6694 - multiple tax years - assessments - appeals

Rev. Rul. 81-171, cited in full below, is precedent for the current tax law on swection 6694. It provides an opportunity to see how the penalty will apply where there is an understatement and a net operating loss, and I took the opportunity to also discuss the lack of guidance on the assessment of the penalty and the appeal of the penalty.


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


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



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.
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In my view, the term "reckless" in section 6694(b) could be measured in part by the impact of an error on other tax years. The IRS could argue that there is a greater duty of care when the negligent error has an impact on other tax years.

These issues are quite serious because of the large size of the penalties. The $5,000 penalty could be applied to multiple years. In this revenue ruling, the $5,000 penalty would have applied 5 times and would have amounted to $25,000 (assuming the penalty under current law). For planning purposes, I believe we have to assume that the IRS will be aggressive in trying to apply the 6694(b) penalty.

Understand that the IRS examiners are not your personal friends. The statutory relief to appeal the penalty is limited and harsh. The IRS can be expected to hit you with the 6694 penalties even if they are not justified by a reasonable analysis of the facts. I have previously discussed the difficulty of proving "reasonable cause" under section 6694(a)(3), as amended under the Emergency Economic Stabilization Act of 2008.

The proposed regulations do not discuss the procedure for assessing the penalty. From my experience with similar penalties, the IRS Examiner just assesses it with or without notice and with or without discussion.

The proposed regulations 1.6694-4(a) requires an examination report for the return preparer before the assisement of the penalty. Note the following IRM provision:

20.1.6.1.4.1 (02-08-2008)

Pre-Assessment Appeals IRC Section 6694 and IRC Section 6695

Treas. Reg.1.6694-4(a)(1) allows for pre-assessment appeal rights of IRC section 6694 penalties. Although the regulation only relates to IRC section 6694 penalties, Area and Campus examiners will follow the same guidelines for IRC section 6695 penalties. With the exception of IRC section 6695(f), all IRC section 6694 and IRC section 6695 penalties will have pre-assessment appeal rights. A return preparer may appeal IRC section 6695(f) and IRC section 6713, Disclosure or Use of Information by Preparers of Returns , penalties using the post-assessment penalty appeal procedures or the denial of a claim for refund procedures.


Examination sends the return preparer a 30-day letter, Letter 1125 (DO), Transmittal of Examination Report, with an examination report and Publication 5, Your Appeal Rights and How To Prepare a Protest If You Don't Agree, for appeal procedures. If there is no timely response to the letter, the penalty is assessed. Pre-assessment appeals consideration will be granted if requested for IRC section 6694 and IRC section 6695 penalties (except IRC section 6695(f)).

Everyone should understand that these penalties will apply to the 2008 tax year. For this reason, if you have any tax issues that you find problematical, you should have them resolved now before the returns are filed. The key to your safety for these massive penalties is to file returns that will not result in any understatement of tax - that means no mistakes and no negligence.

I do not think these administrative rules are consistent with section 6694(c) which gives you the remedy of paying 15% of the assessment and allowing you a claim for refund if you file the claim withing 30 days. If the claim for refund is denied, your remedy is the District Court. Treat the liberal administrative appeal rights as a "gift" from the IRS.