Assessing Professional Tax Advice and Taxpayer Sophistication

EXECUTIVE SUMMARY

• Sec. 6662 imposes an accuracy-related penalty for any portion of a taxpayer’s underpayment that is attributable to negligence or substantial understatement of income tax. However, an exception is provided in Sec. 6664(c) for taxpayers that show there was a reasonable cause for their underpayments and that they acted in good faith with respect to them.
• One way a taxpayer may be able to prove reasonable cause and good faith is to show that he or she relied on the advice of a tax professional regarding the underpayment after providing the tax professional with all the pertinent information regarding his or her situation.
• The regulations state that whether reliance on professional tax advice is reasonable is based on the taxpayer’s facts and circumstances, including his or her experience, knowledge, and education. The regulations do not make clear how the taxpayer’s experience, knowledge, and education are to be taken into account. The courts addressing the issue have come to varying conclusions, thus leaving taxpayers without a coherent standard for determining when reliance is reasonable.

A taxpayer is liable for an accuracy-related penalty for any portion of an underpayment attributable to negligence or substantial understatement of income tax. The law provides a good-faith and reasonable cause defense against the negligence and substantial understatement penalty. In determining the applicability of the penalty, the taxpayer’s reliance on professional tax advice is relevant. However, in evaluating the authority and circumstances of the advice and the adviser, the standards applied by the IRS in the regulations are more stringent than those imposed by the courts. The IRS requires taxpayers to evaluate the expertise of their tax advisers as well as the quality of the advice. The courts generally excuse taxpayers from negligence if they follow the advice of a tax adviser in good faith.

This article investigates the courts’ interpretation of reasonable cause and good faith in circumstances where the IRS has imposed a negligence penalty. By examining cases addressing a similar tax issue, it is possible to contrast the respective reasoning of the IRS and the courts in measuring the reasonable cause and good-faith exception. To reduce the disparity between the IRS and the courts, potential modifications to the regulations are suggested.

The Negligence Penalty and the Reasonable Cause Defense

A taxpayer is liable for an accuracy-related penalty for any portion of an underpayment attributable to, among other things, a substantial understatement of income tax. A substantial understatement of income tax under Sec. 6662(d) occurs if the amount of the understatement exceeds the greater of either 10% of the tax required to be shown on the return or $5,000 ($10,000 for corporations). The Sec. 6662 penalty applies to five distinct taxpayer abuses, the most frequently cited being substantial understatement of income (Sec. 6662(b)(2)) and negligence or disregard of rules or regulations (Sec. 6662(b)(1)). The term “negligence” is defined to include any failure to make a reasonable attempt to comply with the provisions of the Code, and “disregard” includes any careless, reckless, or intentional disregard (Sec. 6662(c)).

A taxpayer may contest the imposition of a negligence penalty by showing that he or she acted reasonably and in good faith (Sec. 6664(c)). Congress left it to the IRS to specify criteria for determining reasonableness and good faith. Unfortunately, the IRS’s response was to impose regulatory standards for reasonableness and good faith that are at least as subjective and difficult to administer as the statutory benchmarks they are meant to define. One involves assessing the level of professionalism of the taxpayer’s tax adviser, and the other involves assessing the level of sophistication of the taxpayer. The application of these criteria is explained in Regs. Sec. 1.6664-4, “Reasonable cause and good faith exception to section 6662 penalties.”

Regs. Sec. 1.6664-4(b)(2) distinguishes between a professional tax adviser and others who provide tax advice. The taxpayer is responsible for determining the difference. If a taxpayer seeks tax advice from “someone that he knew, or should have known, lacked knowledge in the relevant aspects of Federal tax law,” even though the taxpayer sought tax advice, he or she would have “failed to act reasonably or in good faith.” The IRS provides no further guidance on how a taxpayer is to make this determination. For example, there is no specification that the tax adviser must be qualified to practice before the IRS, as set out in IRS Circular 230,¹ which would limit the selection to CPAs, attorneys, or enrolled agents. The purpose of this article is to set out what guidance the courts offer for making the determination that an individual is a professional tax adviser.

