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Sec. 6694 tax preparer penalties: a look at Chapter 11 of the Consolidated Penalty Handbook.

Since 1976, Congress has enacted a number of preparer, promoter and protester penalties designed both to increase voluntary compliance with the nation's revenue laws and to enable the IRS to better monitor the preparation of income tax returns. These penalties, which are applicable to all return preparers (including CPAs in tax practice), may lead to fines, injunctions, license revocations, and/or referrals to the IRS Director of Practice (the Director), who has the authority to suspend or disbar preparers entitled to practice before the Service. To promote greater consistency in penalty administration, the IRS has consolidated its procedures for penalty enforcement in Chapter 11 of the Consolidated Penalty Handbook, in Part XX of the Internal Revenue Manual (IRM).(1)

The Service has been particularly concerned with violations of Sec. 6694, which prohibits the understatement of tax liability due to an unrealistic return position or to willful, reckless or intentional disregard of the tax laws. In 1993, for example, the IRS Office of Penalty Administration imposed 2,392 preparer penalties under Sec. 6694.(2)

This article examines the return preparer penalty program outlined in the IRM, analyzes the preparer penalty guidelines for Sec. 6694 that appear in the IRM(3) and the regulations, and suggests prudent defensive strategies to enable CPAs and other tax preparers to avoid a Sec. 6694 penalty, or, if one is asserted, to contest it administratively or judicially.

The Return Preparer Penalty Program

The IRM's new penalty chapter attempts to coordinate responsibility for penalty enforcement. IRM (20)(11)11(4) provides that Return Preparer Coordinators (RPCs) at IRS Service Centers, as well as the district, regional and national offices, have been designated to administer and monitor return preparers' activity. IRM (20)(11)16 states that penalty enforcement at Service Centers is limited to screening and processing claims to verify that assessed penalties have been paid; that claims have been properly and timely filed, forwarded to the appropriate district and processed to final determination; and that preparers are notified that their claims have either been abated or disallowed.

IRM (20)(11)12(4) provides that, at the district level, RPCs order and screen returns, accumulate all preparer penalty referrals, summarize these referrals for presentation to a district Penalty Screening Committee,(4) and prepare referrals to the Director. Since the imposition of penalties may also affect the suitability of preparers as electronic filers,(5) under IRM (20)(11)1(12), district RPCs are to notify the Electronic Filing Coordinator of all asserted preparer penalties.

IRM (20)(11)12(4) charges the Penalty Screening Committee with reviewing RPC case files to ensure that penalties are asserted appropriately and accurately. In addition, under IRM (20)(11)17(2) and (6), this committee reviews RPC recommendations to open "program action cases" after identifying a pattern of noncompliance by a particular preparer. If the Director approves the initiation of program action, the district RPC then coordinates the examination of that preparer's returns and/or refund claims.

Under IRM (20)(11)12(2)(d), at the regional level, the RPC monitors the return preparer penalty program, developing procedures and guidelines to ensure "uniformity in the application of the return preparer provisions throughout the region." (Emphasis added.) Although the Assistant Commissioner for Examination may designate a staff member to "functionally" supervise the "examination aspects of the program," this individual is not explicitly charged under IRM (20)(11)12(1) with responsibility for ensuring that preparer penalties are asserted, assessed and abated consistently and uniformly at the national level. This may result in inconsistent administration of the preparer penalty program among the regions.(6)

Role of the Examiner

Tax examinations are typically conducted by revenue agents or office auditors.(7) Whenever an examination is undertaken, examiners are required to make an initial determination whether the preparer has violated any of the return preparer penalty provisions. IRM (20)(11)13(1) provides that, only after determining that "sanctions against the preparer are warranted," based on the facts and circumstances of the examination, are examiners to open preparer penalty cases. Examiners may also recommend that the district RPC initiate program action against preparers whose returns indicate a pattern of noncompliance.

Because a preparer penalty case is regarded as independent of the income tax case, the tax examination must usually be completed at the group level before the examiner may propose the assertion of a preparer penalty.(8) Unagreed tax cases must be submitted at the group level before a preparer penalty may be pursued. However, IRM (20)(11)13(3) and (4) indicate that if the preparer case cannot be separated from the tax examination, both may be pursued at the same time. IRM (20)(11)13(2) generally cautions examiners to limit any discussion of preparer penalties during the examination to the development of facts to determine the applicability of a penalty. However, IRM (20)(11)36(1)(b)2 is more explicit when penalties under Secs. 6694 and 6695 may be involved. Examiners are not to propose or discuss conduct penalties per se in the taxpayer's presence.

Limitations Periods, Claims and Appeals

Claims and appeal procedures for preparers assessed penalties under Sec. 6694 are handled differently from those assessed under other sections. In all penalty cases, however, the IRM indicates that examiners will not submit cases to the IRS Appeals Office (Appeals) if there are fewer than 120 days remaining before the statute of limitations expires, without first soliciting an extension of the period.

