IRS Proposes Final Preparer Penalty Regs

On June 17, 2008, the Internal Revenue Service issued a notice of proposed rulemaking and notice of public hearing regarding Tax Return Preparer Penalties under Sections 6694 and 6695 (PDF, 218 pages).

This is the "summary" in the Notice, issued in anticipation of hearings scheduled for for Monday, August 18, 2008:

This document contains proposed regulations implementing amendments to the tax return preparer penalties under sections 6694 and 6695 of the Internal Revenue Code (Code) and related provisions under sections 6060, 6107, 6109, 6696, and 7701(a)(36) reflecting amendments to the Code made by section 8246 of the Small Business and Work Opportunity Tax Act of 2007 [Public Law 110-28 (121 Stat. 190), May 25, 2007 (Link added.)].

The Notice indicated the purpose of the proposed regulations, and the anticipated adoption schedule:

In accordance with the 2007 Act, these proposed regulations amend existing regulations defining income tax return preparers to broaden the scope of that definition to include preparers of estate, gift, and generation-skipping transfer tax returns, employment tax returns, excise tax returns, and returns of exempt organizations.

These proposed regulations also revise current regulations to amend the standards of conduct that must be met to avoid imposition of the tax return preparer penalty under section 6694.

In addition, these proposed regulations reflect changes to the computation of the section 6694 tax return preparer penalty made by the 2007 Act.

These regulations also amend current regulations under the penalty provisions of section 6695 to conform them with changes made by the 2007 Act expanding the scope of that statute beyond income tax returns.

The Treasury Department and the IRS intend to finalize these proposed regulations by the end of 2008, with the expectation that the final regulations will be applicable to returns and claims for refund filed (and advice given) after the date that final regulations are published in the Federal Register, but in no event sooner than December 31, 2008. * * *

Incorporating the text of the Notice, WebCPA noted the issuance of the proposed regulations in a posting entitled "IRS Revises Tax Preparer Penalties" (June 17, 2008):

The 2007 act amended Section 6694 to expand the definition of tax return preparer, broaden the scope of the tax return preparer penalties to include preparers of returns other than income tax returns, revise the standards of conduct that tax return preparers must meet to avoid imposition of penalties, and change the computation of the tax return preparer penalties.

The Treasury Department and the IRS believe that the recent amendments to the tax return preparer penalty provisions necessitate a comprehensive review and overhaul of all the tax return preparer penalties and related regulatory provisions.

The proposed regulations are the first significant step in this process.

The proposed regulations are important for preparers of the affected types of federal tax filings. If a return or related document was prepared willfully in any manner to understate the liability of tax on a tax return or claim for refund, or in reckless or intentional disregard of rules or regulations, the preparer may be subject to a penalty under either Section 6694(a) or 6694(b) of the Internal Revenue Code.

The present internal operating procedures of the IRS regarding preparer penalty cases are contained in the Internal Revenue Manual under Section 8.11.3, Return Preparer Penalty Cases (Rev: 10/17/07).

The proposed regulations should remedy the acknowledged shortcoming noted in that Section of the Manual: "IRC Section 6694 penalties have little in law to directly interpret them."

To remedy that problem -- both for the IRS auditor and for tax preparers -- the IRS had issued, on December 31, 2007, Notice 2008-13, (PDF, 27 pages), which offered interim guidance through the adoption of final regulations (such as those now proposed). These principles were summarized by the IRS in its FAQs Related to Tax Return Preparer Penalty Notices.

In its accompanying Press Statement, entitled "Treasury, IRS Implement Enhanced Standards of Conduct for Tax Return Preparers; Plan Overhaul of Tax Return Preparer Regulatory Regime" (12/31/08, IR-2007-213), the priority of this project was noted:

“The plan to take a fresh look at the preparer penalty regulations will be a top priority for us in 2008,” said IRS Chief Counsel Don Korb.

“We look forward to receiving comments from all interested parties on their recommendations for the final regulations. Our goal is to complete our work on the overhaul of these rules by the end of 2008,” he said. * * *

In addition to Notice 2008-13, additional guidance had been provided by the IRS in Notice 2008-12 (PDF, 6 pages) regarding implementation of the tax return preparer signature requirement, and in Notice 2008-11 (PDF, 4 pages) regarding the transition relief provided in Notice 2007-54 (PDF, 5 pages), issued earlier in 2007.

