The New Tax Return Preparer Penalty

The tax return preparer penalty is a tool used by the IRS to encourage compliance with tax laws and ethical behavior among tax return preparers.

The penalty is imposed when a tax preparer engages in conduct that results in the understatement of a taxpayer’s liability due to fraudulent, reckless, or intentional misconduct. The penalty amount varies depending on the type and extent of misconduct.

Recently, Congress made significant changes to the penalty, which caught both the IRS and the tax community off-guard. The IRS responded by issuing several Notices that were partially amended due to criticism.

To clarify the changes, the IRS has issued Proposed Regulations that incorporate the IRS Notices and amendments, with varying effective dates and new concepts. It is important for tax return preparers to understand the penalty and stay up-to-date with any changes or proposed regulations–particularly since the IRS frequently audits tax return preparers for this issue and return preparers may not have a right to an administrative appeal for these penalties.

About the Tax Return Preparer Penalty

The tax return preparer penalty is set out in Section 6694. It applies to tax return preparers who prepare tax returns or claims for refund that result in an understatement of tax liability.

The penalty only applies if the preparer engages in either reckless or intentional disregard of tax laws or regulations and those who prepare a tax return that includes an unreasonable position.

Under Section 6694, the penalty for preparing an inaccurate return or claim for refund is the greater of $1,000 or 50% of the income earned by the preparer for the preparation of the return or claim for refund. For a willful or reckless violation, the penalty increases to the greater of $5,000 or 50% of the income earned by the preparer.

The penalty for an unreasonable position is $1,000 per return or claim for refund, with a maximum penalty of $10,000 per preparer per year.

Who is a Tax Return Preparer?

As expected, the definition of “tax return preparer” under Section 6694 includes individuals who prepare tax returns–but has been applied to tax returns that the preparer did not even prepare. It only includes those who do so for compensation. Free tax preparation does not trigger a penalty.

Firms, partnerships, corporations, and other entities can also be the tax return preparer. Additionally, Section 6694 applies to tax professionals who participate in the determination of tax benefits, including attorneys, accountants, and enrolled agents.

Examples of actions that may trigger the tax return preparer penalty include:

• Failing to take reasonable steps to ensure the accuracy of information provided by the taxpayer.
• Failing to reasonably apply tax laws and regulations to the taxpayer’s situation.
• Intentionally disregarding tax laws or regulations.
• Failing to disclose a position that is not supported by a realistic possibility of success under Section 6662.
• Failing to disclose a reportable transaction under Section 6707A.

The burden of proof is on the IRS to show that a tax return preparer has engaged in conduct that warrants the imposition of the penalty. Additionally, the IRS may impose additional penalties for other conduct, such as aiding and abetting the understatement of tax liability or engaging in fraudulent conduct.

The New Preparer Penalty Rules

Here is a summary of the new tax return preparer penalty rules:

1. A tax return preparer can be the person who prepares a tax return or any person who advises the taxpayer or tax return preparer on a line item on the return,
2. The recent changes drop the concept of “income” from the term “income tax preparer,” which means that the preparation of tax returns that are not income tax returns may subject the preparer to penalties,
3. The penalty is now equal to the smaller amount of $1,000 or 50% of the amount of income the tax return preparer earns for preparing the tax return or providing the tax advice for the specific item on the return that results in an understatement,
4. The penalty is increased to the smaller amount of $5,000 or 50% of the amount of income the tax return preparer ears for preparing the tax return or providing the tax advice for the specific item on the return if willful or reckless conduct is involved,
5. The penalty applies if the tax return preparer does not reasonably believe that the position will “more likely than not” be sustained on the merits if challenged by the IRS,
6. The “more likely than not” standard means that the tax return preparer must believe that there is a 50 percent chance that the position will be sustained,
7. The penalty will not be imposed if the position is properly disclosed so long as there is a “reasonable basis” for the position, and
8. The “reasonable basis” standard means that the tax return preparer must believe that there is approximately a 10 to 25 percent chance that the position will be sustained.

Issues to Consider About the Changes

The new changes raise a number of questions and issues. Here are a few of the questions and issues raised by the new penalty rules:

1. Pursuant to the proposed regulations, the amount of the penalty is not reduced if the tax return preparer discounts or refunds a portion of their fees (i.e., to reduce the 50 percent of compensation received), but there is no rule that the tax return preparer’s contractual agreement cannot allocate the amount of compensation between tax return preparation and non-tax return preparation services,
2. The penalty only applies to tax return preparation or advice that is provided for compensation and not for services that are provided for free,
3. The penalty does not appear to apply to tax advice that does not end up on a tax return (such as telling a taxpayer not to file a tax return),
4. There are several types of tax documents that are not “tax returns” for purposes of the penalty,
5. There is no clear definition for determining what constitutes a “reasonable” belief,
6. There may be no ability to disclose the lack or records or documents to support a position in order to avoid the tax return preparer penalty (which encourages IRS agents to claim that all adjustments on audit are due to lack of documentation, even if the adjustments should be for a legal or other reason), and
7. There will generally be only one tax return preparer; however, there can be multiple tax return preparers within any one firm (meaning that a subordinate employee can even be a tax return preparer if the supervisor signs off on the tax return).

It will be interesting to see how the IRS administers the return preparer penalty and whether it will be handled by the IRS’s Office of Professional Responsibility (“OPR”).  The OPR has had several notable persons appointed to run it, but it has had a difficult time finding its way.  This penalty might give the OPR the framework it needs to effectively regulate tax return preparers.

This penalty is just another way for the IRS to regulate tax preparers. The IRS has a myriad of other tools to regulate tax return preparers, such as the ability to obtain injunctions against preparers in court and getting to recover tax preparation fees.

The Takeaway

The tax return preparer penalty is a tool used by the IRS to promote compliance with tax laws and ethical behavior among tax return preparers. Recent changes to the penalty raise a number of questions. It is important for tax return preparers to stay up-to-date with any changes or proposed regulations to avoid disputes with the IRS or situations where the IRS could impose penalties. Tax return preparers should factor in these rules into their business model to avoid these penalties.