Tax preparer mistakes: Taxpayer penalties and the tax treatment of indemnity payments

By Edward J. Schnee, CPA, Ph.D.

 MAGE BY RATPACK223/ISTOCK
MAGE BY RATPACK223/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • Taxpayers may be subject to a number of penalties, including the penalty for failure to file a return or failure to pay tax under Sec. 6651 and the accuracy-related penalty on underpayments under Sec. 6662. All of these penalties may be waived if the taxpayer had reasonable cause for the failure.
  • Reliance on a tax adviser will generally not be considered reasonable cause for failing to timely file a return or pay a tax.
  • Reliance on an adviser may be reasonable cause with respect to an accuracy-related penalty where (1) the adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser's judgment.
  • When an indemnity payment is made by a tax adviser to reimburse a tax or related penalty paid by a taxpayer due to a mistake made or erroneous advice given by the adviser, the payment generally is considered a return of capital that is not includible in income.
  • As demonstrated by the Cosentino case, the Tax Court and the IRS disagree about the application of this general rule in certain circumstances where the IRS claims the tax or penalty is due to the transaction giving rise to the tax or penalty rather than by a mistake on the part of the adviser.

Taxpayers are required to file income tax returns on set dates and to pay the tax liability on those dates. If they fail to file the return, file it after the due date, understate their tax liability, or simply fail to pay the tax due, the IRS can impose a penalty in addition to requiring the payment of the tax liability. Congress has adopted rules that allow taxpayers to request that a penalty be abated. One of the ­reasons for the abatement of a penalty is that the taxpayer relied on a tax professional. However, relying on a tax professional does not guarantee that the penalty will be removed.

This article discusses the basic penalty rules and then concentrates on the effect of a taxpayer's reliance on a tax professional. Since reliance does not guarantee that the penalty will be eliminated, this article then discusses the tax treatment of a payment by the professional to the taxpayer for mistakes made on the tax return.

Filing and payment penalties


Sec. 6651(a)(1) contains the penalty rules for the failure to file a tax return. The penalty is 5% of the tax liability if the late period is one month or less, increasing by 5% for each additional month the return is not filed up to a maximum of 25%. The penalty cannot be less than the lesser of $205 ($210 for tax years beginning in 2017) or 100% of the tax liability.1

Sec. 6651(a)(2) provides penalties for taxpayers who file their return on time but do not pay the tax liability. In this case, the penalty is 0.5% if the tax is unpaid for one month. The penalty increases by 0.5% for each additional month the tax is not paid up to a maximum of 25%.

The penalties for failure to file and failure to pay the liability are applied unless the failure is due to reasonable cause and not due to willful neglect.2 The IRS evaluates the existence of willful neglect first. In the absence of willful neglect, the IRS considers whether the taxpayer had reasonable cause for the failure.3

The phrase "willful neglect" is not defined or discussed in the Code or congressional committee reports. The Supreme Court stated that it "may be read as meaning a conscious, intentional failure or reckless indifference."4 The Court also stated that "it would be logical to assume that Congress intended 'willful neglect' to replace 'refusal'—both expressions implying intentional failure."5

Regs. Sec. 301.6651-1(c) explains the requirements for reasonable cause. Specifically, a taxpayer's failure to file is due to reasonable cause if he or she exercised ordinary business care and prudence but still is unable to file the return on time. The taxpayer's failure to pay the tax liability meets the requirement of reasonable cause if he or she exercised ordinary business care and prudence and was either unable to pay the tax or would suffer an undue hardship. For example, if the taxpayer suffers from mental illness, the penalty may be abated.6

The taxpayer will suffer an undue hardship if he or she will suffer a substantial financial loss. A mere inconvenience is not sufficient.7 If the filing or payment penalty is assessed against a taxpayer for the first time, the taxpayer may request and receive an abatement of the penalty under the first-time-abatement procedures.8

Reasonable cause and willful neglect are determined by taxpayer actions. In Chief Counsel Advice 201637012, a taxpayer appointed a person with a durable power of attorney and granted that person the authority to sign and file a tax return. The return was filed late. The IRS stated it would look to the taxpayer and not the assigned agent when determining reasonable cause since under state law the person holding a power of attorney does not have the legal duty to file the return. The Service distinguished this case from Bassett,9 where a minor's guardian did not file the tax return. Since the guardian is legally responsible for filing returns, the Bassett court ruled that the guardian's reason for not filing the return and not the taxpayer's reason determines whether a penalty may be abated. In other words, the person required to file the return must prove reasonable cause to have the penalty abated.

