Tax Return Preparer Penalty (Explained)
The IRS is able to impose tax preparer penalties for inaccurate or incomplete tax return preparation. This is known as the “Section 6694 penalty” or the “tax preparer penalty.”
This penalty is typically imposed on tax return preparers for tax understatements, excessive allowances, omitted income, overstating deductions, and other failures. It applies to misconduct that does not rise to the level of conduct that triggers criminal liability for aiding and assisting in the preparation of a false tax return.
The rules for this penalty are nuanced. There is little guidance that interprets the rules. An experienced tax attorney can help given their knowledge of how the IRS views these failures and rules and how it administers these penalties. They can also help avoid criminal penalties on audit.
If you are a tax preparer who is being audited for these penalties (or have been assessed these penalties and need to appeal the penalty) or if you want to learn more about these penalties, continue reading to find out more.
Who is a Tax Return Preparer?
Congress has changed the tax return preparer penalty rules over time. The general rule that a tax return preparer is a person who prepares your tax return has not changed. This is the common meaning of the term.
Our tax laws include a more nuanced definition. For purposes of the civil tax penalties, a tax return preparer is:
… any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return of tax … or any claim for refund of tax…. For purposes of the preceding sentence, the preparation of a substantial portion of a return or claim for refund shall be treated as if it were the preparation of such return or claim for refund.
This means that an individual who prepares a tax return for free is not a tax return preparer.
It also means that an individual who prepares part of a tax return can be a tax return preparer for that portion of the tax return.
It also means that there can be more than one tax return preparer for each tax return. The regulations say that the individual who is “primarily responsible” is the one who is liable for the penalty.
The reference to “person” means that the preparer can even be a legal entity, such as a partnership or corporation. The regulations say that this can even include a sole proprietorship.
The rules go on to exclude the persons who merely:
- furnish typing, reproducing, or other mechanical assistance;
- prepares a return or claim for refund of the employer (or of an officer or employee of the employer) by whom he is regularly and continuously employed,
- prepares as a fiduciary a return or claim for refund for any person, or
- prepares a claim for refund for a taxpayer in response to any notice of deficiency issued to such taxpayer or in response to any waiver of restriction after the commencement of an audit of such taxpayer or another taxpayer if a determination in such audit of such other taxpayer directly or indirectly affects the tax liability of such taxpayer.
Those who are not excluded by these rules can be subject to penalties for any failures, as discussed below.
What is the Maximum Penalty for Tax Return Preparer?
The short answer is that there is no maximum civil penalty for tax preparers.
As explained below, the civil penalty is either a fixed $1,000 or $5,000 per return amount or a percentage of the fees the tax preparer charges.
Since most tax preparers charge less than the fixed fee amounts for preparing each tax return, the penalties are typically either $1,000 or $5,000 per return.
This may not sound like a large amount, but these penalties are usually quite large. The IRS typically imposes these penalties on several tax returns at once. It is common for these penalties to total $100,000 or more for each tax preparer.
These penalties are set out in Section 6694(a) and Section 6694(b).
IRC 6694(a) – Penalty for Understatement Due to Unreasonable Positions
Section 6694 provides for a penalty on any tax preparer who prepares a tax return that has an understatement of taxes if the understatement is due to an unreasonable position.
An unreasonable position is one where there is no substantial authority for the position, the position is not disclosed to the IRS and/or there is no reasonable basis for the position, or the position is a tax shelter.
The term “substantial authority” was changed in 2007. It now requires a reasonable belief that the position would more likely than not be sustained on its merits. This is usually thought to be a greater than 50 percent chance that a court would uphold the position.
The term “reasonable basis” is something more than “not frivolous.”
The penalty is the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.
IRC 6694(b) – Penalty for Preparer’s Willful Understatement of Tax
Section 6694(b) imposes a penalty for willful or reckless conduct in preparing a tax return.
This penalty applies to tax preparers for a:
- willful attempt in any manner to understate the liability for tax on the return or claim, or
- reckless or intentional disregard of rules or regulations.
This penalty is the greater of $5,000 or 75 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.
It should be noted that the IRS can impose both the Section 6694(a) penalty and the Section 6694(b) penalty for the same tax return. However, the Section 6694(b) penalty is reduced by the amount of the Section 6694(a) penalty that is paid.
