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Beware! Revised tax preparer penalties come into full swing.

Tax preparers who have traditionally taken aggressive positions concerning tax liability for their clients may want to rethink their position as recent changes in regulations concerning preparer penalties come into full swing.

The Tax Reform Act of 1976 imposed certain penalties on those who prepare income tax returns and claims for refunds of overpaid taxes but who fail to meet certain standards of conduct. These penalties remained unchanged until December 19, 1989, when President Bush signed the Revenue Reconciliation Act of 1989. One of the act's more important elements was Subtitle G, entitled Improved Penalty Administration and Compliance Tax Act (IMPACT).(1)

Under IMPACT, a new penalty structure applied to tax preparers went into effect on December 31, 1989. The current penalty provisions are much stricter than the old provisions and could have serious consequences on tax preparers who take aggressive tax return positions. Many preparers have not paid much attention to the act, while others have questioned the legal authority, the current standards preparers must meet and the various definitions included in IMPACT. The IRS provided some preliminary guidance in Notice 90-20.(2) Final regulations have now been issued to clarify the IRS' positions and provide further analysis of tax preparer penalties. These regulations took effect December 31, 1991.(3)

Overview of IMPACT

Prior to IMPACT, the penalty system was often criticized by tax practitioners, tax payers, Congress and even the IRS. Some specific criticisms concerned the complexity of the old penalty system, improper penalty in relation to the violation and bunching of penalties for a single violation. In response to these criticisms, the IRS established a task force that eventually gathered its findings in a report.(4) The task force established four criteria to use in applying the current penalties: fairness, effectiveness, comprehensibility and administratibility.

After modification by Congress, the report was incorporated into the 1989 Revenue Reconciliation Act as IMPACT. Under IMPACT, four categories of civil penalties have been identified: accuracy related, failures to file or pay, document and information return, and preparer.

Accuracy-related penalties include negligence, substantial understatements and substantial overstatements. Before IMPACT, taxpayers were subject to various penalties related to accuracy. IMPACT established uniform accuracy-related and fraud penalties to replace the former negligence, substantial understatement, addition to tax in case of valuation overstatement, overstatement of pension liabilities, understatement of estate and gift taxes, and fraud penalties.(6)

Failure to file or pay amends Code [sections] 6656 and 6651 and increases the fraudulent failing-to-file penalty to 5% or more per month with a 25% maximum.

Document and information return penalties include failure to file correct information returns, failure to furnish correct payee statement, failure to comply with information reporting requirements and regulations requiring returns on magnetic media. These areas have been broadened and penalties have stiffened.(7)

Tax preparer penalties--the focus of this article--have been stiffened and the preparer's scope of liability has been broadened, particularly for understatement due to unrealistic positions and willful or reckless conduct. Preparer Penalties

Before IMPACT, penalties were not effective in curtailing tax shelter activities and other aggressive tax stances by preparers. [Sections] 6694(a) and (b) strengthened penalties for understatement due to unrealistic positions and willful or reckless conduct. The purpose of these sections was to discourage preparers from taking unsubstantiated positions and encourage preparers to disclose questionable positions.

Prior law for [sections] 6694(a) penalized the preparer $100 if any part of the understatement was due to "negligent or intentional disregard of rules and regulations." The basic obligation of the preparer under this rule was to exercise due diligence. This gave preparers quite a bit of leeway to take aggressive stances.

IMPACT substantially modified [sections] 6694(a) by increasing penalties and making expansive changes concerning the tests and standards for tax preparers. The "negligent or intentional disregard of rules and regulations" was replaced by "understatement due to unrealistic positions" test. This modification increases the penalty from $100 per return to $250 and is based on the following three factors: * Was any part of the understatement due to a position

for which there was not a "realistic possibility of

being sustained on its merits"? * The preparer reasonably should have known of such

position. * The position was not disclosed or was frivolous.

The penalty can be waived if the preparer has "reasonable cause" and acted on "good faith."

