Florida Bar Journal

Preparer Penalties: The Thin Line Between Tax Advisor and Return Preparer

The IRS has issued over 1.8 million preparer tax identification numbers (PTINs) since September 2010. Of these, nearly 700,000 remain active.^[1] This number, however, paints only a small portion of the picture, rather like a friendly little bush in the corner of a Bob Ross painting, because anyone can prepare a return. As with many things in life, however, once money is on the table, things get more complicated. If someone is paid to prepare a return or claim for refund, or someone employs a person who is paid to prepare the same, we have crossed the threshold into the regulated world of “tax return preparers.”^[2]

You may be sitting at your desk, diplomas on the wall and leather-bound volumes of the 1939 version of the code on your bookshelf,^[3] peering at the title of this article, and musing to yourself that you have never prepared your own tax return, much less anyone else’s. You would, more than likely, be wrong. When an attorney renders substantive legal advice or opines on a position that is later adopted by the taxpayer on a tax return or claim for refund or credit, the attorney inadvertently crosses a line of demarcation between attorney and preparer.

Before you append “preparer” to your title on the firm’s business cards, “preparer” is not really an honorific, as the IRS does not care about fancy degrees or certifications,^[4] nor whether a preparer is not a U.S. person, nor whether the return was prepared outside the United States.^[5] Thus, when your cousin Bijou — who left school in Quebec the summer after ninth grade to tour with the Grateful Dead, and serving as the band’s bookkeeper for 20 years (a long, strange trip, indeed) — prepares your Uncle Bill’s income tax return in exchange for $50 and a case of Molson, Bijou is a preparer. As a preparer, Bijou is subject to substantial responsibilities and rather unpleasant penalties, as we discuss below.

Who is a Tax Return Preparer?

A “tax return preparer” is any person that prepares (for compensation, or who employs one or more persons to prepare for compensation) any “return of tax” under the code or any claim for refund of such tax.^[6] As noted in the introduction, anyone may be a preparer. When someone prepares or advises a taxpayer as to a “substantial portion” of the return, he will be considered to have prepared the entire return.^[7] Take pause and reread that last sentence. Even if you, as an attorney, do not physically enter numbers on the face of a return, once you render an opinion regarding a “substantial portion” of a return, you have likely branded yourself as a preparer, as weighty label as the scarlet letter that Hester Prynne wore as a mark of her ignominy.^[8] What’s more, you may have brought your firm with you.

Not everyone will bear this burden. The code provides that someone, who merely provides mechanical or clerical assistance, is not a preparer,^[9] nor is someone who prepares a return for his regular employer.^[10] If a person prepares a return in their capacity as a fiduciary^[11] or in response to a notice of deficiency or an audit,^[12] then he, too, will not be considered a preparer. The regulations provide a much longer list of persons who are not preparers.^[13]

Preparers are divided into two general categories, “signing” and “nonsigning” preparers.^[14] A signing preparer is the person having the primary responsibility for the overall substantive accuracy of the return,^[15] whereas a nonsigning preparer is anyone else that prepares all or a “substantial portion” of a return.^[16] In general, therefore, only a person who prepares all or a substantial portion of a return will earn the “preparer” moniker.^[17] A portion of a return — whether a schedule, entry, or other part — is considered “substantial” if the tax attributable to that portion is substantial in comparison to the total tax required to be shown on the return. The regulations provide a nonexhaustive list of factors, including the size and complexity of the item relative to the taxpayer’s gross income.^[18]

Critically, a person who renders tax advice relevant to the “existence, characterization, or amount of an entry on a return,” as tax attorneys often do, will be considered to have prepared the entry.^[19] When that advice leads to a position or entry that constitutes a substantial portion of the return, the advisor rises to the level of preparer.^[20]

If Bijou prepared a return for Uncle Bill’s emu conservancy (a partnership) in 2020, and Bill prepared his personal return in 2020, Bijou will not be considered the preparer of Bill’s individual return unless an item reported on the conservancy’s return is directly reflected on the individual return and constitutes a substantial portion of the individual return.^[21] Thus, when Bijou reported an incorrect loss on the conservancy’s return, and such loss flowed through to Bill’s return, Bijou is the preparer of Bill’s return. What happens if Bijou took an unreasonable position or was as reckless with Bill’s return as he has been known to be while trying to peel off a corner guard when curling under the influence?

