Preparer Penalty Normally Cannot Be Assessed Against Equity Holder of Employer of Misbehaving Preparer

In Chief Counsel Email 201825028 the document addresses the question of how far afield the IRS may go in asserting a preparer penalty under IRC §6694(b).  In this case, the employee was asking whether an individual who is a shareholder of an S corporation that was involved in the preparation of a return could be assessed the penalty personally.

IRC §6694(b) imposes a penalty against a preparer for willful for reckless conduct.  The provision provides:

(1) In general

Any tax return preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to a conduct described in paragraph (2) shall pay a penalty with respect to each such return or claim in an amount equal to the greater of—

(A) $5,000, or

(B) 75 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.

(2) Willful or reckless conduct

Conduct described in this paragraph is conduct by the tax return preparer which is—

(A) a willful attempt in any manner to understate the liability for tax on the return or claim, or

(B) a reckless or intentional disregard of rules or regulations.

As the penalty is applied against the preparer, the email begins by looking at the regulations under §6694 and their definition of a preparer for this purpose.  Generally, a preparer is a single individual as the email notes:

Treasury regulation § 1.6694-1(b) provides that “[f]or the purposes of this section, `tax return preparer' means any person who is a tax return preparer within the meaning of section 7701(a)(36) and § 301.7701-15 of this chapter. An individual is a tax return preparer subject to section 6694 if the individual is primarily responsible for the position(s) on the return or claim for refund giving rise to an understatement. See § 301.7701-15(b)(3). There is only one individual within a firm who is primarily responsible for each position on the return or claim for refund giving rise to an understatement. ... In some circumstances, there may be more than one tax return preparer who is primarily responsible for the position(s) giving rise to an understatement if multiple tax return preparers are employed by, or associated with, different firms.”

However, the regulations do provide that under certain conditions the organization that employs the preparer can also be held liable for the penalty.  The email continues:

Treasury regulation § 1.6694-3(a)(2) provides that “[a] firm that employs a tax return preparer subject to a penalty under section 6694(b) (or a firm of which the individual tax return preparer is a partner, member, shareholder or other equity holder) is also subject to penalty if, and only if—(i) One or more members of the principal management (or principal officers) of the firm or a branch office participated in or knew of the conduct proscribed by section 6694(b); (ii) The corporation, partnership, or other firm entity failed to provide reasonable and appropriate procedures for review of the position for which the penalty is imposed; or (iii) The corporation, partnership, or other firm entity disregarded its reasonable and appropriate review procedures though willfulness, recklessness, or gross indifference (including ignoring facts that would lead a person of reasonable prudence and competence to investigate or ascertain) in the formulation of the advice, or the preparation of the return or claim for refund, that included the position for which the penalty is imposed.” (emphasis added). See also IRM

The email author’s position is that, unless the conditions noted in the above paragraph are met, the penalty applies only to the individual preparer that engaged in the misconduct.  But in this case the question was whether there were circumstances where the penalty could not only go to the firm employing the preparer, but on to person(s) who own(s) an equity stake in that employer.

The email concludes that, normally, the penalty cannot be pushed down to mere equity holders.  The email does discuss one case where such a penalty was applied to an equity holder, but notes that the penalty made its way to the equity holder both because he did individually prepare many of the returns and the individual was the sole-owner of the entity:

We did find one case in which the owner of an entity was subject to the section 6694 penalty. In United States v. Elsass, 978 F. Supp. 2d 901 (S.D. Ohio 2013), aff'd, 769 F.3d 390 (6th Cir. 2014), the court found that the owner of an entity was a “tax return preparer” for the purposes of the penalties provided for under sections 6694 and 6695. However, in that case, the owner was the sole-owner of the entity and personally signed or prepared over twenty-eight of the tax returns at issue. Additionally, the owner and the entity “were the moving force behind the decisions and calculations regarding the returns.” Id. at 911. The court notes that “Congress intended the definition of tax return preparer to encompass those contributing to the material decisions regarding tax returns.” Id. at 912.

Thus, the email concludes that the IRS cannot impose this penalty on someone who is merely an equity holder of the entity, concluding:

We think that unless your co-owner acted similarly to the owner in Elsass, an assessment of the penalty provided for under section 6694(b) against that taxpayer could present a legal hazard. Alternatively, the S-Corp may be a tax return preparer within the definition of section 7701(a)(36), and the proper person on which to assess the penalty under section 6694(b), but only if the requirements set forth in Treasury regulation § 1.6694-3(a)(2) are met. We do not have enough facts in our possession to make a recommendation as to whether the S-Corp in your case meets these requirements.