Six Keys to Avoiding Section 6701 Penalties
Appraisers in Violation of 6701 May Face Devastating Consequences. Learn More About Potential Penalties‚ÄĒand How to Stay in Compliance
Joel N. Crouch and Joseph D. Brophy discuss the IRS Code‚Äôs 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‚Äôs article addresses penalties under section 6701 of the Internal Revenue Code, (the ‚ÄúCode‚ÄĚ) 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‚Äôs 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 ‚Äúwillful and intentional understatement‚ÄĚ 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 ‚Äúmore likely than not‚ÄĚ 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, ‚Äúmost cases arising under Section 6701 involve[d] penalties imposed on income return preparers.‚ÄĚ1 The number of penalties assessed against appraisers was ‚Äúnegligible,‚ÄĚ 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 ‚Äúhas increased significantly, and the trend continues,‚ÄĚ 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.
Chief¬† Counsel Advice 200512016 was issued to give guidance to IRS agents regarding ‚Äúthe¬† 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.‚ÄĚ
The Advice states, ‚ÄúThere are no temporary,¬† proposed, or¬† final regulations issued for section 6701.‚ÄĚ The Advice concludes that the imposition of a Section 6701 penalty against an¬†¬† appraiser requires the appraiser ‚Äôs 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‚Äôs ‚Äúintentionally¬† 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.‚ÄĚ
As¬† to¬† proof¬† of¬† a¬† violation, the Advice¬† says: ‚ÄúThe¬† 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.‚ÄĚ
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 ‚Äúaids,‚ÄĚ ‚Äúassists in,‚ÄĚ and ‚Äúadvises‚ÄĚ 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 ‚Äúdocument‚ÄĚ 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.
Generally, an advisor‚Äôs 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.
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‚Äôs 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.
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.
The appraiser‚Äôs¬† 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.
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‚Äôs 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‚Äô opinion, it is critical for your practice that NACVA¬† be¬† involved with this dialogue.¬†¬†
Reach Joel Crouch at email@example.com and Joseph D. Brophy at firstname.lastname@example.org . This article was originally published the Value Examiner.
1‚ÄúOffice of Chief Counsel Internal Revenue Service Memorandum 200512016, 1(A),‚ÄĚ Internal Revenue Service, accessed September 25, 2012, http://www.irs.gov/pub/irs-wd/0512016.pdf.