The scope of the article is limited to individual taxpayers, and the examination of the Sec. 6662 penalty is limited to Sec. 104 cases in which the taxpayer has received an award or settlement in connection with a personal injury. In such cases, the IRS frequently asserts both negligence and substantial understatement penalties. The discussion is limited in this manner primarily to control for variables that may affect the law’s application; focusing on one legal issue also avoids multiple explanations of the law in connection with each new case. The law controlling the taxability of personal injury awards was selected because its application is generally clear and settled, allowing the discussion to focus on measuring the taxpayer’s reasonableness and good faith in following tax advice.

Negligence Penalty Assessments

In 2008, the IRS reported assessing 391,621 accuracy-related (including negligence) penalties totaling $904,206,000. Of that number, however, it subsequently abated 48,326 (12%) of the penalties totaling $216,870,000 (24%).² According to the “Post-Assessment Abatement Consideration of the Accuracy-Related Penalties” section of the Internal Revenue Manual:³

If a taxpayer receives notice and demand for payment and then makes his/her first response to the Service requesting abatement of the accuracy-related penalties (while not disputing the tax liability and not requesting or not being eligible for audit reconsideration procedures), abatement should be considered based on the evidence provided.

The same guidance continues:

If the evidence is not sufficient to support a reasonable cause claim for the penalty abatement, the taxpayer should be issued the appropriate letter to indicate that the abatement request is denied and the remaining recourse is to pay the tax, penalties and interest and file a claim for refund on Form 843, Claim for Refund and Request for Abatement.⁴

The “reasonable cause claim” in the context of Sec. 6664 refers to good-faith reliance on a professional tax adviser.⁵ If a taxpayer faced with a negligence penalty can demonstrate that the reason for the tax underpayment or negligence was advice sought, received, and followed from a professional tax adviser, he or she may be entitled to the relief provided by the Sec. 6664 reasonable cause exception.

The Courts

The courts are the final arbiter in determining if an IRS-imposed negligence penalty is appropriate. Therefore, it is useful to review a number of decisions in which the court has explained its reasons for upholding the IRS or overturning its imposition of the penalty.

Personal Injury Awards and Sec. 104 Exemption

In an effort to ensure comparability of cases, this article limits its examination of the penalty assessment and its appropriateness to taxpayers receiving personal injury awards that they claimed were exempt under Sec. 104. This is a commonly litigated issue, in part due to taxpayer confusion in interpreting the law and in part because the amount in question is frequently significant. Before the law was modified by the Small Business Job Protection Act of 1996,⁶ the personal injury exemption was broadly available for tort-type personal injuries and sickness but not for damages intended to replace income. For amounts received after August 20, 1996, the law was narrowed and now requires the injury to be a physical personal injury to qualify for exemption. However, this change did not affect the criteria for applying the Sec. 6662 penalty or its relief under the Sec. 6664 good-faith and reasonable cause exception and therefore does not invalidate the comparison of cases before and after the change.

Reasonable Cause and Reliance on Professional Advice

The Supreme Court in Boyle⁷ held that “[w]hether the elements that constitute ‘reasonable cause’ are present in a given situation is a question of fact, but what elements must be present to constitute ‘reasonable cause’ is a question of law.” The test applied by the courts in Neonatology Associates, P.A.⁸ for relieving a taxpayer of an IRS-imposed negligence penalty generally follows the regulations, requiring that a taxpayer reasonably relied on a professional tax adviser and that the adviser was a competent professional who had sufficient expertise to justify the taxpayer’s reliance on him or her.⁹ In addition, the taxpayer must prove that he or she provided necessary and accurate information to the adviser and that the taxpayer relied in good faith on the adviser’s judgment.

