Rev. Rul. 80-266

Rev. Rul. 80-266 1, 1980-2 CB 378


Section 6694.--Understatement of Taxpayer's Liability by Income Tax Return Preparer

26 CFR 1.6694-1: Understatement of taxpayer's liability by income tax return preparer.


A return preparer who asks a taxpayer if entertainment expense substantiation that satisfies the requirements of section 274(d) of the Code exists and receives assurances that it does will not be subject to the negligence penalty under section 6694(a) as a result of the taxpayer's failure to substantiate the expenses in an audit. A return preparer who does not ask for such assurances will be subject to the penalty, as will the first preparer in a subsequent year if the same assurances are received and the preparer is aware of the prior audit results.


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ISSUE


Does the penalty for negligent disregard of rules and regulations under section 6694(a) of the Internal Revenue Code apply to an income tax return preparer where the preparer relied upon incorrect information provided by the taxpayer?


FACTS

Situation 1


A preparer was engaged to prepare a tax return of a taxpayer who claimed to have incurred deductible entertainment expenses. The preparer inquired whether the taxpayer had records showing the amount, the time, the place and the businesspurpose of the expenses and the business relationship to the taxpayer of the persons entertained in accordance with the requirements of section 274(d) of the Code. The taxpayer represented to the preparer that it hadsuch records. The preparer then prepared the return claiming a reduction for entertainment expenses in the amount indicated by the taxpayer.


Upon examination, the Service disallowed a portion of the claimed deductions because the taxpayer could not substantiate with respect to certain expenses either the business purposes or the business relationship of some of the persons entertained. This determination resulted in an understatement of tax liability as defined in section 6694(e) of the Code.


Situation 2


The facts are the same as in situation 1 except that the preparer did not inquire whether the taxpayer had adequate records, and the taxpayer did not make any representations that it had such records. The preparer did not adequately demonstrate that the preparer's normal office practice should prevent the assertion of the penalty.


Situation 3


The preparer in situation 1 completed the return of the same taxpayer for the year following the examination. The taxpayer again claimed to have incurred deductible entertainment expenses. The preparer inquired whether the taxpayer hadrecords showing the amount, the time, the place, and the business purpose of the expenses, and the business relationship to the taxpayer of the persons entertained. The taxpayer again represented that it had such records. The preparer did not make a further inquiry although the preparer was aware that the taxpayer could not substantiate certain entertainment deductions during the examination in the prior year.


Upon examination the Service again disallowed a portion of the deductions claimed by the taxpayer for entertainment because the taxpayer could not substantiate with respect to certain expenses either the business purpose or the business relationship of some of the persons entertained. This determination resulted in an understatement of tax liability.


LAW AND ANALYSIS


Section 6694(a) of the Code provides that if any part of any underpayment of liability with respect to any return is due to the negligent or intentional disregard of rules and regulations by any person who is an income tax return preparer with respect to such return, such person shall pay a penalty of $100 with respect to such return.


Section 274(d) of the Code provides that no deduction will be allowed for travel and entertainment unless the taxpayer substantiates it with adequate records.


Rev. Proc. 80-40, page 774, this Bulletin, sets forth guidelines for the application of the penalty under section 6694(a) of the Code for the negligent disregard of rules and regulations by an income tax return preparer, including factors that will be taken into consideration in determining whether the penalty will be applied. The revenue procedure provides that a preparer must make appropriate inquiries to determine the existence of facts and circumstances required by a Code section or regulations as a condition to claiming a deduction.


In situation 1 the preparer made appropriate inquiries as to whether the taxpayer had records adequate to meet the requirements of section 274(d) and the regulations thereunder. Because the taxpayer represented that it had such records,it was proper for the preparer to claim the deduction.


In situation 2 the preparer failed to inquire whether the taxpayer had records adequate to meet the requirements of section 274(d) of the Code and the regulations thereunder.


In situation 3 the preparer was aware that the taxpayer could not substantiate some of the entertainment deductions in the examination during the prior year and thus had reason to believe that the taxpayer might not have adequate recordsfor the current year. Therefore, although the inquiry made by the preparer was sufficient in situation 1, it was not sufficient in situation 3. The preparer should have made further inquiries to reconcile the inadequacy of the records in the recent examination of an earlier year with the taxpayer's representation in order to reasonably conclude that the taxpayer now has adequate records.


HOLDINGS


The penalty for negligent disregard of rules and regulations under section 6694(a) of the Code does not apply to the preparer in situation 1. The penalty does apply to the preparer in situations 2 and 3.


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1 Also released as New Release IR-80-94 dated Sept. 15, 1980.