Sec. 6696(d)(1) provides that, for penalties asserted under Sec. 6694(a), the penalty is to be assessed within three years after the return or refund claim with respect to which the penalty is assessed was filed. The IRM advises obtaining consent to extend the period when there is insufficient time (generally, fewer than 180 days remaining in the period) to complete the examination. However, IRM (20)(11)19 and (20)(11)81-83 caution examiners that extending the statutory period on a taxpayer case using Form 872, Consent to Extend the Time to Assess Tax, does not extend the statute for preparer penalty cases. To extend that period, the IRS can use Form 872-D, Consent to Extend the Time on Assessment of a Tax Return Preparer Penalty; separate consents are needed for each year being considered. Consents are unnecessary when penalties are asserted under Sec. 6694(b), since there is no statute of limitations for this violation. Nor is there a statutory limit on the IRS's ability to initiate an injunction under Sec. 7407 when the preparer's conduct is subject to a Sec. 6694 penalty.

For Sec. 6694, preparers may use Form 6118, Claim of Income Tax Return Preparers, to file a claim for refund of penalty. Under IRM (20)(11)15(2), the preparer has the option of paying 15% of the penalty and filing a claim for refund within 30 days after the date of notice and demand for payment, or paying the entire penalty assessed and filing a claim for refund within three years of the date the penalty is paid.

If the preparer chooses to pay 15% of a Sec. 6694 penalty, under IRM (20)(11)15(2)(d), the IRS will suspend collection of the balance until the earlier of 30 days (1) after the claim for refund has been denied or (2) from the period ending six months after the preparer files the claim. According to IRM (20)(11)15(e), collection can also be suspended until "final resolution of the proceeding" if the preparer files suit in district court for the determination of the penalty within either 30-day period. IRM (20)(11)15(f) provides that all refund claims for penalties entirely paid, or for abatement of penalties assessed but not paid in full, are sent to the RPC at the appropriate Service Center.

Denials of claims for refund or abatement of Sec. 6694 penalties may be appealed administratively to Appeals. Because of the interrelationship between the penalty and the income tax case, unagreed penalty cases will not be sent to Appeals until the unagreed tax deficiency case is submitted. If the two cases are submitted separately, moreover, IRM (20)(11)14(2)(a) provides that the case file for the proposed preparer penalty will include information on the location and current status of the related taxpayer file.

The IRM, citing Regs. Sec. 1.6694-4(a)(1), identifies the stages of its administrative preassessment appeals procedure. Preparers are sent a 30-day letter informing them of their appeal rights; the penalty is assessed if the preparer does not respond. The preparer may request, and will be granted, a preassessment appeal of penalties asserted under Sec. 6694. Under IRM (20)(11)14(b), postassessment appeal procedures will also apply when the District Director has assessed a Sec. 6694(a) penalty to avoid the expiration of the statutory period for assessment.

Referrals to the Director

CPAs, enrolled agents and licensed attorneys are permitted to practice before the Service and are subject to additional standards of conduct and sanctions that generally do not apply to other commercial preparers. Practice before the Service includes "all matters connected with presentation to the IRS relating to a client's rights, privileges, or liabilities under the revenue laws or regulations administered" by the IRS.(9) According to IRS training materials, preparing and/or filing a taxpayer's return or refund claim, as well as preparing a collections information statement or a closing agreement or acting as a client advocate during an examination, constitute practice before the Service.(10)

The Director monitors compliance with the rules that govern tax practitioners and authorize them to practice before the IRS. Suspected violations of Circular 230 and/or the Code's preparer penalty provisions may be referred to the Director. According to IRM (20)(11)22(1)(b), Sec. 6694(a) and (b) penalties trigger a mandatory referral when they are assessed (i.e., when closed agreed by the examiner or sustained in Appeals, or closed unagreed without Appeals contact). In addition, under IRM (20)(11)22(1)(c), when the IRS seeks to enjoin a preparer pursuant to Sec. 7407 for violating Sec. 6694, a mandatory referral also ensues. CPAs who are judged in violation of Circular 230 may either be suspended or disbarred from practice before the Service, receive a private reprimand letter, or be informed that no action will be taken by the Director.(11)

The Sec. 6694 Penalty

Sec. 6694, which covers all tax preparers, including CPAs, was enacted in 1976 and patterned after the existing taxpayer penalty in Sec. 6653. These penalty provisions were revised in 1989 to reflect the professional conduct standards for return positions incorporated into the professional codes of responsibilities issued by the AICPA and the American Bar Association.(12)

Both signing and nonsigning preparers may be liable for a $250 penalty under Sec. 6694(a) if there is an understatement of tax liability resulting from a return position that the preparer knew or should have known lacked a realistic possibility of success. However, Regs. Sec. 1.6694-1(d) requires that an assessment under Sec. 6694 be abated if it is established at any time in a final administrative determination or judicial decision that there was no understatement of liability. According to IRM (20)(11)1(10)(1)(b), the Sec. 6694(a) or (b) penalty is asserted against only one preparer per firm, pursuant to the modified definition of "return preparer" issued by the Service in 1991.(13)