Penalty for Understatement Due to an Unreasonable Position

The code imposes a penalty when a preparer adopts an “unreasonable position” or engages in “willful or reckless conduct” in preparing a return, but only if such untoward tax behavior results in an understatement of tax liability.^[22] Thus, no matter how badly Bijou bungles Bill’s return, if there is no understatement, no preparer penalty can be asserted.^[23] If there is an understatement, but it is based on an isolated mathematical or transcription error, a preparer penalty is unwarranted.^[24]

When a preparer assumes an unreasonable position, and he or she knew (or should have known) that the position was unreasonable, the preparer will be liable for the greater of $1,000 or 50% of the income earned preparing the return.^[25] Tax shelters are an IRS hot button; so, it should come as no surprise that preparers will be liable for taking a position related to tax shelters.^[26]

If a preparer takes a position regarding a reportable transaction, he or she must reasonably believe that there is over a 50% possibility that the position would succeed on its merits if examined by the tax authorities, which is to say that it is more likely than not to be sustained.^[27] To form this belief, the preparer must examine all pertinent facts and authorities.^[28] One “fact” a preparer may not consider when determining the position’s chance of success is the possibility that the IRS will never challenge the position.^[29]

A preparer also may be liable if the position is not disclosed on the return without substantial authority for adopting it,^[30] and he or she may be liable if the position was disclosed without a reasonable basis for it.^[31] “Reasonable basis” is a low threshold, generally requiring a 20% chance of success.^[32] “Substantial authority” lies somewhere in between the reasonable basis and more likely than not standards.^[33]

If a position was not adequately disclosed on the return, a preparer must have substantial authority for the tax treatment of an item, meaning that the weight of the authorities supporting the treatment is substantial in relation to contrary authorities.^[34] The IRS examines all facts and circumstances, including the preparer’s experience in the area and familiarity with the taxpayer’s affairs and the complexity of the issues.^[35] If the position was adequately disclosed and is not a tax shelter or reportable transaction, a position is unreasonable only if it has no reasonable basis.^[36]

For a signing preparer, “adequate disclosure” of the position may be made by reporting the position on Form 8275, Form 8275-R, or on the tax return itself,^[37] or it may be made by providing the taxpayer with the prepared return, including the required disclosure.^[38] If the return is subject to an accuracy-related penalty,^[39] the preparer makes an “adequate disclosure” by advising the taxpayer of the penalty standards in I.R.C. §6662,^[40] if the preparer contemporaneously documents such advice.^[41] For nonsigning preparers, the rules are far more esoteric, banal, and soporific.^[42]

Under both the substantial authority and reasonable basis standards, a preparer may rely on information furnished by the taxpayer, another advisor, preparer, or a party that is “competent” in the opinion of the preparer.^[43] If made in good faith, this reliance may be made without written verification.^[44] If the taxpayer is the subject of a “written determination,”^[45] the preparer will avoid a penalty for taking a position consistent with the IRS’s determination.^[46]

Reasonable Cause and Good Faith Exception to I.R.C. §6694(a)

If a preparer demonstrates reasonable cause exists for the understatement, and he or she acted in good faith, the preparer will not be liable for a preparer penalty under I.R.C. §6694(a).^[47] The regulations provide a nonexhaustive list of six factors to consider.^[48] The first three examine the type and number of the errors themselves,^[49] and the final three look to whether the preparer’s reliance on standard operating procedures and the advice of others was reasonable.^[50]

The first factor examines whether the error resulted from the misinterpretation of a complex, uncommon, or highly technical tax provision, which could reasonably trip up even the most competent preparer.^[51] If the understatement was isolated and inadvertent, rather than a pattern of errors,^[52] or if the understatement was immaterial in relation to the correct amount of liability, the IRS will be more willing to find reasonable cause.^[53]

The first reliance-based factor considers whether the preparer relied on normal office practices, whether the error was inadvertent and isolated, and whether the error would not have occurred if the preparer had followed protocol.^[54] The next inquiry focuses on whether the preparer’s reliance on the advice of others was appropriate and made in good faith.^[55] If the advice was unreasonable on its face, the preparer knew that the person providing the advice was not aware of all relevant facts, or the preparer knew that the law had changed in the particular area, no reasonable cause exists.^[56] Finally, reasonable cause may exist if the preparer reasonably, in good faith relied on generally accepted administrative or industry practices.^[57]

A law firm that employs a preparer subject to a penalty under IRC §6694(a) may also be subject to penalty under three conditions.^[58] If anyone in the firm’s management knew about the conduct giving rise to the error and liability, the IRS may impute liability onto the firm.^[59] Likewise, if the firm had no reasonable and appropriate quality control procedures to review the penalized position (or others like it), or if the firm had such procedures, but defenestrated and disregarded them willfully, recklessly, or through gross indifference, the IRS likely will find the firm liable for preparer penalties in addition to the preparer-employee.