Accuracy penalty

If taxpayers do not correctly calculate their tax liability, the IRS can impose a 20% accuracy penalty under Sec. 6662. This penalty can be assessed because of negligence, disregard of rules and regulations, or a substantial understatement of the tax liability.

The term negligence includes failure to make a reasonable attempt to comply with the rules. The term "disregard" includes any careless, reckless, or intentional disregard of the rules, including those found in the Code, temporary and final regulations, and revenue rulings and notices.10

The penalty for negligence or disregard of a rule or regulation does not apply if the taxpayer discloses on the return the position taken and meets a specific standard.11 The standard for a position contrary to a regulation is one in which a taxpayer has a good-faith challenge to the validity of the regulation. The standard for a position contrary to a revenue ruling or notice is if the position has a realistic possibility of being sustained on its merits.12 Historically, a realistic possibility of being sustained on its merits means there is a one-in-three chance of success.13

Sec. 6662 imposes a 20% accuracy penalty on taxpayers whose returns have a substantial understatement of tax. This penalty is imposed on taxpayers not guilty of negligence or disregard of rules or regulations. For individuals, a substantial understatement exists if the actual tax liability exceeds the liability on the tax return by an amount equal to the lesser of 10% of the actual liability or $5,000. For corporations, the substantial understatement is the lesser of 10% of the actual tax liability (or if greater, $10,000) or $10 million. Taxpayers can reduce the penalty by the amount of tax due on an item used to determine the tax liability for which they have substantial authority or for an item that was adequately disclosed and for which they have a reasonable basis. Substantial authority generally is considered as a 40% or higher chance of success, and reasonable basis is a 20% or higher chance of success.14

Avoiding penalties


A taxpayer has two ways to avoid an income tax penalty. The first is to prove that the IRS did not meet the requirement of Sec. 7491(c). The second is to qualify under Sec. 6664(c).

Sec. 7491(c) requires the IRS to meet the "burden of production" to assess a tax penalty.15 If the IRS meets this requirement, the burden of proof shifts to the taxpayer. In Higbee,16 the Tax Court noted that Congress used the term "burden of production" not "burden of proof." The court also pointed out that Congress did not define this phrase. The court then referred to the legislative history, which states that the IRS does not have to provide evidence of elements such as reasonable cause or substantial authority. It only has to provide evidence of the appropriateness of the penalty. The court concluded that the Code's stating "burden of production" rather than the more common phrase "burden of proof" imposes a lower standard on the IRS than on the taxpayer. In Powell,17 the Tax Court stated that the IRS meets this requirement if it shows that the substantial-understatement amount exists. In effect, the IRS will always meet the burden of production when it imposes the penalty.

The second, and probably the only realistic way, to reduce or eliminate penalties is contained in Sec. 6664(c).18 This section states that the penalty will not be imposed "if it is shown that there was a reasonable cause for such portion [the understatement] and that the taxpayer acted in good faith with respect to such portion."19 "Good faith" is not defined, but it has been held to mean an honest belief and intent to perform all lawful obligations.20 Qualifying under this rule is based on the facts and circumstances. "Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability."21

Reliance on a tax adviser may demonstrate, but does not guarantee, that the taxpayer had reasonable cause for the understatement.22 All facts and circumstances are considered to determine whether the taxpayer's reliance was reasonable and whether he or she acted in good faith. The taxpayer's education, sophistication, and business experience affect the result.23 In addition, a taxpayer's reliance on an adviser will be rejected if the taxpayer knows or should have known that the adviser lacked knowledge of relevant parts of the tax law.24

The regulations also state that the advice given by the adviser and adopted by the taxpayer will be evaluated based on its facts and circumstances. "For example, the advice must take into account the taxpayer's purposes . . . for entering into a transaction and for structuring a transaction in a particular manner."25 The taxpayer must provide the adviser with all relevant facts, and the advice must not rely on unreasonable factual or legal assumptions and "must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person."26 In other words, the taxpayer, the adviser, and all facts, circumstances, and reasons are evaluated in determining this exemption from the penalty.

Failure to file or pay tax: Reliance on an adviser

As previously discussed, the taxpayer is assessed a penalty if he or she fails to file a return, files it late, and/or fails to pay the tax due. These penalties do not apply if the taxpayer can prove a reasonable cause for the error. One question concerning reasonable cause is this: Does the taxpayer meet the reasonable-cause requirement if he or she relied on the adviser to file the return or accepted the adviser's incorrect filing date?

