The Intersection of Preparer Penalty and Taxpayer Examinations

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In this post, I write briefly about the intersection of preparer penalties and an underlying examination of a taxpayer’s tax return. In particular, I highlight informal email advice the IRS gave earlier this month that considers the intersection of preparer penalties, an examination of the taxpayer’s liability, and the statute of limitations to impose preparer penalties under Sections 6694 and 6695. The issue highlights challenges IRS faces in proposing preparer penalties, given that most preparer penalties under Section 6694 and 6695 are dependent upon an underlying taxpayer’s liability. I say most because that is not so with the EITC due diligence penalty, where a preparer can be dinged even if the taxpayer’s EITC claim is correct, as I discuss below.

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Brief Context

The preparer penalties in Sections 6694(a) and 6695 are subject to a special three-year statute of limitations on assessment under Section 6696(d) that is pegged to the time the underlying taxpayer’s return was filed. (Note though there is no sol on assessment for penalties stemming from an understatement attributable to a preparer’s willful misconduct or recklessness). IRS is supposed to under IRM procedures “generally” wait until the underlying taxpayer exam is complete before proposing preparer penalties. As such, if the underlying exam starts late or takes a long time to complete, the IRS may find itself with its back to the statute of limitations wall when it comes to possibly assessing penalties against preparers. In the email, IRS notes that while the general rule to wait on the preparer exam is the norm, it is not an absolute requirement:

IRM 20.1.6.4 provides that the determination of whether the 6694/6695 penalties are warranted is made based on all the facts and circumstances developed during the examination process of the underlying prepared return. This is consistent with the fact that generally information with respect to the exam of the underlying return will be necessary to develop any potential 6694/6695 penalty. IRM 8.11.3.2(2) provides that in the case of preparer penalty cases based on underlying tax returns, “in general, an unagreed penalty case will not be sent to Appeals before the related tax return is submitted to Appeals.” Now, this does not specifically say that the preparer penalty investigation cannot actually begin before that time. Accordingly, in a specific circumstance, initiating an investigation of any applicable preparer penalty while the examination of the underlying taxpayer’s return continues does not appear to be specifically prohibited.

(emphasis added)

To deal with SOL issues, the email advice provides that the IRM allows for an assessment of the preparer penalty when little time is left if the preparer does not consent to extending the SOL. The advice notes a preparer would not have pre-assessment Appeals rights in such situations, but would be left with the option of post assessment administrative appeal rights. As the 6694 and 6695 penalties are not subject to Tax Court deficiency procedures, preparers are then shoehorned into refund litigation if there is continued disagreement with the penalty.

Some Challenges

A recent write up of the email from the Arizona Society of CPAs blog highlights some of the challenges stemming from the general IRS approach discussed in the email:

First, as a practical matter the details and results of the exam are key factors to be considered in assessing the penalties, since the penalties under §6694 require there be an understatement of tax and the penalty under §6695(g) deals with lack of due diligence in determining if someone was eligible for the earned income credit, so that the final determination if that person was eligible is clearly a useful piece of information.

Second, informing a preparer that he/she is under investigation for a preparer penalty clearly could be seen as an irresponsible attempt at intimidation of the preparer’s representation and, perhaps, even looked at as an attempt to extort concessions in the exam.

Brief Parting Thoughts

The latter point about how a preparer may perceive a penalty exam as an attempt to intimidate the preparer’s representation presents a dynamic I had not considered. The preparer exam creates the possibility for a conflict of interest in the exam and introduces a dynamic that at a minimum complicates the preparer/taxpayer relationship.

As to the relationship between a taxpayer’s underlying EITC claim and a possible preparer $500 EITC due diligence penalty, my understanding of IRS practice on those due diligence exams is that IRS review of preparers’ compliance with the due diligence rules exists irrespective of the accuracy of the taxpayer’s underlying return. While a preparer may be selected for an EITC due diligence audit due to a high likelihood of underlying errors on the clients’ returns (through say DIF scores), the preparer’s liability for the penalty has no relationship to the underlying EITC claim’s accuracy. A preparer can face significant EITC due diligence penalties for example for failing to comply with the regulation’s document retention or knowledge requirements even if the taxpayer’s underlying EITC claim was accurate.

The 6695(g) penalty is pegged at $500 for each failure to comply with the EITC due diligence requirements, limited sensibly by a cap at $500 per return, even if the preparer flunks more than one of the requirements for any one taxpayer.  (A useful summary of the EITC due diligence requirements can be found on the IRS web page, here).

I will have more to say on EITC preparer due diligence audits, where IRS has issued some advice in the past year that is meant to highlight situations where preparers are expected to make additional inquiries of taxpayers. The exposure that preparers face in these due diligence audits is potentially substantial, and the IRS’s guidance in this area has been largely informal and not subject to meaningful formal practitioner or stakeholder comment.

 

 

About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

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