Penalty for Understatement Due to Willful, Reckless, or Intentional Conduct

If an understatement (or any part thereof) is due 1) to a willful attempt by the preparer to understate a taxpayer’s liability for tax or 2) to a reckless or intentional disregard of published rules or regulations,^[60] the preparer will be liable for the greater of $5,000 or 75% of the income derived from preparing the return.^[61] A preparer willfully attempts to understate liability if — in an attempt to wrongfully reduce the tax liability of the taxpayer — he or she disregards any information furnished by the taxpayer or other persons.^[62]

If a preparer knows of — or is reckless in not knowing of — a “rule or regulation,”^[63] aside from a few limited exceptions, the preparer may not take a position contrary to such rule or regulation.^[64] Recklessly disregarding a rule or regulation includes stubborn ignorance, which is typified by a preparer who “makes little or no effort to determine if a rule or regulation exists,” or a preparer who has deviated far off the path of industry standards of conduct well-trodden by other, more reasonable preparers.^[65]

As for the aforementioned exceptions, a preparer may challenge a regulation in good faith, so long as 1) he or she identifies the regulation he or she is challenging; 2) he or she has a reasonable basis for the position taken contrary to a regulation; and 3) he or she adequately discloses such position.^[66] If a preparer challenges a revenue ruling or IRS notice, the preparer’s position must meet the substantial authority standard, and it may not relate to a reportable transaction.^[67]

The penalties under I.R.C. §6694(a) and (b) are not cumulative;^[68] instead, any penalty imposed under I.R.C. §6694(b) will be reduced by any penalty assessed and collected for the same position on a return or claim for refund under I.R.C. §6694(a). Practically, this means that a preparer’s pocketbook will only be 75% lighter under I.R.C. §6694(b) rather than entirely empty under I.R.C. §6694(a) and (b), combined. Notably, this reduction appears to apply only to the liability of the preparer, and not that of the preparer’s firm.^[69]

As under IRC §6694(a), a firm may be liable for its employee’s willful, reckless, or intentional attempt to understate a liability under IRC §6694(b).^[70] The same factors discussed in relationship to firm liability regarding IRC §6694(a) apply equally to IRC §6694(b). Interestingly, the regulations do not appear to impose entity-level liability for a preparer’s violation of IRC §6694(c) (reckless or intentional disregard of rules or regulations).

Extension of Period of Collection

If a preparer is found liable for a preparer penalty, he or she may pay at least 15% of the penalty within 30 days after notice and demand and file a claim for refund to challenge the liability,^[71] thereby forestalling any enforced collection by levy or a proceeding in court regarding the penalty until the final resolution of the refund claim.^[72] If the claim for refund is denied, and the preparer does not initiate a proceeding in a United States district court for the termination of liability for such penalty,^[73] then within 30 days thereof, the IRS may levy against or sue the preparer to collect the penalty balance.^[74] The 10-year period of limitations under I.R.C. §6502 applies to preparer penalties, and this period is suspended as long as the IRS is prohibited from collecting.^[75]

Other Assessable Preparer Penalties under I.R.C. §6695

In addition to the penalties under I.R.C. §6694, the code contains a number of additional penalties that apply specifically to preparers, including seven such penalties under I.R.C. §6695. The first five of these penalties relate to the violation of rules and regulations, while the final two appear concerned with issues of policy rather than violation of rules and regulations.

Pursuant to I.R.C. §6107(a), a signing preparer must sign a paper return when it is complete and before he or she presents it to the taxpayer for signature.^[76] A preparer need not sign a return to be electronically filed prior to presenting the completed copy to the taxpayer; however, the preparer must furnish all of the information that will be transmitted to the IRS at the same time as he or she provides Form 8879, “IRS e-File Signature Authorization,” to the taxpayer.^[77] Further, a return must bear the preparer’s tax identification number (PTIN) pursuant to I.R.C. §6109(a)(4).^[78]

A preparer must retain a completed copy of all returns for three years, or, at the very least, must retain a list of names and taxpayer identification numbers of taxpayers for whom he or she prepared returns.^[79] Failure to do so is a violation of I.R.C. §6107(b). Finally, if a firm employs one or more signing preparers to prepare returns or claims for refund — other than for the firm itself — I.R.C. §6060 requires such firm to maintain a record of the preparers’ name, taxpayer identification number, and principal place of work, and such record must be made available to the IRS for inspection upon request.^[80]

These final two requirements present issues for law firms with inadvertent attorney-turned-preparers, as it is difficult to keep a list of taxpayers for whom the attorneys have prepared returns, when the attorneys do not recognize that their advice constituted “preparation.”