The current [sections] 6694(a), although stricter, still raises many questions. For example, who is included in the definition of preparer? Is the non-signing tax advisor considered a preparer? Further, the phrase "realistic possibility of being sustained on its merits" can have more than one interpretation. The "realistic possibility" language is unclear. "Reasonable cause" and "good faith" are vague terms that need further clarification.

A predecessor to the final regulation, Notice 90-20, gives some guidance on avoiding the [sections] 6694(a) penalty and methods of disclosure that could alleviate some preparer penalties. The final regulations offer more insight into these areas, which can give IMPACT more credence and cause stricter and more widely enforced [sections] 6694(a) penalties. Exhibit 1 presents a summary of changes in the Code pertaining to [sections] 6694(a) and a description of the current law.

Secondly, IMPACT substantially modified [sections] 6694(b) by increasing the preparers scope of conduct. The "willful understatement of liability" rule was amended to include "willful or reckless conduct." The penalty was doubled from $500 per return to $1,000 per return. This gives the IRS a much broader position to enforce a higher penalty. This penalty can be avoided if special disclosure is made for non-frivolous positions. Again, questions can arise regarding violation of this section and the final regulations shed some light on this area as well. Exhibit 2 presents a summary of the changes pertaining to [sections] 6694(b) of the Code along with a description of the current law.

Final Regulations

The final regulations became effective after December 31, 1991. Regulation [sections] 1.6694-1 through 1.6694-4 are concerned with the modifications made to [sections] 6694(a) and (b) of the code. Regulation [sections] 1.6694-1 deals with penalties applicable to the income tax return preparer and answers questions such as: Who is considered the preparer? Regulation [sections] 1.6694-2 deals with penalty for understatement due to an unrealistic position. Regulation [sections] 1.6694 3 addresses penalty for understatement due to willful, reckless or intentional conduct. Regulation [sections] 1.6694-4 considers procedural matters.

Regulation [sections] 1.6694-1

The income tax preparer is defined as both the signing preparer and non-signing preparer. A signing preparer is any preparer who signs return of tax or claim of refund while the non-signing preparer includes anyone who provides advice (written or oral) to the taxpayer or signing preparer. Both an individual preparer and the individual preparing firm are subject to the penalties regardless of who signs. The individual preparer is considered the one who provides overall supervisory responsibility. Given the specification of the regulation, it becomes very difficult for one associated with a return to contest a penalty based on not being a preparer.

Example: Attorney A provides advice to Client C concerning the proper treatment of a significant item on C's income tax return. The advice constitutes preparation of a substantial portion of the return. In preparation for providing that advice, A discusses the matter with Attorney B, who is associated with the same firm as A; however, A is the attorney with overall supervisory responsibility for the advice. Neither Attorney A nor any other attorney associated with A's firm signs C's return as a preparer.

For purposes of the regulations under [sections] 6694, A is a preparer of C's return and is subject to penalty under [sections] 6694 for a position taken on C's return. B is not a preparer of C's return and, therefore, is not subject to penalty. This would be true even if B recommends that A advise C to take an undisclosed position that did not satisfy the realistic possibility standard. In addition, since B is not a preparer for purposes of the regulations under [sections] 6694, A may not avoid a penalty under [sections] 6694 with respect to C's return by claiming he relied on the advice of B in preparing C's return.(8)

Understatement of liability is considered to exist if there is an understatement of net amount payable on any tax imposed by subtitle A. This net amount is not reduced by any carryback. The regulations are fairly clear as to exactly what is considered an understatement of tax liability.

If a penalty has been assessed against any preparers and final administrative or judicial decision has determined that no understatement existed, then the assessment must be abated and any penalty paid must be refunded.

The tax preparer need not require verification from the taxpayer. The preparer may act on good faith on the taxpayer's word. The preparer need not audit, examine or review any documents a taxpayer claims to have. The preparer must make inquiries if information supplied appears to be incorrect or if a particular code section or regulation is a condition of claiming a deduction.

