Tax preparers are required to adhere to the Internal Revenue Code and Treasury Regulations, particularly concerning due diligence. A recent case, United States v. Martha A. Velarde, from the United States District Court for the Central District of California, offers a stark reminder of the serious consequences, including civil contempt and financial sanctions, that can arise from persistent non-compliance with court orders and due diligence requirements. Because, it turns out, the court believes that randomly generating social security numbers to use on tax returns is a failure of a tax preparer to exercise due diligence.

Factual Background of the Case

Martha A. Velarde, a federal income tax preparer since 1998 and owner of MAV Service, was initially sued by the Government on February 17, 2011. The lawsuit alleged that Velarde prepared federal income tax returns containing false information designed to reduce her customers’ tax liabilities. This initial action culminated in a Final Judgment of Limited Injunction on September 13, 2011, which legally prohibited Velarde from various activities. Specifically, the injunction enjoined her from:

Engaging in activity subject to penalty under 26 U.S.C. § 6694, which pertains to preparing federal income tax returns that improperly understate customers’ tax liabilities.
Engaging in activity subject to penalty under 26 U.S.C. § 6695, including § 6695(g), which penalizes claiming an Earned Income Tax Credit without complying with due diligence requirements imposed by Treasury regulations.

Fast forward to July 30, 2024, when the Government filed an Application for Order to Show Cause, asserting that Velarde had continued to prepare tax returns in violation of the Court’s standing injunction. The Government’s allegations centered on two specific areas: (1) Velarde inappropriately claiming the head of household filing status, and (2) her use of social security numbers that did not match the name associated with the qualifying person. The Court granted the Government’s request, leading to an evidentiary hearing on July 14, 2025, and subsequent closing arguments on August 5, 2025. After considering all submissions, the Court ultimately held Velarde in contempt.

The Government’s Sanction Request

In its application, the Government not only sought to hold Velarde in contempt but also requested the Court to sanction her and further enjoin her from directly or indirectly filing or preparing federal tax returns. Specifically, the Government sought a sanction in the amount of $228,575. This substantial amount was requested as disgorgement of Velarde’s "ill-gotten gains," representing the fees she charged for tax returns that the Government alleged were prepared with improperly claimed head of household status between 2021 and 2024.

The Court’s Legal Analysis

District courts possess the inherent authority to enforce their orders through civil contempt. Civil contempt is defined as a party’s disobedience to a specific and definite court order, stemming from a failure to take all reasonable steps within their power to comply. Importantly, the contempt does not need to be willful, and there is no "good faith exception" to the requirement of obedience to a court order, although an action based on a good faith and reasonable interpretation of the order may preclude a contempt finding.

The dual purposes of civil contempt sanctions are to coerce the defendant into compliance with the court’s order and to compensate the complainant for losses sustained. In a civil contempt action, the moving party—in this case, the Government—bears the initial burden of showing by clear and convincing evidence that the contemnor violated a specific and definite order of the court. Once this burden is met, the burden shifts to the contemnor to demonstrate why they were unable to comply.

The case specifically invoked 26 U.S.C. § 6695, which penalizes a tax return preparer for failing to comply with due diligence requirements, particularly concerning the determination of a taxpayer’s eligibility to file as head of household. The Court also referenced 26 U.S.C. § 6694, which penalizes preparers for preparing tax returns that they knew or reasonably should have known would result in an understatement of tax liability, or preparing such returns with willful or reckless disregard for rules and regulations.

The due diligence requirements, as outlined in 26 C.F.R. § 1.6695-2(b)(3)(i), mandate that a tax return preparer "must not know, or have reason to know, that any information used by the tax return preparer in determining the taxpayer’s eligibility to file as head of household . . . is incorrect". Furthermore, the preparer "must also make reasonable inquiries if a reasonable and well-informed tax return preparer knowledgeable in the law would conclude that the information furnished to the tax return preparer appears to be incorrect, inconsistent, or incomplete".

Application of Law to the Facts

The parties in this case did not dispute that the Court’s Limited Injunction was specific and definite. The core issue for the Court was whether the Government presented clear and convincing evidence of a violation and, if so, whether Velarde could explain her inability to comply.

