IRS Examiners Directed to Review Estate and Gift Tax Returns for Preparer Penalties

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By Marianne R. Kayan, Esq. Buchanan Ingersoll & Rooney PC, Washington, DC

The Small Business and Work Opportunity Act of 2007 expanded the application of return preparer penalties of §6694 and §6695 to preparers of estate and gift tax returns. As a result, the IRS released an interim guidance memorandum on May 8, 2009, that directs all IRS estate and gift tax attorneys to include in any transfer tax examination an analysis of whether §6694 and §6695 penalties may be warranted.1 These procedures are scheduled for incorporation into the Internal Revenue Manual at 4.25.1 by May 5, 2010. Preparers of estate and gift tax returns filed after May 25, 2007, should anticipate scrutiny of such returns for the possible imposition of §6694 and §6695 penalties.

Section 6694 applies in the event of an understatement of a taxpayer's liability that is due to an unreasonable position. The Emergency Economic Stabilization Act of 2008 provides as a general matter that a position is unreasonable, unless there is substantial authority for the position.2 More specific rules govern whether certain positions, such as a disclosed position or tax shelter or reportable transaction are unreasonable. For disclosed positions, a position is unreasonable, unless there is a reasonable basis for the position.3 Tax shelters and reportable transactions have an unreasonable position unless it is reasonable to believe that the position would more likely than not be sustained on its merits.4 Section 6694(a) applies a penalty of the greater of $1,000 or 50% of the income derived by the tax return preparer with respect to the return or claim. In addition, when the understatement is due to willful or reckless conduct, §6694(b) provides for a penalty of the greater of $5,000 or 50% of the income derived by the tax return preparer with respect to the return or claim.

Section 6695 penalties are likely to be of less concern for the preparers of estate and gift tax returns than the §6694 penalties. Section 6695 penalties are applied in situations including: failure of the tax return preparer to furnish a copy of the return to the taxpayer; failure of the tax return preparer to sign the return; failure of the tax return preparer to furnish an identifying number; failure of tax return preparer to retain a copy of the return or a list of taxpayer's name and identification number; failure of the tax return preparer to file correct information returns; and a tax return preparer negotiating a check issued to the taxpayer.

The statute of limitations on the assessment of these penalties is generally three years from the date the return is filed; there is, however, no statute of limitation under §6694(b) for understatements due to willful or reckless conduct. The time limits for assessment are of note because the tax return preparer penalty will not be proposed until the completion of the estate or gift examination at the group level. At all times, the preparer penalty case is separate from the estate or gift examination. Preparer penalties will not be discussed with the taxpayer. However, the examiner is directed to question the taxpayer and tax return preparer as to issues that could lead to the assessment of the preparer penalties. Questions the examiner may ask the taxpayer center around compensation paid to the tax return preparer and the extent of meetings with or documentation supplied to the return preparer. Tax preparers should anticipate questions regarding documentation received from the taxpayer, authorities relied upon, the length of the relationship with the taxpayer, the extent of meetings with the taxpayer, and whether the tax return preparer is aware of errors, omissions or mistakes on the return.

This memorandum from the Service is a useful resource for tax practitioners to solidify their understanding of the standards that must be maintained in order to avoid tax return preparer penalties.

For more information, in the Tax Management Portfolios, see Peebles and Janes, 822 T.M., Estate, Gift and Generation Skipping Tax Returns and Audits, and in Tax Practice Series, see ¶6290, Valuation -- Generally.


1 IRS Small Business/Self-Employment (SB/SE) Memorandum, Interim Guidance on Return Preparer Penalty Procedures for Estate and Gift Preparer Penalty Cases (May 18, 2009).

2 §6694(a)(2)(A).

3 §6694(a)(2)(B).

4 §6694(a)(2)(C).