The Supreme Court considered this question in Boyle,27 a frequently cited case. In this case, the taxpayer relied on an attorney to file an estate tax return. The attorney accidentally filed the return late. The taxpayer argued that he relied on the adviser and therefore should not be penalized. The Supreme Court ruled against the taxpayer, stating that the return due date is a fixed date. Therefore, it is a bright line and a taxpayer cannot reasonably fail to file on time by relying on an adviser to handle the paperwork. The courts have applied this decision, which prevents avoiding the penalty for failure to file because of reliance on an adviser, on a consistent basis.28

Boyle left open the question of the existence of reasonable cause when the filing was delayed past the due date based on incorrect information about a due date from an adviser. The courts seem to have answered this question, holding taxpayers liable for the penalties in this situation because removing the penalty would encourage an adviser to say that he or she gave incorrect advice to protect the client, which will produce a benefit for the client without creating a detriment.29 Recently, a district court ruled that the penalty for failure to pay the tax was valid even though the taxpayer was able to prove that the outside adviser embezzled the money given to pay the tax.30 In another recent case, the taxpayer had to pay a penalty even though she could prove that the adviser lied to her about the tax position.31 Based on these decisions, it is reasonable to assume that the taxpayer will not be able to prove reasonable cause based on reliance on a tax adviser if the return was not filed on time or the liability was not paid. The IRS will penalize the taxpayer in these situations.32

Substantial-understatement penalty: Reliance on an adviser

As previously discussed, it is possible for a taxpayer to avoid a substantial-understatement penalty if it is the result of reliance on a tax adviser. Recently, a number of taxpayers have attempted to rely on tax return software as their tax adviser. In Powell,33 the Tax Court found that the taxpayer had claimed incorrect deductions and had omitted his Social Security income from his taxable income. The Tax Court rejected the taxpayer's argument that he was not liable for a penalty because he used tax software. According to the court, to avoid the penalty, the taxpayer would have to prove that there was a mistake in the software. Based on this decision, it is reasonable to conclude that reliance on tax software will not result in removal of the penalty unless the software is programmed incorrectly.

Receipt of specific, professional advice from an adviser is not sufficient by itself to avoid the penalty. The Tax Court has stated: "Unconditional reliance on a tax return preparer or CPA does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise 'diligence and prudence.' "34 In other words, a taxpayer needs to discuss the issue with the adviser. The more tax knowledgeable the taxpayer is, the more detailed the discussion should be. However, no amount of advice and discussion will meet the reasonable-cause requirement if the taxpayer knew the transaction was a tax shelter or that it lacked economic substance.35

One of the frequently cited cases related to tax adviser reliance is Neonatology Associates.36 The Tax Court upheld the IRS's denial of deductions for contributions to a voluntary employees' beneficiary association. The IRS applied a substantial-understatement penalty, and the taxpayers argued that they relied on tax advisers.

The Tax Court created a three-prong test for the tax adviser exception. The test requires:

  1. The adviser was a competent professional who had sufficient expertise to justify reliance;
  2. The taxpayer provided necessary and accurate information to the adviser; and
  3. The taxpayer actually relied in good faith on the adviser's judgment.

The first prong of the test examines the competency of the tax adviser whom the taxpayer relied upon. There is no uniform statement that defines or explains adequate competency. The determination is made based on the experience and knowledge of the adviser in relation to the tax question as well as the difficulty of the tax question.37 This approach requires the taxpayer to know and evaluate the adviser and not assume that an individual adviser can answer all questions.

The fact that the tax adviser is competent and prepares the return is not sufficient to satisfy this factor. The adviser must consider and determine the reasonableness of the position included on the tax return. In other words, the adviser must opine on the issue.38 In addition, the adviser may not be involved in creating and marketing the transaction,39 but must instead analyze the transaction and the reasons that the taxpayers engaged in it independently.

The second prong of the test requires the taxpayer to provide the tax adviser with all necessary information. The omission of relevant information prevents the avoidance of penalties based on reliance on the tax adviser.40 If the taxpayer provides the tax adviser inaccurate information, the taxpayer cannot be said to have reasonably relied on the tax adviser.41 It would be difficult or impossible for the adviser to provide a taxpayer with a valid position without all the necessary and correct information.

