District Court Applied Wrong Definition of "Willful" in Return Preparer Penalty Case

(Parker Tax Publishing July 2019)

The Ninth Circuit reversed and remanded a decision in which a district court held that, under Code Sec. 6694(b)(2)(A), a return preparer willfully understated tax on returns he prepared. According to the Ninth Circuit, the district court incorrectly included recklessness in the definition of "willful." Rodgers v. U.S., 2019 PTC 233 (9th Cir. 2019).

Background

John Q. Rodgers is a CPA and tax attorney who has worked in his own practice since 1986. During 2009 and 2010, the years at issue, Ramon Barbieri, also a CPA, was Rodgers' partner. For the years at issue, Rodgers' firm prepared personal tax returns for Joseph Ross and Scott Keller. Rodgers also prepared corporate tax returns for Rossmith Packaging, Inc., Ross Pac, Inc., and Freshtech Inc. (the companies), which were owned and operated by Ross and Keller. Dana Styck was the bookkeeper/controller of the companies.

The companies shared office space and expenses. Rossmith generally paid the companies' expenses. Ross Pac and Freshtech occasionally made payments to Rossmith, which Rossmith would allocate to various expenses. Funds not otherwise allocated went into a "suspense account." All of the companies had suspense accounts, although Barbieri directed Styck to rename Rossmith's suspense account "corporate operating expenses." In 2009, Ross Pac transferred $212,000 to Rossmith, which Rossmith entered in its corporate operating expense account. Styck entered the $212,000 payment in Ross Pac's cost of goods sold (COGS) account at the direction of Rodgers' firm. There was no evidence that Ross Pac purchased $212,000 of goods from Rossmith.

Rossmith's tax returns for 2009 and 2010, which Rodgers prepared, understated income by not including funds received from Ross Pac and Freshtech that were not reimbursements. Rossmith's 2009 return overstated deductions for salaries, taxes and other expenses by including amounts for which it did receive reimbursements. Rossmith's 2010 return claimed deductions for expenses related to Keller's condominium that were also claimed by Keller on his personal return and that were not, in any event, business-related expenses. Ross Pac's 2009 return overstated its deduction for salaries by including over $202,000 of expenses that were paid by Rossmith and were not reimbursed by Ross Pac. Ross Pac overstated its COGS by including the $212,000 transfer to Rossmith and by including payroll tax expenses it did not incur. Ross Pac's and Freshtech's 2010 returns overstated various expenses, including rental expenses and expenses for dues and subscriptions.

The IRS assessed nine penalties against Rodgers for willful or reckless understatements of tax on returns prepared for Keller, Ross, and their companies. Under Code Sec. 6694(b)(1), 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 willful or reckless conduct must pay a penalty with respect to each such return or claim in an amount equal to the greater of $5,000, or 75 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim. Code Sec. 6694(b)(2)(A) defines willful or reckless conduct to include a return preparer's willful attempt to understate tax liability on a return, while Code Sec. 6694(b)(2)(B) penalizes a return preparer's reckless or intentional disregard of rules or regulations. Rodgers paid the penalties and sued for a refund in a district court.

The district court upheld the penalty assessments, finding that understatements on the returns prepared by Rodgers were willful or done in reckless or intentional disregard of IRS rules or regulations. In reaching this conclusion, the district court determined that under Safeco Ins. Co. of Am. v. Burr, 551 U.S. 47 (2007), the definition of willfulness in Code Sec. 6694(b)(2)(A) includes reckless disregard.

The district court determined that Rodgers willfully understated tax based on several findings. The court noted that although Rodgers' standard practice was to have someone other than himself review the returns after their initial preparation, he did not require that reviewin the cases of Ross's, Keller's, or the companies' returns. The court found that Rodgers' firm directed Styck to classify the $212,000 payment from Ross Pac to Rossmith as COGS when Ross Pac did not purchase any goods from Rossmith. The district court found that Rodgers and his associates directed Styck to make other changes to the companies' general ledgers and profit and loss statements but never reviewed the general ledgers when preparing the tax returns. According to the district court, its finding of willfulness was supported by the fact that Rossmith's profit and loss statements had four iterations, which were necessary due to negative balances indicating that items were not adequately characterized. The district court said that the negative balances created a situation in which a tax return preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. The district court concluded that Rodgers did not make reasonable inquiries in a situation which required him to do so.

In his appeal to the Ninth Circuit, Rodgers argued that there was insufficient evident to sustain the penalties against him and that the district court erred by defining willful in Code Sec. 6694(b)(2)(A) to include recklessness.

Ninth Circuit's Analysis

The Ninth Circuit reversed the district court and remanded because it agreed with Rodgers that the district court applied the wrong definition of "willful" for purposes of Code Sec. 6694(b)(2)(A). The Ninth Circuit found that willfulness requires a conscious act or omission made in the knowledge that a duty is therefore not being met. According to the Ninth Circuit, the definition of "willful" in Code Sec. 6694(b) is the same as the definition used in Code Sec. 7206, which criminalizes the making of false or fraudulent statements on tax returns. The Ninth Circuit noted that in U.S. v. Bishop, 412 U.S. 346 (1973), the Supreme Court explained that the definition of "willful" does not include recklessness.

Because it found that the district court applied the wrong definition of "willful" in Code Sec. 6694(b)(2)(A), the Ninth Circuit remanded to the district court to reconsider, in the first instance, whether the penalties predicated solely on violations of Code Sec. 6694(b)(2)(A) - the penalties assessed for the tax returns of Rossmith, Ross Pac, and Freshtech - remained justified in light of the evidence adduced at trial.

However, the Ninth Circuit affirmed the district court's findings concerning the penalties assessed under Code Sec. 6694(b)(2)(B) for the Keller and Ross personal returns. The Ninth Circuit found that the district court's conclusion that Rodgers recklessly or intentionally disregarded tax rules or regulations was based on an application of the correct statutory standard, and was not clearly erroneous.

For a discussion of tax return preparer understatement penalties, see Parker Tax ¶276,305.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com