Example: A taxpayer, during an interview conducted by the preparer, stated that he had paid $6,500 in doctor bills and $5,000 in deductible travel and entertainment expenses during the tax year, when in fact he had paid smaller amounts. On the basis of this information, the preparer properly calculated deductions for medical and travel and entertainment expenses, resulting in an understatement of liability for tax. The preparer had no reason to believe that the medical and travel and entertainment expenses information presented was incorrect or incomplete. The preparer did not ask for underlying documentation of the medical expenses but inquired about the existence of travel and entertainment expense records. The preparer was reasonably satisfied by the taxpayer's representation that the taxpayer had adequate records (or other sufficient corroborative evidence) for the deduction of $5,000 for travel and entertainment expenses. The preparer is not subject to a penalty under [sections] 6694.(9)

Regulation 1.6694-1 gives basic guidance for definitions of preparer understatement of liability while providing the tax preparer with guidance for what information from the taxpayer must be verified and what information need not be verified.

Regulation 1.6694-2

This regulation relates to understatement due to unrealistic position and gives insight as to what "realistic possibility" is. The rule states that if the preparer should have reasonably known that any part of the tax liability found to be understated was not "realistically possible of being sustained on its merits," the preparer is imposed a penalty of $250. The employer of the return preparer is also subject to penalty if management knew of the conduct and failed to provide appropriate procedures of review or if such review procedures were disregarded in formulation of advice. The question then becomes, what is "realistic possibility?"

This standard states that a position is considered to have a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by a person knowledgeable in tax law would lead such a person to conclude that the position has approximately a one-in-three or greater likelihood of being sustained on its merits. This portion of the regulation does offer some insight but also creates some controversy. Several issues are not addressed, including the propriety of-one-in-three likelihood, the definition of a person who is knowledgeable in tax law or what constitutes "a reasonable and well informed analysis." Because these areas are not clear, problems will most likely arise.

A favorable written determination from the taxpayer satisfies the realistic possibility standard. The date on which realistic possibility is determined is the date on the return. If a non-signing preparer is involved, the proper date is the date on which advice was given.

As mentioned earlier, a [sections] 6694(a) penalty can be waived if the preparer has reasonable cause and acted in good faith. In establishing reasonable cause and good faith, the regulations list five factors that should be considered for this waiver: * The nature of the error causing

the understatement: This factor

focuses on the complexity or

technicality of the error. Highly

complex or technical provisions

in which other competent tax

preparers might have also made

mistakes may lead to waiver of

the penalty. * Frequency of errors: The reasonable

cause and good faith exception

is likely to apply if only

one isolated error occurred. If

many reoccurring errors are

present or if the isolated error is

flagrant, obvious or is found in a

pattern over many returns, the

exception does not apply. * Materiality of errors: If the error

is immaterial, then the reasonable

cause and good faith exception

will apply. Immateriality is

judged relatively rather than absolutely.

In other words, it is

based on percentage of error, not

dollar amount. * The preparer's normal office

practice: If guidelines and rules

exist for a normal office practice,

then the reasonable cause and

good faith exception will apply.

A normal office practice includes

a system that promotes accuracy,

completeness and consistency;

provides checklists; has

readily available information;

and has established review procedures.

Flagrant errors are not

included in the exception. * Reliance on the advice of another

preparer: The exception

will apply if the tax preparer

relied in good faith on the advice

of another preparer he or she

deemed competent. The exception

will not apply if the advisor

is from the same firm.

For the tax preparer to be alleviated of penalty under the reasonable cause and good faith exception, the burden of proof is placed on the tax preparer in all instances.

Regulation 1.6694-3

This regulation provides insight into [sections] 6694(b). A $1,000 penalty is imposed if an understatement of tax liability is due to: * A willful attempt to understate

the tax liability by a return

preparer; or * Any reckless or intentional disregard

of rules or regulation by

such person.

No exceptions apply in cases of willful attempt. The penalty will be imposed if the tax preparer does not consider all relevant information available.