The third prong of the test requires that the taxpayer relied in good faith on the adviser's judgment. This test requires the taxpayer to receive advice concerning the specific tax issue that created the understatement. Advice normally is considered to be information communicated to the taxpayer. However, in American Metallurgical Coal Co., the court ruled, in part, that the taxpayer did not meet this third requirement since the "advice" that the taxpayer claimed to have received was informal and not "up to the strict standards of his firm's opinion letters on which [he] could reasonably rely."42 Therefore, the taxpayer must receive specific, relevant advice in a professionally written memo or letter from the adviser.

The Tax Court recently evaluated the three-part test to determine reliance on a tax adviser's advice in Exelon Corp.43 Simplifying the facts substantially, the taxpayer sold real estate with a $1.6 billion gain. To defer tax on the sale, the taxpayer did not report the disposition as a sale but, instead, engaged in a transaction that it reported as a nontaxable Sec. 1031 like-kind exchange. The taxpayer received tax advice from a law firm and accounting and valuation advice from accounting firms. The IRS determined that the taxpayer sold the property and engaged in a loan rather than a nontaxable Sec. 1031 exchange, and applied a Sec. 6662 accuracy penalty on top of the additional tax. The taxpayer argued that the transaction was a like-kind exchange, and even if it was not, the taxpayer was not liable for the penalty since it relied on a tax adviser. The Tax Court used the three-part test from Neonatology to determine whether the penalty should be abated.

Part one of the test looks to the adviser's competence. The Tax Court found the law firm was sufficiently competent. It also rejected the IRS's argument that the adviser was too involved in the structuring of the transaction to provide a tax opinion that the taxpayer could reasonably rely on. The court did not discuss or explain its reasoning. It is reasonable for advisers to discuss the facts and questions with each other. The fact that one adviser accepts the opinion of another is reasonable and acceptable.

The second part of the test examines the information that the taxpayer provided the adviser. There is no question that the taxpayer provided the law firm and the accounting firm with all the necessary information. However, as previously mentioned, the law firm based its tax opinions on appraisals provided by the accounting firm. The Tax Court found that the law firm provided the accounting firm with a list of conclusions it wanted to see in the appraisals, thereby interfering with the integrity and independence of the appraisal. Because it drafted the transaction documents, the law firm knew or should have known of the defects in the appraisals, the court held, and "that its tax opinions were therefore based on unreasonable assumptions and arrived at unreasonable conclusions."44

The Tax Court concluded that the second test had not been met. This decision emphasizes the requirement that an adviser consider the reasonableness of information it receives. It does not matter if the information is from the taxpayer or another adviser. To provide acceptable advice, the adviser must be knowledgeable enough to reject unreasonable facts and information.

The third test is that the taxpayer actually relied on the advice. The Tax Court stated that the taxpayer had long experience in its industry, and because of its sophistication and experience, knew or should have known the advice was inconsistent with the true facts of the transaction. The taxpayer knew or should have known that it did not really acquire replacement property. Therefore, the transaction was a sale and not a Sec. 1031 like-kind exchange. In other words, the taxpayer failed the second and third prongs of the test, and the IRS had properly imposed the penalty.

Although this is a complex situation, it does emphasize that taxpayers must rely on a quality adviser, and if they realize or should realize that the advice is not correct, the IRS will impose a penalty. The fact that taxpayers are not personally knowledgeable of the tax rules does not allow them to accept any and all advice.

Taxpayers will be assessed a penalty if their tax return contains a substantial understatement. As discussed, taxpayers may be able to avoid the penalty if they relied on a qualified tax adviser. However, to be successful in avoiding the penalty, taxpayers should be able to prove that they meet the three-prong test inNeonatology.

Tax treatment of indemnity payments


If a tax professional gives a taxpayer inaccurate advice or does not fulfill other requirements, the taxpayer may demand compensation. Some advisers will settle; others may be required to make an indemnity payment by a court's decision in a lawsuit brought by the taxpayer. The taxation of these payments has been the subject of litigation. In Sager Glove Corp.,45 the Tax Court stated that "[t]he taxability of the proceeds of a lawsuit, or of a sum received in settlement thereof, depends upon the nature of the claim and the actual basis of recovery."46

If the recovery is for lost profits or other items of income, it is taxable as ordinary income.47 If the recovery is for damaged or destroyed property, the recovery is not taxable except to the extent it exceeds the basis of the property.48 Recently, the Tax Court in Cosentino49evaluated the question and held that the taxpayers received nontaxable funds from the settlement of a lawsuit. The IRS has nonacquiesced to this ruling.50 These results create an uncertain outcome for future indemnity payments.