It should also be noted that the IRS has the burden to prove that the preparer acted willfully to understate tax.
IRC 6695 – Due Diligence Penalties
These penalties are different from the due diligence penalties set out in Section 6695.
The due diligence penalties are much smaller in amount and are less likely to be assessed for multiple tax returns than Section 6694 penalties.
The due diligence penalty is $545 (in 2022) for each failure on a tax return.
These penalties are imposed for failure to comply with the due diligence requirements.
The due diligence requirements are documented on Form 8867, Paid Preparer’s Due Diligence Checklist. The form asks the tax preparer to certify that they made inquiries about any of the following items included on the tax return: Earned income tax credit (EITC), Child tax credit (CTC), additional child tax credit (ACTC), credit for other dependents (ODC), American opportunity tax credit (AOTC), or Head of household (HOH) filing status.
These penalties are in addition to other remedies available to the IRS, such as injunctions barring the preparer from preparing tax returns.
The regulations say that a tax preparer is not liable for penalties if they relied on the taxpayer, other tax advisors and prior tax returns. They say that a tax return preparer:
may rely in good faith without verification upon information furnished by the taxpayer. A tax return preparer also may rely in good faith and without verification upon information and advice furnished by another advisor, another tax return preparer or other party (including another advisor or tax return preparer at the tax return preparer’s firm). The tax return preparer is not required to audit, examine or review books and records, business operations, documents, or other evidence to verify independently information provided by the taxpayer, advisor, other tax return preparer, or other party.
They go on to say that:
a tax return preparer may rely in good faith without verification upon a tax return that has been previously prepared by a taxpayer or another tax return preparer and filed with the IRS. For example, a tax return preparer who prepares an amended return (including a claim for refund) need not verify the positions on the original return.
Each provision says that the return preparer cannot ignore the implications of information that is provided and must make reasonable inquiries.
When is a Tax Return Prepared?
The regulations say that a tax return is prepared on the date the tax preparer signs the return. If the tax return preparer does not sign the return, the return is prepared when the tax return is filed.
If the tax preparer merely provided tax advice that triggered the penalty, the tax return is considered to be prepared on the date the advice is given. All of the facts and circumstances are considered in making this determination.
No Penalty if Reasonable Cause
What happens if the tax preparer makes a mistake? The IRS is not normally interested in whether or not an error was intentional or inadvertent. A tax preparer who makes a substantial error may be subject to penalties.
With that said, Section 6694 states that any person who prepares a tax return shall not be subject to a penalty for an understatement if the tax preparer had reasonable cause and acted in good faith.
There are several factors that are considered in making this determination, including the nature of the error that caused the understatement, the frequency of the errors, the materiality of the errors, the preparer’s normal office practice, and reliance on the advice of another tax preparer.
No Penalty if No Understatement
Tax return preparer penalties should not be imposed where there is no understatement of tax for the taxpayer. Thus, if the taxpayer challenges their tax liability and prevails, there is no tax return penalty that should be imposed. The IRS is to refund these penalties to the tax return preparer in these cases. There is no time limit that bars the IRS from making these refunds.
If the IRS opts to not adjust the taxpayer’s account, it is not clear whether the tax preparer penalty applies. The IRS has taken the position that it does.
The regulations say that a carryback is not considered in determining whether there is an understatement. They do not address affirmative issues raised on later returns or omitted carryforwards.
The regulations also confirm that penalties and interest are not considered tax for purposes of this penalty. An understatement is only based on tax.
Criminal Aiding and Assisting Penalty
In addition to the civil penalties noted above, tax return preparers can also be subject to criminal penalties. Section 7206(2) says that it is a felony to aid and assist in the preparation of a false tax return.
This can include a fine of up to $250,000 ($500,000 for corporations) and imprisonment of up to three years.
Unlike the civil penalty counterparts, the tax return preparer does not have to be paid for his or her services to trigger criminal liability.
These cases usually require the tax preparer’s clients to testify against the preparer. This can present an evidentiary hurdle the IRS has to overcome to secure a conviction.
Tax Preparer Penalty Attorney
We are tax attorneys in Houston, Texas and we help tax preparers with these penalties. We have an enviable track record when it comes to these penalties.
If you are a tax return preparer and you have a preparer audit or have been assessed a preparer penalty, we want to hear from you. Call us at (713) 909-4906.
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