“Reliance on professional advice” can, as clarified by the Tenth Circuit in Van Scoten,¹⁰ “in certain circumstances, provide a defense to a negligence penalty. However, reliance on such advice must be reasonable.” The court specified that part of the test for reasonableness involves the tax adviser’s independence from the taxpayer. “[A] court will scrutinize the relationship between the adviser and the taxpayer to decide whether a true ‘advisory’ relationship existed.”11 The promoter of a tax shelter may give tax advice to a customer, but the court will presume that the advice is not independent and hence the taxpayer’s reliance is not reasonable. Reliance on a tax adviser “may be unreasonable when it is placed on insiders, promoters, or their offering materials, or when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about.”¹²

“Whether the taxpayer acted with reasonable cause and in good faith depends upon all the pertinent facts and circumstances, including the taxpayer’s reasonable reliance on a professional tax adviser, the taxpayer’s efforts to assess his or her proper tax liability, and the knowledge and experience of the taxpayer.”¹³ “Reasonable cause [also] requires that the taxpayer have exercised ordinary business care and prudence.”¹⁴ In addition, according to the court in Mitchell,¹⁵ when the law is unclear, it is unreasonable for the IRS to impose a negligence penalty.

Stadnyk Case

In a 2008 Tax Court memorandum decision,¹⁶ the court considered the propriety of a Sec. 6662 negligence penalty imposed on a taxpayer who had received professional tax advice. The advice concerned whether or not a personal injury award was taxable under Sec. 104(a)(2). Under that section, as applied to this case, if the award is directly related to a physical personal injury, the proceeds of the settlement are excludible from income. In Stadnyk, the wife had received an award of $49,000 as the result of a claim mediated with Bank One. However, according to the court, “[T]he mediation agreement did not state the basis for the award or allocate the award in any way.” The basis for the physical injury claim asserted by the taxpayer against Bank One was her alleged false imprisonment. Her arrest by the police and subsequent detention arose from a dispute with the bank regarding a dishonored check. The petitioners argued that physical restraint and detention constitute physical injury for purposes of Sec. 104(a)(2). The court disagreed and held that the settlement was unrelated to any physical injury.

When the taxpayers filed their income tax return for the year of the settlement, they did not include the $49,000. “Petitioners relied on statements made by their attorney, Bank One’s attorney, and the mediator during the course of the mediation conference that the settlement award would not be subject to Federal income tax.” In addition, according to the court—in reference to the qualifications of the tax advisers—“none of those individuals had specialized knowledge in the tax law,” although they were experienced in personal injury lawsuits and settlements. In spite of this and the fact that the taxpayers did not seek additional professional tax advice after receiving a Form 1099-MISC for $49,000—relying instead on the opinions of nontax attorneys—the court held that they had “acted reasonably and in good faith when following their advice.” As a result, the court held that the Stadnyks were not liable for the Sec. 6662 negligence penalty.

This outcome is at odds with the strict requirements for reasonable cause and good faith set forth by both the IRS and the court in Neonatology Associates, and it begs the question of what responsibility a taxpayer has to seek professional tax advice and how the quality of the tax advice will be judged. In particular, is acting reasonably and in good faith “when following” tax advice (the court’s words) equivalent to acting reasonably and in good faith in seeking professional tax advice (the emphasis of the regulations)? The second implies a higher standard of responsibility for taxpayers than simply following faithfully whatever advice an adviser provides. The IRS standard, which is more rigorous, states that “[r]eliance on an information return or on the advice of a professional tax adviser or an appraiser does not necessarily demonstrate reasonable cause and good faith” unless “under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith” (Regs. Sec. 1.664-4(b)(1)). The court in Stadnyk applied a lower standard by making reliance on the advice of professionals (nontax attorneys) equivalent to reasonable reliance on professional tax advisers.

Advisers

For the IRS, reliance on an adviser is not enough. As indicated, the adviser must be someone the taxpayer knew or should have known was qualified. Although Circular 230 provides standards for individuals who practice before the IRS, the Service has made no attempt in the regulations or elsewhere to sketch a hierarchy of tax advisers from which taxpayers may choose. The regulations acknowledge that a taxpayer’s relative ability to deal with the law is not an objective or uniform standard but depends on the taxpayer (Regs. Sec. 1.664-4(b)(1)). “Circumstances that may indicate reasonable cause and good faith” are based on facts and circumstances, “including the experience, knowledge and education of the taxpayer” (Regs. Sec. 1.664-4(b)(1)).

