Revised LMSB Examiner Procedures for Tax Preparer Penalty Cases

By Michael Coley, CPA, MST, Irvine, CA

Editor: Mark G. Cook, CPA, MBA

Procedure & Administration

In a memorandum issued June 9, 2010, the IRS’s Large and Mid-Size Business (LMSB) Division (now known as the Large Business and International Division) revised examiner procedures for tax return preparer penalty cases (LMSB-4-0310-012). The June 2010 memorandum modifies and clarifies procedures that the division first introduced in a memorandum it published in 2008.

The stated goal of those procedures is to increase voluntary compliance. In that regard, the notice directs examiners to incorporate steps throughout all LMSB field examinations to ascertain tax preparer compliance with specific preparer identification and conduct provisions of the Code. Further, if it is determined that preparer violations exist and the preparer cannot demonstrate reasonable cause for those violations, the memorandum directs examiners to assert preparer penalties.

The examination procedures generally focus on penalties asserted under Secs. 6694, 6695, and 6701, pertaining to standards of conduct to which preparers will be held accountable, compliance with enumerated identification and administrative provisions such as signing and retaining copies of returns, and aiding and abetting the understatement of tax liabilities, respectively.

While the procedures generally provide an overview of examination, documentation, and administrative procedures for establishing and working a preparer penalty case, they also serve to remind preparers of the continuing trend of shifting accountability for tax return compliance to return preparers. This shift has been effected by raising preparer conduct standards, broadening the definition of tax return preparers, and increasing preparer penalties for violations.

Background: Preparer Penalties

The preparer penalties of Secs. 6694 (preparer standards of conduct) and 6695 (penalties for failure to comply with enumerated identification and administrative requirements) were introduced to the Code with the enactment of the Tax Reform Act of 1976, P.L. 94-455. Sec. 7701(a)(36), which defines a tax return preparer, was also added to the Code by the 1976 act. As explained in the legislative history, the enactment of these provisions was largely in response to congressional perception of widespread fraudulent returns prepared by, and abusive practices of, income tax preparers. In addition, before the 1976 act the only sanctions available to the IRS to encourage compliance were criminal penalties. Because criminal sanctions were often deemed inappropriate, too costly, or too time-consuming to prosecute, they were unlikely to be imposed except for the most egregious violations. Secs. 6694, 6695, and 7701(a)(36) were drafted to provide the IRS with tools to address those issues.

The preparer penalties of Sec. 6694 have seen many changes since they were first enacted in 1976. Over the years, amendments to that section significantly raised the standards of conduct to which tax preparers are held accountable and increased penalties for noncompliant preparers. An overview of the relevant provisions is included below.

As originally enacted, Sec. 6695 imposed a $25 penalty for each failure by a tax return preparer to furnish a copy of a return or claim for refund to the taxpayer, to sign a return or claim for refund, or to comply with various other identification and administrative rules enumerated in that section. The maximum penalty for each type of violation was limited to $25,000. The enactment of the Omnibus Budget Reconciliation Act of 1989, P.L. 101-239 (OBRA), increased penalties for each violation to $50. However, the $25,000 overall limit was retained. There have been few changes to those provisions in the subsequent years.

The Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248, first introduced penalties assessable against preparers who aid and abet the understatement of a tax liability under Sec. 6701. Violations under Sec. 6701 are subject to penalties of $1,000 unless the violation is related to corporate tax liability, in which case the penalty is $10,000. Other than slight modifications by the 1989 act, the provisions of Sec. 6701 are unchanged.

With its definition of a preparer, Sec. 7701(a)(36) and the related regulations established who would be subject to the new penalty regime. Those provisions broadly defined tax preparers to include anyone who prepared a “substantial portion” of an income tax return or claim for refund for compensation, including nonsigning preparers and advisers. The Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), further broadened the definition of a tax preparer to include any person who prepared a substantial portion of any return, thereby extending the IRS’s authority to levy penalties against preparers of returns other than income tax returns.

Evolution of Preparer Standards of Conduct: Sec. 6694

As originally enacted, Sec. 6694 imposed a two-tiered penalty regime for preparers who failed to meet certain standards of conduct. A first-tier preparer penalty of $100 was imposed under Sec. 6694(a) for the understatement of liabilities resulting from a preparer’s “negligent or intentional disregard” of the rules and regulations. Generally, tax preparers could avoid the imposition of first-tier penalties by exercising due diligence when preparing tax returns. Provisions of Sec. 6694(b) imposed a second-tier preparer penalty of $500 if any understatement was due to a preparer’s willful attempt in any manner to understate a tax liability.

