Section 6694 Tax Return Preparer Penalties: Unreasonable Positions, Willful Conduct and Reasonable Cause

Section 6694 imposes two preparer penalties for an understatement of the taxpayer's liability. Under subsection (a), the penalty for an unreasonable position is the greater of $1,000 or 50 percent of the income the preparer derived or will derive from the return or claim. Under subsection (b), the penalty for willful or reckless conduct is the greater of $5,000 or 75 percent of that income. This article explains each trigger, who is liable, and which defenses a firm can document.

When does the 6694(a) penalty apply?

The preparer must know, or reasonably should have known, of the position, and one of three situations must exist (Treas. Reg. 1.6694-2(a)(1)):

1. The position is a tax shelter or reportable transaction under section 6662A, and it was not reasonable to believe the position would more likely than not be sustained.
2. The position was not disclosed, is not a shelter or reportable transaction, and lacked substantial authority.
3. The position was disclosed, is not a shelter or reportable transaction, and had no reasonable basis.

Section 6694(a)(2) states the same three-tier structure. A position is unreasonable unless there is or was substantial authority for it. A disclosed position needs only a reasonable basis. A tax shelter or reportable transaction position needs a reasonable belief that it would more likely than not be sustained.

The "more likely than not" test under the regulation means the preparer analyzes the facts and authorities and reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained. Controlling precedent from a U.S. Court of Appeals to which the taxpayer can appeal counts, while cases tied only to the taxpayer's residence do not.

When does the 6694(b) penalty apply?

Subsection (b) reaches two kinds of conduct: a willful attempt in any manner to understate the liability for tax on the return or claim, and a reckless or intentional disregard of rules or regulations. The penalty is the greater of $5,000 or 75 percent of the income derived by the preparer for the return or claim. The statute reduces the (b) penalty by the amount of any penalty the same person paid under subsection (a).

The regulation text in 1.6694-1 still describes the (b) penalty as the greater of $5,000 or 50 percent of the income derived. The 75 percent figure comes from the statute text, and it is the one to apply.

Worked example: how the amounts are computed

Assume the preparer derives the following income from three returns, each of which has an understatement caused by a conduct the IRS asserts.

For Return 3, if the IRS asserted both penalties, the (b) amount of $6,000 would be reduced by the (a) penalty the preparer paid. A preparer who paid the $4,000 would owe the $2,000 difference under (b).

Who is the preparer for 6694 purposes?

A tax return preparer is a person described in section 7701(a)(36) and Treas. Reg. 301.7701-15. Under Treas. Reg. 1.6694-1(b), an individual is subject to section 6694 if the individual is primarily responsible for the position that causes the understatement.

• There is only one individual within a firm who is primarily responsible for each position.
• A signing preparer is generally treated as primarily responsible for all positions on the return, unless credible information shows otherwise.
• If there is no signing preparer in the firm, or the signing preparer is not primarily responsible, the nonsigning preparer with overall supervisory responsibility for the position is generally treated as primarily responsible.
• The penalty can be assessed against one of the signing or nonsigning preparers, but not both.

The firm can be liable too. Under 1.6694-2(a)(2), a firm's partners, members or equity holders are liable for the (a) penalty only if principal management or a branch office participated in or knew of the conduct, the firm lacked reasonable review procedures, or the firm disregarded its review procedures through willfulness, recklessness or gross indifference. Written review procedures that are actually followed are therefore a defense for the firm, not just good practice.

How does disclosure protect the preparer?

No penalty applies to a non-shelter position that has a reasonable basis and is adequately disclosed (1.6694-2(d)). A signing preparer can disclose in three ways:

• on Form 8275 or Form 8275-R, or on the return as the annual revenue procedure allows;
• by giving the taxpayer a return that includes the disclosure; or
• by advising the taxpayer of the applicable penalty standards and documenting that advice.

A nonsigning preparer can use the forms or return, or advise the taxpayer of penalty avoidance options and disclosure standards, or advise another preparer that disclosure may be required, and must document the advice. The advice must be particular to the taxpayer and contemporaneously documented. General disclaimers do not count, although established forms or templates are allowed for explaining the penalty rules. Regulation Example 1 involves a signing preparer who gave the taxpayer a Form 8275; the preparer avoided the penalty even though the taxpayer filed without making the disclosure.

What counts as reasonable cause and good faith?

Section 6694(a)(3) says no penalty applies if there is reasonable cause for the understatement and the preparer acted in good faith. Regulation 1.6694-2(e) lists the factors considered:

1. Nature of the error: a complex, uncommon or highly technical provision helps; an error apparent from a general review does not.
2. Frequency: an isolated error, not a pattern.
3. Materiality: the understatement is immaterial relative to the correct liability.
4. Normal office practice: a real accuracy system, such as checklists, information gathering, prior-year review and review procedures, followed for this return.
5. Reliance on others: good-faith reliance without verification on the taxpayer, other advisors or other preparers who appeared competent. Reliance fails if the advice is facially unreasonable, if the preparer knew the provider lacked the facts, or if the law had changed since the advice was given.
6. Reliance on industry or administrative practice: allowed if reasonable and not outdated.

How can a preparer contest the penalty?

Under section 6694(c), if the preparer pays at least 15 percent of the penalty within 30 days after notice and demand and files a refund claim, collection of the remainder is barred until the related suit is finally resolved. The preparer must file suit in the appropriate district court within 30 days after the refund claim is denied, or within 30 days after six months pass without a decision. Under section 6694(d), if a final administrative determination or judicial decision finds no understatement of liability, the assessment is abated and amounts paid are refunded.

What should the firm document?

1. Authority memos for positions below clear authority, identifying substantial authority or reasonable basis with disclosure.
2. Dated, taxpayer-specific penalty advice, consistent with Circular 230 section 10.34.
3. Written review procedures and sign-offs showing they were followed, tied to SSTS No. 2 return position rules.
4. A record of who was primarily responsible for each position.
5. Reliance records for information from clients and other advisors.

Separate due diligence penalties for certain credits are covered in section 6695(g) paid preparer due diligence.

CORAA prepares ready-to-review audit files for US CPA firms; see /us.

Sources

• Cornell Law School Legal Information Institute, 26 U.S.C. 6694: https://www.law.cornell.edu/uscode/text/26/6694
• Cornell Law School Legal Information Institute, 26 CFR 1.6694-1: https://www.law.cornell.edu/cfr/text/26/1.6694-1
• Cornell Law School Legal Information Institute, 26 CFR 1.6694-2: https://www.law.cornell.edu/cfr/text/26/1.6694-2

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error