Section 6694 Tax Preparer Penalties: How Unreasonable Positions, Willful Conduct, and Section 6695 Due Diligence Failures Cost CPAs and EAs Real Money

Imagine signing 800 returns during tax season, then receiving a letter from the IRS one summer afternoon proposing a penalty of $5,000 — or worse, a penalty equal to 75 percent of every fee you collected on a series of related returns. The taxpayers paid the tax. They are fine. The penalty is yours, personally, and it can run into six figures before you ever set foot in front of an examiner.

That is the world that Section 6694 of the Internal Revenue Code creates for paid tax return preparers. The statute is short, the regulations are dense, and the enforcement is real. CPAs, enrolled agents, attorneys, and unenrolled preparers are all on the same hook, and the hook is not abstract. It is per return, per position, and in some cases per credit claimed on a single return.

If you prepare returns for compensation — or if you supervise people who do — this guide walks through the penalty structure, the standards you must meet, the Section 6695 due diligence trap that catches preparers who never thought of themselves as aggressive, and the defenses that actually work when an examiner shows up at your door.

The Two Tiers of Section 6694

Section 6694 has two separate penalty tiers. They are not alternatives; the IRS can assert one or the other depending on what the examiner believes happened in your office.

Section 6694(a): Unreasonable Position

The first tier targets preparers who take a position on a return that results in an understatement of tax and that the preparer knew or reasonably should have known was an "unreasonable position." The penalty is the greater of $1,000 or 50 percent of the income derived (or to be derived) from preparing that specific return.

Read that carefully. The penalty floor is fixed, but the ceiling scales with your fee. A small return with an aggressive deduction can cost $1,000. A complex consulting engagement on a single transaction that drives an understatement can cost a multiple of the engagement fee — half of everything the firm billed for that work product.

Section 6694(b): Willful or Reckless Conduct

The second tier is for preparers who willfully attempt to understate liability or who recklessly or intentionally disregard the rules and regulations. The penalty is the greater of $5,000 or 75 percent of the income derived from preparing the return. A Section 6694(b) assertion also carries reputational weight — it shows up in disciplinary referrals, Circular 230 proceedings, and, occasionally, criminal investigations.

The two penalties are not additive on the same conduct, but a preparer who is hit with a 6694(b) penalty effectively gets the worse of two outcomes: a higher dollar amount and a permanent mark on the preparer tax identification number history.

What Counts as an "Unreasonable Position"

The hardest part of Section 6694 is not the math; it is the standard. A position is "unreasonable" under 6694(a) unless the preparer can show that the position met one of three thresholds, and which threshold applies depends on how the position was treated on the return.

• Undisclosed positions (the default for most returns): There must be substantial authority for the position. Substantial authority is more than reasonable basis but less than "more likely than not." Practitioners commonly describe it as roughly a 40 percent chance of being sustained on the merits — not a precise threshold, but a useful mental model.
• Disclosed positions (typically via Form 8275 or 8275-R): A reasonable basis is enough. Reasonable basis is significantly higher than the "not frivolous" bar but lower than substantial authority — roughly a 20 to 30 percent chance of being sustained.
• Tax shelters and reportable transactions: The standard is "more likely than not" — the preparer must reasonably believe the position will be sustained on its merits, meaning greater than a 50 percent likelihood.

The practical upshot: when an authority disagrees with treatises, when the regulations are silent, when only one obscure circuit case supports the deduction, you must either move up to substantial authority before signing, or disclose the position to push the floor down to reasonable basis.

Substantial Authority Is Not the Same as Winning

Examiners and Appeals officers sometimes confuse substantial authority with "the IRS would agree." It does not. The Treasury regulations explicitly list the kinds of authority that count — the Code, regulations, revenue rulings, court cases, technical advice memoranda, joint committee reports, and so on. The weight of authority is judged objectively. A well-reasoned private letter ruling from another taxpayer can be substantial authority. A blog post, no matter how persuasive, cannot.

