Six Keys to Avoiding Section 6701 Penalties

Appraisers in Violation of 6701 May Face Devastating Consequences. Learn More About Potential Penalties—and How to Stay in Compliance

Joel N. Crouch and Joseph D. Brophy discuss the IRS Code’s Section 6701 and the relevant penalties that can be leveraged against violators. While IRS sources say that the number of penalties imposed is still negligible, this number has increased significantly and the trend continues.

Crouch and Brophy’s article addresses penalties under section 6701 of the Internal Revenue Code, (the “Code”) particularly focusing on penalties against appraisers. While the information in this article does not address section 6695A of the Code, a section specifically directed at appraisers, the information contained in the article remains in effect.

Section 6695A was enacted in 2006 as part of the Pension Protection Act. This section was enacted to address many of the weaknesses of the application of section 6701 to appraisers, because the standard for prosecution under section 6701, being similar to that required to properly develop a fraud case, inhibited action and virtually disabled the Service’s ability to properly discipline appraisers. I know because I proposed the change, worked hard to see it through enactment, and pursued the first cases against appraisers under section 6695A.

Section 6701 remains in effect, and can be applied to appraisers, should the Service choose to do so. The standard remains unchanged, that is, a “willful and intentional understatement” of a tax liability. Section 6695A is far simpler, and only requires a finding of a substantial or gross valuation misstatement. This finding is a mere mathematic calculation, comparing the appraisal amount with the correct amount as determined by the Service. The only exception applies if an appraiser can establish that the appraisal value was “more likely than not” correct. This showing remains unclear, as to just what the Service would accept to establish the exception.

Section 6701 of the Internal Revenue Code imposes penalties against anyone who assists in the understatement of a tax liability. Before last year, “most cases arising under Section 6701 involve[d] penalties imposed on income return preparers.”¹ The number of penalties assessed against appraisers was “negligible,” according to our discussions with Howard Lewis, former IRS National Program Manager for Valuations.

On March 25, 2005, the IRS chief counsel issued Advice 200512016, which provides guidance regarding the circumstances in which an appraiser may be  held liable for Section 6701 penalties. Since this Advice, the  number of penalty examinations “has increased significantly, and the trend continues,” says  Lewis.

Any appraiser who is subject to these penalties could find it to be devastating to his or her practice.  In this article, we will suggest six precautions you can take to avoid violating Section 6701. First we will give you a brief summary of Advice 200512016, Section 6701, and the disqualification provisions of Circular 230.

The Advice
Chief  Counsel Advice 200512016 was issued to give guidance to IRS agents regarding “the  criteria that Service personnel should consider to determine whether to assess a section 6701 penalty, the  administrative procedures to impose a section 6701 penalty, and   the  rights of a  person who has  been  the subject of a section 6701  penalty assessment.”

The Advice states, “There are no temporary,  proposed, or  final regulations issued for section 6701.” The Advice concludes that the imposition of a Section 6701 penalty against an   appraiser requires the appraiser ’s knowledge that  false statements would  lead  to an  understatement of tax. A slightly more elaborate version appears near the beginning of the  Advice: Treas. Reg. section 1.170A-13(c)(5)(D)  provides that  an appraiser’s “intentionally  false or  fraudulent overstatement of the  value of the  property described in the  qualified appraisal or appraisal summary may  subject the  appraiser to  a civil penalty under section 6701 for aiding and  abetting an understatement of tax  liability.”

As  to  proof  of  a  violation, the Advice  says: “The  Service would  be required to show  by a preponderance of the  evidence that an appraiser helped prepare or present a  document that led  to an  understatement of tax  by  a taxpayer, for an  appraiser to be held  liable for a section 6701 penalty. The  Service would  also need   to  demonstrate that  the appraiser had  actual knowledge that the  taxpayer would  rely  on the  document that would  lead  to an  understatement. Particular cases should be considered individually until the  application of section 6701  in  this  context is more  established.”

Circular 230
The  potential impact of the imposition of a Section 6701 goes far beyond just the  payment of the relatively small penalty. An appraiser who  is subject to  a Section 6701  penalty is also  subject to disqualification under Circular 230.  If an  appraiser is disqualified, he or she is barred from presenting evidence or testimony in any administrative proceeding before the Department of Treasury or  the IRS. 

Any appraisal made by a disqualified appraiser after the   effective date of disqualification will not have any probative effect in any administrative proceeding before Treasury or the IRS.

This  raises many questions. For instance, what would  your liability be to a client who could not use your report if challenged in an  unrelated matter? Would  your  clients then be forced to compromise or concede other pending cases?

Section 6701  Penalties
IRC Section  6701 imposes a penalty on any person who (1) aids or  assists  in, procures, or advises with respect to the  preparation or presentation of any  portion of a return, affidavit, claim, or any other document, (2) knows or has reason to believe that the portion of the document will be used in connection with any material matter arising under the Internal  Revenue laws,  and  (3) knows that  document would result in the understatement of a tax liability of another person. The amount of the penalty is $1,000  unless it relates to the  tax  liability of a corporation, in which case it is $10,000.

The terms “aids,” “assists in,” and “advises” have been broadly interpreted to include not only the preparation of a tax return, but also the preparation or presentation of any portion of a document that will be provided to the IRS. Providing an appraisal would fall within this definition.

