Preparer penalties under IRC 6694: unreasonable positions and willful or reckless conduct

• Calculate the 6694(a) and 6694(b) penalty amounts for a given fee
• Apply the position standards in 6694(a)(2) to disclosed and undisclosed positions
• Explain the reasonable cause and good faith defense under 6694(a)(3)
• Describe the collection and abatement rules in 6694(c) and (d)

Two tiers

Section 6694 imposes a civil penalty on a tax return preparer for an understatement of liability on a return or refund claim. It has two tiers.

"Understatement of liability" in 6694(e) means any understatement of the net amount payable, or overstatement of the net amount creditable or refundable. It is determined without regard to administrative or judicial action involving the taxpayer, except for the abatement rule in 6694(d).

The penalty is per return. A preparer who takes the same unsupported position on 40 returns faces 40 penalties.

What makes a position unreasonable

Section 6694(a)(2) sets the standards:

• Default: a position is unreasonable unless there is or was substantial authority for it.
• Disclosed positions: if the position was disclosed as provided in 6662(d)(2)(B)(ii)(I) and is not a shelter or reportable transaction position, it is unreasonable unless there is a reasonable basis.
• Tax shelters and reportable transactions: for a tax shelter (as defined in 6662(d)(2)(C)(ii)) or a reportable transaction to which 6662A applies, the position is unreasonable unless it is reasonable to believe it would more likely than not be sustained on its merits.

Substantial authority is an objective standard based on the weight of the tax law authorities (the Code, regulations, court cases, revenue rulings and similar). Reasonable basis is a lower standard but still requires authority, not just an arguable theory. Circular 230 section 10.34(a) uses the same ladder, so meeting 6694 also addresses the conduct rule.

Reasonable cause and good faith

Under 6694(a)(3) no 6694(a) penalty applies if the preparer shows reasonable cause for the understatement and acted in good faith. Treas. Reg. 1.6694-2(e) lists the factors: the nature of the error (a complex, uncommon or highly technical provision, not an error a general review would catch), whether it was an isolated error rather than a pattern, its materiality, whether the preparer's normal office practice (checklists, information requests, prior-year comparison, review) was followed, and reliance on advice of others. Documentation in the workpapers is what turns these facts into a defense.

Willful or reckless conduct

Section 6694(b)(2) describes conduct that is a willful attempt in any manner to understate tax, or a reckless or intentional disregard of rules or regulations. Examples include inventing deductions, ignoring a regulation the preparer knows applies, and taking a position contrary to a regulation without disclosing it. There is no reasonable cause exception in the statute for 6694(b).

Collection, refund and abatement

• 6694(c): if, within 30 days after notice and demand, the preparer pays at least 15 percent of the penalty and files a refund claim, the IRS may not levy or sue to collect the rest until the refund proceeding is resolved.
• 6694(d): if a final administrative determination or final judicial decision finds there was no understatement on the return, the penalty is abated and any amount paid is refunded, without regard to the normal refund limitations period.

Staff takeaways

• Write down the authority for any judgment position, even a short note.
• If you cannot find substantial authority, raise disclosure with the reviewer before the return is signed.
• Never adjust numbers to hit a refund target the client wants.

The uncertain tax positions standard shows how entities document similar judgments for financial reporting.

Computing the penalty: Cove Street Tax and a disallowed credit