negligence and 6694(b)

Taxpayers are required to maintain records sufficient to enable the Commissioner to determine their correct tax liability. Sec. 6001; Higbee v. Commissioner, 116 T.C. 438 (2001); sec. 1.6001-1(a), Income Tax Regs. The records must substantiate both the amount and purpose of the claimed deductions. Taxpayers have the burden of proving they are entitled to the claimed deduction. The burden of proof to avoid a 6694 penalty is obviously much higher because it is required that the return preparer substantiate a position with an analysis of the relevant authorities. Therefore, if one cannot even meet the negligence burden of proof, the 6694 penalties would be automatic. And any negligence that is "reckless" whould easily be the type covered by the $5,000 6694(b) penalty.

Section 6662(a) imposes a penalty of 20 percent of the portion of the underpayment of tax which is attributable to, negligence or disregard of rules or regulations under section 6662(b)(1), or a substantial understatement of income tax, section 6662(b)(2). For purposes of section 6662(a), the term "negligence" includes any failure to make a reasonable attempt to comply with the Code, and the term "disregard" includes any careless, reckless, or intentional disregard. Sec. 6662(c); section 1.6662-3(b), Income Tax Regs. Negligence has also been defined as a "'lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances.'" Neely v. Commissioner, supra at 947 (quoting Marcello v. Commissioner, supra at 506); Criss v. Commissioner, T.C. Memo. 2002-62.

I have been "pounding the table" trying to wake up the return preparation industry that there is a new technical paradigm for return preparation that is coming at you like a tsunami. Unless you wake up and make changes, the IRS will hammer you with 6694 penalties that could range from $1,000 to perhaps $25,000 for any tax return in any tax year beginning with the tax returns filed for the 2008 tax year.

Do not assume that you are immune from making a mistake on a tax return that the IRS will view as “reckless” because you did not file a 1099, follow the detailed regulations for substantiation on travel or entertainment expenses, a home office deduction, the correct depreciation formula, or technical requirements for any other personal or business expense. You all have made hundreds of those kinds of mistakes. I represent taxpayers and return preparers in civil and criminal examinations and I am witness to massive negligence by return preparers that today would justify large amount of $5,000 reckless penalties under section 6694(b).

In the typical civil examination that I have monitored, there is normally some item of income that was not reports, normally some lack of substantiation for some expense or deduction and some technical problem with an expense or deduction. Or perhaps the IRS examiner will determine that the return preparer should have had his client file a Form 1099 which was not filed. On these simple facts, there is the potential of a $5,000 6694(b) penalty for each issue or a possible $15,000 or $20,000in return preparer penalties for each tax year because each failure is arguably a “reckless” failure within the meaning of section 6694(b). If one of the issues is that the travel and entertainment substantiation regulations were not completely followed, that will be a “per se” reckless issue.

The penalties will not arise until the 2008 tax returns hit the audit cycle in 2010, 2011 and thereafter. The penalties will hit and drive a large body of return preparers out of business and collectible for large amounts of penalties.

Whether you know this or not, the IRS has software that targets return preparer negligence. They check the error rate in the returns you prepare. If the error rate is high, they audit the return preparer in civil and criminal examinations. The IRS does interview the customers of return preparers to check for civil and criminal fraud. Going forward, given the large size of the 6694 penalties, they will go for the penalties.

I am certain that the IRS will be motivated by the large size of the return preparer penalties and that the IRS examination software will be updated to track errors in client’s returns, not only for possible fraudulent returns, but for abusive preparation practices and negligence.

I have criticized your professional organization for lobbying for the “substantial authority” standard when they should have lobbied to reduce the large size of the return preparer penalties. Further, your professional organizations has not giving you the “wake up” call that I am giving you.

It is not only the need for you do prevent negligence on your part (e.g., doing a better job of tracking tax law and regulations, but also the Internal Revenue Manual), YOU WILL HAVE TO BE ABLE TO SUPPORT THE POSITIONS TAKEN WITH AN ANALYSIS OF THE RELEVANT AUTHORITIES whether or not you disclose problematical positions taken to the IRS in compliance with IRS disclosure procedures.

Unfortunately, I have discovered that most of the larger return preparation firms have their “head in the sand” and have not taken any action to reduce the risk of 6694 penalties, including their failure to instruct employees on ways to minimize potential 6694 penalties. That is a formula for “firm self-destruction.”

In order to avoid "reckless" 6662 penalties and corresponding 6694(b) penalties, return preparers will have to focus on the 2008 tax year now - before the returns for the 2008 tax year are filed in 2009. If you wait for the audit or a reaction from the IRS from disclosed positions, that is too late to correct "negligence." The substantiation should be done before the returns are filed and before the data is misplace or forgotten when the returns are examined.

The days of failing to veryify substantiation requirements are over. It would be foolish to rely on the section 1.6694-1(e) of the proposed regulations that indicate you can rely on information supplied by your client. TThat reliance is a trap for the unwary return preparer. Note the following statement in the same regulations:

"The tax return preparer, however, may not ignore the implications of information furnished to the tax return preparer or actually know by the tax return preparer. The tax return preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete."

The out-of-control and aggressive IRS examiners can be expected to allege that you need to make reasonabile inquiries because you should have known that the information appeared to be incorrect or incomplete. This is what you must do in 2008 and not wait for thia "trap" to nail you with $5,000 reckless penalties. Whether you should have relied on your client or not relied on your client's data is an issue that will haunt return preparers when the filing season starts for the 2008 tax year.

You will all have to spend more time on the tax returns for the 2008 tax year, and you will need to revist your client contracts and charge them for that additional time.