IMPACT added reckless or intentional disregard to [sections] 6994(b). Regulations further define "reckless" as the preparer taking a position contrary to a rule or regulation or the preparer exhibiting deliberate negligence in applying a rule or regulation. "Reckless" is defined as making little or no effort to determine whether a rule or regulation exists. "Rules and regulations" are defined quite broadly to include the Internal Revenue Code, temporary or final Treasury regulations, revenue rulings and notices.

Two exceptions apply. If a position is taken contrary to a rule and the preparer was not frivolous and documented the positions, the preparer is not considered to be reckless. If a position is taken contrary to revenue ruling or notice and the preparer was not frivolous or documented the position, the preparer is not considered reckless.

The government assumes the burden of proof as to whether the preparer willfully attempted to understate liability. The preparer assumes the burden of proof for reckless or intentional disregard, a position contrary, non-frivolous acts and adequate disclosure.

Regulation 1.6694-4

This regulation relates to procedural matters and contesting the penalty. The IRS will send a 30-day letter to the preparer notifying him or her of the proposed penalty. The preparer then has opportunity to request further administrative consideration. The notice of penalty is separate from any notice of tax deficiency.

Other Preparer Penalties

Other miscellaneous preparer penalty provisions were revised under [sections] 6695 when IMPACT became effective. Preparers who fail to furnish a copy of the tax return to the taxpayer, fail to sign the return or fail to furnish an ID number will be penalized $50 for each return, with a $25,000 maximum. Also, failure to file correct information returns on employed preparers under [sections] 6060 will result in the same penalty. Exhibit 3 presents a summary of changes pertinent to other preparer penalties and gives a description of the current law.

Court Decisions

Several court decisions have dealt with issues concerning preparer penalties.

In Goulding v. United States, the courts upheld a [sections] 6694 penalty against a CPA attorney who prepared K-1 schedules for a limited partnership. The district court held that the K-1 preparation constituted a "substantial portion" of tax returns and Goulding was considered a tax return preparer for such purposes.(10)

In Weidmann v. United States, the courts found the IRS properly imposed a tax return preparer penalty for understatement of liability. The preparer was found to violate Code [sections] 6694(a) under the definition of negligent or intentional disregard for IRS rules.(11)

In United states v. Nordbrock, the courts found the IRS properly imposed preparer penalties under Code [sections] 6695(c) because of the tax preparer's willful refusal to provide the IRS with a list of taxpayer identification numbers of all taxpayers for whom he had prepared returns or claims.(12) Nordbrock later appealed and was granted a jury trial for this case.(13)

In Chandler v. United States, the courts found that the preparer was improperly assessed tax preparer penalties under Code [sections] 6694(a) under the definition of negligent or intentional disregard of rules because the tax preparer exercised due care in the matter.(14)

Although the final regulations offer some guidance for the stricter preparer penalties, one can expect to see more court cases in the future concerning preparer penalties involving practitioners who continue to be aggressive in their tax stances.


This article gives a brief summary of some of the more important points of IMPACT and final regulations concerning tax preparer penalties. It is not intended as a broad review of IMPACT or the final regulations but rather to make tax preparers aware of the revised law, final regulations and the recent and expected trends of the Internal Revenue Service's harsher stance on tax preparers.

Tax preparers need to be aware of the current laws, regulations and recent trends and may need to adjust their methods accordingly. Many aggressive tax preparers are finding out about the stricter rules the hard way. Many preparer penalties could lead to disbarment or suspension of practice before IRS, along with state discipline involving the preparer's professional license.(15)

Conservative preparers should carefully scrutinize the material concerning this issue and should practice full disclosure if the law is uncertain in a particular area or if the client is prepared to litigate a position challenged by the IRS. Aggressive preparers should study the stricter standards of [sections] 6694(a) and (b) to calculate their increased risk of penalty and realize their positions need to be stronger than in the past.


