negligence & 6694 expanded

There was a great deal of interest in the blog published yesterday. Given the large amount of interest in this topic, I expanded the discussion and analysis of that blog and have copied it, as follows:


Prior to the Omnibus Budget Reconciliation Act of 1989, the section 6694 penalty was triggered if “any part of any understatement of liability with respect to any return or claim for refund is due to the negligent or intentional disregard of rules and regulations by any person who is an income tax return preparer”.

Mere “negligence” triggered the penalty under section 6694(a).

The Omnibus Budget Reconciliation Act set forth a new technical standard by providing for the section 6694(a) penalty for any part of any understatement of liability by a return preparer is due to a position for which there was “not a realistic possibility of being sustained on its merits.”Presently, and effective as of May 25, 2007, the Emergency Economic Stabilization Act of 2008 provides that the 6694(a) penalty applies if there is an understatement of liability and the return preparer “knew (or reasonably should have known) of the position” and there was no “substantial authority” for an undisclosed position.

The reason for this review is to put the term “negligence” into perspective. This legislative history makes it clear that any understatement of liability attributable to either a disclosed or undisclosed position caused by “negligence” will always trigger the 6694(a) penalty of $1,000 and if sufficiently “reckless” will trigger the $5,000 penalty (or the greater of 50% of the income derived by the return preparer). The high threshold for “reasonable cause” under section 6694(a)(3), as amended by the Emergency Act, is limited by the proposed section 6694 regulations to the analysis and technical issues identified in section 1.6662-4(d)(3)(ii) and (iii).

For perspective on the term “negligence,” Rev. Proc. 80-40, 1980-2, CB 774 is instructive and contains the following statement: “The case of Marcello v. Commissioner, 380 F. 2d 499, 506 (5th Cir. 1967) holds that negligence is lack of due care or failure to do what a reasonable and ordinary prudent person would do under the circumstances.”

Rev. Rul. 80-263, 1980-2 CB 376 held that the 6694(a) penalty applied when the return preparer made two errors: not including an amount in one of the Forms 1099-INT and made an adding error in totaling the amount of itemized deductions.

In Rev. Rul. 80-28, 1980-1 CB 304, the 6694(a) penalty was applied because the return preparer failed to report the minimum tax liability of $300. Rev. Ru. 80-28 holds the return preparer to the standard of “due diligence.”

The above is enough to give the return preparation industry a “wake up” call. Your mistakes or lack of due diligence will trigger the section 6694(a) penalty. The reason for this observation is that Congress has legislated higher standards of conduct - in 1989, 2007 and now in 2008 (amending 6694 in the Small Business Act of 2007). The legislative history is clear that Congress and Treasury are adamant in cutting down abusive tax return preparation. Lack of negligence is not enough because higher standards of conduct were legislated by Congress. This explains the reason the current proposed regulations on 6694 require an "analysis" of the relevant "authorities" to support both disclosed and undisclosed postions.

In effect, the 6694 proposed legislative regulations expect strong technical support for the posiitons taken, whether disclosed or not disclosed. The same technical requirements should be anticipated in the final 6694 amended regulations.

I do not give too much credence to the lower reasonable basis standard for section 6694 disclosed positions because the proposed regulations still require an "analysis" of the relevant authority to support the disclosed positions. Furthter, "reasonable basis" is a subjective standard, and I do not expect IRS examiners to understand the nuance between "substantial authority" and "reasonable basis" when the distinction is one that is subject to their discretion.

The additional reason return preparers need to provide strong technical support for disclosed positions is that the disclosure of a position to the IRS is an automatic "red flag" for an audit examination. The 6694 statute uses the term "unreasonable position" when referencing the positions disclosed and not disclosed. One has to expect the IRS to audit any disclosed postion that is identified as an "unreasonable position." For this reason, the technical support for a disclosed position should be just as high or higher for an undisclosed position to both discourage the return from being selected from examination and also to prevent the negligence penalty for your client.

Back to the "negligence" issue. There can never be technical support for computational mistakes, not using a required IRS Form, failure to understand the complexity of an issue, failure to know then data is patently wrong, etc. Although the proposed regulations suggest that you can rely on information given to you by a client, do not count on that relief when the tax return is audited. How will you be able to defend against an accusation by the IRS examiner that you were "reckless" for not verifying documentation for a number and proposes to assess a $5,000 penalty for each position in the return that was not substantiated? Even if you were not "reckless," who needs that kind of aggrivation given the complexity and difficulty of opposing the imposition of the section 6694(b) penalty? The penalty can be assessed without immediate appeal rights and without notice to you during the examination or after the examination. I have discussed the problematical appeal issues in a prior blog.

Reliance on client data is high-risk reliance due to the large size of the potential penalties. If any of the client data is wrong, as it often wrong, the return preparer will be on shaky ground when arguing with a return preparer who argues that the return preparer should have investigated the documentation for the data. Does anyone want to be in a position to defend that accusation? The conservative return preparer will not want to rely on client data without confirming the accuracy of that data because the penalty risk is far too high. I do not see the downside to taking a conservative approach if the return preparer is being compensated for that extra effort.