Regarding the alleged violation of 26 U.S.C. § 6695 (Due Diligence), the Government presented clear and convincing evidence. The Government contended that Velarde and her associates prepared a total of 2,807 tax returns between 2021 and 2024 with social security numbers that did not match the names associated with the qualifying persons. Velarde herself did not dispute the use of mismatched names and social security numbers for "qualified persons". In fact, she admitted in her response and testimony to purposefully using "a random nine-digit number" as a "workaround" to what she perceived as a "flaw" in her tax preparation software. Her understanding was that she did not need to provide a social security number for qualifying persons.

However, the Court found Velarde’s explanation insufficient, noting her failure to explain why she knowingly provided "incorrect, inconsistent, or incomplete" information rather than making reasonable inquiries to request the correct names and social security numbers. The Court explicitly stated that knowingly providing incorrect social security numbers without making reasonable inquiries is a violation of due diligence requirements under 26 C.F.R. § 1.6695-2(b)(3)(i). Consequently, Velarde failed to demonstrate why she was unable to comply with these requirements.

Concerning the Government’s argument that Velarde inappropriately claimed the head of household filing status in violation of 26 U.S.C. § 6694, the Court did not find it necessary to reach this argument given the clear violation under § 6695. Nevertheless, the Court briefly noted that the Government failed to carry its burden to show by clear and convincing evidence that Velarde improperly claimed head of household status. While the Government argued that 2,079 returns had improperly claimed this status and presented evidence of multiple taxpayers at the same dwelling claiming head of household status, an IRS Revenue Agent, Carol Lee, conceded that it is possible for multiple family units to reside in the same dwelling and for each head of those units to properly claim head of household status. The Court concluded that the Government failed to provide evidence demonstrating that such exceptions did not apply to the returns in question.

Court’s Conclusions and Sanctions

Based on the clear and convincing evidence presented, the Court ultimately held Martha A. Velarde in civil contempt for violating the Limited Injunction by failing to exercise due diligence under 26 U.S.C. § 6695.

Regarding the Government’s requested sanction of $228,575 for disgorgement, the Court deemed this amount inappropriate. The rationale was that the Government failed to prove by clear and convincing evidence that Velarde had improperly claimed head of household status for all 2,079 tax returns, which formed the basis of the requested disgorgement amount.

Instead, the Court imposed a sanction in the amount of $20,000. This sanction was deemed appropriate to compel Velarde to comply with the Limited Injunction. The Court highlighted that this was not Velarde’s first transgression against due diligence requirements, noting previous IRS fines of $6,000 in 2016 and $4,080 in 2018 for similar failures. These prior penalties did not deter her, as she persisted in knowingly using fictitious social security numbers for qualified persons. The Court also noted that sanctions not exceeding $25,000 are permitted under 26 U.S.C. § 6695.

Velarde was ordered to pay the $20,000 sanction within sixty days of the Order, which was signed on September 4, 2025.

Key Takeaways for Tax Professionals

This case underscores the importance of due diligence in tax preparation and adherence to judicial orders. The court’s decision serves as a reminder that:

Court orders, such as injunctions, must be strictly observed, and disobedience can lead to civil contempt findings.
Due diligence requirements under 26 U.S.C. § 6695 and related regulations are non-negotiable. Knowingly providing incorrect or incomplete information, even under the guise of a "workaround" for software issues, constitutes a violation.
The burden of proof for contempt is "clear and convincing evidence," which is a high standard for the moving party. However, once a violation is established, the onus shifts to the preparer to justify non-compliance.
Prior penalties for non-compliance can influence subsequent sanction amounts, indicating a pattern of disregard for regulations and increasing the likelihood of more significant financial penalties.
While the Government may make broad allegations, it must meet its burden of proof for each specific claim.
The maximum sanction permitted by statute can guide the court’s decision in imposing penalties for violations.

This case emphasizes that tax preparers must prioritize accuracy, make reasonable inquiries when information appears questionable, and ensure full compliance with due diligence standards to avoid legal and financial repercussions.

Prepared with assistance from NotebookLM.