* IRS backs away from crackdown after court ruling
* Many preparers were complying with new IRS rules
By Patrick Temple-West and Kim Dixon
WASHINGTON, Jan 22 (Reuters) - The tax return preparation industry was thrown into disarray on Tuesday when the U.S. Internal Revenue Service rescinded new registration and training rules affecting up to 700,000 tax return preparers.
The tax-collection agency backed away from its new program, meant to crack down on unscrupulous preparers, after a court decision on Friday barred the IRS from enforcing tax return preparer regulations.
In complying with the court's permanent injunction, the IRS said nonprofessional tax return preparers "are not currently required" to register with the agency, pass a competency test or take continuing education classes to do tax returns.
"I'm just picking my jaw off the ground," said Jeff Trinca, a Washington lobbyist who represents some tax preparers, adding that the suspension of the IRS program could put billions of dollars in tax returns at renewed risk of being mishandled.
"This isn't chicken feed, this is dramatic," Trinca said.
The government can appeal the decision, written by Judge James Boasberg for the U.S. District Court for the District of Columbia, who was nominated by President Barack Obama in 2010.
The IRS "continues to have confidence in the scope of its authority to administer this program," the agency said in a statement. "It is considering how best to address the court's order and will take further action shortly."
The IRS said lawyers, accountants and other licensed tax return professionals must still meet the regulatory requirements related to their certifications.
The IRS rules were criticized by some because of the new fees they slapped on practitioners, but broadly supported as a way to regulate a free-wheeling industry and fight tax refund fraud.
Thousands of independent "mom and pop" operators, as well as employees for tax return companies H&R Block Inc and Jackson Hewitt Tax Service Inc were complying with the IRS rules.
"It is quite a mess," Mark Steber, chief tax officer at Jackson Hewitt, told Reuters in the wake of the court ruling.
About a quarter of the roughly 140 million individual tax returns filed annually are done with help from a non-professional tax preparer, said Gil Luria, an analyst with investment firm Wedbush Securities.
The court ruling could hurt institutional tax-preparation providers such as H&R Block and Jackson Hewitt by reopening the market to small competitors that the IRS program had been expected to squeeze out, said Luria, who covers the industry.
Under the IRS requirements, preparers had 2 1/2 hours to finish a 120-question competency test that cost $116. They also had to take 15 hours of continuing-education classes annually.
About 55,000 individuals have already passed the test, said Chuck McCabe, chief executive of the Income Tax School in Richmond, Virginia. Some of these individuals will seek a refund from the IRS for their test fee, he said.
If the court decision is not reversed on appeal "it could be a real can of worms," McCabe said.
Regulating tax preparers was a top priority for former IRS Commissioner Doug Shulman before he stepped down in November.
Shulman called in 2009 for an IRS effort to root out tax preparation fraud. The return preparer initiative began in 2011.
Shulman, now a guest scholar at the Brookings Institution, could not be reached for comment.
In March 2012, three independent tax preparers and the Institute for Justice, a conservative civil-liberties advocacy group, challenged the program's legal authority. They accused the IRS of enforcing the requirements without congressional approval.
The IRS said a law dating to 1884 gave it that authority, but the court disagreed and halted the agency's initiative.
The IRS wants to weed out dishonest tax preparers who can abuse their access to clients' sensitive financial information. Tax refund fraud soared in the years leading up to the regulations as Congress passed new tax credits refundable for cash.
The IRS prevented $6.1 billion of tax refund fraud in 2012, according to the agency.