Avoiding Penalties: Choosing a Reliable Tax Return Preparer

Published Categorized as Tax, Tax Penalty, Tax Returns
avoid penalties tax return preparer

With the tax season around the corner, a significant number of taxpayers are seeking the services of tax return preparers. This often involves choosing a preparer who has been recommended by friends and family members.

Tax return preparers may be referred based not on their qualifications, but on their reputation for generating large refunds for clients. While this may be due to legitimate tax deductions and tax planning, there are some tax return preparers that do not play by the rules. They take positions on tax returns that are not valid to generate large refunds, with the goal of getting referrals for their own tax preparation business. These few taxpayers give legitimate tax return preparers a bad name and, unfortunately, take prospective clients away from the legitimate tax return preparers.

The IRS eventually catches up to unscrupulous tax return preparers. The result is penalties and interest and additional tax due to the IRS. This often results in large back taxes owed by their clients. This is why it is important for taxpayers to do their due diligence in selecting a tax return preparer. One such recent example is the Mulu v. Commissioner, T.C. Summary Opinion 2023-2, case, which serves as a cautionary tale for taxpayers looking to hire a tax preparer.

Facts & Procedural History

The case involves a 2018 tax return filed with the IRS. David Clerie, the tax return preparer for the taxpayer, died and his brother, Mr. Motoban, was handling Mr. Clerie’s tax return preparation business.

Neither Mr. Clerie nor Mr. Motoban had a preparer tax identification number (PTIN). The taxpayer’s 2018 tax return was prepared and e-filed using FreeTaxUSA tax preparation software as if the taxpayer had filed it himself.

Prior to the return being filed, the taxpayer became concerned when he did not receive a copy of his 2018 federal income tax return as the time for filing was approaching. He decided to check whether the return was filed and after making several efforts to obtain a copy of the return, he visited Mr. Clerie’s home and met Mr. Motoban. Mr. Motoban told the taxpayer that he was Mr. Clerie’s brother and that he was handling Mr. Clerie’s tax return and tax return preparation business after Mr. Clerie had passed away. The taxpayer agreed to have Mr. Motoban file his 2018 federal tax return. The taxpayer did not review the tax return before it was filed.

The IRS audited the return and disallowed various expenses. The audit concluded with a notice of deficiency for a deficiency of $11,688 and a penalty of $2,337.60 for 2018.

The taxpayer filed a petition with the U.S. Tax Court. The taxpayer and IRS Attorney reached an agreement on the tax deductions with the parties each conceding some of the deductions. The only issue left for the court was the accuracy-related penalty under Sec. 6662(a).

The Sec. 6662 penalty is designed to encourage individuals and businesses to accurately report their taxable income and pay the correct amount of tax owed. The penalty is imposed on underpayments of tax, meaning that if a taxpayer owes more tax than was reported on their tax return, the penalty may be imposed.

The amount of the penalty depends on the extent of the underpayment and whether the underpayment was due to negligence, disregard of rules and regulations, or substantial understatements of income. If the underpayment was due to negligence, the penalty can range from 20% to 40% of the underpaid tax amount. If the underpayment was due to a substantial understatement of income, the penalty can be equal to 20% of the underpaid tax amount. The IRS may waive the penalty in certain circumstances, such as when the underpayment was due to reasonable cause and not willful neglect.

The Reliance on an Advisor Defense

Reasonable cause for abating a penalty imposed under Sec. 6662 for underpayment of tax can be established if the taxpayer relied on a tax professional to prepare their return and the taxpayer had no knowledge or reason to know of the error.

The reasonable cause defense for relying on a tax professional was established in the case of Neonatology Associates, P.A. v. Commissioner. In this case, the taxpayer relied on a tax professional to prepare their tax returns, and the tax professional made errors in the returns. The taxpayer had no knowledge or reason to know of the errors, and the court held that the taxpayer had reasonable cause for the underpayment of tax and abated Sec. 6662 penalties.

The factors to consider when determining whether a taxpayer can claim reasonable cause for reliance on a tax advisor include:

  1. The taxpayer’s education and experience level with tax laws and regulations.
  2. The quality of the advice provided by the tax advisor, including the thoroughness of the analysis and the advisor’s qualifications and experience.
  3. The taxpayer’s good faith efforts to comply with the tax laws, including seeking the advice of the advisor and providing all necessary information to the advisor.
  4. The clarity of the advice given and the extent to which the taxpayer understood and relied on the advice.
  5. The complexity of the tax laws and regulations and the taxpayer’s ability to determine their applicability.
  6. The extent to which the taxpayer followed the advice given, and whether the taxpayer had any reason to question the validity of the advice at the time it was received.
  7. The timing of the reliance on the advice, with greater weight given to advice received closer in time to the filing of the tax return.

In this case, it was discovered that Mr. Motoban was not Mr. Clerie’s brother and did not have a PTIN (Preparer Tax Identification Number). A tax return preparer is required to have a PTIN issued by the IRS in order to prepare federal tax returns for compensation. This as well as the errors on the tax returns suggest that Mr. Clerie was not a tax return preparer that would allow the taxpayer to avail himself of this defense to the imposition of penalties.

Reasonable Conduct is Required

The court in this case concluded that the taxpayer did not act with reasonable cause in relying on Mr. Motoban to prepare and file his 2018 tax return, as he did not review the return before it was filed and did not inquire about Mr. Motoban’s qualifications to handle tax return preparation. This was deemed a sufficient reason for the court to deny the taxpayer’s request to abate the Sec. 6662 penalties imposed by the IRS.

The Takeaway

Not only does this case emphasize the importance of reviewing the tax return before it is filed, but it also highlights the need for taxpayers to hire tax return preparers who are not only authorized to file income tax returns but also have a PTIN.

This case does not provide any insight as to how a taxpayer can ensure that the tax return preparer they hire is qualified and trustworthy. What type and amount of due diligence is sufficient? Is researching the preparer’s credentials and checking for any disciplinary actions or negative reviews sufficient?