According to an old cartoon, to err is human, and subject to penalty. If you’ve erred on your taxes and incurred a penalty, one avenue of relief is reasonable cause. What is reasonable cause? That depends on the facts and circumstances of the situation.
In T.C. Memo. 2016-152 (Rogers), the taxpayer failed to file her 2009 federal income tax return. In 2013, the IRS prepared a substitute for return, which is a basic tax return prepared using income information reported to the IRS by payors. The IRS prepares the substitute for return by assuming you are single, and without regard to the deductions or exemptions you might be entitled to.
The IRS also assessed failure to file and failure to pay penalties. The taxpayer requested abatement of those penalties due to reasonable cause.
Here is her story.
A fire in the taxpayer’s apartment on November 25, 2006, damaged the living room, the kitchen, and a walk-in closet. The taxpayer moved out. She lived with a friend for a year. During that time, she received $21,469 from her insurance company in payment of her claim for damages from the fire. The taxpayer prepared and timely filed her 2006 federal income tax return.
On March 27, 2007, the taxpayer was in the apartment working by candlelight packing items to be put into storage, and a second fire damaged the entire apartment. The taxpayer filed a claim with her insurance company in 2007 for the second fire. She estimated her losses from the 2007 fire to be more than $150,000. She filed her 2007 tax return on time, but did not claim a casualty loss deduction relating to the 2007 fire. She erroneously believed that her casualty loss was not deductible until her insurance claim was settled (which happened in 2009).
After the second fire, the taxpayer was barred from reoccupying her apartment until it was declared safe by the city building department. During 2008, the taxpayer rented a room with shared kitchen and bath facilities at a Young Women’s Christian Association. While living at the YWCA, the taxpayer had considerable difficulty with the YWCA board and with other residents. On occasion the police were called to resolve conflicts. The taxpayer experienced bouts of depression during this time. She filed her 2008 tax return on time, and did not claim a casualty loss for the 2007 fire because she had not yet received reimbursement from the insurance company.
In February 2009, the taxpayer fell off a subway platform and hit her head on the subway rails, fracturing her skull. After the fall, she spent five days in a hospital in the intensive care unit. Medical personnel were with her continuously while she was in the hospital. While there, she was interviewed by a psychiatrist regarding the circumstances of her fall onto the subway tracks. She suffered from dizzy spells after her fall.
The taxpayer received a $43,964 insurance reimbursement in 2009 for the 2007 fire. She did not file a tax return for 2009. After taking into account her deductible casualty loss, she believed she was not required to file an income tax return for 2009.
In 2013, after the IRS prepared a substitute for return, the taxpayer realized she had erred regarding the year of deduction for the casualty loss. She settled the issue with the IRS, except for the penalties.
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The taxpayer had reasonable cause and the penalties should be abated.
Failure to File. Internal revenue code section 6651(a)(1) imposes an addition to tax for failure to timely file a required tax return. One of the facts and circumstances meriting consideration here is precisely what the error was that the taxpayer made which led her to believe she was not required to file a 2009 return.
That error related to the question of the proper timing of her casualty loss deduction resulting from the 2007 fire. At the time her 2009 return was due, the taxpayer believed the loss was deductible for 2009 because that was the year her claim was resolved.
If an insurance claim is not paid in the year of the loss and the taxpayer has a reasonable prospect of recovery, the deduction for the loss is deferred until it can be ascertained whether such reimbursement will be received. However, if or to the extent there is no reasonable prospect for compensation for the loss through insurance, the loss is deductible for the year incurred.
The parties’ settlement of this issue suggests that there was no reasonable prospect of recovery of a portion of the loss under the taxpayer’s insurance policy. The taxpayer’s error (regarding the proper year of deduction of the portion of a casualty loss for which there is no prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic.
Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique, especially compared with chronic failure to file tax returns.
The taxpayer’s life was in a state of upheaval after the second fire and through the period when the return was due. She was barred from reoccupying her apartment and, during the times relevant to the 2009 return, she was living under conditions she found to be dehumanizing at a YWCA. Later, she experienced bouts of depression, a fall from a subway platform in 2009, and a skull fracture. She was subject to continuous monitoring and psychiatric examination while hospitalized. Her living conditions and the resulting bouts of depression make reasonable her not understanding the correct year of deduction.
Taking into account all of the facts and circumstances, we conclude the taxpayer exercised ordinary business care and prudence under the difficult circumstances in which she was living at the time leading up to the due date of her 2009 return and that her error (claiming a deduction for a year later than the current year) did not constitute a conscious, intentional failure or reckless indifference to her tax filing obligations for 2009.
Failure to Pay. Internal revenue code section 6651(a)(2) provides for an addition to tax where there is a failure to timely pay the amount of tax shown on a return. A substitute for return properly prepared by the IRS is treated as the return filed by the taxpayer for purposes of determining an addition to tax under section 6651(a)(2).
The reasonable cause standard under section 6651(a)(2) is given an analysis similar to that under section 6651(a)(1).
Therefore, for the reasons stated above in our discussion of the addition to tax under section 6651(a)(1), we hold that the taxpayer is not liable for the addition to tax under section 6651(a)(2) for failure to pay timely the tax due for 2009.