Nonetheless, if a preparer fails to satisfy any of these five requirements, he or she will be liable for a penalty of $50 for each failure, with a maximum of $25,000 per person, per year. No penalty will be assessed if the failure is shown to be due to reasonable cause and not willful neglect.^[81] For purposes of I.R.C. §6695(b) only, reasonable cause is defined as “a cause that arises despite ordinary care and prudence exercised by the individual preparer.”^[82] Reasonable cause is not specifically defined for other sections under I.R.C. §6695; thus, reliance on the generally accepted definition is appropriate.^[83]

A preparer may not endorse or negotiate a check — either directly or through an agent — for the refund of tax under the code that is issued to a taxpayer for a return that the preparer had a hand in preparing, or he or she will be liable for a penalty of $500 for each check (with no ceiling).^[84] No penalty will be asserted if the check is fully deposited into the taxpayer’s bank account.^[85] Hearkening back to our earlier example, because Bijou prepared the return that gave rise to Uncle Bill’s refund, Bijou may not cash or deposit the refund check into his own account; however, he may affix Bill’s name on the check and deposit it into Bill’s bank account.^[86]

Failure to be Diligent in Determining Eligibility for Certain Tax Benefits

When it comes to the eligibility for certain tax credits, the IRS is notoriously stingy, and preparers are the IRS’s front line in this parsimonious war. Preparers must perform due diligence to ensure that the taxpayer is entitled to any claimed credit,^[87] and they must retain records of the same.^[88] The signing preparer must properly compute and document the amount of any credit,^[89] complete Form 8867, “Paid Preparer’s Due Diligence Checklist,” file it electronically with the return or see that it is filed with a paper return.^[90] The Form 8867 must be based on information provided by the taxpayer otherwise reasonably obtained or known by the preparer,^[91] who has no actual knowledge that such information is incorrect.^[92]

The same factors of knowledge and failure to act, institutional review failures, and disregard of its review procedures through willfulness, recklessness, or gross indifference that impose firm-level liability under IRC §6694(a) apply equally to a firm’s liability for their employee’s due diligence failures under IRC §6695(g).^[93] Although reasonable cause is not an exception to the due diligence penalty, a preparer may show that he followed normal procedures and that the failure to meet the due diligence requirements was isolated and inadvertent.^[94]

Other Penalties that Apply to Preparers

In addition to two categories of penalties listed above, the code contains six other penalties that can be applied to preparers. Three are civil in nature, while the other three are criminal in nature. The civil penalties are for promotion of abusive tax shelters under I.R.C. §6700, aiding and abetting the understatement of tax liability under I.R.C. §6701, and disclosure or use of information by preparers under I.R.C. §6713. The three criminal penalties are related to fraud and false statements under I.R.C. §7206, fraudulent returns, statements, or other documents under I.R.C. §7207; and criminal disclosure or use of information by preparers under I.R.C. §7216. The civil penalties are quite substantial, and they are in addition to other penalties under the code. Notably, however, imposition of these three civil penalties may affect the assessment of the other preparer penalties discussed above.^[95]

Conclusion

The potential exposure of the tax preparer, the preparer’s supervisor, and the preparer’s firm is substantial. It is critical that all parties involved with the compensated preparation of returns and claims for refund or credit understand the requirements and the penalties that apply if they color outside the lines that are sharply defined by the code and regulations.

The most important takeaway from this article is that tax attorneys rendering advice to a taxpayer on a position that the taxpayer later adopts on its return may be considered a preparer if the position is “substantial” in light of the rest of the return. As tax attorneys, we are, more often than we care to admit (or even realize), technically preparers. Thus, it is critical that tax attorneys and the firms that employ them understand the contours of the preparer rules and penalties to ensure that the proverbial line is toed. Losing sight of the implications of substantive tax advice could lead to unwelcome and unforeseen penalties.

This column is submitted on behalf of the Tax Section, Harris L. Bonnette, chair, and Taso Milonas, Charlotte A. Erdmann, Daniel W. Hudson, and Angie Miller, editors.