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Just before April 15th of last year, a married couple I am acquainted with asked me to help them with their 2017 tax return. I agreed to do so for free (note: I am not registered as a paid tax preparer and my name was not listed anywhere on the return). He is a minister and receives a housing allowance. His church does not withhold anything from his paychecks. Also, he has not at any point applied for an exemption from SE tax via Form 4361.

Their AGI was low enough to qualify for TurboTax Free File, so we sat together and used that to prepare their return. When we got to the section on Self-Employment tax, the software asked a question about which income they would pay self-employment taxes for. There were several options, two of which were something along the lines of "Pay SE taxes on wages only" and "Pay SE taxes on both wages and housing allowance".

We did not immediately know how to answer this question and didn't have much time to research. We had a copy of their 2016 return at hand, so I decided to consult that to save time, instead of researching the IRS documentation. They had paid a professional to prepare the 2016 return, so I assumed it would correctly handle this. For that year, they had only paid self-employment taxes on the wages, so we answered the same for the 2017 return.

Fast forward to this year. I am helping them once again, and we have a bit more wiggle room time-wise before the filing deadline. So when this question came up, I decided to research it properly to be certain. Based on what I've read, it is fairly obvious to me that they should have been paying self-employment taxes on the housing allowance all along.

To see how large the problem might be, I went back through some of their older documents. In 2014 and 2015, it seems they paid SE tax on their housing allowance. At that time, they were paying someone else to do their taxes. They used a different preparer for 2016 only.

I am advising that we amend their returns for both 2016 and 2017. Ballpark estimate is that they underpaid by about $4K each year (EDIT: "underpaid" is probably the wrong term to use here. "Under-calculated" seems more appropriate. They received a $5K refund from the 2016 return and a $2K refund last year.) To my knowledge, they have sufficient savings to cover the bill in full.

I think we will be able to amend the 2017 return using TurboTax, but we will probably need to do the 2016 1040-X and related calculations by hand. I assume there will be penalties/interest involved, and this is where my questions start to come in:

  1. Do they have any recourse to avoid penalties and/or interest, at least on the amount underpaid for the 2016 return, since their paid preparer made an error?
  2. If not, is there some free, publicly available tool to help us calculate the penalties and interest in a situation like this? Seems like a rather complex calculation, from what I've read so far...
  3. Should I recommend that they report this guy to the IRS or some other entity governing tax preparers?

Thanks in advance.

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"underpaid" is probably the wrong term to use here. "Under-calculated" seems more appropriate.

Both are correct; they paid less than the correct tax because they miscalculated it.

  1. Do they have any recourse to avoid penalties and/or interest, at least on the amount underpaid for the 2016 return, since their paid preparer made an error?

I think they're okay on penalties. As I read the rules (although I have not personally been in this situation) failure-to-pay penalty (6651(a)(2)) does not apply because they did pay (actually, overpay) the tax shown on the returns, even though that tax was incorrectly computed. And the accuracy-related penalty (6662) applies in two relevant cases: 'negligence or disregard of rules or regulations' or 'substantial understatement of tax' which latter is defined as at least the greater of 10% of the correct tax and $5k, and from your figures does not apply. This is an area where reliance on a professional may count as an excuse. As summarized in the Taxpayer Advocate's recent 2018 annual report in volume 1 at Most Litigated Issue #1, citations omitted:

... Reliance on a return preparer may constitute reasonable cause and good faith if the reliance was reasonable and the taxpayer acted in good faith. Neonatology Associates v. Commissioner establishes the three-part test for reasonable reliance on a tax professional in accuracy-related penalty cases:
(1) The adviser was a competent professional who had sufficient expertise to justify reliance;
(2) The taxpayer provided necessary and accurate information to the adviser; and
(3) The taxpayer actually relied in good faith on the adviser’s judgment

They can't escape interest; that is required by law.

  1. If not, is there some free, publicly available tool to help us calculate the penalties and interest in a situation like this? Seems like a rather complex calculation, from what I've read so far...

I don't know of any calculator, although the rules for the penalties possibly applicable are fairly simple. Interest is more complicated; it varies by quarter, tracking the Treasury short-term financing rate with a lag. (In fact, I periodically sample TIGTA audits of the IRS, and I'd say the most frequent problem they detect -- in auditese, a 'repeat finding' -- is IRS' own systems miscomputing interest!) But if you call it 3% a year -- 6% for the 2016 return to this month and 3% on the 2017 return -- that should be pretty close. You certainly don't need to try to compute it and include it with the 1040X -- IRS will bill for it.

  1. Should I recommend that they report this guy to the IRS or some other entity governing tax preparers?

They can file form 14157 available on the IRS website. But IRS has no leverage to discipline most preparers; they tried to do so by regulation a few years ago, but the courts struck that down. (Google Loving v IRS, the oddly inappropriate case name.) But compared to some of the abuses they confront, unless this practitioner hurt quite a lot of other people, this complaint isn't likely to get much priority in the IRS.

Some states regulate tax preparers, or at least try to. You don't give your location, but try checking with your state's consumer affairs or similar department to see if they can help you.

Preparers who are CPAs -- a very small subset -- are regulated and (at least usually) can be disciplined by state accounting boards

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