Case — Penalty Abatement – Reasonable Cause

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TL Case Summ

THE QUESTION

When does reliance on a return preparer constitute reasonable cause?

THE DISPUTE

Taxpayer Says: Because he relied on his tax preparer to include all his income on his tax return, he has reasonable cause to avoid a penalty for underpayment of tax due to unreported income.

Internal Revenue Service Says: The reasonable cause exception does not apply. The penalty was properly assessed.

THE LAW

From Internal Revenue Code Section 6662(a) and (b)(2): Imposes an “accuracy-related penalty” of 20% of the portion of the underpayment of tax attributable to any substantial understatement of income tax.

From Internal Revenue Code Section 6662(d)(1): By definition, an understatement of income tax for an individual is substantial if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return.

From Internal Revenue Code Section 6664(c)(1): A taxpayer who is otherwise liable for the accuracy-related penalty may avoid the liability if he can show reasonable cause for a portion of the underpayment and that he acted in good faith with respect to that portion.

From Federal Tax Regulation 1.6664-4(b)(1): [paraphrased] Whether the taxpayer acted with reasonable cause and in good faith depends on the pertinent facts and circumstances, including efforts to assess proper tax liability, knowledge and experience, and the extent to which the taxpayer relied on the advice of a tax professional.

THE CAUSE OF THE DISPUTE

As a general rule, you’re responsible for the information on your tax return, and the IRS can assess penalties when you fail to report that information accurately. Penalties are higher when you’re unreasonably careless, or when you understate your income tax liability by an amount defined as “substantial” under tax law.

You can request relief from penalties. That relief falls into three categories: 1) when you exercise ordinary business care and prudence (reasonable cause); 2) when tax law grants specific relief (statutory exceptions); and 3) in the case of natural disasters or other events (administrative waivers).

In this case, the taxpayer, the founder of an investment firm, signed and filed a joint federal income tax return for 2006. The return was prepared by a tax service that specialized in the type of investment activities in which the taxpayer participated (private equity, swaps and hedges).

On the October 15 due date, the taxpayer met with the preparer to review the 115-page federal return, along with 27 state returns. The returns contained information from over 160 information forms (Schedules K-1 and Forms 1099), and showed income of more than $30 million.

One item was missing – a Form 1099 reporting approximately $3.4 million of income from a swap transaction that the taxpayer terminated early because of what he considered poor investment performance. Due to its size, the transaction would have been the third largest line item on the taxpayer’s Schedule D (Capital Gains and Losses). The IRS subsequently issued a notice for additional tax, as well as a penalty of $104,295.

While agreeing the $3.4 million should be included on the return, the taxpayer says he didn’t spot the missing item, as he relied on the preparer to include all his income on his tax forms. He believes the penalty should be abated for reasonable cause.

The IRS says reliance on the preparer does not constitute reasonable cause in this situation, because the taxpayer did not exercise care in reviewing the return. The taxpayer knew about the transaction, which was a substantial part of his income, and should have realized it was not reported.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 28KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. The tax preparer’s omission was apparently a clerical error, not advice that could be relied upon. In addition, the taxpayer did not fulfill his duty to review the return. “When his own receiving of income was in question, the taxpayer was evidently alert and careful. But 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. We cannot hold that this understatement was attributable to reasonable cause and good faith.”
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