The first major change to the provisions of Sec. 6694 came with the enactment of OBRA in 1989. Title G of OBRA, the Improved Penalty Administration and Compliance Tax Act of 1989 (IMPACT), altered the standard of conduct to which preparers would be held accountable and distinguished undisclosed positions from disclosed positions, generally requiring higher standards of conduct for undisclosed positions. IMPACT replaced the original “negligent or intentional disregard” provisions of Sec. 6694(a) with language assessing first-tier penalties for liabilities that were understated as the result of any frivolous or undisclosed position for which there was not a realistic possibility of its being sustained on its merits. Prior to amendment, Regs. Sec. 1.6694-2(b) defined the new “realistic possibility” standard as a one in three or greater likelihood of the position’s being sustained. The original second-tier “willful attempt” provisions of Sec. 6694(b) were retained. However, the amendments added language imposing penalties for understatements attributable to “any reckless or intentional disregard of rules or regulations.” In addition to effectively raising the bar for preparer compliance, IMPACT increased first-tier penalties from $100 to $250 (for Sec. 6694(a) violations) and for second-tier violations from $500 to $1,000 (Sec. 6694(b)).

The enactment of SBWOTA raised the standards of conduct again. That act replaced the realistic possibility standard for undisclosed positions with one requiring preparers to have a reasonable belief that positions were more likely than not to be sustained. The more likely than not (MLTN) standard is construed to mean a greater than 50% probability of being sustained if challenged. SBWOTA also replaced the not frivolous standard for understatements attributable to disclosed positions with a standard requiring preparers to have a reasonable basis for such positions taken on returns. The act also increased first-tier penalties from $250 to the greater of $1,000 or 50% of the income derived from any understatement attributable to an unsustained position. SBWOTA increased second-tier penalties to the greater of $5,000 or 50% of the income derived from any understatement attributable to the willful or reckless conduct of the preparer. Provisions of SBWOTA were effective for returns filed after May 25, 2007.

Due to widespread controversy over the MLTN standard, Congress retroactively amended the general provisions of Sec. 6694(a) in the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, P.L. 110-343. That act replaced the MLTN standard with a “substantial authority” standard for undisclosed positions. For disclosed positions not related to tax shelters or reportable transactions, preparers must have a reasonable basis for taking such positions. Although the MLTN standard was eliminated from the general provisions of Sec. 6694(a), that standard of conduct was retained under a special rule that was enacted with the 2008 act for tax shelters (defined in Sec. 6662(d)(2)(C)(ii)) and reportable transactions to which Sec. 6662A applies. Accordingly, for positions on tax shelters or reportable transactions, preparer penalties may be asserted if the preparer does not reasonably believe the position has a more likely than not probability of being sustained on its merits whether the positions are disclosed or undisclosed. The 2008 act left unchanged the increased penalties introduced with SBWOTA for both first-tier and second-tier violations.

A Target-Rich Environment?

It is in this context of stricter standards of preparer conduct, a broadened definition of preparers, and increased penalties that the IRS mandated preparer examination procedures with every LMSB examination. According to the 2008 LMSB memorandum:

The Small Business and Work Opportunity Tax Act of 2007 broadened the definition of a tax return preparer to include any person that has prepared a substantial portion of any tax return or claim for refund. This law change will greatly expand the number of practitioners subject to return preparer penalty consideration. [LMSB-04-0308-009]

That being said, the June 2010 LMSB memorandum advises examiners to exercise discretion in making referrals to the Office of Professional Responsibility (OPR) based on the assertion of Sec. 6694(a) (first-tier) penalties as well as penalties asserted under the provisions of Sec. 6695 (generally, identification and administration compliance penalties). (Under provisions of Circular 230, the OPR is responsible for conducting disciplinary proceedings against attorneys, CPAs, enrolled agents, enrolled actuaries, enrolled retirement plan agents, and appraisers.)

Referrals to the OPR may result in additional disciplinary action against practitioners, including censure, disbarment, or suspension. However, per the June 2010 memorandum, referrals to the OPR are mandated for any penalties asserted under the willful or reckless conduct provisions of Sec. 6694(b) (second-tier penalties).


Heightened preparer conduct standards, broadened application of preparer penalties, and increased penalties have raised the bar for preparer accountability. While the recent memorandum is brief and was directed toward LMSB examiners, it serves to remind preparers that the IRS is increasing its scrutiny of tax preparers as well as their work products and is prepared to levy meaningful penalties against preparers who engage in negligent or abusive practices.


Mark Cook is a partner at Singer Lewak LLP in Irvine, CA.

For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or

Unless otherwise noted, contributors are members of or associated with Singer Lewak LLP.

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