IRS Letter Ruling 2/29/1980

Letter Ruling 8022027, February 29, 1980

Uniform Issue List Information:

UIL No. 6694.00-00

Understatement of taxpayer's liability by income tax return preparer

National Office Technical Advice Memorandum

Issues


1. Whether A disregarded the tax preparer's regulations in the preparation of B's income tax return for the year 1976 under the circumstances described below; and



2. If so, whether A may be assessed with the penalties imposed by sections 6694 and 6695 of the Internal Revenue Code with regard to the preparation of such returns.



Facts


A, an attorney-tax return preparer, prepared B's tax return for the year 1976. Prior to the year 1976, B's tax returns were prepared by C, a certified public accountant.



B's 1975 tax return was audited by the Internal Revenue Service in the latter part of 1976. C handled the negotiation with the auditor in connection with the 1975 audit. Subsequently, B employed A to prepare their 1976 income tax return. C supplied A with the taxpayer's records which consisted of the items of income and items of expenses to be used in the 1976 income tax preparation.



A prepared and filed B's tax return. Upon audit, the agent disallowed the same deductions that were disallowed previously. The taxpayers agreed to the Service's adjustments.



Due to the agreement, the agent states that A had ample time to ascertain whether or not the records relating to the 1976 return were correct.



The agent contends that A is responsible, under the Code, for the accuracy of the taxpayer's income tax return, and that A was also responsible to exercise due diligence to determine if the taxpayers were maintaining proper records. The agent also contens that A did not make proper taxpayer inquiries with respect to whether the rules and regulations were followed during the preparation of the return. Consequently, the agent proposed a preparer penalty against A.



Generally, A contends that (1) the temporary regulations under section 6694 were published on April 1, 1977, without proper public notice, and that he was unaware of such regulations when he prepared the taxpayer's return; (2) he relied on information furnished by the taxpayer's former preparer; (3) due to the attorney-client relationship his only responsibility is to his client; and (4) the law under section 6694 is unconstitutional.



Applicable Law


Section 6694(a) of the Code provides that if a taxpayer's income tax liability is understated due to the negligent or intentional disregard of rules and regulations by the person who prepared the return or claim for refund, then the preparer will be subject to a $100 penalty. Section 6694(b) provides a $500 penalty if a return preparer willfully understates the taxpayer's income tax liability.



Section 6695 of the Code deals with other assessable penalties with respect to the preparation of income tax returns for other persons. Under this section, penalties ranging from $5 to $100, but not exceeding $25,000 in one instance for any return period, may be assessed on the tax return preparer for (1) failure to furnish copy to taxpayer, (2) failure to sign return, (3) failure to furnish identifying number, (4) failure to retain copy or list, and (5) failure to file correct information return.



Section 6653(a) of the Code (formerly section 1091 of the 1939 Code) states that if any part of any underpayment of income tax is due to negligence or intentional disregard of rules and regulations there shall be added to the tax an amount equal to 5 percent of the underpayment.



Section 1.6694--1(a)(4) of the Income Tax Regulations provides that if a preparer in good faith and with reasonable basis takes the position that a rule or regulation does not accurately reflect the Code and does not follow it, the preparer has not negligently or intentionally disregarded the rule or regulation. This test will be applied in the same manner as it is applied under section 6653(a) (relating to disregard of rules and regulations by taxpayers). For example, if a preparer reasonably takes the position in good faith that a previous ruling does not accurately reflect the Code, the preparation of a return or claim for refund by the preparer in conflict with the revenue ruling is not a negligent or intentional disregard of the revenue ruling.



Section 1.6694--1(b)(2) of the regulations provides guidance in determining what constitutes a willful attempt to understate tax liability. A preparer is considered to have willfully attempted to understate liability if the preparer disregards information furnished by the taxpayer or other persons in an attempt wrongfully to reduce the tax liability of the taxpayer. For example, if a preparer disregards information concerning certain items of taxable income furnished by the taxpayer or other persons, the preparer would be subject to the penalty. Similarly, if a taxpayer states to a preparer that the taxpayer has only two dependents, and the preparer reports six dependents on the return, the preparer would be subject to the penalty.



Rev. Rul. 78--344, 1978--2 C.B. 334 deals with a situation similar to the instant case.



The revenue ruling states that A, a tax return preparer, was engaged by B, a taxpayer, to prepare B's federal income tax return. B had certain items of income which B did not believe were properly includible in gross income, and instructed A not to include the items in gross income as reported on the tax return. Although the income tax regulations provide for the inclusion of these items in gross income, A did not bother to consult the regulations, but chose instead to follow B's instructions on the assumption that B was probably correct. A's failure to include these items in B's gross income resulted in an understatement of B's income tax liability.



The revenue ruling holds that A is subject to the penalty under section 6694(a) of the Code for understating B's income tax liability due to negligent or intentional disregard of the regulations. (Although there are variances between the facts in the instant case and Rev. Rul. 78--344, we believe that the revenue ruling is similar enough to the facts in the instant case to be cited herein).



Rationale


Generally, in preparing a return, the preparer may in good faith rely without verification upon information furnished by the taxpayer. To avoid the penalty, the preparer is not required to examine or review documents or other evidence in order to verify independently the taxpayer's information. However, the preparer may not ignore the implications of information furnished. The preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. Additionally, many sections of the Code require the existence of specific facts and circumstances, such as maintenance of specific documentation, before a deduction may properly be claimed. The preparer must make appropriate inquiries of the taxpayer to determine the existence of facts and circumstances required by a Code section or regulations incident to claiming a deduction.



Sections 6694(a) and (b) do not specifically define what is meant by 'negligent or intentional disregard of rules and regulations' or 'willful understatement of liability.' However, the Income Tax Regulations cited above provide some guidance. Although these regulations were not adopted until 1977, tax return preparers should have been aware how they would be implemented, because the proposed regulations stated that they would be applied in the same manner as the long existing section 6653. The proposed regulations were published in the Federal Register for August 3, 1977. A public hearing was held on September 19, 1977. Comments were received and presented during the hearing, and the income tax preparer regulations were adopted only after thorough consideration had been given to the views of those affected.



The initial consideration of whether a penalty may be applicable is of course up to the judgment of the Internal Revenue Service auditor since he or she is in the position to weigh the facts of the case. However, the standards to be applied are not those of the individual auditor. Also, the Conference Report on the Revenue Act of 1978, H.R. Rep. No. 95--1800, 95th Cong., 2d Sess. 284 (1978) states:


. . . The Conferees further direct that the Internal Revenue Service shall reasonably interpret section 6694(a) according to the standards of section 6653(a) and in light of all the facts and circumstances of each case, takin into account any and all mitigating factors . . ..



Conclusion


It is our position, based on the above, that A did not use due diligence in ascertaining the accuracy and completeness of B's 1976 records. A was aware of the 1975 audit which resulted in certain deductions being disallowed, and after the taxpayer's 1976 return was audited, which resulted in the disallowances of the same deductions, A should have been put on notice that B's tax records were not accurate and that such deductions should not have been claimed.



Therefore, we conclude that:


1. A disregarded the applicable tax preparer's rules and regulations in the preparation of B's income tax return for the year 1976; and


2. The agent who disallowed the deductions acted properly by proposing the $100 preparer penalty against A. Accordingly, A is liable for the preparer penalty imposed by section 6694(a) of the Code.