On the advice of an accounting firm, the Cosentinos entered into a tax-avoidance plan that involved certain transactions designed to inflate the basis of rental property they owned and then disposing of the rental property in a Sec. 1031 like-kind exchange with boot. They then disposed of appreciated income-producing commercial property that they had received in the exchange for the rental property in another like-kind exchange without boot.

Had the Cosentinos not used this tax-avoidance plan, they claimed that they would have simply transferred the property in a Sec. 1031 exchange without boot, as they had done in past transfers of rental property they owned. Their plan was to continue to defer tax on any realized gain on the disposition of appreciated property indefinitely by using like-kind exchanges without boot.

After engaging in the transaction recommended by their accountants and filing their return, the taxpayers learned that the transaction was an abusive tax shelter. They filed amended returns for the relevant periods correctly reporting the taxable gain recognized because of the boot received. They paid federal and state income tax, federal tax penalties, and federal and state interest. They then filed suit against their adviser and accepted a settlement of $375,000. The Cosentinos did not include that money in income on their tax return for that year. The IRS issued a notice of deficiency after determining that the $375,000 should have been included in their income as an award resulting from a lawsuit.

The issue in the Tax Court was the taxation of the $375,000 settlement payment. The Cosentinos argued that the money was a replacement of capital and therefore not includible in income, citing Clark,51 Concord Instruments Corp.,52 and Rev. Rul. 57-47 for the proposition that "no taxable income is derived from that part of the recovery received by the taxpayer which does not exceed the amount of tax which she was required to pay because of the error made by her tax consultant."

The court agreed that the ­Cosentinos paid more in federal and state tax and paid other expenses that they would not have paid if they had not followed their accountants' advice and engaged in the tax-avoidance plan. The court also agreed that the cited authorities "establish that an amount paid to a taxpayer in order to compensate the taxpayer for a loss that the taxpayer suffered because of the erroneous advice of the taxpayer's tax consultant generally is a return of capital and is not includible in the taxpayer's income."53 Thus, the court held that the portion of the settlement payment that was a reimbursement of the additional tax paid by the Cosentinos due to their undertaking the tax-avoidance transaction advised by their accountant was not includible in income.54

The IRS nonacquiesced to the ­Cosentino decision. In AOD 2016-01, the Service said:

Unlike the taxpayers in Clark . . . the taxpayers in [Cosentino] paid the correct amount of Federal income tax based on the transaction they entered into. In this transaction, the taxpayers received taxable boot as part of their consideration upon the disposition of the rental property . . . Once this transaction was completed, no choices were available to the taxpayers to reduce this taxable gain. It was the facts of the transaction, and not a failure to make an election or a failure to timely file an appeal, that caused the taxpayers to incur additional tax.55

For the Tax Court's decision in Cosentino to be correct, the tax paid on the amended return must have been higher than the amount of tax that the taxpayers would have paid absent the adviser's error. To determine if this was the case, the court considered what would have been the tax result if the Cosentinos had engaged in a valid Sec. 1031 transaction without the receipt of any boot. The IRS disagreed with this approach. It argued that the Sec. 1031 exchange with boot was the taxpayers' actual transaction and therefore the one that produces the basic tax liability. The IRS appears to be arguing this approach on the basis that the Sec. 1031-without-boot transaction is simply hypothetical and therefore irrelevant to determining the taxpayers' tax liability.

To help understand the disagreement between the court and the IRS, consider a different situation.

Example 1: A taxpayer was not going to sell some specific property but was told by her adviser that she could sell it in a transaction that would be treated as tax-free. She sells the property and omits the gain from her return. On reviewing the return, the IRS requires the taxpayer to recognize the gain and pay the additional tax. The adviser reimburses the additional tax.

For the additional recovery in this example to be tax-free, the taxpayer must prove that the originally reported income and tax liability were the correct amounts and the increase in tax was due solely to the adviser's error. This can be found to be the case only if it is accepted that the taxpayer would not have engaged in the transaction without the advice and did not receive any benefit. Since the taxpayer actually sold the property, she received cash, which she can use to buy new property. A future sale of the newly acquired property will result in a gain only equal to appreciation after the purchase since the property's basis is cost. Analyzing the two sale transactions would result in a taxpayer's not paying tax on the total gain (cost of the original property minus the sale price of the new property). Instead she would only pay tax on the new property gain. Based on this outcome, it would be very difficult to accept that the taxpayer had to pay additional tax based solely on the wrong advice.