According to Regs. Sec. 1.6694-2(b), as quoted in IRM (20)(11)33(2)(b)1, a return position is one that has a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by a person knowledgeable in the 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. The IRM provides examiners with examples of the application of the Sec. 6694(a) penalty drawn from Regs. Sec. 1.6694-2(b)(3).(14) These examples do not provide adequate guidance for determining how the one-in-three standard applies in typical practice circumstances.(15) As the AICPA pointed out in a critique of an earlier draft of the IRM, this absence of definitive illustrations is troubling. For example, examiners need "to know and understand how to evaluate a District Court opinion in the taxpayer's circuit that is contrary to a Circuit Court of Appeals opinion in another circuit"; similarly, examiners need to be able to assess whether "a well-reasoned District Court decision outweighs a mediocre Tax Court decision."(16)

In concluding that a return position satisfies the realistic possibility of success standard in Sec. 6694(a), the "knowledgeable" preparer is required by Regs. Sec. 1.6694-2(b)(2) to use the same authorities recognized by the IRS in Regs. Sec. 1.6662-4(d)(3)(iii) as appropriate for a "substantial authority" analysis under Sec. 6662, which would exclude reliance on secondary sources. The Service's position, of course, is contrary to the AICPA's Statements on Responsibilities in Tax Practice (SRTP) No. 1, which permits CPAs to use secondary sources.(17)

The standards for a disclosed return position have also changed as a result of the Revenue Reconciliation Act of 1993. While taxpayers may take a disclosed return position only if they have a "reasonable basis" for it, preparers are still covered under the nonfrivolous standard outlined in Regs. Sec. 1.6694-2(c).(18) Thus, a preparer may sign the return and avoid a Sec. 6694(a) penalty if nonfrivolous return positions are adequately disclosed on form 8275, Disclosure Statement, or Form 8275R, Regulation Disclosure Statement, if the position is contrary to a regulation. Regs. Sec. 1.6694-2(c)(2), which defines a frivolous return position as one that is "patently improper,"(19) does not require proof that the position be asserted in bad faith.

Regs. Sec. 1.6694-1(e) provides that for purposes of Sec. 6694 penalties, a preparer generally may rely in good faith without verification on information furnished by the taxpayer. A preparer does not have to examine, audit or review books or records, documents, business records or other evidence to independently verify a taxpayer's information. No preparer, however, may ignore information that he actually knows or the implications of information furnished to him. A preparer is required by Regs. Sec. 1.6694-1(e)(1) to make reasonable inquiries if the information furnished appears to be incorrect or incomplete. A preparer also must make appropriate inquiries to determine whether specific circumstances or facts exist before certain deductions may be claimed (e.g., documentation for travel and entertainment expenses).(20)

According to Regs. Sec. 1.6694-2(d), preparers may also avoid a Sec. 6694(a) penalty if the tax understatement is due to reasonable cause and the preparer acted in good faith. The regulation lists five factors the examiner is to consider in determining whether this exception applies; the nature and frequency of preparer errors are the first two factors listed. For example, uncommon, highly complex or highly technical tax provisions that could cause a competent preparer to make an error may excuse a preparer's error under the reasonable cause and good faith exception.(21) However, if the error is apparent from a general review of either the return or the refund claim, this exception will not apply. According to Regs. Sec. 1.6694-2(d)(2), an isolated error, such as a mathematical mistake, may qualify under this exception unless it is so obvious, flagrant or material that it should have been discovered during a review of the return or claim. Likewise, a pattern of errors may prevent the application of the reasonable cause exception, even if an error taken in isolation might have qualified.

Regs. Sec. 1.6694-2(d)(3) provides that the materiality of errors is a third factor in determining whether the good faith exception applies to an apparent Sec. 6694(a) penalty. Ordinarily, the exception will apply only if the tax understatement is relatively immaterial(22) and if the error that created the tax understatement is not sufficiently obvious or numerous. A preparer's normal office practice is a fourth factor to be considered. According to Regs. Sec. 1.6694-2(d)(4), a "normal office practice" should include a system for promoting accuracy and consistency in the preparation of returns and claims and generally would include, in the case of a signing preparer, checklists, methods for obtaining necessary information from the taxpayer, a review of the prior year's returns, and review procedures.(23) The preparer's normal office procedures must have been followed, and when evaluated along with the preparer's knowledge, must indicate that the error would occur only rarely. Flagrant errors, as well as those that are part of a pattern or are repeated on numberous returns or claims for refund, will prevent application of the reasonable cause exception.