Due to the size of the penalties, you cannot take the chance of "negligence" in preparing a tax return. Anytime the IRS examines a tax return and finds that a taxpayer is subject to penalty under section 6662(a) for negligence (in all cases where there is not substantial authority), the return preparer will be hit with either the penalty under section 6694(a) or (b). I expect the IRS go push for the section 6694(b) penalty in most of these cases because the term "reckless" in section 6694(b) is the same term used in the definition of "negligence" in section 6662(c).

Section 6662(c) states: For purposes of this section, the term "negligence" includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term "disregard" includes any careless, reckless, or intentional disregard." Any understatement of tax for conduct described in section 6662(c) will likely be subject to the section 6694(b) penalty which also uses the term "reckless."

Most IRS examinations cover multiple tax adjustments; therefore, mutiple $5,000 penalties could be assessed in any examination for any tax year. Since IRS examinations normally cover a three year period, the same penalties could apply for three years. I would not be surprised to see section 6694(b) assessments totaling $30,000 or more (asuming two $5,000 penalties for each of three years). That number can go higher, using my assumption that IRS examiners can treat any negligent error as a "reckless" error un der section 6694(b).

It is obvious that the risk of these kinds of penalties is so large that the return preparer has little choice but to spend much more time documenting the data used in a tax return and also documenting the positions taken in a tax return, whether or not the positions are disclosed to the IRS as required in the section 6694 proposed regulations.


Once you understand the higher standards for return preparation for the 2008 tax year and beyond, you will have to reevaluate your fee schdules to account for the addtional time you will need to spend on each return. Given the much higher risk for penalties on return preparers, your engagement letters should factor in the higher risk.

An equally serious question is: are you qualified to support "disclosed" or "undisclosed" positions based on the the requirments to provide the "analysis" required under section 1.6662-4(d)(3)(ii) and the authority referenced under section 1.6662-4(d)(3)(iii)? There is no "analysis" or "authority" for "negligence." This is the reason that the "reasonable cause" exception for "negligence" under section 6664(c) (i.e., relying on section 6664(c) case law and the 6664(c) regulations) will not apply to "negligence" under section 6694 with its much higher legislative standards of conduct and with a much higher threshold for "reasonable cause."

How can you support the posiiton disclosed or not disclosed if you do not have the resources to research the applicable and relevant technical support for the positions taken? Even if you have those technical resources, do you have the skill-set to be able to find the relevant technical support? You can see that the section 6694 penalties are a large trap for the unskilled, unwary and unprepared tax return preparer on the technical issues as well as the potential for negligent error.

The inability of a return preparer to provide an "analysis" of the relevant "authorities" for positions taken in a return should be expected to be viewed by the IRS as automatic negligence. I can testify that as a tax attorney I find the IRS is frequently wrong even on simple tax law issues. You cannot expect that the IRS examiners will be well trained on any tax issue. It follows that in a situation where the IRS is wrong and the tax return preparer correct, the 6694 penalty can still apply IF the position of the return preparer is not supported with the requisite "analysis" and relevant "authority." The brden of proof is on the return preparer that the positions taken are based on "substantial authority" or "reasonable basis."

My personal observation is that the return preparation industry is “in denial” about the impact of section 6694, as amended. I believe it is because this penalty has been previously ignored by the IRS in examinations (even criminal examinations) because of the prior small size of the penalties (i.e. prior to May 25, 2007). Due to the very large size of the preparer penalties under current law, you can expect that the IRS examiners will eagerly make section 6694 penalty assessments. They can make that assessment without notice. For that reason, the IRS software programs could automatically apply the 6694 penalty anytime there is a substantial understatement of income under the objective standards of section 6662(d).

My experience with the current IRS examiners is that they have become extremely aggressive. Forget “fair and balanced” determinations. The IRS will assess the penalty for mistakes of all forms and varieties. Obviously, technical mistakes will trigger the penalty with the further risk that the mistake will be treated as “reckless” and make you vulnerable to the $5,000 penalty. I am certain that the IRS examiners will be motivated by the large size of the penalty in the same way that the IRS is aggressive in assessing the negligence penalty.

I am personally taken aback by the fact that professional organizations like the ABA, the AICPA and NAEA have not made members aware of the new high risk for those who are in the trenches preparing tax returns. I am personally “pounding the table” to make return preparers aware of that risk. And why did these professional organizations not lobby against the large draconian size of the 6694 penalties instead of the standard of conduct which is still a very high standard? Without question, return preparers will be targeted for these large penalties when errors are found in any filed tax return.

Factual and legal issues that will be taken for the 2008 tax year to be filed in 2009 should be resolved now before the filing season begins.

Continue to sent requests for technical opinions to ab@irstaxattorney.com.