A Preparer's Duties After Discovering an Altered Receipt
Devon, a CPA, prepared the 2023 Form 1040 for Nadia, a bakery owner. In June 2024, while preparing the 2024 return, Devon discovers that Nadia's 2023 return claimed a $48,000 charitable deduction for a donation of baked goods to a food bank. Nadia's contemporaneous records show the fair market value of the goods was $12,000 and her cost was $5,000; the $48,000 figure came from an email Nadia wrote to herself and a receipt that appears to have been altered. Nadia's 2023 gross income was $240,000, taxable income $150,000, and total tax $28,000. Devon advises Nadia to amend the 2023 return and pay the additional tax. Nadia refuses, saying, 'The IRS won't audit a small bakery, and I need the money for a new oven.' She also asks Devon to prepare the 2024 return and to represent her if the IRS audits 2023. Devon's firm has a policy requiring written documentation for charitable deductions over $250. The 2023 return is still within the three-year statute of limitations. Devon has not yet signed the 2024 return.
1. What are Devon's Circular 230 obligations upon discovering the 2023 error?
Read the worked answer
Circular 230 §10.21(a) requires Devon to advise Nadia promptly of the error or omission and explain the consequences. He has done that. Because Nadia refuses to correct the 2023 return, §10.21(b) says he should consider withdrawing from the engagement. Section 10.21(c) requires him to advise the client and withdraw if the client insists on a position that violates Circular 230. Section 10.34(d) allows reliance on client information in good faith, but only if the information does not appear incorrect or incomplete; the altered receipt is a red flag that requires reasonable inquiry. Section 10.51 defines disreputable conduct to include knowingly giving a false opinion or making a false statement. Devon must not sign a return or submit a document he knows is false. He has no duty to notify the IRS of the error without Nadia's consent, except as required by law; §7216 and §10.21 protect confidentiality.
2. May Devon prepare and sign the 2024 return and represent Nadia in an audit of 2023?
Read the worked answer
Devon may prepare the 2024 return only if it is correct and he does not rely on the false 2023 information. He should obtain independent support for every charitable deduction and document his inquiries. The 2024 return is a separate engagement, but the firm policy and §10.34 still apply. He may represent Nadia in an audit of 2023 only if he can do so without presenting false facts or signing a false document. If the audit reaches the $48,000 deduction and Nadia insists on defending it, Devon must withdraw; §10.51 and §10.34 prohibit assisting a false position. Continuing to represent her while she refuses to correct a known error creates a conflict with his professional obligations and may expose him to §6701 aiding and abetting and §6694 preparer penalties if he signs a return with an understatement. The safest course is to withdraw from both the 2024 preparation and the audit representation unless Nadia agrees to correct the 2023 return.
3. Quantify the 2023 tax exposure and identify the correct charitable deduction, including the food inventory rules.
Read the worked answer
The correct 2023 charitable deduction for the donated baked goods is governed by §170(e)(3), the enhanced deduction for contributions of apparently wholesome food by a trade or business. The deduction is basis plus one-half of the unrealized appreciation, capped at twice basis. Basis is $5,000; appreciation is $7,000; half is $3,500; basis plus half is $8,500; the cap is $10,000. So the deduction is $8,500, subject to the 15% limitation, not $48,000. The overstatement is $39,500. At a 24% marginal rate (2023 single, taxable income $150,000), additional tax is about $9,480, plus interest and a 20% accuracy-related penalty of about $1,896. The understatement exceeds the greater of 10% of the tax required to be shown ($2,800) or $5,000, so §6662(b)(2) applies. The six-year statute does not apply because $39,500 is less than 25% of $240,000 gross income; the normal three-year period applies. If fraud is established, the statute is unlimited and the fraud penalty is 75%.