Finally, a preparer may qualify for the reasonable cause exception if he relied on the advice of or schedules prepared by another preparer, as defined under Regs. Sec. 1.6694-1(b).(24) Although the regulations permit advice from another preparer to be given either orally or in writing, preparers have the burden of proof in establishing that they actually received advice from another preparer.

Regs. Sec. 1.6694-2(d)(5) provides that to qualify for the exception, a preparer must have relied in good faith on the advice of a preparer, whom the preparer had reason to believe was competent to give such advice, including a person who would be considered a preparer under Regs. Sec. 1.6694-1(b) had the advice constituted preparation of a substantial portion of the return or refund claim. The exception is not available if the preparer knew or should have known that the other preparer was not aware of all of the relevant facts; nor will it apply if, on its face, the advice is unreasonable or if the preparer actually knew or should have known that the advice received from the other preparer was not reliable because of developments in the law after the advice was given.

IRM (20)(11)38 reprints two examples from Regs. Sec. 1.6694-2(b)(3) to illustrate the possible application of the reasonable cause exception. In IRM (20)(11)38(1)(d), IRS instructions were incorrect and clearly contrary to the regulations. The Service subsequently announced a correction to the instructions. A preparer who took a return position based on the erroneous instructions would have violated the realistic possibility standard; however, he might qualify under the reasonable cause exception if he was unaware of the announced correction or the initial regulations. In the second example, IRM (20)11)38(1)(f), a preparer finds, while researching a return position, that a taxpayer who was audited several years ago had taken the same position. The preparer is told by the taxpayer that the revenue agent was aware of the position and indicated that it was correct. Unfortunately, the revenue agent's report makes no mention of the position. While the revenue agent's oral evaluation does not constitute authority for purposes of determining whether the realistic possibility standard is met, it may be sufficient to trigger the reasonable cause and good faith exception, depending on all the facts and circumstances.

The Sec. 6694 regulations provide more guidance on the reasonable cause exception than appears in the IRM. Unfortunately, neither the manual nor the regulations define key terminology such as "materiality" or the "unreasonableness" of advice received from another preparer; nor do they provide clear guidance on how to evaluate a preparer's competence or education, or how to weigh the five factors listed in Regs. Sec. 1.6694-2(d). The absence of training materials raises a final problem. The Office of Penalty Administration has not issued preparer penalty training materials or published current examples illustrating administration of the reasonable cause and good faith exception. Thus, it is doubtful that the exception will be uniformly implemented throughout the United States.(25)

A $1,000 penalty may be assessed under Sec. 6694(b)(1) for an understatement of tax liability that results either from a willful attempt to understate income tax liability or form any Sec. 6694(b)(2) intentional or reckless disregard of IRS rules or regulations. However, according to IRM (20)(11)33(2)(f), this penalty must be reduced by the Sec. 6694(a) $250 penalty for violation of the unrealistic position standard if both penalties apply to the same return. In addition, IRM (20)(11)34(1) provides that the $1,000 penalty is not imposed if a Sec. 6701 penalty is assessed against the preparer for aiding and abetting an understatement of tax with respect to a document (or portion of a document) that the preparer knows will produce an understatement of tax liability.

Although Sec. 6694(b) does not explicitly provide a reasonalbe cause and good faith exception, a preparer will not have intentionally or recklessly disregarded a regulation or rule if the return position is properly disclosed on either Form 8275 or 8275R and is not frivolous. A challenge to regulations must also be in good faith. IRM (20)(11)33(3)(c)1 states that different disclosure methods are mandated for nonsigning and signing preparers. Additionally, if an undisclosed return position has a realistic possibility of success, there is no penalty for the reckless or intentional disregard of a notice or revenue ruling.(26) These exceptions, however, are not available for willful attempts to understate tax liability.(27)

IRM (20)(11)33(2)(g) provides that, under Sec. 6694(a), a preparer must prove whether (1) he knew or reasonably should have known about the return position, (2) the reasonable cause/good faith exception applied and (3) adequate disclosure was provided. Under Sec. 6694(b), the preparer bears the burden of proof in determining whether (1) disclosure was adequate, (2) a return position contrary to a regulation was made in good faith and (3) a CPA intentionally or recklessly disregarded a regulation or rule. The burden of proof shifts to the Service when the preparer is charged with a willful attempt to understate tax liability.

