Consultant faces section 6701 penalties for studies supporting excessive depreciation deductions

Plain-English summary

A tax consultant and engineer prepared written asset-classification studies that recharacterized components of 39-year property as property depreciable over 5, 7, or 15 years. The IRS determined that the studies incorrectly accelerated depreciation and caused clients to claim excessive deductions. Chief Counsel advised that furnishing each study satisfied section 6701 because the consultant knew clients would use it on returns and knew that doing so would understate tax. It also concluded that the consultant aided preparation of every client return that used the study, even though the consultant did not prepare the returns or send the studies to the IRS. The penalty was $1,000 for each affected noncorporate return or study and $10,000 for each affected corporate return or study, subject to the rule against multiple penalties for documents relating to the same taxpayer and tax period. The advice noted that written supervisory approval under section 6751(b)(1) was also required before assessment.

Ruling snapshot

• Question: Does furnishing an incorrect depreciation study make its preparer liable under section 6701 for the study and for each client return that uses it to understate tax?
• Outcome: advice given, the penalty applies
• Key authorities: IRC §§ 168, 6701, 6751(b)(1), and 7206(2); Mitchell v. United States; Mattingly v. United States

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201805001
           Release Date: 2/2/2018
           CC:PA:01:GSemasek
           GL-149415-13

 UILC:     6701.02-00

  date:    October 26, 2017

     to:   Kristen I. Nygren
           Attorney
           (Small Business/Self-Employed)

  from:    Blaise G. Dusenberry
           Senior Technician Reviewer
           (Procedure & Administration)


subject:   Penalty for aiding and abetting understatements of income tax

           This Chief Counsel Advice responds to your request for assistance dated October 26,
           2017. This advice may not be used or cited as precedent.

           LEGEND

           P      ---------------------------------

           S      -------------------------------------------

           ISSUE

           Whether P is liable for the section 6701 penalty for aiding and abetting understatements
           of tax liability for returns on which his clients claimed incorrect depreciation deductions
           in accordance with a written “S”, which had been furnished by P.

           CONCLUSION

           Yes. When P furnished to clients a S that mischaracterized components of 39-year
           depreciable property as property with a shorter useful life (e.g. 5-year property), P aided
           in the preparation or presentation of the returns of clients who understated tax liability
           through claiming excessive deductions for depreciation. P knew that the S would be
           used in connection with a material matter under the internal revenue laws and that when

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his client relied upon such study to claim a depreciation deduction this would result in
the client understating tax liability. Consequently, there is a $1,000 penalty for each
client’s return that understated tax liability by virtue of claiming excessive depreciation
deductions based on the S.

FACTS

P is a tax consultant-engineer who furnishes an analysis of a taxpayer’s assets in order
to determine the classification of articles of property for purposes of depreciation
deductions. For a fee, P analyzes a taxpayer’s assets and prepares a S, which is
aimed at identifying assets among a taxpayer’s property that could be classified as
tangible personal property and other tangible property (I.R.C. section 1245 Property)
and land improvements. The S re-characterizes components of 39-year depreciable
property (e.g. a building) to 5-year, 7-year, or 15-year depreciable property.1 The result
of the S, which P specially prepares based on the particular types of assets owned or
used by the taxpayer, details the cost of each component of a building, new or
otherwise, and the number of years it can be depreciated on the taxpayer’s returns. P
does not prepare returns or furnish the IRS with copies of the S. Rather, P furnishes
the completed S to his clients, who use them in preparing Forms 1040 or Forms 1120.

The IRS determined that the S incorrectly reclassifies property in order to accelerate or
“front-load” depreciation deductions during the first 5 years the property is placed in
service, thereby creating larger tax losses for P’s clients. The IRS considers the
portions of the S categorizing certain structural components as 5- year property to be
the most egregious misrepresentations concerning the classification of property for tax
purposes. You requested our views on whether P is liable for a $1,000 penalty for each
taxpayer’s return upon which an excessive depreciation deduction was claimed as a
consequence of following the conclusions in the S.

LAW AND ANALYSIS

Section 6701 imposes a penalty on a person who aids or abets another person in the
understatement of that person’s tax liability. It states:

       Any person—
      (1) who aids or assists in, procures, or advises with respect to, the preparation
      or presentation of any portion of a return, affidavit, claim or other document,
      (2) who knows (or has reason to believe) that such portion will be used in
      connection with any material matter arising under the internal revenue laws,
      and
      (3) who knows that such portion (if so used) would result in an understatement
      of the liability for tax of another person,


1
    Section 168(e) includes classifications of property for purposes of determining depreciation deductions.

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    shall pay a penalty with respect to each such document in the amount
    determined under subsection (b).

