Latest / VoraPrep Audio — Professional Licensure & Certification Exam Prep / [EA] SEE3: Mastering Preparer Penalties: IRC Section 6694
Transcript
- Hey, welcome to VoraPrep Audio. Let’s talk about something that can make even the most seasoned tax pro’s stomach drop: a penalty notice from the IRS that’s addressed to *you*, not your client. Imagine opening that letter. It’s from the Office of Professional Responsibility, and it’s proposing a penalty under Internal Revenue Code Section 6694 for a return you prepared. Suddenly, it’s not about defending a client’s position; it’s about defending your own conduct. Knowing these rules cold isn’t just about the exam—it’s about protecting your career. So, let's get into the two big penalties you need to know under Section 6694. Think of it like a referee in a basketball game. There are two kinds of fouls. There’s the regular, everyday foul, and then there’s the flagrant foul that gets you ejected. The regular foul is Section 6694(a). This is for taking an "unreasonable position." The flagrant foul is Section 6694(b). That’s for "willful or reckless conduct." Your first job on any exam question is to figure out which game is being played. Is it a simple mistake, or is it something much worse? Before we go further, who are we even talking about here? The term "tax return preparer" is really broad. It’s not just the person who signs the return. If you prepare a substantial portion of a return for compensation, you're a preparer. You could be a non-signing preparer, maybe a specialist who gave advice on one complex area. The only people who get a pass are clerical staff just doing data entry. So, if you're making judgment calls, these rules apply to you. Alright, let's look at that first penalty, the more common one. Section 6694(a), for an understatement due to an unreasonable position. This happens when you take a stance on a return that causes the client to underpay their tax, and you didn't have a good enough reason to take that stance. Now, what counts as a "good enough reason" depends on one critical question: did you disclose the position? If you took a gray-area position and you *didn't* tell the IRS about it on, say, a Form 8275, then you needed to have "substantial authority" for that position. That’s a high bar. It means you had some serious legal or administrative precedent on your side. But what if you *did* disclose it? You flagged it for the IRS, saying, "Hey, we're taking a position here that's a little aggressive, and here's why." In that case, the bar is much lower. You only need a "reasonable basis." It's the trade-off for being transparent. If you fail either of those tests, the penalty under 6694(a) is the greater of two numbers: one thousand dollars, or 50% of the income you made for preparing that return. Then you have the flagrant foul: Section 6694(b). This is for willful or reckless conduct. This isn't about a technical disagreement on a fine point of law. This is for preparers who are intentionally trying to cheat the system or are just completely ignoring the rules. Think about someone fabricating deductions out of thin air, or a preparer who sees a document from their client that clearly invalidates a credit, but they take the credit anyway. That's willful or reckless. And because it's so much more serious, the penalty is much bigger. For a 6694(b) violation, the penalty is the greater of five thousand dollars, or 75% of your fee. Big difference. Let's walk through how this looks on an exam. Here’s a typical scenario. David is an Enrolled Agent. He prepares a return for TechCorp and takes a questionable business expense deduction. He doesn't disclose it on a Form 8275. The IRS audits, says the position lacks substantial authority, and disallows it. The client owes another $12,000 in tax. David’s fee for the whole return was $2,200. What's his penalty? Okay, let's break it down. First, what kind of conduct is this? The facts say the position "lacks substantial authority." They don't say David was being malicious or reckless. This points straight to a 6694(a) violation—the "unreasonable position." Next, because the position was *undisclosed*, we know the standard he needed to meet was substantial authority. He didn't meet it. So a penalty applies. Now we just have to calculate it. The 6694(a) penalty is the greater of $1,000, or 50% of the preparer's income. David's fee was $2,200. Half of that is $1,100. So, we compare $1,000 and $1,100. The greater amount is $1,100. That's the penalty. Now, notice what we didn't use. We didn't use that $12,000 understatement of the client's tax. That number is a classic distractor. They put it there hoping you'll try to calculate the penalty based on the client's tax bill. Don't fall for it. The penalty is about punishing the preparer, so it’s based on the preparer's fee. Think of it like a mechanic who does a faulty repair. The fine against the mechanic is based on his service fee, not the total value of the car he was working on. So, if you find yourself in a 6694(a) situation, is there any way out? Yes, sometimes. There's a defense available if you can show the understatement was due to "reasonable cause" and you acted in "good faith." This is a facts-and-circumstances test. Did you have good quality control procedures in your office? Was this just one isolated, honest mistake? If you can show that, you might avoid the penalty. But notice, this defense only works for the '(a)' penalty. It doesn't work for the '(b)' penalty. You can't really argue you had "good faith" when you were being willfully reckless. That just doesn't fly. Here’s a simple way to keep the two sections straight in your head. Think of 6694(a) where 'A' stands for an 'Aggressive' or maybe 'Accidental' position. It's a technical foul. But 6694(b), 'B' is for 'Bad Faith' or 'Blatant' disregard for the rules. That's the flagrant foul. One last thing to watch out for is confusing these preparer penalties with the *taxpayer* penalties, like the accuracy-related penalties under Section 6662. The standards can sound similar—they both use terms like "substantial authority"—but the rules, the penalty amounts, and the defenses are different. Always be clear on the exam: who is this question about? The person who signed the check, or the person who prepared the return? If you're finding these kinds of detailed walkthroughs helpful, you should know that this is exactly what we do at VoraPrep. It’s a full exam-prep app with lessons, thousands of practice questions, and even an AI tutor to help you when you get stuck. You can check it out and get started for free at Vora Prep dot com. So, on exam day, when you see a preparer penalty question, take a breath. Your first move is to read the facts and figure out the preparer’s state of mind. Was it an honest disagreement on a complex rule? That's probably a 6694(a) situation. Or did they knowingly cook the books? That's 6694(b). That one distinction will guide you to the right standard and the right penalty calculation almost every time. Alright, that's it for today. Keep up the great work. You've got this.