Section 6695: The Due Diligence Trap

Section 6694 is the headline statute, but Section 6695(g) — the due diligence penalty — is what catches preparers who would never dream of taking an aggressive position. The penalty applies when a preparer claims any of the following four items on a client's return without meeting the regulatory due diligence requirements:

1. The Earned Income Tax Credit (EITC)
2. The Child Tax Credit / Additional Child Tax Credit / Other Dependent Credit (CTC/ACTC/ODC)
3. The American Opportunity Tax Credit (AOTC)
4. Head of household filing status

For returns filed in 2026, the penalty is approximately $650 per failure, and — critically — each item on the return is a separate penalty. A single return claiming all four items where the preparer failed to perform due diligence on all four can produce a stacked penalty of around $2,600. Multiply that by a hundred EITC returns in a season and the exposure climbs into six figures fast.

The Four Due Diligence Requirements

To meet Section 6695(g), a preparer must:

• Complete and submit Form 8867 (Paid Preparer's Due Diligence Checklist) with each e-filed return claiming any of the four items, or attach a copy to a paper-filed return.
• Compute the credit or filing status accurately using the worksheets in the form instructions and retain those worksheets.
• Make reasonable inquiries when information from the client appears incomplete, inconsistent, or incorrect — and document those inquiries in writing.
• Retain records for three years from the latest of the return's due date, filing date, or the date you presented the completed return to the client.

The recordkeeping requirement is where the IRS wins many of these cases. Auditors do not need to prove that the credit was wrong — they need to show that you cannot produce the worksheets, the Form 8867, the client-provided documents, or the contemporaneous notes on the inquiries you made. If the file is empty, the penalty stands.

Who Is a "Tax Return Preparer"?

Section 6694 only applies to a "tax return preparer" as defined in Section 7701(a)(36) and Treasury Regulation 301.7701-15. The regulation distinguishes between two roles, and both are on the hook.

Signing Preparers

A signing preparer is the individual who physically signs the return. They are presumed to have primary responsibility for the overall substantive accuracy of the return and are the first target of any preparer penalty inquiry.

Nonsigning Preparers

A nonsigning preparer is someone who prepares a "substantial portion" of the return but does not sign it. The most common examples:

• A senior partner who gives written or oral tax advice on a discrete transaction (a Section 351 incorporation, a 1031 exchange, a Section 754 election) that flows directly into an entry on the return.
• A specialist in another firm — say, an international tax attorney — whose memo dictates the position the signing preparer takes.

For the nonsigning preparer to be liable, the advice must relate to events that have already occurred at the time the advice is rendered. Pure planning advice — before the transaction closes — does not create preparer status.

The De Minimis Rule

A schedule, entry, or other portion of the return is not "substantial" if it involves amounts that are both less than $400,000 and less than 20 percent of the gross income shown on the return. Separately, a nonsigning preparer is not penalized if less than 5 percent of the total tax advisory time on the transaction was theirs.

In practical firm life, this rule protects the junior associate who looked up one citation, but it does not protect the partner who shaped the entire position.

The Reasonable Cause and Good Faith Defense

Both Section 6694(a) and Section 6694(b) include a built-in defense: no penalty if there was reasonable cause for the understatement and the preparer acted in good faith. The factors that matter:

• Nature of the error. Isolated computational mistakes lean toward reasonable cause. Patterns suggesting indifference do not.
• Frequency of the error. A single missed citation is easier to defend than a repeated practice across many returns.
• Materiality of the understatement. The smaller the understatement relative to the return, the easier the defense.
• Reliance on the taxpayer's information. A preparer is generally entitled to rely in good faith on information provided by the client, but cannot ignore information that is incorrect or incomplete on its face.
• Reliance on advice of other preparers. A signing preparer can sometimes shift responsibility to a credible nonsigning specialist, but only if the reliance was reasonable and the specialist was actually qualified on the issue.

Reasonable cause is fact-specific, which means it is also document-specific. The preparer who can pull a contemporaneous memo, a research log, an engagement letter scoping the work, and a written client representation walks into the exam with a defense. The preparer who shows up with only the signed return walks in with a check.

