Tax Court Sustains § 6701 Penalty Against Preparer (7/10/19)

In Kapp v. Commissioner, T.C. Memo. 2019-84, here, the Tax Court sustained § 6701 penalties of $3,218,000 (after certain IRS concessions per slip op., at 114-115).

Section 6701 imposes a penalty on any person who (1) aids, assists, procures, or advises with respect to the preparation or presentation of any portion of a return, affidavit, claim, or other document, (2) knows (or has reason to believe) that the document will be used in connection with any material matter arising under the internal revenue laws, and (3) knows that the document would result in an understatement of another person's tax liability.   The penalty is $1,000 (increased to $10,000 for corporate returns) for each false document for each taxpayer for each tax period affected by the document (but no more than one penalty per period).  This penalty is the civil penalty analog to the tax crime of aiding and assisting, § 7206(2).

Kapp was a return preparer with a specialized client base as follows:  "(1) 75% were deep sea mariners, (2) 18% were tugboat mariners, (3) 5% were offshore mariners, (4) 1% were offshore oil rig workers, and (5) 1% were marine ferry drivers."

Basically, on many returns he prepared, Kapp deducted claimed miscellaneous itemized deductions for unreimbursed employee business meals and incidental expenses, computed by using the full Federal per diem rates for the meals and incidental expenses (M&IE rate) referenced in Rev. Proc. 96-28, 1996-1 C.B. 686, superseding Rev. Proc. 94-77, 1994-2 C.B. 825, multiplied by the number of days traveling for work.

The problem was that the employer paid the meal expenses.  In Tax Court litigation for two of his clients (although he did not represent them in the Tax Court), the Tax Court held that the taxpayers could not deduct the per diem for meal expenses that the employer rather than they incurred.  Kapp read those decisions shortly after they were issue in September 2000.

Kapp then "began advising his tugboat mariner clients and some of his other mariner clients that they were allowed to claim meals expense deductions even if meals were provided by their employers."  (Slip op., at pp. 20-21.) Kapp set up a website advertising the ability to obtain large income tax returns, falsely stating "that he successfully sued the IRS in the Tax Court and won “his cases”.  (Slip op., at pp. 21-22.)  He also published articles and documents with the same claims.  (Slip op. pp. 23-29.)

Kapp then prepared returns for his large base of clients claiming the meal expense without questioning whether the employer paid the meal expenses (as was industry practice).

The IRS objected on audit.  Throughout the audit, Kapp argued that the Tax Court opinions were favorable to his position.  (Slip Op. at pp. 42-51.) He was wrong on that point.  Not just wrong, but clearly wrong.  And he kept it up.

DOj then filed a suit for injunction and prevailed. (Slip op., pp. at pp. 55-61.)

After the injunction, the Tax Court rendered opinions for two of Kapp's petitioners denying their claimed per diem deduction for meals paid for by the employer.

The IRS then issued its § 6701 penalty assessment against Kapp.

The Tax Court's "Opinion" section (beginning on Slip Op., at p. 75) then decides the following key issues (I omit some issues, such as some evidentiary issues, I don't deem important for most readers, although they were certainly important for Kapp):

1. The Court sustained the submission of proof of written supervisor approval in § 6751(b), although the IRS did not meet the 14-day rule in the standing pretrial order.  (Slip op., at pp. 76-82; and 94-96.).

2. The Court grants de novo review of the merits of the § 6701 penalties in the CDP proceeding citing appropriate authority.  (Slip Op., at p. 93.)

3.  Moving to the merits of the § 6701 penalties, the Court holds that the IRS met its burden of proof for the penalty. Court holds that the IRS proved liability by clear and convincing evidence.  (Slip Op., at pp. 97-98.)  For this reason, the Court did not have to address the circuit split as to whether the § 6701 burden on the IRS was preponderance or clear and convincing.  The Court cited in a footnote (Slip Op., at p. 98 n. 34):

Clear and convincing evidence is “that measure or degree of proof which will produce in the mind of the trier of facts a firm belief or conviction as to the allegations sought to be established. It is intermediate, being more than a mere preponderance, but not to the extent of such certainty as is required beyond a reasonable doubt as in criminal cases. It does not mean clear and unequivocal.” Scharringhausen v. Commissioner, T.C. Memo. 2012-350 at *34 (quoting Ohio v. Akron Ctr. for Reprod. Health, 497 U.S. 502, 516 (1990)); see also Waits v. FritoLay, Inc., 978 F.2d 1093, 1105 (9th Cir. 1992) (“Clear and convincing evidence means evidence sufficient to support a finding of ‘high probability.’” (quoting Mock v. Mich. Millers Mut. Ins. Co., 5 Cal. Rptr. 2d 594, 610 (Ct. App. 1992)))

4.  Moving to the elements of § 6701, the Court said (Slip op., at p. 99):

The first element of section 6701(a) requires that the person to be penalized must aid, assist in, procure, or advise with respect to “the preparation or presentation of any portion of a return, affidavit, claim, or other [tax] document”. The second element requires that the person know or have reason to believe that such portion of a document will be used in connection with a material matter arising under the internal revenue laws.

5.  The Court held (Slip Op., at pp.100-109)  that the knowledge element of § 6701 is not the same as the knowledge elements of two sommewhat related penalties (§ 7206(2) and 6694(b) both of which have willful requirements with a stricter level of scienter than § 6701).  The Court states that "Congress has clearly distinguished the scienter requirement of section 6701 from that in other statutes, e.g., section 6694(b) and section 7206(2)," citing Sansom v. United States, 703 F. Supp. 1505, 1509-1510 (N.D. Fla. 1988) as instructive.  I won't get into the cut and paste from Sansone, because I don't think it helpful.  The Court then says:

The plain text of section 6701 (“knows”) indicates that actual knowledge is necessary. The Government must establish that the tax preparer “knows” the use of the return or other document will result in an understatement of tax liability. “[A]ctual knowledge is a higher standard than the ‘willfulness’ standard utilized in other statutes. Simply put, ‘know’ requires knowledge--awareness of the facts and the ultimate result of the conduct.” Carlson v. United States, 754 F.3d at 1229 (quoting Sansom, 703 F. Supp. at 1510); see also Mattingly, 924 F.2d at 791; Warner v. United States, 698 F. Supp. 877, 882 (S.D. Fla. 1988).

I have not gone to those authorities, but I do question the implicit assertion that the knowledge standard is higher than the willfulness standard in § 7206(2). and perhaps even in § 6694(b).  I think that is worth some further analysis, but just don't have time to do it here.  Still for those persons subject to the penalty, a higher burden of proof is always helpful.

6.  The Court holds (Slip Op. at p. 110):

Thus, the penalty applies where a tax document would have caused the harm “if so used,” whether or not the taxpayer ever files an understated return. See id.; see also Bailey v. United States, 117 F.3d 1424 (9th Cir. 1997); Kuchan, 679 F. Supp. at 769. Following Golletz, it is clear that a client need not file a tax document resulting in an understatement in order for section 6701 to apply; a tax preparer needs only to have prepared one.

Added 7/14/19 9:00pm:

Two other good treatments of Kapp from different perspectives are:

• Peter Reilly, PA Sinks Under Millions In Aiding And Abetting Penalties On Mariners Deductions (Forbes 7/13/19), here.
• Lew Taishoff, The Rouges - March Part Deux (Taishoff Law Blog 7/9/19), here.