The IRS, by putting taxpayers in the position of having to decide on the relative authority and expertise of their tax advisers— without at the same time providing any concrete guidance—is exacerbating the problem of assessing reasonable cause and determining if someone acted in good faith. In addition, the very taxpayers who may most need professional tax advice may also be the ones least able or likely to understand that not all tax advisers are authorities.

Good Adviser, Bad Advice

In addition to Stadnyk, numerous cases deal with the taxability of awards for personal injuries resulting in the IRS’s assessment of a negligence penalty. Their varying results expose the subjectivity of determining “good faith” and “reasonable cause” as well as the uneven scrutiny with which the courts examine the credentials of the taxpayer’s tax adviser and the taxpayer’s relative sophistication.

In Coblenz,¹⁷ the application of Sec. 104 was again tested. The upshot of a complex set of facts found that the taxpayer received a settlement of $266,686 resulting from a business purchase that went bad when anticipated financing failed to materialize. From the court’s description of the facts, it appears clear that the exclusion for personal injury awards provided by Sec. 104 did not apply. In spite of this, the court, although agreeing with the IRS in including the settlement in the taxpayer’s income, did not find that the taxpayers acted negligently, thereby exposing them to the Sec. 6662 penalty. The court’s reasoning was that the taxpayers relied on a tax adviser who was a practicing “tax attorney, C.P.A., and former IRS revenue agent and Appeals officer” for advice regarding the taxability of the settlement proceeds. Thus, the court found that the taxpayer acted reasonably and in good faith, notwithstanding the erroneous advice. For the taxpayer this is the expected outcome from the Sec. 6664 exception.

A similar fact pattern prompted the court in Gibson¹⁸ to state:

Petitioner has no relevant tax education, sophistication, or business experience. Petitioner engaged an experienced tax attorney to determine the proper tax treatment of petitioner’s settlement award. After discussing the relevant facts and circumstances of the class action lawsuit with the class action attorneys, the tax attorney advised petitioner to report $12,500 of the $175,000 settlement as taxable income. On the basis of that advice, petitioner reported $12,500 on his 2002 tax return. Accordingly, petitioner is not liable for the accuracy-related penalty.

According to the Tax Court, the erroneous omission of $162,500 resulted from reasonable reliance on a tax adviser.

Unsophisticated Taxpayer

In Quantum Co. Trust,¹⁹ the taxpayer received a settlement from the state of Alaska resulting from a fishing rights dispute. The taxpayer, a commercial fisherman, had just landed 150 tons of herring when a state trooper ordered him to release the fish. The taxpayer sued the state for damages and was awarded a $45,000 settlement, which the Tax Court determined to be includible in income.

The court was unable to determine from the settlement agreement whether the sum was received for a personal injury, as claimed by the taxpayer, which would exempt it from tax. The tax year at issue was 1993, before the change to Sec. 104 requiring that personal injuries be physical to receive exemption from taxation. By examining the underlying issues, the court found that the settlement was economic (replacing income) and not the result of a personal injury as the taxpayer contended. The courts have reiterated their approach in such situations. “When a settlement agreement lacks express language stating what the settlement amount was paid to settle, the most important factor for courts to consider is the intent of the payor.”²⁰ In such circumstances a key question to ask is, “In lieu of what were the damages awarded?”²¹

In spite of ruling that the settlement proceeds should have been recognized as income, the taxpayer and his wife were not held liable for the Sec. 6662 negligence penalty. According to the court, they “were not tax sophisticated.” As a result, the court reasoned, “they actively sought assistance in determining their tax liability. Although some of that advice was inaccurate [including the treatment of the fishing settlement as excludible from income,] we accept [their] testimony that they reasonably relied upon the advice of two attorneys as well as their tax preparer in reporting their income and expenses.” Not addressed in this case were the expertise of the attorneys or the qualifications of the tax preparer. As in Stadnyk—and in opposition to the regulations—it was the mere reliance rather than the quality of the advice (or the adviser) that carried the day for the taxpayer.