The Quiet Cost: Where Bookkeeping Saves You

The penalty regulations measure your conduct against what was knowable at the time the return was signed. Most preparers lose Section 6694 cases not because their position was indefensible, but because the underlying numbers were a mess — categorized wrong in the client's books, restated late in the engagement, or impossible to tie back to source documents.

Clean, transparent books for every client cut your preparer-penalty exposure in two ways. First, you can actually compute the right answer the first time. Second, when an examiner challenges a position years later, you can reconstruct exactly what you knew when you signed — every entry traceable, every reclassification dated. Without that, "reasonable cause" becomes an argument about memory rather than a paper trail.

Practical Steps for 2026

The following habits separate firms that occasionally pay preparer penalties from firms that essentially never do.

Tighten Your Engagement Letters

Spell out the scope of work, the client's responsibility to provide complete and accurate information, and the firm's right to rely on that information. An engagement letter that documents the client's representations is the single most useful piece of paper in a 6694 exam.

Build a Position-Disclosure Discipline

When a position is supported by reasonable basis but not substantial authority, disclose it on Form 8275. Disclosure is not an admission of weakness — it is the cheapest insurance available. The Form 8275 itself costs nothing to prepare and instantly drops the standard you must meet.

Document the Research

For any return position that is not routine, write a one-page memo summarizing the issue, the authorities you considered, and the conclusion you reached. Save it to the client file before the return is signed. Years later, this is what reasonable cause looks like.

Operationalize Form 8867

Build EITC, CTC, AOTC, and head-of-household due diligence into your intake checklist. Confirm the worksheet was completed, the inquiries were made, and the supporting documents were retained for every applicable return. A single missing Form 8867 in a sample of 30 returns is enough to open a broader exam.

Audit Your PTIN Activity

Every preparer should periodically review the universe of returns associated with their PTIN. Ghost preparers, dropped supervisor reviews, and orphan returns are common sources of unexpected penalty proposals.

Train Nonsigners

If your firm uses specialists who do not sign returns, train them on the substantial-portion and de-minimis rules. A specialist memo that ends with "we recommend this be reflected on the return as..." can convert a planning engagement into a preparer relationship, with all the liability that implies.

A Worked Example

A regional CPA firm prepares a return for a closely held S corporation. The firm's senior partner advises that a $1.2 million payment to a retiring shareholder should be characterized as a Section 736(b) distribution rather than a Section 736(a) guaranteed payment. The advice is written, the events have already occurred, and the position is the single largest item on the return. A junior partner signs the return.

Years later, the IRS recharacterizes the payment as a guaranteed payment. There is a colorable argument for the firm's position, but the only published authority was a 1987 Tax Court memo that the IRS has consistently disagreed with. The position was not disclosed.

The exam team asserts a Section 6694(a) penalty against the signing junior partner and the nonsigning senior partner. The firm bills the engagement at $42,000. The proposed penalty against each preparer is 50 percent of the income derived — and the IRS computes that based on the income each individual derived, not the firm's gross fee. The defense will hinge on whether the firm can show substantial authority for the position or, failing that, reasonable cause and good faith. Without a contemporaneous research memo, the firm is likely going to write a check.

The lesson is not that the position was indefensible — many practitioners would have taken it. The lesson is that disclosure on Form 8275 would have shifted the standard to reasonable basis, where the position clearly qualifies, and the penalty discussion would never have started.

Keep Your Practice and Your Clients' Books Audit-Ready

The thread running through every Section 6694 and Section 6695 case is documentation. Preparers who can reconstruct what they knew, when they knew it, and why they made a particular call rarely pay penalties; preparers who cannot, often do. The same is true for the clients whose returns you sign — the engagements that go smoothly are the ones built on books you can actually trust.

Beancount.io gives accounting firms and their clients a plain-text, version-controlled ledger that is transparent end to end. Every transaction is a line of text, every reclassification is a tracked change, and every prior-year file is reproducible from a Git history rather than a spreadsheet you hope someone saved. When an examiner asks what the books showed on the day the return was signed, you can answer with a commit hash instead of an apology. Try it for free and bring the same discipline to your clients' bookkeeping that you already bring to your tax positions.