It is very common for taxpayers to seek tax return preparation advice and services from a tax professional. If it is ultimately determined that there are errors in the tax return, a taxpayer may incur an accuracyrelated penalty under Sec. 6662(a). While reliance upon the advice of a tax professional may allow a taxpayer to avoid a penalty based upon reasonable cause, such reliance is not an absolute defense to the accuracy-related penalty. In a recent decision, the Tax Court partially upheld accuracy-related penalties against a taxpayer because it failed to reasonably rely in good faith on advice from its tax return preparer (January Transport Inc., T.C. Memo. 2008-268).
In January Transport, the taxpayer hired an accounting firm to provide bookkeeping, financial statement, and tax return preparation services. In April 2002, the taxpayer bought a used Cessna airplane. During this same time period, the taxpayer read an article titled “30% Immediate Bonus Depreciation for New and Used Aircraft Approved by House Ways and Means Committee: Anticipated Passage into Law Within Two Weeks.” An accountant at the firm had initially warned the taxpayer that bonus depreciation was not available for used assets. However, after the taxpayer shared the article with the accountant, they decided to claim bonus depreciation on the used Cessna. The Job Creation and Workers Assistance Act, P.L. 107- 147, which was enacted in March 2002, months after the article was written, allowed for bonus depreciation on certain original use assets or new assets but not on used assets.
Upon examination of the taxpayer’s tax return, the IRS adjusted various items reflected on the return. One such adjustment was to disallow the bonus depreciation on the Cessna claimed by the taxpayer. Although the taxpayer agreed to the IRS’s adjustments, the taxpayer challenged the imposition of accuracy-related penalties because it believed that it had reasonable cause and acted in good faith.
Grounds for Imposition of the Accuracy-Related Penalty
The IRS imposed the accuracy-related penalty on two alternative grounds. First, the IRS asserted that the taxpayer’s underpayment of tax was due to negligence or disregard of rules or regulations under Sec. 6662. Second, the IRS asserted that there was a substantial understatement of income tax under Sec. 6662(d). Negligence includes any failure to reasonably comply with internal revenue laws. A taxpayer disregards the rules or regulations when it does not exercise reasonable diligence to determine the correctness of a return position (Regs. Sec. 1.6662-3(b) (2)). Sec. 6662(d)(1) provides that an understatement of income tax for a corporation is substantial when it exceeds the greater of 10% of the tax required to be shown on the return or $10,000.
The accuracy-related penalty can be reduced under Sec. 6664(c)(1) if the taxpayer shows that reasonable cause exists for the understatement and the taxpayer acted in good faith. Reasonable cause is determined on a case-by-case basis after considering all the pertinent facts and circumstances (Regs. Sec. 1.6664-4(b)(1)). In certain circumstances, reliance upon a tax adviser may establish reasonable cause (Boyle, 469 U.S. 241 (1985)). To justify reliance on a tax adviser, the taxpayer must prove that:
- The adviser was a competent professional with sufficient expertise;
- The taxpayer provided necessary and accurate information to the adviser; and
- The taxpayer actually relied in good faith on the adviser’s judgment (Neonatology Associates, P.A., 115 T.C. 43, 99 (2000)).
However, reliance on a return preparer is not reasonable where a cursory review of the return would reveal inaccurate entries (Pratt, T.C. Memo. 2002-279).
In January Transport, the Tax Court held that the taxpayer failed to reasonably rely on the accountant with regard to the bonus depreciation on the Cessna airplane. The court found that the taxpayer’s reliance on the accountant was undermined because the taxpayer knew the accountant was relying on an article that referred to pending legislation. According to the court, a prudent person would have inquired about the enactment of the final bill, given that the accountant initially warned the taxpayer that bonus depreciation was available only on certain new assets. Further, the court stated that because bonus depreciation was such a large item on the tax return, a cursory review of the tax return by the taxpayer would have revealed that bonus depreciation was taken on the airplane.
What Constitutes Substantial Authority?
The January Transport case highlights the need for tax professionals to understand the types of “authorities” that can be relied upon to avoid penalties if a position taken on a tax return is not sustained. Some of the significant authorities the regulations allow taxpayers to rely on include the Code, Treasury regulations, IRS revenue rulings and revenue procedures, tax treaties, and court cases (Regs. Sec. 1.6662-4(d)(3)(iii)).
Taxpayers and their advisers should understand that articles written by tax professionals do not constitute substantial authority. Further, conclusions reached in treatises, legal periodicals, legal opinions, or opinions rendered by tax professionals are not considered authorities for purposes of determining if substantial authority exists for a tax return position. However, the authorities considered in expressing such opinions may provide substantial authority where the authorities are applicable to the facts of a particular case.
The January Transport case serves as a good reminder for taxpayers and their tax professionals that reliance upon a tax professional’s advice does not guarantee that a taxpayer cannot be assessed an accuracy-related penalty if the tax return position does not meet basic reporting standards.
This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation.
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. John Keenan is a tax director and Vibhuti Patel is a manager with Deloitte Tax LLP in Washington, DC. Mr. Keenan is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at firstname.lastname@example.org.