Section 6701 imposes a penalty for assisting another person in understating their tax liability.
The Section 6701 penalty is not subject to a statute of limitations. The IRS can assess these penalties at any time, even years and decades after the fact.
This can result in very large penalty assessments for those who prepare tax returns for a living.
These penalties can even be the basis for an injunction barring the preparer from practicing as a tax professional.
The recent Kapp v. Commissioner, T.C. Memo. 2019-84, court case helps demonstrate when this type of penalty can apply.
Facts & Procedural History
Mr. Kapp is a CPA. His tax preparation business focused on assisting mariners with their individual income tax returns.
Mr. Kapp had written several articles about mariners and their ability to deduct the cost of meals incurred while at sea. Mr. Kapp took the position that mariners working as employees could deduct a portion of the meal costs even though the costs were paid for by the employers.
The U.S. Tax Court eventually considered the issue in two cases and concluded that the meal expense was not allowable. Mr. Kapp continued to prepare tax returns taking a position that these meals were deductible by the employees. He did so even though his tax attorney had prepared a memo disagreeing with the position.
Eventually the IRS assessed Sec. 6701 and 6694 tax penalties for Mr. Kapp. It did so for several thousand returns Mr. Kapp prepared. The penalty was $5 million.
The IRS attempted to collect the penalties and Mr. Kapp used the collection due process hearing rules to litigate his liability for the penalties in U.S. Tax Court. The court focused on the Sec. 6701 penalty.
The Sec. 6701 Penalty
Our tax laws provide for a penalty for assisting a taxpayer in understating their tax liability. The penalty is $10,000 if the understatement is by a corporation and $1,000 if the understatement is by non-corporate taxpayers. The penalty is applied on a per tax return basis.
This 6701 penalty applies to any person:
- 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.
The last element, the knowledge requirement, makes the Sec. 6701 penalty unique. Sec. 6701 requires the person to know that there would be an understatement. This is different than the Sec. 6694 tax return preparer penalty, which can penalize mere negligent conduct (the Section 6694 penalty also applies to tax return preparers; whereas, the Sec. 6701 penalty applies to anyone who advises on the tax position).
What Facts Count as Knowledge?
But what facts count as knowledge for this penalty?
In the present case, the U.S. Tax Court had heard two prior tax disputes involving Mr. Kapps’s clients and their tax returns. In both cases, the court had concluded that meals were not deductible by the employee if they were provided by the employer.
There was also other evidence in the record that indicated that Mr. Kapp knew that meals were not deductible by the employee. This included articles he had published after the court cases and a legal memo prepared by his tax attorney. Given this evidence, the court concludes that Mr. Kapp met the knowledge requirement.
That there was a written position by the CPA is consistent with other court cases involving Sec. 6701 penalties. For example, in United States v. Camp, 629 F.Supp 2d 1224 (W.D. Wash 2009), the taxpayer was a CPA who prepared a legal memo describing his position on the deductibility of mining expenses that were not paid. The legal memo served as the basis for establishing his knowledge.
Proving Knowledge Absent Written Evidence
But in the present case, what if there were no published articles or tax attorney’s memo? The result might not have been the same.
It is not clear why Mr. Kapp chose to testify in the case. But he did. The court considered his testimony. Mr. Kapp testified that he did not regularly ask clients about whether their employer paid for the meals. He did not keep records of the employer meal policies. While the court mentions these facts, it is not clear whether this shows knowledge. These facts would appear to be facts that would support a negligence penalty, such as the Sec. 6694 penalty.
The outcome may have been different in a different court. While Mr. Kapp chose to litigate this matter in U.S. Tax Court, which requires an appointed judge to consider the case, he could have paid the penalties and contested the penalties via a refund claim in U.S. District Court. This could have afforded him the ability to have a jury decide the issue. A jury may not have had the same view as to what knowledge Mr. Kapp had at the time he prepared the tax returns in question.
Absent this testimony, it may have been difficult for the IRS to assess Sec. 6701 penalties. Given that Mr. Kapp prepared several thousand tax returns and the penalty is $1,000 per return, this could have saved him several million dollars in penalties. This amount is possible as the Sec. 6701 penalty is not subject to a statute of limitations. The IRS can assess it at anytime, even after may years have passed.
But Mr. Kapp would not be home free. While this may have avoided Sec. 6701 penalties, the IRS would no doubt still assess Sec. 6694 tax return preparer penalties. The IRS assessed both Sec. 6701 and 6694 penalties in this case.
These penalties have other consequences too. Both the Sec. 6701 and 6694 penalties are prerequisites for an injunction. The injunctions typically bar the tax return preparer from preparing tax returns or providing tax advice. The IRS will typically assess these penalties and use them as the basis for obtaining an injunction.