The sophistication of the taxpayer is a relative condition, as noted by Regs. Sec. 1.6664-4(b)(1). As one commenter points out, this judgment is sometimes made on the basis of formal education. “[T]he higher the level of the taxpayer’s education, the less likely the courts are willing to accept a claim that he acted in good faith in following his adviser’s questionable advice.”²² However, it is not obvious whether a lack of sophistication requires a taxpayer to seek a professional tax adviser or, on the contrary, whether a lack of sophistication should excuse the taxpayer from knowing that the tax issue is sufficiently complex that he or she should consult a professional tax adviser. A lack of sophistication—as measured by the experience, knowledge, and education of the taxpayer (Regs. Sec. 1.6664-4(b)(1))—is thus a double-edged sword. Justice Holmes observed that “a law which punished conduct which would not be blameworthy in the average member of the community would be too severe for that community to bear.”²³ Are we to assume that the average taxpayer has (1) the sophistication to know when it is appropriate to seek a professional tax adviser and (2) the ability to determine the quality of the advice? The regulations answer “yes” to both conditions, while the courts back off on the second.

The taxpayer in Griffin²⁴ relied on a tax adviser who the court was surprised did not do further research before giving his advice. In spite of the poor advice, the court held that the taxpayer needed advice and, by following the advice, acted reasonably and in good faith. This and the earlier examples cited show that for the court it is often the fact of receiving advice and following it that measures reasonableness and good faith. As noted, this is a less stringent test than required by the regulations.

Not Showing Everything to a Professional Tax Adviser

In some instances, the courts have found that although a taxpayer properly sought the advice of a professional tax adviser, the taxpayer kept the adviser partially in the dark. Framing a tax problem in a particular way or not supplying all the facts can negate the defense that a taxpayer relied on professional tax advice. In Green,²⁵ the taxpayer was a university lecturer. When a tenure-track position opened at the university, she applied but was turned down.

The taxpayer sued the university for discrimination and for retaliating against her for complaining about discrimination. Although the court found that the university had not discriminated against her in the hiring process, it did determine that she was the subject of retaliation. The court awarded Green $1.5 million in damages. As the Tax Court noted, the taxpayer never alleged that she had suffered any physical personal injury resulting from the university’s actions, so the award was taxable income. However, when filing her tax return she omitted the $1.5 million on the grounds that she received it for physical personal injuries and it was therefore excludible under Sec. 104.

The IRS imposed a negligence penalty on Green by authority of Sec. 6662. The taxpayer argued that she had in fact consulted a professional tax adviser and in accordance with Sec. 6664 had acted reasonably and in good faith in not including the $1.5 million in her taxable income. Here the court first addressed the qualifications of her tax adviser and agreed that he was “a competent professional who had sufficient expertise to justify reliance on him.” However, the court concluded that the taxpayer had not “provided all the necessary and accurate information” to the adviser necessary for him to render tax advice. “Moreover,” the court noted,²⁶ “petitioner did not show that she relied in good faith on [her professional tax adviser’s] tax advice because she did not establish what tax advice, if any [he] rendered.” The court therefore upheld the IRS’s imposition of the negligence penalty.

The Tax Court reached a similar result in Sanford,²⁷ where the recipient of a settlement that did not qualify for exclusion under Sec. 104 failed to report her income. The taxpayer defended her action by claiming that she had relied on her tax adviser. According to the court, “Petitioner argues that she reasonably relied on H & R Block to prepare the returns, [but] petitioner was unclear in her testimony about when she received advice and what advice she received.” As a consequence, the court upheld the IRS’s imposition of a negligence penalty.

The taxpayer in Connolly²⁸ used a paid tax preparer but also provided no evidence that she told the preparer about a $75,000 settlement she received and for which the payer issued a Form 1099. The Tax Court upheld the negligence penalty. The Fifth Circuit held likewise in a case where the taxpayer offered “no evidence as to what [the taxpayer] told the preparer, what the preparer told [the taxpayer], and whether or not [the taxpayer’s] reliance on any advice from the preparer was reasonable.”²⁹

No Tax Adviser

In some cases, the court has found that although a taxpayer may have acted in good faith, there was no reasonable cause.³⁰ In Tamberella,³¹ the taxpayer claimed that his mental illness constituted “reasonable cause” for his not reporting an $89,840 settlement, but the court noted that “while the settlement agreement specifically put Tamberella on notice that some or all of the $89,840 might be taxable, he did not seek the advice of a tax professional.” Further, the taxpayer’s claim of mental illness was undermined, according to the court, by the fact that “throughout the relevant period, Tamberella was able to manage his personal affairs and even represented himself in a lawsuit he brought against his former employer . . . and prepared a petition for writ of certiorari to the Supreme Court.”