Applying this approach to Cosentino, the IRS appears to have the more reasonable approach unless a taxpayer's statement that he will never sell and only engage in Sec. 1031 transactions without boot is fully acceptable. Even if that is the taxpayer's desire, it is hard to be certain that the taxpayer will never dispose of the replacement asset without reduced gain being recognized. As the IRS stated in a footnote in AOD 2016-01, the Cosentinos' plan to defer tax indefinitely through Sec. 1031 exchanges without boot "was purely speculative, and a change in the taxpayers' circumstances, or even a change to the provisions of the Internal Revenue Code, could have altered the strategy at any time."

There is a way that the Tax Court decision could be completely correct. If the court required the Cosentinos to reduce the basis of the replacement property proposed by the amount of gain that was recognized on the corrected return, then they would be taxed on the gain on the appreciation if they ever sold the replacement property. If they engage in a nonboot Sec. 1031 transaction, there will be substituted basis and retention of potential gain recognition in the future. If they simply keep the property, its basis will be adjusted when their heirs inherit it. In other words, this requirement guarantees that the taxpayer will have to pay tax on the full amount of gain realized before the challenged disposition of the property as well as the gain realized on the replacement property if it is ever disposed of in a taxable transaction. This recommended change that prevents nontaxation of recognized gain is a limited possibility. Therefore, most taxpayers should recognize income for tax indemnities if a taxable transaction occurs.

In Letter Ruling 9728052, the IRS, in determining whether reimbursements of penalties and interest that were due to an adviser's error were includible in income, indicated that penalties and interest are treated like the taxes with which they are associated. In that letter ruling, the IRS found that the reimbursement of the taxes the taxpayer paid were not a return of capital and thus were includible in income, so the reimbursement of penalties and interest was also includible in income. In Cosentino, consistent with this ruling, the Tax Court held that, like the taxes paid that were reimbursed to the taxpayer through the settlement, the penalties the taxpayers actually paid that were reimbursed were not includible in income.

Relief is very difficult to achieve


The taxpayer may fail to file a required return or pay tax on time as a result of a mistake by a tax adviser. In almost all of these cases, the taxpayer will be required to pay a penalty. A taxpayer may also file a return with an understated tax liability because of an adviser's mistake. The taxpayer will be required to pay a penalty unless the understatement occurred because the taxpayer reasonably relied on the adviser as explained in Neonatology Associates.

Many taxpayers do not rely on tax advisers sufficiently to meet this test. For example, in Perry,56 the taxpayer reported only one-half of the retirement payments she received. She said she relied on her advisers. The Tax Court upheld the penalty, stating that the taxpayer did not prove that her advisers were sufficiently knowledgeable, that she gave the advisers all of the necessary information, or that the advisers recommended reporting only one-half of the retirement funds. Therefore, she failed all three parts of the test.

In situations in which an adviser makes a mistake, the adviser may reimburse the taxpayer for the damages caused by the mistake. If any of the reimbursement is based on a deducted expense, that part is taxable. If the reimbursement is based on the tax liability, it is nontaxable so long as the liability exceeds the amount of tax the taxpayer would owe if he or she had ignored the advice. The Tax Court in Cosentino liberally construed the circumstances under which a reimbursement of additional tax paid by a taxpayer will qualify as a nontaxable return of capital. However, as it expressed in AOD 2016-01, the IRS does not agree with the Tax Court, and taxpayers with facts similar to those in Cosentino who claim that a reimbursement of tax is not includible in income should expect the IRS to challenge them on that point.  

Footnotes

1Sec. 6651(a) (flush language); Rev. Proc. 2016-55. The minimum was $100 prior to 2008. The minimum is increased after 2014 with a cost-of-living adjustment (Sec. 6651(i)).

2Secs. 6651(a)(1) and (2).

3See Kimdun Inc., No. 2:16-cv-01500-CAS (RAOx) (C.D. Cal. 8/15/16).

4Boyle, 469 U.S. 241, 245 (1985).

5Id. at 247.

6Chief Counsel Advice 201637012.

7Regs. Sec. 1.6161-1(b).

8Internal Revenue Manual §20.1.1.3.6.1.

