posted February 12, 2014 12:04 AM            

Nearly half of the estimated 142 individuals filling out tax returns use a paid preparer. (Photo credit: 401(K) 2013)
In a blow to the Internal Revenue Service and unsuspecting taxpayers, an appellate court today nixed the agency’s attempt to regulate commercial tax return preparers, upholding a federal district court decision from last year.

“It’s a clear loss for the IRS, and for some taxpayers, it’s a tremendous loss,” says Lawrence Gibbs, a former IRS commissioner and lawyer at Miller & Chevalier in Washington, D.C., who explained why he thought the regulations should have been upheld in a law review article here.

It’s an important issue—especially during tax season. Taxpayers filed an estimated 142 million individual income tax returns, with nearly 70 million taxpayers using a paid return preparer, according to the latest IRS data for 2011. Some tax return preparers are licensed as CPAs or credentialed by the IRS as enrolled agents, but most tax preparers don’t have such qualifications, potentially leaving taxpayers at risk.

In an effort to tackle tax preparer fraud, the IRS issued regulations in 2011 requiring tax return preparers to take a certification exam, pay annual fees and take continuing education coursework. The legal back-up was an 1884 statute that authorizes the IRS to “regulate the practice of representatives of persons before the Department of the Treasury.”

Three independent tax return preparers, represented by the Institute of Justice, quickly filed suit, Loving v. IRS, contending that the regulations exceeded IRS authority. The district court ruled in favor of the independent preparers.

Now the U.S. Court of Appeals for the District of Columbia Circuit has upheld that decision, making the point that the authority the old statute gave the IRS didn’t extend to tax return preparer regulations. “[W]e are confident that the enacting Congress did not intend to grow such a large elephant in such a small mousehole,” the court stated. The appellate decision is available here.

The National Consumer Law Center and the Former Commissioners of Internal Revenue filed friends of the court briefs in support of the IRS.

The decision is a victory for libertarians. There’s a good deal of debate about whether licensing “schemes” are really good for consumers, says Eugene Volokh, a law professor at UCLA. “Licensing might weed out some bad apples, but it also drives up prices, and can create a false sense of security,” he notes.

The IRS could appeal to the Supreme Court, but most likely, any remedy now rests in the hands of Congress. What took the tax lawyer community aback was that the IRS made the unusual move of pulling out such an old statute to promulgate new regulations. “The IRS overstepped its legislative mandate, and the judicial branch had to rein in the agency,” says Charles Ruchelman, a tax lawyer with Caplin & Drysdale in Washington, D.C. He concedes that there are problems with tax return preparers who do bad things, and the new regulations would have been one way to address that. Going forward, he predicts, the Treasury Department might work with Congress on a statutory fix.

Return preparer fraud is a real problem. It’s one of the IRS’s Dirty Dozen Tax Scams for 2013.

Consumer advocates are looking to states to boost regulation of tax preparers. The National Consumer Law Center put out a telling report last fall: How Errors And Fraud By Paid Tax Preparers Put Consumers at Risk and What States Can Do. New York just became the fourth state to regulate tax preparers, effective Dec. 11, 2013.

Meanwhile the Justice Department issued a release today highlighting its ongoing efforts to shutdown fraudulent tax return preparers and promoters of tax fraud schemes. In the last year it has obtained permanent injunctions against more than 60 preparers and promoters—franchises including Mo’ Money Taxes, a Memphis, Tenn.-based chain and ITS Financial LLC’s Instant Tax Service as well as independent operators.

Some of the fraudulent claims that have been stopped in these cases: false education and homebuyer credits, false and inflated deductions, false filing status, false dependents, and inflated Earned Income Tax Credits. In addition, taxpayers should watch out for deceptive loan products with exorbitant fees.