IRM (20)(11)34(4) advises that imposition of a Sec. 6694 penalty does not preclude the assessment of identification penalties under Sec. 6695. IRM (20)(11)34(3) provides that, in addition to asserting a Sec. 6694 penalty against the preparer, the examiner may conclude that the taxpayer is also liable for a Sec. 6662 accuracy penalty. However, when the facts suggest that both Sec. 6694 and Sec. 6701 preparer penalties apply, IRM (20)(11)34(1) provides that the IRS cannot assert both penalties, but must choose which to assess "for the same act." Currently, the IRM requires that Sec. 6694 penalties be considered during all tax examinations. IRM (20)(11)36(1)(a) provides that the preparer penalty provisions under Sec. 6694 focus on preparer conduct and state that "examiners will not automatically assess preparer penalties based solely on a determination of deficiency proposed in a related taxpayer examination." Because a potential preparer penalty case is considered separate and distinct from the taxpayer case, the examiner is not permitted to discuss or propose any Sec. 6694 penalty in the taxpayer's presence. However, an examiner may make sufficient inquiries to determine whether a preparer penalty case should proceed. According to IRM (20(11)36(1)(b)4, generally, no return preparer penalty will be proposed until the income tax examination is completed at the group level. However, if the preparer case is inseparable from the income tax examination, both cases may be closed together. If the income tax case is unagreed, the examiner may pursue the preparer penalty after the unagreed case is submitted at the group level.

The AICPA Tax Division's Tax Practice and Procedures Committee has expressed a number of concerns both about the role of the examiner in the preparer penalty program and the timing of penalty assertion.(28) For example, the committee has recommended that different examiners be assigned to conduct the taxpayer audit and to determine whether a preparer penalty should be assessed. In addition, because the IRM permits an examiner to assess preparer penalties during the audit, the threat of preparer penalties could be inappropriately used as leverage during the examination. Thus, the AICPA has urged the Service to amend Chapter 11 to prohibit the consideration of return preparer penalties until the completion of the audit. Committee members also urged that return preparers be notified that a preparer penalty case is being considered before the "decision has been made to assess a penalty" and before the Service has questioned the taxpayer about conduct that could give rise to a preparer penalty.(29)

Despite these reservations within the practitioner community, the Service will probably attempt to interview taxpayers regarding the specific conduct for which a preparer penalty is being considered. IRM (20)(11)36(6)(a) states in oblique language that "when the taxpayer is questioned ... the questions will be phrased narrowly and directly without having to introduce or define a 'preparer penalty' issue ...." It is doubtful that this goal can easily be achieved. During such questioning, it may become evident to taxpayers that they may be subject to a taxpayer penalty under Sec. 6662(30) and that their preparer may be liable for a preparer penalty. In an attempt to shift the burden of responsibility onto the preparer, as provided in the Regs. Sec. 1.6664-4 reasonable cause and good faith exception, taxpayers may claim they gave all relevant information to their preparer.

IRM (20)(11)36(6)(b) cautions IRS examiners that "care should be taken in interpreting ... conversations" between taxpayers and preparers. Despite this caution, CPAs would be well-advised to carefully and fully document the facts in particular situations, as well as all client conferences and conversations. Such documentation may protect the preparer both from taxpayer attempts to shift responsibility to him and from any liability claim that the client may subsequently file as a result of taxpayer penalties imposed by the IRS.(31)

IRM (20)(11)36(6)(b) provides the following example illustrating how "conversations" between clients and CPAs can be used to assess culpability:

The statement, "mileage claimed for commuting" ... does not affix preparer culpability for the disallowed expense. However, if the preparer specifically questioned the taxpayer about business related travel and received the above response without qualifying or explaining the term "business-related" to the taxpayer and/or without further questioning the taxpayer concerning the nature of this travel, a penalty may be warranted.

Thorough documentation in client files may enable the CPA to provide a more complete explanation of situations similar to those found in this example, thus preventing assertion of a Sec. 6694 penalty. If the examiner determines, after questioning the taxpayer,(32) that a Sec. 6694 penalty against him is warranted, IRM (20)(11)36(6)(d)1 advises the examiner to further develop the penalty case by contacting the practitioner regarding facts about the preparation of a taxpayer's return, such as the CPA's explanation of the error, office procedures, and the preparer's education, training and experience. The group manager's approval must be obtained before contact with the preparer can be initiated. By always using questionnaires and checklists and fully documenting any discussions with the taxpayer as part of the preparer's normal office procedures, a CPA may be able to demonstrate that Sec. 6694 has not been violated. However, the IRM does not indicate how preparer education, training and experience will be used in the assessment of preparer penalties, an omission noted with concern by the AICPA Tax Division and other commentators.(33) For example, would a CPA with an MBA degree and 10 years' experience be held to a higher standard than a commercial preparer lacking such education and experience?

Although the IRM guidelines do not require a mandatory review of a Sec. 6694 penalty assertion, IRM (20)(11)37 indicates that the preparer has the opportunity to prepare a protest requesting that the issue be reviewed at the appelate level. An unagreed case may not be sent to Appeals until the taxpayer case is submitted; nor may a preparer case be submitted if there are fewer than 120 days remaining on the statute of limitations. In cases in which the examiner decides that no penalty is warranted, a no-change letter will be prepared and left undated in the file, unless the case is subsequently selected for "sample review" by the district Quality Measurement Staff. Pertinent information regarding the possible penalty and the no-change letter will also be sent to the RPC in that district, to be retained for no less than one year.

