Rev. Rul. 81-171, 1981-1 CB 589


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.

(Also Section 7701; 301.7701-15.)

Return preparers; multiple penalties.--

Separate penalties may be asserted under section 6694(a) of the Code for each taxable year return affected by a return preparer's negligent or intentional overstating of expenses on a taxpayer's return thereby creating a net operating loss that was carried back on amended returns for 3 years to claim refunds and carried forward to the succeeding year's return. The penalty for the succeeding year will apply even though that year's return was prepared by a second preparer who used the information from the prior years' returns. No penalty may be imposed against the second preparer.


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ISSUE 1


May the penalty under section 6694(a) of the Internal Revenue Code, for understating tax liability on a return, be separately applied for other taxable year returns affected by the preparer's negligent or intentional disregard of rules and regulations?


ISSUE 2


May the penalty under section 6694(a) of the Code be imposed against an income tax return preparer when an understatement of liability on a return prepared by that preparer is caused by the negligent or intentional disregard of rules and regulations by another preparer?


FACTS


B, an income tax return preparer, in preparing A's 1979 return, negligently or intentionally overstated A's expenses, thereby creating a net operating loss for the year. B then prepared amended income tax returns for the years 1976, 1977, and 1978 and claimed refunds for those years based on the net operating loss carryback from 1979. Because the carryback was not exhausted in 1978, a portion of the loss was available to be carried forward to 1980. C, another income tax return preparer, prepared A's 1980 return, using the information presented to C by A, including a copy of the 1979 return. C was not aware of the negligent or intentional overstatement of expenses by B but checked the amount of the net operating loss deduction claimed in 1976, 1977, and 1978 so that C could show what appeared to C to be the proper amount of net operating loss deduction on the 1980 return. The net operting loss deduction constituted a substantial portion of A's 1980 return.


The Internal Revenue Service determined that the overstatement of A's expenses for the taxable year 1979 had resulted in an understatement of tax liability on A's 1979 return and that the erroneous net operating loss deduction had resulted in an understatement of tax liability on A's 1980 return and on the amended returns for the taxable years 1976 through 1978.


LAW AND ANALYSIS


Section 6694(a) of the Code provides that if any part of any understatement 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 6696(e) of the Code defines "return" to mean any return of tax imposed by subtitle A. This definition would include an amended return as well as an original return.


Under section 1.6694-1(d) of the Income Tax Regulations, an understatement of liability exists if, viewing the return as a whole, there is an understatement of the net amount payable of any income tax, or viewing the claim for refund as a whole, there is an overstatement of the net amount creditable or refundable.


Section 301.7701-15(b) of the Regulations on Procedure and Administration provides that only a person who prepares all or a substantial portion of a return or claim for refund shall be considered to be a preparer of the return or claim for refund. A preparer of a return is not considered to be a preparer of another return unless the entry or entries reported on the prepared return are directly reflected on the other return and constitute a substantial portion of the other return.


Under section 172 of the Code, a net operating loss may generally be carried back to the 3 years immediately preceding the year in which the loss occurs and, if not entirely used to offset income in those years, may be carried forward for as many as 7 years. Section 172(c) defines "net operating loss" as the excess of allowable deductions over gross income.


In this situation, the negligent or intentional overstating of expenses on A's 1979 return by B created a net operating loss and resulted in an understatement of tax liability on the 1979 return. Such understatement subjected B to the penalty under section 6694(a) of the Code with respect to the 1979 return. In addition, the carryback and carryover of the net operating loss to the years 1976, 1977, 1978, and 1980 resulted in understatements of liability for those years.


B is considered the preparer of the 1980 return because the net operating loss from the 1979 return was directly reflected as a deduction on the 1980 return and constituted a substantial portion of that return. C is also the preparer of the 1980 return. However, the understatement of A's 1980 tax liability was not due to the negligent or intentional disregard of rules and regulations by C.


HOLDING

ISSUE 1


The penalty imposed by section 6694(a) of the Code for negligent or intentional disregard of rules and regulations may be asserted against B with respect to A's return for 1979. Penalties may also be asserted against B with respect to the amended returns prepared by B for 1976, 1977, and 1978 based on the erroneous net operating loss deduction. A penalty may also be asserted against B because of the understatement of liability on A's 1980 return caused by the erroneous net operating loss deduction. Furthermore, if the Service establishes willfulness on the part of B under these circumstances, the penalty under section 6694(b) of the Code also applies for each of the years 1976 through 1980. See Rev. Proc. 80-40, 1980-2 C.B. 774, for a listing of some of the factors that will be taken into considerating in determining whether the penalty under section 6694(a) will be applied to a negligent preparer. See also Rev. Rul. 80-262, 1980-2 C.B. 375, Rev. Rul. 80-263, 1980-2 C.B. 376, Rev. Rul. 80-264, 1980-2 C.B. 377, and Rev. Rul. 80-265, 1980-2 C.B. 377, which consider the applicability of the penalty under section 6694(a) in various situations.


ISSUE 2


No penalty may be imposed against C.