The “document” at issue includes a tax return, claim for refund, affidavit or any other document that is used in connection with a material tax matter. An appraisal used to support a position on a tax return, claim for refund or in litigation falls within this definition of a document. Likewise, an  affidavit from an appraiser that is used to resolve a matter with the  IRS  falls within the definition of a document for purposes of Section 6701.

Defense
Generally, an advisor’s best line of defense to a Section 6701  penalty is to establish that the document at issue is not false. Failing that, the advisor can show that he or she did not know that the  use of the document would  result in an understatement of tax liability.

Likewise, the penalty would  be inapplicable where an  advisor can establish that he or she did not know  and had no reason to believe that the  document would  be used in an  Internal  Revenue matter. For example, an  appraiser may  be retained to appraise a business for a buy-sell agreement. Unbeknownst to the  appraiser, that same appraisal is being  used for preparation of a tax  return. The appraiser can establish  by his  fee agreement that he or she  was  retained only  for  the  buy-sell appraisal and   had   no  knowledge  of the  tax  return.

Investigation
If the IRS decides that a Section 6701 penalty investigation is warranted, the advisor will be notified of the investigation in writing, but only after the IRS has finished gathering information from third parties.  Sometime thereafter, the investigating Revenue Agent will meet with the advisor to develop and document the advisor’s defenses to the proposed penalty.

If the investigating agent decides a Section 6701  penalty is applicable, the  penalty will be assessed. The advisor has no right to a pre-assessment appeal of the penalty, nor is the IRS required to comply with the  deficiency  procedures used in  tax  cases. To contest the penalty assessment, the advisor must pay at least 15 percent of the assessed penalty, file a claim for refund, and, if necessary, file   an action in   federal district court.  This can be expensive and time-consuming.

Contest
Section 6703(b)  provides a special  procedure that  allows an  advisor to contest the  imposition of a Section 6701 penalty without paying the entire amount. Within 30 days  of receiving notice  and  demand for payment from  the  IRS,  an  advisor may  pay 15  percent of the  liability and   file  a  claim  for  refund. If  the claim  for refund is denied, the  advisor  is  sent a  letter advising him or her  that the  claim  will be disallowed unless a written request for Appeals consideration is  received within 30 days  from  the  date  of  the letter.

Appeals will consider the claim for refund on an expedited basis.

If the claim for refund is ultimately disallowed, the appraiser may file a petition in federal district court within 30 days of the refund disallowance. If the appraiser complies with the 30-day rule, the IRS will be barred from collecting the balance of the penalty until resolution of the court case.

If an advisor fails to comply with the requirements of Section 6703(b), he or she can only contest the penalty by paying the entire amount, filing a claim for refund, and filing a petition in federal district court.

Six Precautions

The appraiser’s  job is  to  arrive at values, such  as fair market value, frequently used for tax  matters that approximate the  market. To the extent an appraiser can demonstrate that he or she used all professional care in arriving at their opinion, then the   appraiser should be able to rebut challenges including penalty assessments. By taking the following precautions, you can demonstrate your use of professional care and limit exposure to Section 6701 penalties:

• Always use an engagement letter
• Confirm   the   scope   of  the engagements that you accept
• Verify client data independently
• Be sure you know  for exactly what purpose the  appraisal will be used
• Be  selective and  accept only engagements that you have the expertise to complete
• If needed, bring in other experts for second opinions before you issue your reports

The  appraisal  profession may have to  do  what has  become  standard  in  the  audit  profession and implement a  peer-review process to demonstrate that procedures measure  up  to  those of other professionals. Tax controversies may add to the pressure to establish peer  review.

Conclusion
Appraisals for tax  matters have always involved risk for  the appraiser, but  the  current tax administration environment is a particularly difficult one  for professionals assisting on tax  matters.

No one would disagree that bad actors need to be penalized and stopped from defrauding the government, but  we hope  the IRS  will acknowledge there are  many legitimate differences of opinion when dealing with valuations.

For instance, when valuing a raw land partnership, the taxpayer’s expert may determine that the combined discounts should be 45 percent, while the   IRS economist believes that the maximum combined discounts should be 14 percent.  

Assuming both  professionals are using their best judgment, will the IRS examiner be able to fairly distinguish between legitimate differences of opinions and bad actors that need to be penalized? Will the threat of potential penalties cause appraisers to settle issues in areas debated by knowledgeable professionals?

Unfortunately, valuation discounts are still the subject of great controversy within the profession and are hardly subject to universal agreement. Will those in the  profession  lose  the  ability to fairly represent clients because they fear  their own ability to represent clients will be  compromised by  disagreements on the  computation and  application of discounts?

The answers to these questions will develop as the IRS implements the penalties over the next few years.

Stay tuned. This area of tax administration requires continued dialogue between IRS and valuation professionals. In the authors’ opinion, it is critical for your practice that NACVA  be  involved with this dialogue.  

Reach Joel Crouch at jcrouch@meadowscollier.com and Joseph D. Brophy at jdbrophy@jdbrophycpa.com . This article was originally published the Value Examiner.

¹“Office of Chief Counsel Internal Revenue Service Memorandum 200512016, 1(A),” Internal Revenue Service, accessed September 25, 2012, http://www.irs.gov/pub/irs-wd/0512016.pdf.