Defensive Planning Strategies

The IRS has implemented a detailed penalty assertion system currently in place throughout its entire organization. CPA firms that in the past may not have had much experience with preparer penalties are now potentially subject to a system in which examiners have the responsibility in all cases to determine whether a particular preparer should be subject to preparer penalties and/or possibly referred to the Director. Unfortunately, as the AICPA Tax Practice and Procedures Committee has noted, the same examiner who conducts the taxpayer's audit is also assigned to conduct preparer penalty investigations. Conflicts of interest may exist, because this individual may not be totally objective in identifying both taxpayer and preparer penalties. In addition, an examiner's contact with the taxpayer may result in tensions developing between the CPA, as client representative, and the client.(34)

CPA firms should take prudent steps to provide for systematic documentation of client contacts and efforts regarding due diligence. All CPA firms should participate in a quality review system such as that developed by the AICPA. The AICPA's Guidelines for Voluntary Tax Practice Review outline nine factors that should form the basis for any firm's quality control system. The guidelines, for example, stress such obvious factors as advocacy, professional development, supervision, and both acceptance and continuance of clients. Such a review may be conducted internally or may involve an outside firm's participation in the assessment process. This review should also help the firm determine whether it engages in a sufficiently detailed process of client risk assessment, use of engagement letters and maintenance of detailed, written documentation of contact with clients.(35)

Firms should require continuing education coursework of all personnel involved in tax planning and compliance to ensure knowledge of current tax practitioner responsibility standards. Tax personnel should also be familiar with the various penalty provisions outlined above, as well as their responsibilities under both Circular 230 and the SRTPs. The Director regards the SRTPs as enforceable; in addition, they are often cited in liability claims brought against preparers by former clients.(36)

Practitioners should continue to practice as client advocates. They must adopt prudent steps, however, to ensure that they are not subject to monetary fines and possible referral to the Director. At a minimum, a firm must use engagement letters to outline the responsibilities that it is willing to assume with regard to the tax work of particular clients. In addition, all contact with clients, whether in person or by phone, should be documented in writing. Moreover, preparers should maintain a written record of all facts as presented by the client.

CPAs have both a legal and professional responsibility to adhere to the realistic possibility of success standard outlined in the Sec. 6694 regulations and SRTP No. 1. Under Regs. Sec. 1.6694-1(e), tax preparers must make reasonable inquiries concerning information furnished to the preparer or actually known to the preparer that may be either incorrect or incomplete, even though they are not required to perform an audit of the underlying documentation. The reasonable cause exception under the Sec. 6694 regulations suggests, more-over, that preparers use checklists and questionnaires, along with the prior year's tax return, as part of their normal office practice.(37)

Involvement of qualified tax attorneys may also help ensure that preparer rights are protected once a penalty has been asserted. In addition, knowledge about the operation of the penalty system may afford the practitioner the opportunity to contest a penalty. The steps for contesting a penalty outlined in this article should be reviewed whenever a CPA determines that he may be subject to a possible preparer penalty. Penalty amounts that the preparer believes are undeserved should be vigorously contested, because the potential sanctions may not be limited to relatively minor dollar amounts (such as the $250 Sec. 6694(a) penalty). A CPA might be better off contesting even small penalties, given the cumulative nature of the "preparer's file," which may lead to heightened scrutiny by the RPC, including examinations and possible referral to the Director.(38)

The full range of procedural challenges outlined above should also be used by any CPA who may be subject to a penalty. If the practitioner is successful in appealing the preparer penalty, the IRS will issue a "no change" letter, but if Appeals concludes that the penalty is appropriate, the preparer will be asked to sign a waiver on Form 5838, Waiver of Restrictions on Assessment and Collection of Tax Return Preparer Penalty. Preparers should not sign waivers without consulting a tax attorney who can thoroughly explain the consequences of such a waiver, including the likelihood that the preparer may be referred to the Director.(39)

Practitioners in the 1990s are increasingly being subjected to a new regulatory environment. Clients expect that CPAs will continue to defend their interests as client advocates in a cost-effective manner. Congress and the IRS have established a regulatory environment in which a CPA in tax practice must not only satisfy his clients, but also be aware of potential preparer sanctions. Thus, it is essential that each practitioner familiarize himself with the consequences of this brave new preparer penalty world.

(1)Issued Sept. 20, 1993.

(2)Memo to the authors dated June 6, 1994 from Joan Dolian, Director of the IRS Office of Penalty Administration.

(3)The "Preparer/Promoter/Protester Penalties" chapter, issued by Michael L. Killfoil, Acting IRS Assistant Commissioner (Examination) (9/20/93), is cited as IRM (20)(11)00.

Other procedural topics in the IRM, e.g., IRS initiation of program action cases and procedures for enjoining preparers and promoters, as well as a more extended discussion of referrals to the Director, are beyond the scope of this article. In addition, although the IRM outlines the administrative processing of other preparer, promoter and protester penalties (e.g., Secs. 6695, 6700, 6701 and 6713 and the interrelationships among the various preparer penalties), they are not addressed in this article.