In Goode,³² the taxpayer received a $135,000 settlement. Because he received no Form 1099, the taxpayer decided not to include the award in his income and not to seek professional tax advice. The Tax Court upheld the IRS’s imposition of a negligence penalty. It held similarly in Moulton.³³

Negligence and Professional Codes of Conduct

What Is a Professional?

Society’s expectations for a profession are high; its practice occurs within a sphere of trust.³⁴ A researcher on occupational socialization notes, “Occupations of professional status are granted varying degrees of autonomy in their performance. Unless balanced by self-imposed responsibility, the exercise of professional power would be intolerable and unstable.”³⁵ According to Cheffers and Pakaluk, “[T]he entire orientation and outlook of a professional has to be marked by a recognition of the priority, in particular, of ethical considerations over monetary benefit. . . . The good that a profession provides is indistinguishable from the ethical commitment of those who provide it.”³⁶

Central to professionalism is exercising informed judgment and regulating one’s conduct in accordance with the expectations and highest interests of the profession and the client, customer, or patient as well as the society that recognizes and values the profession. “The actions of accountants impact others. Professional values, ethics and attitudes that identify professional accountants as members of a profession involve a commitment to enhancing the interests of the community.”³⁷ For a tax professional, this involves a tension between advocating for the client yet remaining within the spirit of the law. Conflicting standards of taxpayer negligence penalties (Sec. 6662) and tax preparer penalties (Sec. 6694) have made this patently clear.³⁸

Professional Codes of Conduct

As with most professions, the conduct of accountants and other professional tax advisers (attorneys, CFPs, enrolled agents) is guided by a code of professional conduct. The code of conduct, in turn, defines what is reasonable within the profession. In their interpretation of the law, the courts and the IRS use a universal or general standard of reasonableness. If instead they relied on the profession’s own standards of reasonableness, determining the application of Sec. 6664 would be more predictable. The advice provided by a tax preparer would then be placed in its proper context. What might appear unreasonable to the courts or to the IRS might be squarely within the profession’s guidelines for reasonableness. Consider Statement No. 1, “Tax Return Positions,” from the AICPA’s Statements on Standards for Tax Services³⁹ regarding the advocacy of a return position (an interpretation of the law favorable to the client):

1. The following standards apply to a member when providing professional services that involve tax return positions:
   1. A [CPA] should not recommend that a position be taken with respect to any item on a return unless the [CPA] has a good-faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged.
   2. A [CPA] should not prepare or sign a return that the [CPA] is aware takes a position that the [CPA] could not recommend under the standard expressed in paragraph 2a.
   3. Notwithstanding paragraph 2a, a [CPA] may recommend a tax return position that the [CPA] concludes is not frivolous as long as the [CPA] advises the taxpayer to appropriately disclose. Notwithstanding paragraph 2b, the [CPA] may prepare or sign a return that reflects a position that the [CPA] concludes is not frivolous as long as the position is appropriately disclosed.

Here the initial guidance in paragraph 2a is clear and unambiguous and calls for the tax position recommended to be measured empirically against existing administrative or judicial standards and accorded a “realistic possibility.”⁴⁰ Further, preparing and signing a return containing a position that the tax preparer does not recommend, the subject of paragraph 2b, is, prima facie, a violation of the AICPA’s Code of Professional Conduct (Article III)⁴¹ requiring integrity of a member CPA; preparing a return that takes a position that a CPA does not recommend violates the good-faith belief required by paragraph 2a. Finally, in paragraph 2c the guidance in paragraph 2a is uprooted, and recommending any return position is acceptable as long as it is disclosed in the return and is not frivolous. These rules indicate the public accounting profession’s view of reasonableness and, as far as they also reflect the Code’s penalties for tax return preparers (Sec. 6694), they also reflect the law’s view of reasonableness.⁴²