I believe that these regulations sprung from perceived abuse of the IRS by taxpayers, often acting through their tax preparers. However, such preparer penalty requirements can also be applied to protect taxpayers from unscrupulous tax preparers.

For an example how these rules can be applied in enforcement litigation to protect elderly taxpayers, read the federal court Complaint filed by the Chief Counsel's Office of the IRS in U.S. v. Harris on March 8, 2008:

Defendant Hazel Harris * * * has been preparing and filing federal income tax returns since 2001. Harris, a cosmetologist and former factory worker, falsely claims that she is an accountant. She has no tax training or tax-related education. * * *

Harris is a tax return preparer who has prepared over 8,000 federal income tax returns for others since 2001. Harris prepares customers' returns for multiple years at one time, regardless of whether a return has already been filed for those years. * * *

Harris targets elderly people who receive social security benefits, telling them she is an accountant who specializes in refunds for people receiving social security. To expand her customer base, Harris tells potential customers to contact her current customers who have received refunds as a result of her fraudulent return preparation.

On the returns Harris prepares, she understates the taxable amounts of her customers' social security benefits and fabricates amounts of tax purportedly withheld from those benefits. * * *

Harris claims refunds on all returns she prepares.

Harris tells many of her customers they are entitled to refunds, even though she knows they are not. * * *

Harris customers have been harmed because they paid her fees to prepare tax returns that understate their federal tax liabilities, thereby subjecting them to interest and possible penalties. * * *

The Complaint seeks various kinds of injunctive relief against the Defendant.

Read the Complaint. Do you think that preparer penalties will be forthcoming in that case?

Update: 07/18/08:

On July 15, 2008, in an emailed IRS Guideline, corrections were noted to the previous notice of proposed rulemaking, published on June 17, 2008:

REG-129243-07 contains corrections to a notice of proposed rulemaking (REG-129243-07) that was published in the Federal Register on Tuesday, June 17, 2008 (73 FR 34560) implementing amendments to the tax return preparer penalties under sections 6694 and 6695 of the Internal Revenue Code and related provisions under sections 6060, 6107, 6109, 6696 and 7701(a)(36) reflecting amendments to the Code made by section 8246 of the Small Business and Work Opportunity Tax Act of 2007.

The proposed regulations affect tax return preparers and provide guidance regarding the amended provisions.

Update: 10/03/08:

Following is the section on preparer penalties contained in HR 1424 -- the "Bail-Out" bill (PDF, 451 pages), recently adopted by Congress, that, among many other provisions, amended IRC Section 6694 retroactively:

SEC. 506. MODIFICATION OF PENALTY ON UNDERSTATEMENT OF TAXPAYER’S LIABILITY BY TAX RETURN PREPARER.

(a) IN GENERAL.—Subsection (a) of section 6694 is amended to read as follows:

‘‘(a) UNDERSTATEMENT DUE TO UNREASONABLE POSITIONS.—

‘‘(1) IN GENERAL.—If a tax return preparer—

‘‘(A) prepares any return or claim of refund with respect to which any part of an understatement of liability is due to a position described in paragraph (2), and ‘‘(B) knew (or reasonably should have known) of the position, such tax return preparer shall pay a penalty with respect to each such return or claim in an amount equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.

‘‘(2) UNREASONABLE POSITION.—

‘‘(A) IN GENERAL.—Except as otherwise provided in this paragraph, a position is described in this paragraph unless there is or was substantial authority for the position.

‘‘(B) DISCLOSED POSITIONS.—If the position was disclosed as provided in section 6662(d)(2)(B)(ii)(I) and is not a position to which subparagraph (C) applies, the position is described in this paragraph unless there is a reasonable basis for the position.

‘‘(C) TAX SHELTERS AND REPORTABLE TRANSACTIONS.—If the position is with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies, the position is described in this paragraph unless it is reasonable to believe that the position would more likely than not be sustained on its merits.

‘‘(3) REASONABLE CAUSE EXCEPTION.—No penalty shall be imposed under this subsection if it is shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith.’’

(b) EFFECTIVE DATE.—The amendment made by this section shall apply—

(1) in the case of a position other than a position described in subparagraph (C) of section 6694(a)(2) of the Internal Revenue Code of 1986 (as amended by this section), to returns prepared after May 25, 2007, and

(2) in the case of a position described in such subparagraph (C), to returns prepared for taxable years ending after the date of the enactment of this Act.