The IRS’s power to regulate tax return preparers was limited by the Loving v. Internal Revenue Service, 742 F.3d 1013 (D.C. Cir. 2014) line of cases. These cases generally limit the IRS’s ability to regulate tax preparer conduct at an administrative level.
But the IRS still has a number of tools at its disposal to regulate tax return preparers. Many of these tools impose more severe consequences than those struck down in the Loving-type of cases.
The IRS’s response has been to use these other tools more often, which for many tax preparers, is not a good answer. The James v. Commissioner, T.C. Summary Opinion 2020-11, case involves a tax return preparer penalty audit that went wrong. It provides an opportunity to consider some of these other tools that the IRS can use to regulate tax preparers and how the IRS uses them.
Facts & Procedural History
The petitioner is a tax return preparer. Eight years after immigrating to the U.S., the petitioner had started a tax preparation business and was preparing quite a few tax returns. In 2008 and 2009, he prepared approx. 2,000 tax returns.
The IRS conducted a due diligence audit for the petitioner. It found several problem tax returns, including tax returns with an erroneous claim for the first-time homebuyer credit (FTH credit) and tax returns with erroneous claims for deductions on Schedule A, Itemized Deductions, and Schedule C, Profit or Loss From Business.
A year after the due diligence audit, the IRS criminal investigation unit opened an investigation. It interviewed several of the petitioner’s clients. Some of the clients indicated that the petitioner altered their documents or ignored information provided to him.
A year later, the court entered an injunction barring the petitioner from preparing returns. It also said that petitioner engaged in conduct that is subject to penalty under Section 6701.
A year later, the petitioner was indicted and charged with willfully aiding or assisting in the preparation of fraudulent or false Federal income tax returns under Section 7206(2). He received a 36-month prison sentence.
Two years later, the IRS sent proposed 6701 penalties of $14,000 and $12,000 for the taxable years 2008 and 2009.
These penalties were before the U.S. Tax Court, as the petitioner had requested a collection due process hearing for the penalties.
Section 6701 Penalties
Section 6701 provides for the imposition of a penalty on any person who aids and abets another person in understating his or her tax liability. The penalty is $1,000 for each document involved.
The Section 6701 penalty has three main elements. It applies to anyone:
- who aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document,
- who knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and
- who knows that such portion (if so used) would result in an understatement of the liability for tax of another person
Section 6701(f) also says that the penalty imposed by this section shall be in addition to any other penalty provided by law, except:
- No penalty shall be assessed under Section 6694(a) or (b) on any person with respect to any document for which a penalty is assessed on such person for this penalty.
- No penalty shall be assessed under Section 6700 on any person with respect to any document for which a penalty is assessed on such person for this penalty.
The Section 6694 penalty is the tax return preparer penalty that applies if there is a substantial understatement on a tax return.
The Section 6700 penalty applies to those who promote tax shelters.
Section 7206(2) Fine
Section 7206(2) imposes criminal liability for preparing fraudulent tax returns:
Willfully aids or assists in, or procures, counsels, or advises the preparation or presentation under, or in connection with any matter arising under, the internal revenue laws, of a return, affidavit, claim, or other document, which is fraudulent or is false as to any material matter, whether or not such falsity or fraud is with the knowledge or consent of the person authorized or required to present such return, affidavit, claim, or document;
In addition to criminal liability, it authorizes a fine of up to $100,000 ($500,000 in the case of a corporation).
Section 6701 Penalties & Section 7206(2)
In this case, the petitioner argued that the Section 6701 penalties could not be imposed as he was appealing his Section 7206(2) aiding and abetting conviction at the time.
The court noted that:
civil penalties under section 6701 and criminal penalties under section 7206(2) are separate and distinct penalties. Although they share some common elements, one can be established wholly independent of the other.
The court cited its Kapp v. Commissioner, T.C. Memo. 2019-84, case. The decision in Kapp does note that the Section 6701 penalty has a “knowing” element and the 7206 fine has a “willful” element. It also notes that the Section 6694 penalty uses a negligence standard.
Conduct that is knowing, willful, and negligent has been defined by the courts in various opinions. For ‘knowing’ conduct, the Government must establish that the tax preparer ‘knows’ the use of the return or other document will result in an understatement of tax liability. For willful conduct, must show a ‘voluntary, intentional violation of a known legal duty.’ For negligent conduct, the government has to show a ‘lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances.’
Thus, knowing is harder for the government to establish. Willful is also a fairly high hurdle. Negligence is easier for the government.
So the petitioner was arguing that he was appealing the lower standard fine, so he should not be subject to a penalty with a higher standard.
The court did not agree, as it merely concluded that the penalties were separate and distinct. The court’s holding is consistent with the language in Section 6701 which says that the penalty is separate and distinct.
Interplay with Section 6694 Penalties
While it wasn’t part of this case, it is interesting to note that the IRS could have imposed a Section 6694 penalty. The penalty is the same amount as the Section 6701 penalty. And if the Section 6694 penalty had been imposed, then the petitioner could not have been assessed a Section 6701 penalty.
The IRS typically imposes Section 6694 penalties for tax return preparers. At some point during the due diligence audit by the IRS agent, a criminal referral was made. This was likely due to the tax return preparer’s clients saying that the tax preparer had falsified their tax return. Even if the statements were not true, this type of event can result in a criminal referral and the case processing as this one did. It can be the difference between a simple Section 6694 penalty versus jail time.
This case highlights the web of penalties and sanctions the IRS has at its disposal in handling tax preparer cases. Tax preparer penalty cases and due diligence audits have to be handled with caution.