The penalty amount under subsection (b) is $1,000 and, if the return, affidavit, claim or
other document pertains to the tax liability of corporation, the amount is $10,000. The
extent to which a person may be liable for the penalty is limited by section 6701(b)(3),
which reads:

     . . . If any person is subject to a penalty under subsection (a) with respect to any
     document relating to any taxpayer for any taxable period (or where there is no
     taxable period, any taxable event), such person shall not be subject to a penalty
     under subsection (a) with respect to any other document relating to such
     taxpayer for such taxable period (or event).

The structure of section 6701 requires the Service to identify what documents the
person liable for the penalty helped prepare or present, and which also meet the criteria
set out in section 6701(a)(2) and (3). Mitchell v. United States, 977 F.2d 1318, 1321-22
(9th Cir. 1992). Section 6701(a)(1) requires that the person or entity to be penalized
must “aid[] or assist[] in, procure[], or advise[] with respect to the preparation or
presentation of any portion of a return, affidavit, claim or other document.” Mitchell, 977
F.2d at 1322. The penalty for aiding and abetting an understatement of tax liability is
imposed with respect to each document identified in section 6701(a)(1) that further
meets the criteria under paragraphs (2) and (3) of subsection (a). Mitchell, 977 F.2d at
1322; Berger v. United States, 1997 U.S. Dist. LEXIS 6297, 19 (D. Conn. 1997) (“. . .
the statute plainly imposes a penalty as to each document through which the plaintiff
aided or assisted in the understatement of a tax liability.”).

S

The written S satisfy the elements of a section 6701 penalty. P prepared and furnished
to each of his clients a detailed S. Consequently, the S fall within the requirements of
section 6701(a)(1). The S also meet the criteria of section 6701(a)(2) and (3);P knew
that they would be used in connection with the preparation of individual and corporate
tax returns. Thus, P knew or had reason to believe that his clients, both individual and
corporate taxpayers, would use the S as guidance in claiming depreciation deductions
on returns, a material matter under the internal revenue laws, and that the S would (if so
used) result in understatements of tax liability of other persons. Thus, each S is a
document that supports a penalty in an amount determined under section 6701(b). To
the extent the S related to the tax liability of a corporation, the penalty amount is
$10,000 per S furnished. For S furnished to taxpayers other than corporations, the
penalty equals $1,000 per S furnished. I.R.C. § 6701(b)(1).2

2
 Note that the Service would also need to comply with section 6751(b)(1) before assessing the section
6701 penalty. The immediate supervisor of the revenue agent who initially recommended pursuing the
penalty would need to approve the penalty in writing.

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Returns of Individuals and Corporations

You also asked whether P is liable for a $1,000 penalty for each of the five years a
client used the S to prepare his tax return and claim an excessive depreciation
deduction. This raises the question of whether P aided or assisted in the preparation or
presentation of his client’s tax returns. Each of P’s clients had to file a Form 1040 or
1120 with the IRS in order to claim a deduction for depreciation.3 P aided or assisted in
the preparation of each individual or corporate tax return upon which a client claimed a
depreciation deduction in an incorrect amount by virtue of misclassifying personal or
real property in accordance with the S. The purpose behind P’s review, analysis and
classification of a client’s articles of property was to assist his client in preparing and
filing a tax return that included a depreciation deduction exceeding the allowable
amount under the Code and thereby understating taxable income. By furnishing a S to
a client that classified certain real property as personal property, with purported useful
life of only 5 years, P aided or assisted his clients in the preparation of incorrect returns
for 5 different tax periods. As a result, he is liable for one penalty for each of the years
for which a return was filed with the IRS claiming an excessive deduction for
depreciation. In regard to P’s individual clients, the penalty on P would be $5,000
($1,000 for each of the 5 understatements reflected in 5 separate tax returns) and for
corporate clients the penalty is $10,000 per return.

These facts are analogous to those in Mitchell, in which a tax shelter organizer reviewed
and signed tax returns for an S corporation and K-1 forms for each of the shareholders
which showed their purported shares of deductions and credits. Although Mitchell
clearly aided in the preparation or presentation of the S corporation returns, the court
found that section 6701(a)(1) was satisfied with respect to other documents as well.

