Reasonable inquiry required to avoid tax-preparer penalties.

In a recent case, the court held that the owner and president of an accounting firm who signed a client's tax return was the preparer of that return. As such he was liable for preparer penalties for failing to make a reasonable inquiry. IRC section 7701(36)(A) defines an income tax preparer as "any person who prepares for compensation, or who employs one or more persons to prepare for compensation" a tax return.

Generally a preparer can rely on representations--explicit or implicit--a taxpayer makes to the preparer or to his or her employees. However, the preparer may not ignore the implications of information the taxpayer furnishes or of which the preparer is aware. To avoid penalties under IRC section 6694, the preparer must make reasonable inquiries if the information the taxpayer provides appears to be incorrect or incomplete.

James Schneider, a licensed CPA and attorney, was owner and president of an accounting firm, Schneider & Co. Inc. He was the firm's "executive reviewer." William Conour, an attorney and sole practitioner, was Schneider's client. Brian D. Rhea, CPA, was an employee of Schneider & Co. and the accountant "in charge" of preparing Conour's return.

Conour first hired Schneider's firm in the late 1970s. It prepared adjusting journal entries, tax-basis compilation financial statements and tax returns for Conour's business. The firm also provided a variety of other financial and accounting services to him.

For many years Conour collected original works of art for both his home and office. Sometime during the preparation of iris 1992 tax return, Conour asked Schneider if he could deduct the cost of the artwork. Rbea had treated the artwork as nondeductible capital expenditures in the financial records of Conour's law practice. A letter from the accounting firm, prepared by Rhea, dated April 26, 1993, and signed by Schneider says, "During 1992, you spent $99,530 on various works of art. We have reviewed the regulations and case law regarding the tax treatment of artwork and have determined that it should be capitalized rather than expensed or depreciated."

Conour asked Schneider under what circumstances a taxpayer could deduct the cost of artwork. In the past Conour had purchased items to give his employees as in-kind compensation, including mink coats, diamond tennis bracelets, trips to Europe and Mercedes-Benz automobiles. Conour treated these purchases as in-kind compensation for tax purposes and deducted them as a business expense. He often bought items in pairs and treated those he did not give employees as personal expenses. Schneider told Iris client that when given as in-kind employee compensation, the artwork would qualify as a deductible business expense.

In October 1993 Schneider signed Conour's 1992 tax return as preparer. The return included a deduction of $49,767 (roughly one-half the total cost of the artwork) as an office expense, not as compensation expense.

The IRS audited this return and disallowed the artwork deduction. Conour, no longer represented by Schneider & Co., agreed to the increased tax liability that resulted from the adjustment. The IRS assessed Schneider a preparer penalty under section 6694(b)(2) for intentionally disregarding rules or regulations that resulted in an understatement of tax liability. Schneider filed a protest letter and administrative appeal of the penalty, which be paid in full. After the IRS denied his appeal, Schneider filed a motion for summary judgment based on two assertions:

* Because Rhea had prepared a substantial portion of the return he, not Schneider, should be considered the legal preparer even though Schneider signed it as such.

* Schneider did not intentionally disregard rules or regulations. He included the deduction because he justifiably believed Conour had given the artwork as in kind compensation, not because he thought it qualified as a depreciable asset.

Schneider claimed Conour specifically told him the artwork was in-kind compensation. In fact, Conour did not give the artwork in question as compensation and denies ever telling Schneider or anyone else to take an office expense deduction on that basis. There was no evidence to show Conour expressly told Schneider or Rhea he had given the artwork as compensation to Iris employees.

Result. For the IRS. The court denied Schneider's motion for summary judgment. It ruled his arguments were without merit. Schneider was both the signer of the return and Rhea's employer, and under the law, he was without question the return's lawful preparer. Additionally, Treasury regulations section 1.6694-2 says a "signing preparer" is one who signs a tax return of refund claim in this capacity.

By taking the office expense deduction for the artwork on Conour's 1992 tax return, Schneider intentionally disregarded revenue ruling 68-232, which says taxpayers may generally not expense of depreciate fine art. Regulations section 1.6694-1(e)(i) addresses whether Schneider could rely on the representations--explicit or implicit--Conour made to him or his employees with respect to the artwork. It is the preparer's duty to make further inquiry to determine a violation under section 6694(b). At a minimum Schneider should have sought Conour's assurance that he indeed gave the artwork as in-kind compensation and that documentation existed for the claimed $49,767 expense.

* James J. Schneider, CPA v. United States (S.D. Ind.), 2003-1 USTC [paragraph] 50,352.