As I pass by the strip mall near my office on those chilly late winter/early spring days, I almost always see someone dressed up like the Statue of Liberty outside the tax preparation storefront beckoning cars to pull over. That sight triggers two thoughts in my mind. The first one is this clip from a semi-popular cartoon show, and the other one is a more cerebral idea about tax preparer liability.

Most of us know that Miss Liberty wants to attract “your tired, your poor, your huddled masses yearning to breathe free” and the “wretched refuse of your teeming shore.” So, some of the taxpayers who saunter into the H&R Block (or whatever it is) are not exactly as pure as the driven snow. In fact, I would guess that a sizeable percentage of them are looking to commit tax fraud, and they need someone to take all of the blame, or at least part of it, if things go sideways.

These liability questions normally start coming up about this time of year, since by May or June, the first “Dear Taxpayer” letters are usually in the mail.

The Big Picture

Broadly speaking, professionals are liable for discipline or other penalties if their behavior falls well below the standard of care and their mistakes were material to the procedure. Attorneys aren’t necessarily negligent if their clients are found guilty. However, if a criminal lawyer does not call a key alibi witness, and the failure had a substantial bearing on the outcome, the attorney will probably answer to the licensing authority, and perhaps to a civil jury as well.

The same idea applies to paid tax preparers. Mistakes on the return will almost certainly irritate the taxpayer but are no big deal as far as the IRS is concerned. The question is: Where does the Service draw the line between understandable error or a rosy interpretation of existing law and negligence or fraud?

The answer lies partly in the purpose of tax preparer penalties, which is to discourage the good folks at Jackson Hewitt from aiding and abetting tax fraud, whether they do so intentionally or unintentionally.

The Penalties

In 2007, Congress substantially elevated the standard of care regarding paid tax preparers. Now, anyone who accepts anything of value for preparing all or a “substantial portion” of a return (whether or not they sign) may be liable for:

• Substantial understatement of income and other reckless or intentional conduct (Section 6694), or
• Dereliction of duty, such as not giving the taxpayer a copy of the return (Section 6695).

The “substantial portion” element refers not so much to the gross number of lines that the preparer either filled in or helped fill in, but the amount of advice that’s relevant to a refund. In-house tax preparers (e.g. the boss says “get me a coffee with extra cream and fill out the 1040”) and most volunteers (especially if they are volunteering on behalf of the IRS) are not paid preparers as a matter of law and therefore not liable no matter what they do (or don’t) do.

In either case, the preparer can raise a reasonable cause defense. That’s usually not very useful in cut-and-dry 6695 actions, because preparers either do everything on the tax preparation checklist or they don’t. But 6694 actions are a lot more subjective, and also much more common.

Substantial Understatement, Etc.

In 2015, Congress substantially increased the penalties for:

• Understating Tax Liability: In addition to understating income, penalties also apply for overstating credits, like the child tax credit or EITC.
• Unreasonable Basis: The IRS has a number for almost everything, including whether or not there is “substantial authority” to support the claim or deduction. This is a term of art which means, according to a 1999 Joint Committee on Taxation report, that the claim has at least a 40 percent chance of surviving in Tax Court. In contrast, individual taxpayers must have a “reasonable basis,” which is a 20 percent chance of success.

The understatement penalty is usually $1,000 or 50 percent of the preparation fee, whichever is greater. However, if the preparer was reckless, the penalty goes up to $5,000 or 75 percent; individuals who file Form 8275 disclosure statements nearly always avoid the enhanced penalties.

The Reasonable Cause Defense

Theoretically, the same penalties apply to all tax preparers no matter how much training and experience they have. However, 6694(a)(3) does give an accommodation of sorts. Liability does not attach if the understatement:

• Involved a law which is unusually technical or complex,
• Was an isolated, one-off item,
• Resulted from reasonable reliance on the information of others, including taxpayer-provided data,
• Was immaterial, or
• Resulted from industry practices that are generally accepted.

As for the data-reliance element, preparers do not have to ask lots of questions and can usually rely on information from prior returns.

To answer the question posed above, the two key numbers seem to be 40 percent and 8275. To avoid the underlying penalty, one must be able to give a rationale for the return that does not begin with “I thought that. . .” or, even worse, “I hoped that. . .” Next, to avoid the enhancements, timely file the disclosure form.