        Mitchell’s aiding also pertains to portions of all 34 investors’ individual tax
        returns, because each investor incorporates the tax information contained
        on the Form K-1 supplied by Mitchell into his or her U.S. individual tax
        returns. Thus, Mitchell aided in the preparation or presentation of
        documents that relate to the returns of 35 persons.

Mitchell, 977 F.2d at 1322. Just like the investors in Mitchell, every client of P
incorporated onto his or its tax return a claim for a depreciation deduction that was
directly tied to the misclassified property included in the S. P aided in the preparation or
presentation of the tax returns of his clients.



3
  An individual taxpayer receiving net profits (loss) from a trade or business can claim a deduction for
depreciation on Schedule C, and a taxpayer who receives net rental income may claim a depreciation
deduction on Schedule E. 2016 Form 1040, Schedule C, part II, line13; Schedule E, line 18. The returns
of corporate taxpayers include spaces upon which the taxpayer can claim depreciation deduction. 2016
U.S. Corporation Income Tax Return (Form 1120), line 20; 2016 U.S. Income Tax Return for an S
Corporation (Form 1120S), line14.

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The opinion in Berger v. United States, supra, is distinguishable from the present case.
In Berger, the government sought to impose a penalty under section 6701 based solely
upon the plaintiff’s filing of false Forms 5300, “Application for Determination for
Employee Benefit Plan” with the IRS. Each form related to a separate corporation that
claimed tax benefits for more than one year in reliance on a false Form 5300. The court
held that the section 6701 penalty was limited by the number of false Forms 5300
prepared and was not calculated by the number of tax years affected. Berger, 1997
U.S. Dist. LEXIS 6297, at 20. That case is distinguishable from P’s conduct because
the government did not argue in Berger that the plaintiff had aided or assisted with
respect to the preparation or presentation of the corporate returns that claimed tax
benefits in reliance on the Forms 5300. “[T]he conduct allegedly warranting imposition
of a section 6701 penalty was the plaintiff’s alleged falsification of the forms 5300.” Id.

You also raised the question of whether section 6701(b)(3), quoted above, applies to
the facts presented here. That provision precludes the IRS from imposing separate
section 6701 penalties for multiple documents in the same year involving the same
taxpayer. Mattingly v. United States, 924 F.2d 785, 792-93 (8th Cir. 1991). The Court of
Appeals for the Eighth Circuit ruled that an individual who prepared 46 returns for
taxable year 1983 with understatements of tax attributable to non-allowable investment
tax credits was subject to the section 6701 penalty on each of the returns, but not for
the 8 carry-over returns prepared for subsequent tax years. Id. at 793. In Emanuel v.
United States, 705 F.Supp. 434 (N.D. Ill. 1989) the IRS assessed a section 6701
penalty against an individual for each return he prepared for taxable year 1982
containing an incorrect investment tax credit, and also one or more penalties for every
application for tentative refund (Form 1045) filed on behalf a client for an earlier or
subsequent tax year.4 The district court held that the IRS violated section 6701(b)(3) by
imposing additional penalties based on the Forms 1045 because they “related to” the
year 1982. 705 F.Supp. at 438.

Here, because the tax returns and relevant schedules of P’s clients do not claim credits
or deductions that are carried over from a previous taxable year, neither Emanuel nor
Mattingly controls. The above interpretation is also consistent with section 6701(b)(3)
because P will not be subjected to multiple penalties for a given client for a single
taxable period.

The legislative history to section 6701 states that the penalty was intended to apply as a
civil counterpart to the criminal penalty on aiding or assisting in the preparation or
presentation of false or fraudulent returns or other documents. S. Rep. No. 97-494, at
1022 (1982). Section 7206(2) is the criminal penalty applicable to a person who willfully
“aids or assists in, or procures, counsels, or advises the preparation or presentation . . .
of a return, affidavit, claim, or other document . . . .” This language is virtually the same
as in section 6701(a)(1). Courts have applied the criminal penalty to all participants in a

4
  The preparer filed the Forms 1045 for those of his clients who did not use up entirely the purported
investment tax credit in year 1982.

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scheme which results in the filing of a false return, whether or not those parties actually
prepare it. United States v. Hooks, 848 F.2d 785, 791 (7th Cir. 1988). Likewise, section
6701 is the civil counterpart applicable to P in connection with furnishing the S to his
clients and for assisting in the preparation of tax returns reflecting understatements of
tax.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

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