Irc section 6694 preparer penalty provisions apply to

Introduction to irc section 6694

IRC Section 6694, often referred to as the "preparer penalty" provision, is a crucial part of the Internal Revenue Code. It addresses penalties imposed on tax return preparers who prepare tax returns that result in an understatement of tax liability. This section is designed to ensure accuracy and due diligence in tax return preparation, protecting both taxpayers and the integrity of the tax system. Tax preparers, including CPAs, enrolled agents, and other professionals who prepare tax returns for compensation, must be aware of these rules.

The penalties under section 6694 are triggered when a preparer either knowingly or recklessly disregards rules and regulations or takes an unreasonable position that leads to an understatement of tax. The IRS enforces these provisions to maintain the integrity of the tax filing process and to encourage preparers to provide accurate and compliant tax preparation services.

Understanding the penalties

Section 6694 outlines two main types of penalties that can be imposed on tax preparers. Each penalty relates to different levels of culpability and the nature of the preparer's actions.

• Penalty for Understatement Due to Unrealistic Position: This penalty applies when a preparer takes a position on a tax return that they knew, or reasonably should have known, lacked a realistic possibility of being sustained on its merits. The penalty is the greater of $1,000 or 50% of the income derived (or to be derived) by the tax preparer with respect to the tax return or claim for refund. For returns prepared or advice given after December 31, 2023, the penalty is $6,220 per return.
• Penalty for Understatement Due to Willful or Reckless Conduct: This penalty applies when a preparer knowingly or recklessly disregards rules and regulations, or makes a willful attempt to understate tax liability. The penalty is the greater of $5,000 or 75% of the income derived (or to be derived) by the tax preparer with respect to the tax return or claim for refund. For returns prepared or advice given after December 31, 2023, the penalty is $33,000 per return.

It's important to note that these penalties are per return or claim for refund, meaning that a preparer can face multiple penalties if they are involved in preparing several returns with similar errors.

"realistic possibility" and due diligence

A key concept in understanding IRC Section 6694 is the term "realistic possibility." This refers to a position on a tax return that has at least a one-in-three chance of being sustained on its merits if challenged by the IRS. Preparers are expected to perform due diligence to ensure that the positions they take on tax returns meet this standard.

Due diligence includes, but is not limited to, reviewing relevant tax law, gathering and assessing supporting documentation, and questioning clients about the accuracy of information provided. Preparers are expected to act in a way that a reasonably competent tax professional would under similar circumstances. If a preparer relies on information provided by a client, they must make reasonable inquiries if the information appears incorrect, incomplete, or inconsistent. For example, if a client claims a charitable contribution deduction, the preparer should verify that the client has documentation of the donation.

Exceptions and defenses to penalties

While IRC Section 6694 sets out significant penalties, there are certain exceptions and defenses available to preparers. Recognizing these is critical for avoiding penalties.

• Reasonable Cause and Good Faith: A preparer may be able to avoid a penalty if they can demonstrate that the understatement was due to reasonable cause and that they acted in good faith. This typically requires showing that the preparer exercised due diligence but made an error despite their best efforts.
• Reliance on Client Information: If the understatement resulted from a client providing incorrect, incomplete, or inconsistent information, the preparer may have a defense if they reasonably relied on the information provided and did not know, or have reason to know, that the information was incorrect. However, the preparer must make reasonable inquiries if the information seems questionable.
• Specific Disclosure: If the position taken on a tax return is adequately disclosed and has a reasonable basis, it may prevent a penalty. This requires following specific IRS guidelines for disclosure on the tax return.

Practical examples

To illustrate how Section 6694 works in practice, consider the following examples:

• Example 1 (Unrealistic Position): A tax preparer claims a large deduction for business expenses based on minimal documentation provided by the client, without conducting further inquiries. If the deduction is disallowed by the IRS and there was no realistic possibility of the deduction being sustained, the preparer may be subject to the penalty for taking an unrealistic position.
• Example 2 (Willful or Reckless Disregard): A preparer knowingly inflates a client's income or credits to reduce their tax liability. This is a clear violation of Section 6694 and would result in a penalty for willful or reckless conduct.
• Example 3 (Reasonable Cause): A tax preparer makes a mathematical error on a return due to a software glitch. They acted in good faith and exercised due diligence. This is an example where the preparer may be able to successfully argue for reasonable cause and avoid a penalty.

These examples highlight the importance of following professional standards, asking the right questions, and maintaining thorough documentation.