If the IRS and the courts are basing reasonableness and good faith on the professionalism of the tax adviser, they should consider the next step: determining whether the type of tax advice provided is reasonable within the tax professional’s code of conduct and the Code’s constraints on tax preparers (Secs. 6694, 6701, and 7407) as well as Circular 230. As one court noted, “[I]t seems reasonable to the Court that a tax professional might look to a Treasury Circular for at least general guidance in determining the level of quality necessary for a tax opinion.”⁴³

In the case of a tax adviser who is not bound by any organizational code of conduct, the reasonableness of a taxpayer’s reliance would be more difficult to establish. In such a case, the IRS and the courts would likely have to continue employing a standard reflective of general industry practices and expectations but likely referring to such organizations as the AICPA as benchmarks.

If this procedure is deemed impractical because of the breadth of the professions providing tax advice—accountants, attorneys, insurance agents, enrolled agents, financial planners, seasonal employees of national tax preparation firms—a more expedient solution would be to establish a safe-harbor exception.

Proposed Safe-Harbor Exception for the Negligence Penalty

Rather than attempting to navigate the complexities of determining the tax adviser’s professionalism and the taxpayer’s sophistication, the regulations could offer a simple and easily administered safe-harbor test based on objective evidence:

• Did the taxpayer employ a paid tax preparer as evidenced by the required signature on the tax return (Sec. 6695)?
• Was the tax item in question included in the return, either as part of the income or tax calculation or by way of a disclosure explaining why the item was not so included?
• Was the paid tax preparer assessed a penalty under Secs. 6694, 6701, or 7407 in connection with his or her treatment of the item in question?

If the answers to these three questions are Yes, Yes, and No, the conditions of Sec. 6664 would be deemed met and the taxpayer not held subject to the Sec. 6662 negligence penalty. If the answer to the first question is “No,” the taxpayer would be presumed not to have acted reasonably and in good faith. The taxpayer may still rebut this presumption by showing specific evidence of advice sought, received, and followed. This does not imply that a taxpayer who does not employ a paid preparer would be presumed to act unreasonably because such a taxpayer could not appeal a negligence penalty by claiming good faith and reasonable reliance on a tax adviser.

If the answer to the second question is “No,” the taxpayer has not met the reasonableness and good-faith exception. It would be presumed that the taxpayer did not properly inform the preparer of the particular tax item in question. If the answer to all three questions is “Yes,” the taxpayer may have a cause of action against the tax preparer but would not be presumed to have acted reasonably and in good faith.

Conclusion

The law provides a good-faith and reasonable cause excuse for the negligence and substantial understatement penalty. The standard applied by the IRS in the regulations is more stringent than that often upheld by the courts. The IRS requires taxpayers to evaluate their tax adviser’s expertise as well as the quality of the advice. The courts frequently excuse taxpayers from negligence if they merely follow the advice of a tax adviser.

Noting this difference, the IRS should consider modifying Regs. Sec. 1.6664. Two options have been suggested here, but there are likely others that would close the gap between the IRS’s and the courts’ interpretations of Sec. 6664’s reasonable cause and good-faith exception to Sec. 6662. Uniformity in administering the Sec. 6664 requirements would be beneficial in setting expectations for taxpayers as well as in providing the IRS with less subjective measures than the sophistication of the taxpayer or the quality of the tax adviser.

EditorNotes

Donald Morris is an assistant professor of accounting in the College of Business and Management at the University of Illinois in Springfield, IL. For more information about this article, contact Prof. Morris at dmorr2@uis.edu.

Notes

¹ Treasury Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, Enrolled Retirement Plan Agents, and Appraisers Before the Internal Revenue Service (31 C.F.R. Part 10).

² IRS Publication 55B, Data Book, 2008, Table 17, “Civil Penalties Assessed and Abated, by Type of Tax and Type of Penalty, Fiscal Year 2008,” available at www.irs.gov/pub/irs-soi/08databk.pdf.

³ IRM §20.1.5.4.