(1) IMPACT is contained in the Omnibus Budget Reconciliation Act of 1989 (OBRA). OBRA made substantial changes to tax preparer penalties under Title VII Subtitle G of the Code. (2) IRS Notice 90-20, 1990-1 C.s. 328, offers preparers guidance on [sections] 6694 concerning the imposition of penalties. It offers important information for understatement of liability with respect to reasonable possibility. Possibility of success is defined as a one-in-three or greater likelihood. (3) Code [sections) 6694, Regulation [sections] 1.6694-0 through 1.6694-4. Volume 11 CCH: Standard Federal Tax Reports, pp 67, 661-67, 689. (4) "Report on Civil Tax Penalties by Executive Task Force," Commissioners Penalty. Study, February 1989. (5) Congressman J.J. Pickle, Chairman of the Subcommittee on Oversight of the House Ways and Means Committee held hearings with IRS Commissioner Gibbs on the Commissioners Penalty study and formed a task force concerning the matter. (6) Code [sections] 6662 and 6633 replaced 6653(a)(1), 6661, 6659, 6659A, 6660 and 6653(b). (7) Code [sections] 6721, 6722, 6723 and 6011(e) replace 6721, 6722, 6723 and 6011 (e). (8) Regulation [sections] 1.6694-1 (b)(3). (9) Regulation [sections] 1.6694-1 (e) (2). (10) 89-1 USTC 9,309 (11) 89 1 USTC 9,197. (12) 90-1 USTC 50,249. (13) 91-2 USTC 50,391 (14) 90-2 USTC 5,025. (15) Treasury Department Circular 230 includes responsibilities of tax practitioners who recommend or advise with respect to tax return positions or who prepare tax returns. Also, Proposed Modification of Regulations Governing Practice before Internal Revenue Service, 51 Fed Reg. 29113 (Aug. 14, 1986) offers more information.

Exhibit 1

Summary of Preparer Penalty Provisions Under 6694(a)

Current law

Number Name Penalty
6694(a) Understatement due to $250 per return
 unrealistic positions
 Old Law

Number Name Penalty
6694(a) Negligent or intentional $100 per return
 disregard of rules and

Description of Current Law

Tax preparer is charged the penalty if a deemed understatement of liability was due to:

1) A position for which there was not a realistic possibility

of being sustained on its merits.

2) The preparer knew or reasonably should have known

of such position.

3) The position was not disclosed or was frivolous.

Note: Penalty waived if preparer had reasonable cause and acted in good faith.

Exhibit 2

Summary of Preparer Penalty Provisions under 6694(b)

Current Law

Number Name Penalty
6694(b) Willful or Reckless $1,000 per return
 Old Law

Number Name Penalty
6694(b) Willful Understatement of $500 per return

Description of Current Law

Tax preparer is charged a penalty if a deemed understatement of liability is due to a willful attempt to understate or any reckless or intentional disregard of rules or regulations.

Note: The $1,000 penalty is reduced by any penalty paid for the return or claim under subsection (a) of 6694.

Exhibit 3

Other Tax Preparer Penalties Section
Number Name Old Penalty Current Penalty
6695(a) Failure to furnish copy $25 $50 each
 to taxpayer
6695(b) Failure to sign return $25 $50 each
6693(c) Failure to furnish tax $25 $50 each
 identification number
6695(d) Failure to retain $25 $50 each

Description of Current Law

The tax preparer is charged with the penalty if the tax preparer fails to furnish the taxpayer a completed copy of the return; fails to sign as preparer; fails to supply preparer tax ID number or fails to retain for three years after close of the return period, a copy of returns prepared or a list of taxpayers and tax ID numbers.

Note: The penalty is limited to 25,000 per subsection. If the prepare fails to file correct information returns concerning employees, the 6695 penalty will be assessed.

L. Craig Foltin, CPA, is a teaching fellow of accountancy and is currently at Cleveland State University in Cleveland, Ohio. He is a former management advisory service auditor for the auditor of the state of Ohio.
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Author:Foltin, L. Craig
Publication:The National Public Accountant
Article Type:Cover Story
Date:Oct 1, 1993
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