6694 - when is there a duty to investigate?

Watson v. Commissioner, TC Memo. 2008-276, December 10, 2008 is a case decided yesterday that deals with “negligence.” As readily apparent from the “substantial authority” standard of conduct for undisclosed positions and the “reasonable basis” standard for disclosed positions, the section 6694 penalty will apply if the return preparer is “negligent.”
Therefore, the case law dealing with “negligence” is relevant as guidance for tax return preparers.

In the Watson case, the taxpayers invested in a partnership that the Tax Court determined was not a reasonable investment from an income tax perspective. Even if the taxpayers had invested to make money, and had no purpose to obtain tax breaks, they were sufficiently experienced investors that the generous tax benefits accompanying the investment should have raised a red flag. A reasonable and ordinarily prudent person would have seen the red flag and made a proper investigation or exercised due diligence to verify the tax benefits. This is a standard that applies to tax return preparers under 6694. Return preparers will be subject to the penalty if they do not see “red flag” situations under the facts given to them by their client. If the client has made an investment in a partnership, it would be imprudent for the return preparer to fail to inquire about the function and business purpose of that investment. Under section 1.6694-2(b)(2) of the proposed regulations, a tax return preparer cannot rely on information supplied by a client if the reliance is unreasonable.

The Tax Court in Watson noted:,

Negligence is lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances." Fincher v. Commissioner, 105 T.C. 126, 140 (1995); Santa Monica Pictures, L.L.C. v. Commissioner, T.C. Memo. 2005-104. In cases involving deductions resulting from a taxpayer's investments, courts generally look both to the reasonableness of the underlying investment and to the taxpayer's position taken on the return in evaluating whether the taxpayer was negligent. E.g., McDonough v. Commissioner, T.C. Memo. 2007-101. In Neonatology Associates, P.A. v. Commissioner, 299 F.3d 221, 234 (3d Cir. 2002), affg. 115 T.C. 43 (2000), the Court of Appeals said: "When * * * a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril." That is, a taxpayer must make a "proper investigation or exercise due diligence to verify the * * * tax legitimacy" of such an investment.

In any circumstnace where a client has a duty to make a proper investigation or exercise due dil(igence to verify an investment, the return preparer who is aware of that investment in preparing the tax return)also has the corresponding duty to investigate.

In the Watson case, the taxpayer was held to be negligence for failure to investigate an investment; by the same rationale return prepares have similar constructive notice when a client reports an investment in an organization that may be tax-motivated. In those circumstances, the failure of the return preparer to investigate the investment would be unreasonable within the meaning of the 6694 proposed regulations.

Consider the following cases for guidance on the duty of a return preparer to investigate the underlying investment of a client.


An investor was liable for the negligence penalty as a result of his investment in a nonexistent cargo container business. The taxpayer was negligent because he never verified the existence of the containers or the alleged lessees of the containers. His reliance on an investment advisor was not unreasonable. The advisor was not required to be an expert in the area of the investment and was a disinterested party. S. Anderson, CA-10, 95-2 USTC ¶50,463, 62 F3d 1266.

The negligence penalty was imposed on a rancher for failure to exercise due care when he took a deduction for large amounts of prepaid feed expenses that he re-sold a short time later. The taxpayer failed to show a valid business purpose for the prepaid feed deduction. O.L. Gragg, CA-5 (unpublished opinion), 94-2 USTC ¶50,631, aff'g, per curiam, an unreported District Court decision.

A taxpayer negligent because he invested in an oil and gas limited partnership. Neither the taxpayer nor his accountant had experience in the investment and the investment advertised improbable tax advantages. L. Goldman, CA-2, 94-2 USTC ¶50,577, 39 F3d 402.

An attorney who claimed substantial tax benefits with respect to his investment in a sham plastics recycling limited partnership was liable for the negligence penalty because he failed to act reasonably or exercise due care in making the investment. Nothing in the record suggested that the taxpayer's law firm associate consulted with anyone who had expertise in plastics or investigated the partnership beyond looking at materials in the offering memorandum. J.H. Weitzman, 82 TCM 419, Dec. 54,450(M), TC Memo. 2001-215.


A divorced taxpayer, who invested in a sheep breeding tax shelter partnership with her ex-husband was liable for the negligence penalty under Code Sec. 6662 for each year at issue. Although the taxpayer argued that she reasonably relied on the tax shelter promoter, who was an enrolled agent, to accurately prepare her tax returns, such reliance was unreasonable because the taxpayer never independently researched the investment or consulted an independent tax advisor about her investment in the partnership. Moreover, she never inquired into how the large deductions or credits on her tax return were calculated and never questioned their legitimacy.
D.J. Barnes, 88 TCM 569, Dec. 55,809(M), TC Memo. 2004-266.

It should be obvious that if any transaction looks as if it is tax motivated, the return preparer would be held to be liable for the 6694 penalty (i.e., deemed to be negligent) for failure to investigate the underlying facts that includes the documentation for that transaction even if the client was guided by a tax expert. That reliance in the above cases was held to be not readonable.

For any questions on these types of transactions, contact ab@irstaxattorney.com