9Bassett, 67 F.3d 29 (2d Cir. 1995).

10Regs. Sec. 1.6662-3(b).

11Regs. Sec. 1.6662-3(a).

12Id.

13Pre-2008 Regs. Sec. 1.6695-2(b).

14Pratt and Kulsrud, Federal Taxation, pp. 2-45 (2017 ed.).

15The burden of production applies to the IRS for penalties assessed on individuals. This requirement does not apply to entities such as corporations and partnerships.

16Higbee, 116 T.C. 438 (2001).

17Powell, T.C. Memo. 2016-111.

18The reduction does not apply to penalties resulting from lacking economic substance as defined in Sec. 7701(o).

19Sec. 6664(c)(1).

20See Barnes, T.C. Memo. 2016-79, and Sampson, T.C. Memo. 2013-212.

21Regs. Sec. 1.6664-4(b)(1).

22Id.

23Regs. Sec. 1.6664-4(c).

24Id.

25Regs. Sec. 1.6664-4(c)(1)(i).

26Regs. Sec. 1.6664-4(c)(1)(ii).

27Boyle, 469 U.S. 241 (1985).

28See, e.g., McMahan, 114 F.3d 366 (2d Cir. 1997), and Hoeffner, 587 Fed. Appx. 147 (5th Cir. 2014).

29See Bolving, 650 F.2d 493 (8th Cir. 1981), and Knappe, 713 F.3d 1164 (9th Cir. 2013).

30Kimdun Inc., No. 2:16-cv-01500-CAS (RAOx) (C.D. Cal. 8/15/16). See also Vaughn, 635 Fed. Appx. 216 (6th Cir. 2015).

31Specht, No. 15-3095 (6th Cir. 9/22/16).

32The IRS listed eight reasons for late filing that will avoid a penalty. It does not include reliance on advisers. See Boyle, 469 U.S. 241 (1985).

33Powell, T.C. Memo. 2016-111.

34Stough, 144 T.C. 306, 327 (2015).

35Macsteel, 139 T.C. 67 (2012).

36Neonatology Associates, P.A., 115 T.C. 43 (2000).

37See CNT Investors, LLC, 144 T.C. 161 (2015).

38See Neonatology Associates, 115 T.C. at 101.

39See Peek, 140 T.C. 216 (2013).

40Id.

41See Brinks Gilson & Lione, P.C., T.C. Memo. 2016-20, at *33.

42American Metallurgical Coal Co., T.C. Memo. 2016-139, at *39.

43Exelon Corp., 147 T.C. No. 9 (2016).

44Id., slip op. at 183.

45Sager Glove Corp., 36 T.C. 1173 (1961), aff'd, 311 F.2d 210 (7th Cir. 1962).

46Id., 36 T.C. at 1180.

47See Hort, 313 U.S. 28 (1941).

48Sager Glove Corp., 36 T.C. at 1180.

49Cosentino, T.C. Memo. 2014-186.

50AOD 2016-01.

51Clark, 40 B.T.A. 333 (1939). For a complete analysis of the Clark case, see Zelenak, "The Taxation of Tax Indemnity Payments: Recovery of Capital and the Contours of Gross Income," 46 Tax Law Review 381 (1991).

52Concord Instruments Corp., T.C. Memo. 1994-248.

53Cosentino, T.C. Memo. 2014-186 at *31.

54The settlement agreement did not allocate the settlement payment to the various damages the Cosentinos alleged in their complaint. Because some of the alleged damages were includible in income and some were not, the Tax Court was required to allocate the settlement to determine how much of the payment was taxable. Citing Concord Instruments, it allocated the settlement payment pro rata based on the amount of the damages the Cosentinos alleged in their complaint. See also Rev. Rul. 85-98.

55The rule that a recovery is nontaxable because an appeal was not filed on time was decided in Concord Instruments Corp., T.C. Memo. 1994-248.

56Perry, T.C. Memo. 2016-172.

 

Contributor

Edward J. Schnee is the Culverhouse Professor of Accounting at the University of Alabama in Tuscaloosa, Ala. For more information about this column, contact thetaxadviser@aicpa.org.

 

Newsletter Articles

SPONSORED REPORT

CPEOs provide peace of mind around payroll services

The creation of these new IRS-certified service providers for small businesses clarifies some issues around traditional professional employer organizations.

PRACTICE MANAGEMENT

2016 Best Article Award

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”