In the case of Foxx v. United States, U.S. Court of Federal Claims, No. 1:15-cv-01266 the IRS had assessed a penalty against a tax preparer, claiming he had failed to exercise proper due diligence in reporting over $18,000 from an auto detailing business that caused a taxpayer to qualify for the earned income tax credit. When the IRS examined the taxpayer’s return, the taxpayer admitted she had no such business and, thus, was not eligible to have received the credit.

The IRS had assessed a penalty against Dr. Foxx under IRC §6694(b) for “willful or reckless conduct” in preparing the tax return. Dr. Foxx argued that he has simply relied upon the representations of the taxpayer about her income. So the key question became whether Dr. Foxx’s actions were sufficient to show an exercise of proper due diligence.

Under IRC §6694(b) a preparer is subject to penalty for willful or reckless conduct if:

The preparer prepared a return or claim for refund;
There existed an understatement of tax on that return or claim; and
The underpayment was due to conduct which was either a willful attempt in any manner to understate the liability for tax on the return or claim, or a reckless or intentional disregard of rules or regulations.

The basic facts begin with the following description provided by the Court, as well as the beginning of the different stories that would be given by the client and the preparer:

Ms. Bryant brought her W-2, which indicated that she had received a total of $15.51 in 2007 from a brief employment at Busch Gardens, and information regarding her children. Bryant Decl. ¶ 3. She did not bring any documents indicating additional income. Id.; James Dep. at 24:20-24. According to Ms. Bryant and Mr. James, Dr. Foxx told Ms. Bryant that she could nonetheless receive a tax refund if she reported additional income from a business. Bryant Decl. ¶ 4; James Dep. at 17:9-22.3

Dr. Foxx disagreed with the claim of the client and her friend who accompanied her that he had suggested she should show additional business income.

The Court continues:

Ms. Bryant applied for and received a business license for auto detailing, and returned to Dr. Foxx's office that same day with the license. Bryant Decl. ¶¶ 4-5; James Dep. at 15:16-24, 31:3 to 32:6. Dr. Foxx then prepared Ms. Bryant's tax return and reported $18,288 in business income from Ms. Bryant's purported auto-detailing business. See Def.'s Cross-Mot. Ex. 1, Ex. 9. As a result, Ms. Bryant qualified for earned income tax credits and received a refund of $2,577 from the IRS. Def.'s Cross-Mot. Ex. 1, Ex. 6. Ms. Bryant paid Dr. Foxx $169 as a tax preparation fee. Def.'s Cross-Mot. Ex. 9

As the Court points out, the first two requirements for a penalty under IRC §6694(b) are met, as Dr. Foxx prepared the return and there was an understatement of tax on that return. So the question boiled down to whether Dr. Foxx’s conduct met the requirements of being either willful or reckless, leading to the understatement.

The taxpayer and her friend claimed that Dr. Foxx had been the person to come up with the false business income. Dr. Foxx disputed that point, claiming that the client had claimed to have such a business with the income he reported on the return.

The Court found it didn’t need to decide which party was telling the truth in this case, as it found Dr. Foxx intentionally or recklessly disregarded the due diligence rules in place for preparers when a taxpayer claimed the earned income credit.

The Court noted:

Even if the court were to adopt Dr. Foxx's account of the event, accepting that he possessed a good faith belief that Ms. Bryant had an auto-detailing business, Dr. Foxx intentionally or recklessly disregarded tax preparer rules and regulations. Under the applicable Treasury regulation in effect in 2008, Dr. Foxx was required to perform due diligence before filing Ms. Bryant's tax return for earned income tax credits. See 26 C.F.R. § 1.6695-2 (2008). This due diligence included an obligation to “make reasonable inquiries if the information furnished to, or known by, [Dr. Foxx] appear[ed] to be incorrect, inconsistent, or incomplete.” Id. § 1.6695-2(b)(3) (2008). Dr. Foxx stated that he received training in preparing tax returns and that he required substantiation of reported business income from his clients. Def.'s Cross-Mot. Ex. 15 (Foxx Dep. at 106:3 to 109:8, 129:1-22). But in reporting more than $18, 000 for Ms. Bryant's purported auto detailing business, Dr. Foxx did not examine any bank statements, business expense receipts, or business ledgers. He instead relied upon Ms. Bryant's business license, obtained the same day Dr. Foxx filed Ms. Bryant's return, and two pages of notes written by Dr. Foxx that outlined expenses associated with the business. See Def.'s Cross-Mot. Ex. 9.5 Dr. Foxx argued before the IRS that his reliance on Ms. Bryant's alleged statements regarding her business was reasonable because Ms. Bryant otherwise would have only earned approximately $15 in 2007 based on the W-2 she provided to Dr. Foxx. Id. Such an argument is misplaced; Ms. Bryant's financial situation did not relieve Dr. Foxx of his obligation to make reasonable inquiries into any auto detailing business purportedly conducted by Ms. Bryant after she did not provide adequate documentation. His failure to do so was an intentional or reckless disregard of relevant Treasury Regulations.

The Court therefore found that the IRS was justified in imposing the penalty on Dr. Foxx.

Advisers should take heed that Congress, in the Protecting Americans from Tax Hikes Act of 2015, expanded these due diligence rules to cover any returns claiming the American opportunity tax credit or the child tax credit. Presumably a similar level of inquiry into a taxpayer’s circumstance would be required in the case of such claimed credits or a preparer may face a penalty under §6694(b).