Avoiding Tax Preparer Penaltiesby
For tax preparers, the primary Code provision, titled “Underpayment of taxpayer’s liability by tax return preparer,” is section 6694(a) and (b). Penalties they can incur typically relate to understatement of liability or overstatement of refund claims.
As a tax preparer, the primary issue to avoid down the road is whether you were “unreasonable” on a day you signed a return.
Our emphasis is debatable return positions, but our preparer penalty topic has many aspects, such as failure to furnish a copy, failure to sign, failure to furnish ID, etc (See the list in section 6695). The definition of a tax return preparer focuses on getting compensation for preparing a return (Sec. 6694(f) citing Sec. 7701(a)(36)).
We find “reasonable position” coming up in the discussion, a phrase that basically requires “substantial authority” for the reporting position on a return. The issue normally comes up in circumstances of debatable positions. Re disclosure, see generally Form 8275 Rev. January 2021. When a position is taken contrary to a regulation, see Form 8275-R (Rev. August 2013) and instructions.
“Form 8275 is filed by individuals, corporations, pass-through entities, and tax return preparers…..
For items attributable to a pass-through entity, disclosure should be made on the tax return of the entity. If the entity does not make the disclosure, the partner (or shareholder, etc.) can make adequate disclosure of these items.” (Instructions to Form 8275).
In 2020, the IRS generally updated its guidance on when “adequate disclosure” will avoid penalty (Rev. Proc. 2020-54, 12/29/20, updated by Rev. Proc. 2021-52). There are also issues focused on having a “reasonable basis” for a return position. In this regard, the regulations provide:
“Reasonable basis. Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in section 1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in section 1.6662-4(d)(2) (See section 1.6662-4(d)(3)(ii) for rules with respect to relevance, persuasiveness, subsequent developments, and use of a well- reasoned construction of an applicable statutory provision for purposes of the substantial understatement penalty). In addition, the reasonable cause and good faith exception in section 1.6664-4 may provide relief from the penalty for negligence or disregard of rules or regulations, even if a return position does not satisfy the reasonable basis standard.” (Regs. 1.6662-3(b)(3)).
Our context also requires a view toward a 20 percent taxpayer underpayment penalty that can be added to the tax (Sec. 6662(a)). A focus here is the taxpayer and whether the understatement exceeds the greater of 10% of the tax required to be shown on the return, or $5,000 (Sec. 6662(d)(1)(A)). Special rules can apply in determining underpayments involving Section 199A qualified business income deductions.
“While preparing the 2008 tax return for an individual taxpayer, Preparer F realizes that the taxpayer did not provide a Form 1099-INT, “Interest Income”, for a bank account that produced significant taxable income in 2007. When F inquired about any other income, the taxpayer furnished the Form 1099-INT to F for use in preparation of the 2008 tax return. F did not know that the taxpayer owned an additional bank account that generated taxable income for 2008, and the taxpayer did not reveal this information to the tax return preparer notwithstanding F's general inquiry about any other income. F signed the taxpayer's return as the tax return preparer. F is not subject to a penalty under section 6694..” (Regs. 1.6694-1(e)’(3), Example 2).
Tax professionals weigh, debate our concerns above with debatable return positions, the degree of support for a particular position, etc. However, the penalty issue can arise is cases of an inadvertent mistake.
The author was asked to explain the circumstances to the IRS when the penalty question(s) arose in “just forgot” circumstances involving multiple years. The preparer signed a series of amended entity returns asserting a credit and properly disclosed the taxable income increase (deduction decrease) arising from asserting the credit.
In the circumstances, it was too late to assert a reduced credit, which can avoid having to include the plus to taxable income that normally arises from asserting the credit. The properly prepared entity return was even attached to the Form 1040, but the taxable income increase on the Form 1040 was omitted even though the credit was asserted.
The IRS is currently wrestling with whether to assert the penalty, and whether to assert section 6694(a) or (b) given the omission, despite the obvious disclosure in the amended entity return attached to the amended Form 1040. There were complications and circumstances to discuss but the error did basically get back to the preparer “just forgot.”
We mention this in the context of return administration. For example, including reviews can be helpful considering the potential for the “just forgot” circumstance.
The preparer penalty is independent of any taxpayer issues, though the timing of any taxpayer exam can affect the timing of any preparer penalty.
“A determination on a preparer penalty case is conducted independently of, and without regard to, the determination on the income tax case. The tax case has bearing on the preparer penalty case only insofar as assertion of the penalty requires an understatement of tax.” (Internal Revenue Manual, 22.214.171.124.2 (05-14-1999), IRS.gov.) Preparer penalties are subject to appeal (See “Penalty Appeal Eligibility,” IRS.gov.).
The Preparer’s Caution/The Preparer’s Perspective
The time for research and weighing any issues of potential preparer penalties is during the preparation and review process, toward the goal of comfort (and penalty avoidance) after signing a return. As we’ve noted, while potential preparer penalties are usually considered issues to weigh and research, they can also be potential issues in cases of inadvertent oversight. The basic rules governing such penalties need to be understood by every preparer.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...