(4)The Penalty Screening Committee is appointed at the discretion of the District Director, who may appoint two "management officials" who are "thoroughly familiar" with the technical and procedural requirements of the revenue laws dealing with preparer penalties, to "oversee operations." See IRM (20)(11)1(10)(10) and (20)(11)12(4).

(5)See Rev. Proc. 91-69, 1991-2 CB 893.

(6)If the IRS continues to decentralize penalty enforcement to the district level, there is a possibility of inconsistent national penalty enforcement. See Raby, "Bad Tax Practice Can Drive Out Good? Here Come Congress And the IRS to the Rescue!" 61 Tax Notes 848 (11/15/93) (hereinafter, "Raby").

(7)Feldheim, et al., "Representing Your Audited Clients Before the IRS," at 2-6.10 and 2-1.80 (Callaghan Publishing Corp., 1991). An office auditor conducts less complicated office audits and is only required to have completed two accounting courses; revenue agents, in contrast, conduct more complicated audits and must have at least 20 hours of accounting courses.

(8)The AICPA Tax Division's Tax Practice and Procedures Committee has expressed concern that the IRM permits examiners to assert preparer/promoter penalties during a taxpayer audit. "AICPA Panel Advises IRS to Amend Handbook for Tax Preparer Penalty Assessments," BNA Daily Report for Executives (5/19/94), G-6 (hereinafter, "AICPA Panel"). See also text accompanying note 28.

(9)Treasury Department Circular 230 (hereinafter, "Circular 230"), Section 10.2(a).

(10)See Lesson 2 in Referrals to the Director of Practice, Instructor Guide (Training 9994-101) and Coursebook (Training 9994-102), issued by the IRS (Dec. 1992).

(11)See Circular 230, note 9, Sections 10.50--10.76, for the rules applicable to disqualifying proceedings.

(12)Explanation of Revenue Provisions of the Revenue Reconciliation Bill of 1989, 101st Cong., 1st Sess. 289 (1989).

(13)Regs. Sec. 1.6694-1(b)(1). Under the revised definition, only one employee, partner or other person associated with a firm is regarded as the preparer of the return in question. This rule, however, neither precludes the assertion of a penalty against the firm (as employer) nor the imposition of a Sec. 6694 penalty on more than one preparer not associated with the firm whose "advice constitutes a substantial portion of the return." IRM (20)(11)33(1)(a)3.

(14)The IRM refers IRS examiners to the analysis in Regs. Sec. 1.6662-4(d)(3)(ii) for the standards in determining both substantial authority under Sec. 6662 and realistic possibility under Sec. 6694, and advises them to use the same authorities permitted by Regs. Sec. 1.6694-2(b) for either penalty.

(15)For an extensive discussion of this problem, see Banoff and Coustan, "Final Regulations on Return Preparers' Penalties: IRS Refuses to Deal, Preparers' Fears Prove to Be Real/Penalty Roulette--Roll the Wheel/Who Knows How the Courts Will Feel?" 70 Taxes 137 (Mar. 1992) (hereinafter, "Banoff"). See also Gardner, Willey and Woehlke, "The Final Return Preparer Regulations," 23 The Tax Adviser 208 (Apr. 1992), at 211, for a discussion of problem areas and the realistic possibility analysis.

(16)AICPA Tax Executive Committee, "Comments on Draft of Preparer/Promoter Chapter 11 of IRS Consolidated Preparer Handbook," submitted to the IRS on Jan. 22, 1993 (hereinafter, "Comments on Draft"), Comment 17, p. 3.

(17)AICPA Federal Taxation Executive Committee, Statements on Responsibilities in Tax Practice (SRTP) (1988 Rev.) No. 1, Section 112, .07; see also TD 8382 (12/31/91), SECTION 6694(a) PROVISIONS, 2. Authorities, for a discussion of the IRS rationale on authorities.

(18)The IRS issued proposed and temporary regulations under Sec. 6662 to provide practitioners with guidance on the new reasonable basis disclosure standard. See TD 8533 (3/15/94), Accuracy Related Penalties, Background, for a discussion of the temporary regulations. The temporary regulations do not define "reasonable basis"; Temp. Regs. Sec. 1.6662-7T(d)(2) merely states that it is "significantly higher" than the "not patently improper" standard of a nonfrivolous return position. The IRS plans to include a new definition in the final regulations. See Tax Clinic, "Penalty Regulations Address New Reasonable Basis Disclosure Standard," 25 The Tax Adviser 341 (June 1994).

(19)Regs. Sec. 1.6694-2(e)(ii) sets forth the rules for disclosure for a nonsigning preparer under Sec. 6694(a).

(20)See Regs. Sec. 1.6694-1(e)(1) and (2).

