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Individual Tax

Preparer penalties subject to full payment rule before district court has jurisdiction

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Davis, (DC MD 8/14/2019) 124 AFTR 2d ¶2019-5143

A district court has found that Code Sec. 6694(b) preparer penalties are subject to the full payment rule. A taxpayer, who was assessed preparer penalties for multiple tax years, had to pay all of them, not merely the penalty for one year, before she could sue the IRS in district court.

Background. A tax return preparer who prepares a return or claim for refund with respect to which any part of an understatement of liability is due to the preparer’s willful or reckless conduct must pay a penalty (preparer penalty). (Code Sec. 6694(b))

IRS can be sued in district court by those seeking a refund of preparer penalties. (28 USC § 1346(a)(1)) But a taxpayer’s full payment of a tax penalty is typically a jurisdictional prerequisite to sue in district court. (Flora (S Ct 1960) 5 AFTR 2d 1046) This is commonly referred to as the full-payment rule.

Flora did suggest, though, that if a tax assessment is “divisible,” such as an excise tax that is levied on multiple transactions or events, then payment of a single instance of the tax may be sufficient to satisfy the full-payment rule.

No court has determined whether penalties assessed pursuant to Code Sec. 6694(b) are divisible, and the Fourth Circuit (to which this case is appealable) has provided no guidance on what constitutes a divisible tax.

But the Court of Appeals for the Federal Circuit has found that a tax is only divisible where the resolution of one tax dispute will necessarily determine the outcome for each of the other tax disputes. (Cencast Servs., L.P. (CA FC 2013) 12 AFTR 2d 2013-6029)

Facts. Ms. Davis, the founder of a tax preparation business, was penalized $115,000 under Code Sec. 6694(b) for the tax years of 2010, 2011, and 2012. The penalty amounts for each tax year were $55,000, $50,000, and $10,000 respectively. Part of the total penalty was paid when the IRS seized her income tax refunds for tax year 2016 and 2017.

She sued in federal court challenging the validity of these penalties.

The IRS argued that federal court did not have subject matter jurisdiction since she failed to make full payment of her tax penalties.

Davis claimed that the Code Sec. 6694(b) penalties for each year are divisible and her full-payment of a divisible tax assessment established jurisdiction.

Checkmark Observation.  The court does not provide details, but presumably, the amount of income tax refunds that the IRS seized equaled at least an amount which would cover the full payment of the penalty for one of the tax years in question.

Decision. The district court, following Cencast, found that the Code Sec. 6694(b) penalties for each year were not divisible and that therefore the court did not have jurisdiction.

Each of the tax penalties levied on Davis asserted that she willfully or recklessly prepared separate tax returns that contained understatements of liability. The merits of each of these penalties must be evaluated individually as to understatement, willfulness, and/or recklessness. Therefore, the court held, the penalties cannot be said to be divisible; resolving one on the merits would still leave each remaining penalty to be resolved. Therefore, Davis’s tax penalties remained subject to Flora’s full-payment rule.

References: For what assessments and penalties are divisible, see FTC 2d/FIN ¶T-9007.

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