined by Internal Revenue Code (IRC) §7701(a)(36) as any person who prepares for compensation—or who employs one or more persons to prepare for compensation—any return of tax imposed or any claim for refund of tax imposed. Reg. §301.7701-15(f) provides some exceptions to that general rule.
Reg. §1.6694-3 sets the definition of willful or reckless conduct. It states that “a preparer is considered to have willfully attempted to understate liability if the preparer disregards, in an attempt wrongfully to reduce the tax liability of the taxpayer, information furnished by the taxpayer or other persons.” The regulation illustrates examples of willful disregard. For example, a taxpayer provides the tax preparer with a detailed check register reflecting personal and business expenses. An expense for domestic help is identified as personal on the check register. If the tax preparer knowingly deducted this expense of the taxpayer’s domestic help as wages paid in the taxpayer’s business, the tax preparer is subject to the penalty. Similarly, if a tax preparer reports more dependents than the taxpayer has, the preparer is subject to the penalty.
This memorandum discusses several issues involving the potential application of IRC §6694 when a tax return preparer’s conduct is willful and reckless.
Return not filed. The first issue addresses whether a return preparer is subject to an understatement penalty under IRC §6694(b) if the tax return wasn’t filed. If the return preparer signed the return and his or her conduct was willful or reckless, then the preparer is subject to the penalty. This conclusion seems odd. How would the IRS even know a tax return exists if it hasn’t been filed? The CCA includes a scenario to help clarify the mystery:
For three consecutive years, a return preparer prepared amended returns that contained an understatement of liability due to willful or reckless conduct. The taxpayer filed the Year 1 amended return but not the returns for Years 2 or 3, waiting to see if the amended return was accepted. The refund claimed on the Year 1 amended return was disallowed. The taxpayer provided the IRS a copy of the amended returns for all three years—all of which have the signature of the return preparer. And during its investigation, the IRS also obtained copies of the amended returns for all three years from the return preparer. They don’t have a signature but do have a watermark stating “Preparer Copy.”
Also related to this issue is what constitutes the signing of the tax return. Treasury Regulation §1.6694-1(a)(2) provides that for purposes of the penalties under IRC §6694, a return or claim for refund is deemed prepared on the date it is signed by the preparer. Furthermore, if a signing tax return preparer within the meaning of Treas. Reg. § 301.7701-15(b)(1) fails to sign the return, the return or claim for refund is deemed prepared on the date the return or claim is filed.
The CCA holds that a strict reading of the tax code suggests that the penalty under IRC § 6694(b) could technically apply if the amended return is signed by the return preparer or if the unsigned amended return is filed.
The Chief Counsel extended this interpretation by questioning in another scenario whether the penalty would apply if the preparer provided an amended return that contained an understatement but (1) the taxpayer didn’t file the return and (2) the IRS was unable to gather evidence to the effect that the preparer signed the return. This situation suggests that neither the taxpayer nor the preparer had a copy of the return. In this case, the memorandum holds the understatement penalty wouldn’t apply.
Refund disallowed. The second scenario raises the question of whether the penalty can be assessed if the amended tax return is filed but the IRS disallows the refund. The CCA notes the penalty would apply in this scenario. It notes that there is no requirement that the IRS allow the amounts claimed on an amended return before the penalty may be assessed.
Expired statute of limitations for requesting refund. The final issue raises an interesting twist to the first two issues: Do the understatement penalties (IRC §6694(a) and (b)) or the aiding and abetting understatement penalty (IRC §6701) apply if the amended return is filed after the statute of limitations for requesting a refund has expired? The CCA concludes that the penalties don’t apply because the refund is denied for being made too late. As such, it doesn’t fall under the understatement definition in IRC §6694(e).
Although these penalties are intended to discourage a tax preparer’s willful disregard of the tax laws, there will always be those who decide to take a chance because so few tax returns are audited. The IRS’s response to these people is probably “Do you feel lucky today?” As noted in §10.37(a)(2)(vi) of Treasury Department Circular No. 230, when a practitioner gives written advice, he or she must not take into account the possibility that a return won’t be audited or that a matter won’t be raised on audit in evaluating a federal tax matter.
© 2015 A.P. Curatola
DID YOU KNOW?
IRC §6110 governs the public inspection of written determinations by the IRS. It codifies the outcome of several Freedom of Information Act lawsuits brought by Tax Analysts, Inc., dating back to the early 1970s.
Section 3509 of The 1998 IRS Restructuring and Reform Act amends §6110 to include rules for the disclosure of Chief Counsel Advice (CCA).
CCA material includes essentially all Chief counsel legal interpretations of the internal revenue laws (or related state, federal, or foreign laws) issued by the national office to the field. The advice may not be used or cited as precedent.