(21)"Provision" is not defined and probably includes such items as the Code, related tax acts and regulations; however, it is uncertain whether it also includes such items as notices or revenue rulings. Banoff, note 15, at 149.

(22)"Materiality" is not defined in the regulations. Banoff, note 15, at 150, expresses concern about the absence of precise definitions in discussing "relative immateriality": "The word 'relative' is important; in a tax return featuring a large tax liability, an understatement may be material in absolute dollars (e.g., $5,000) but 'relatively immaterial' in comparison to the total tax liability."

(23)The IRS in TD 8382, SECTION 6694(a) PROVISIONS, 9. Reasonable Cause and Good Faith, b., Preparer's Normal Office Practice, stressed that the specifics of a preparer's normal office practice are not mandated and that the factors listed in the regulations will help determine if this part of the reasonable cause exception applies.

(24)Banoff, note 15, at 150, notes that to avoid a Sec. 6694 penalty, a preparer may not rely on advice from another preparer associated with his firm.

(25)Banoff, id., at 151, states that examiners may still check Rev. Proc. 80-40, 1980-2 CB 774, issued under Sec. 6694 prior to its 1989 amendment, for guidance regarding the reasonable cause exception.

(26)Regs. Sec. 1.6694-3(c)(3). TD 8382, SECTION 6694(b) PROVISIONS, 2. Rules or Regulations, indicates that revenue procedures may or may not be included in rules or regulations, depending on all the facts and circumstances.

(27)Banoff, note 15, at 151.

(28)AICPA Panel, note 8.

(29)Id. Committee members told Joan Dolian, Director of the IRS Office of Penalty Administration, that examiners should talk to preparers, not the taxpayer, when initially considering the appropriateness of a preparer penalty. With earlier notification, preparers might be able to provide IRS examiners with necessary documentation or information to demonstrate that the preparer penalty under consideration would not be warranted.

(30)Sec. 6662 accuracy-related penalties are the most likely taxpayer penalties.

(31)See SRTP No. 8 for helpful suggestions about the actual form and content of advice given to clients.

(32)See text accompanying note 30.

(33)The AICPA Tax Executive Committee has expressed concern that the reference to education, training and experience in the IRM suggests that CPAs may be held to a higher tax practice standard than are enrolled agents or commercial preparers who also practice before the Service. The AICPA argued that all these preparers should be considered at the same level, so their educational level should be "judged in comparison to taxpayers who would not be expected to have the same expertise as a preparer," not in relation to other preparers. Comments on Draft, note 16, at Comment 12, at 3.

Raby, note 6, at 850, notes that if preparers with more education and/or experience are held to higher standards than are other preparers, they will need to practice more defensively and charge higher fees, which could result in their clients seeking less-qualified preparers. In addition, the imposition of a higher standard may make it more difficult for CPAs to prove the reasonable cause/good faith exception to a Sec. 6694(a) penalty or that a Sec. 6694(b) violation was not willful. Raby, note 6, at 850--851.

(34)AICPA Panel, note 8.

(35)See Raby, et al., Guide to Successful Tax Practice (Practitioners Publishing Co., 3d ed. 1993) (hereinafter, "Raby Guide"), Chapter 1, Section 115, for a more extended discussion of the AICPA Voluntary Tax Practice Review Program. In addition, he suggests useful guidelines for tax practice assessment and risk management, in Chapters 3, 5, 7 and 12.

(36)See Gardner, Willey and Moore, "CPAs' Responsibilities in Tax Practice," 59 The CPA Journal 12 (Jan. 1989). In a Feb. 7, 1991 letter to one of the authors, the Director stated in part: "... depending upon the facts and circumstances pertinent to the matter at issue, interpretation of various provisions of Circular 230 may require us to consider the professional standards of ethical conduct adopted by the AICPA...Accordingly, in order to measure the compliance of a certified public accountant with certain provisions of Circular 230, it may be necessary for us to consider appropriate professional standards contained in the Statements on Responsibilities in Tax Practice." In addition, the AICPA Tax Executive Committee unanimously adopted a motion on July 20, 1994, recommending that the SRTPs be enforceable. See Behrenfeld, et al., Tax Practice Management (AICPA, 5th ed., 1994), Part 301.3.4.

(37)Failure to do so may result in the imposition of a preparer penalty. See, e.g., John Brockhouse, 577 F Supp 55 (N.D. Ill. 1983)(52 AFTR2d 83-5756, 83-1 USTC [paragraph]9410), aff'd, 749 F2d 1248 (7th Cir. 1984)(55 AFTR2d 85-445, 84-2 USTC [paragraph]10,005). Raby Guide, note 35, also recommends practical guidelines for tax practice risk management in Chapter 3, Section 350.

(38)Behrenfeld, note 36, at Part 302.7.

(39)Id.
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Author:Willey, Susan L.
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Date:Feb 1, 1995
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