Section 6694 penalty abatement - reasonable cause

The penalties imposed under Code Sec. 6694(a) or (b) apply only in cases where there is an understatement of a taxpayer's tax liability (Code Sec. 6694(a)(1), as amended by the Small Business Tax Act of 2007 (P.L. 110-28)). However, penalties will not apply if there is a reasonable cause for the understatement and the tax return preparer acted in good faith (Code Sec. 6694(a)(1), as amended by P.L. 110-28). Such an understatement occurs only if the net amount payable with respect to any income tax is understated or if the net amount that is refundable or creditable against taxes is overstated. These penalties can be imposed against a preparer regardless of what administrative or judicial actions the IRS has taken against the taxpayer involved if it is shown that an understatement does exist (Code Sec. 6694(e)).

In determining whether an understatement exists, the net amount payable in a tax year with respect to the return for which the preparer engaged in the prohibited conduct is not reduced by any carryback. Tax imposed does not include additions to tax under Code Sec. 6654 and Code Sec. 6655, relating to underpayments of estimated tax. Further, no final administrative or judicial determination with respect to any taxpayer is required as a prerequisite to imposition of the preparer penalties (Reg. §1.6694-1(c)).

However, penalties assessed against a preparer can be abated later if it is established at any time during a final administrative determination or a final judicial decision that there was, in fact, no understatement of liability underlying the penalty. Any amount of preparer penalty paid must be refunded to the penalized party as if the payment were an overpayment of tax and without any consideration to any period of limitations (Code Sec. 6694(d) and Reg. §1.6694-1(d)).