By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Woodsum v. Comr., 136 T.C. No. 29 (2011), the Tax Court concluded that taxpayer's reliance on their return preparer did not constitute reasonable cause for the omission of a $3.4 million income item and therefore, the IRS had properly assessed an accuracy related penalty under §6662. This case serves as an important reminder that financially sophisticated taxpayers cannot shield them themselves for penalties where errors are made by blindly relying on a paid preparer.
In 2006, Taxpayers received a gain of $3.4 million upon the termination of a "swap" transaction. Taxpayers received a Form 1099-MISC, Miscellaneous Income, which reported the $3.4 million payment. Taxpayers retained an accounting firm to prepare their 2006 income tax return. Taxpayers gave to the firm all 160-plus information returns they had received from third-party payors, including the Form 1099-MISC reporting the $3.4 million gain. The 115-page Form 1040, U.S. Individual Income Tax Return, that the firm prepared reported $29.2 million of adjusted gross income for Taxpayers but omitted the $3.4 million from the swap transaction. After a cursory review on the day of filing, Taxpayers signed and filed the return. The IRS determined a $521,473 deficiency of tax, which Taxpayers conceded and paid, and a $104,295 accuracy-related penalty under §6662(a), which Taxpayers disputed on grounds of "reasonable cause" exception under §6664(c)(1).
Under §6662(a) and (b)(2), taxpayers may be liable for an "accuracy-related penalty" of 20% of the portion of the underpayment of tax attributable to any substantial understatement of income tax. Under §6662(d)(1) with respect to an individual, an understatement of income tax is substantial if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. The undisputed tax deficiency attributable to Taxpayers' omitted income was $521,473, which is in excess of $5,000 and also in excess of 10% of the correct tax liability of $4,240,927. Accordingly, Taxpayers' understatement of tax was therefore "substantial" for purposes of §6662(d)(1).
Under §6662(c)(1), a taxpayer who is otherwise liable for the accuracy-related penalty may avoid all or a portion of the liability if he can demonstrate that he had reasonable cause for a portion of the underpayment and that he acted in good faith with respect to that portion. Regs. §1.6664-4(b)(1) provides that the determination of whether a taxpayer acted with reasonable cause and in good faith must be made on a case-by-case basis, taking into account all relevant facts and circumstances. Under Regs. §1.6664-4(b)(1), reliance on professional advice may constitute reasonable cause and good faith if, under the circumstances, that reliance was reasonable and the taxpayer acted in good faith. For a taxpayer to take advantage of the reasonable cause exception, the taxpayer must prove by a preponderance of the evidence that: (1) the adviser was a competent professional with sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the professional adviser; and (3) the taxpayer actually relied in good faith on the adviser's judgment.1 Seeking to meet these standards, Taxpayers asserted (i) the individuals employed by the accounting firm were attorneys and certified public accountants who were competent and experienced professionals, (ii) that Taxpayers provided the accounting firm with the Form 1099-MISC reporting the $3.4 million, and (iii) that Taxpayers relied on the accounting firm to prepare the return and report the $3.4 million.
For purposes of the reasonable cause exception, the term "advice" includes "any communication, including the opinion of a professional tax advisor, setting forth the analysis or conclusion of a person, other than the taxpayer, provided to (or for the benefit of) the taxpayer and on which the taxpayer relies, directly or indirectly… ."2 The Tax Court found that Taxpayers presented no testimony of the preparer (nor any other evidence) to show that the income was omitted from the return because of any "analysis or conclusion" or "judgment" by the accounting firm that the income was not taxable. The Tax Court further noted that there was no evidence that in omitting the item the accounting firm was exercising "analysis" or "judgment" or was making a professional recommendation to Taxpayers; rather, the accounting firm was failing to carry out Taxpayers' general instruction to properly prepare the return. Therefore, the Tax Court concluded that in signing the erroneously prepared return, Taxpayers were not deliberately relying on substantive professional advice; but rather inadvertently perpetuated a clerical error. Accordingly, the Tax Court concluded that the defense of reliance on professional advice had no application to Taxpayers' circumstance.
Although Regs. §1.6664-4(b)(1) provides that "[a]n isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith," the Tax Court concluded that Taxpayers had failed to demonstrate the reason for the error and, therefore, the understatement did not fall within the category of a "computational or transcriptional error." Moreover, the Tax Court stated that even if it assumed that the $3.4 million omission was an innocent oversight by the return preparer, the reasonable cause defense is unavailing because the duty of filing accurate returns cannot be avoided by placing responsibility solely on the tax return preparer. However, the Tax Court stated that the reasonable cause defense may be available to a taxpayer who conducts a full review of his or her third-party prepared return with the intent of ensuring accuracy, but despite exerting reasonable efforts under the circumstances to assess the taxpayer's proper tax liability nonetheless failed to discover an omission of an income item. The Tax Court concluded, however, that Taxpayers had not demonstrated a reasonable level of review. Despite Taxpayer-Husband being personally involved in the swap transaction and terminating early because it was not performing satisfactorily as an investment, the Tax Court found that "when he was signing his tax return and reporting his tax liability, his routine was so casual that a half-million-dollar understatement of that liability could slip between the cracks." Accordingly, the Tax Court declined to find that the understatement was attributable to reasonable cause and good faith.
While sophisticated taxpayers often rely on their sophisticated attorneys and accountants for tax advice, that reliance alone is not a defense against penalties where an omission is made. In order to qualify for the reasonable cause exception, a taxpayer must be able to show that they spent time reviewing the return and ensuring its accuracy. Since the taxpayer bears the burden of substantiating this review, a taxpayer may want to take precautions to document their review in real time through electronic mail and other written correspondence. Moreover, the only review by a taxpayer of a complex return should not be made the same day the return is due and filed.
For more information, in the BNA Tax Management Portfolios, see Tarr and Drucker, 634 T.M., Civil Tax Penalties, and in Tax Practice Series, see ¶3830, Penalties.
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