⁴ According to the same section of the IRM, “Post-assessment consideration of IRC section 6662 and 6662A accuracy related penalty abatement requests are not forwarded to Appeals.”

⁵ A number of IRS penalties provide a means for their avoidance if the action prompting the penalty was undertaken in good faith and with reasonable cause, including Sec. 6161, extension of time for paying tax; Sec. 6332, surrender of property subject to levy; Sec. 6651, failure to file tax return or pay tax; Sec. 6652, failure to file certain information returns, registrations, statements, etc.; Sec. 6654, failure by individual to pay estimated income tax; Sec. 6656, failure to make deposit of taxes; and Sec. 6657, penalty for bad check.

⁶ Small Business Job Protection Act of 1996, P. L. 104-188, §1605, 110 Stat. 1838.

⁷ Boyle, 469 U.S. 241 (1985).

⁸ Neonatology Associates, P.A., 115 T.C. 43 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

⁹ The extent to which a court may allow an “after the fact” adviser to testify regarding the reasonableness of a taxpayer’s attempts to meet the law’s requirements is addressed in Banoff and Lipton, “Establishing Reasonable Cause: Court Wouldn’t Let Tax Experts Testify,” 109 J. Tax’n 62 (July 2008), and again in Banoff and Lipton, “Establishing Reasonable Cause: This Court Let Tax Experts Testify,” 109 J. Tax’n 314 (November 2008).

¹⁰ Van Scoten, 493 F.3d 1243, 1253 (10th Cir. 2006).

¹¹ Oliva, “When Will Reliance on a Tax Adviser Avoid an Accuracy-Related Penalty?” 28 The Tax Adviser 772 (December 1997).

¹² Neonatology Associates, P.A., 115 T.C. 43 (2000).

¹³ Moulton, T.C. Memo. 2009-38.

¹⁴ Neonatology Associates, P.A., 115 T.C. 43 (2000).

¹⁵ Mitchell, T.C. Memo. 200-145.

¹⁶ Stadnyk, T.C. Memo. 208-289.

¹⁷ Coblenz, T.C. Memo. 2000-131.

¹⁸ Gibson, T.C. Memo. 2007-224.

¹⁹ Quantum Co. Trust, T.C. Memo. 2000-149.

²⁰ Pipitone, 180 F.3d 859 (7th Cir. 1999).

²¹ Raytheon Prod. Corp., 144 F.2d 110, 113 (1st Cir. 1944).

²² Oliva, supra note 11, at 776.

²³ Holmes, The Common Law 50 (Little, Brown & Co. 1881).

²⁴ Griffin, T.C. Memo. 2001-5.

²⁵ Green, T.C. Memo. 2007-39.

²⁶ Id.

²⁷ Sanford, T.C. Memo. 2008-158.

²⁸ Connolly, T.C. Memo. 2007-98.

²⁹ Green, 507 F.3d 857 (5th Cir. 2007).

³⁰ Sean Murphy notes that in some cases “the court’s failure to distinguish between ‘reasonable cause’ and ‘good faith’ could eventually cause the section 6664(c)(1) defense to be both over and under inclusive if the court’s reasoning is for any reason followed by either a future court or practitioner.” Murphy, “MacMurray v. Comm.: Distinguishing Between Reasonable Cause and Good Faith Requirements of the Section 6664 Exception to Accuracy Related Penalties,” 61 Tax Law. 657 (Winter 2008).

³¹ Tamberella, 139 Fed. Appx. 319 (2d Cir. 2005).

³² Goode, T.C. Memo. 2006-48.

³³ Moulton, T.C. Memo. 2009-38.

³⁴ Esland and Salaman, eds., The Politics of Work and Occupations 239 (University of Toronto Press 1980).

³⁵ Moore, “Occupational Socialization,” in Goslin, Handbook of Socialization Theory and Research 869 (Rand McNally College Publishing Company 1969).

³⁶ Cheffers and Pakaluk, Understanding Accounting Ethics 92 (Allen David Press 2005).

³⁷ International Federation of Accountants, International Education Practice Statement 1, Approaches to Developing and Maintaining Professional Values, Ethics, and Attitudes (October 2007).

³⁸ For more on this topic, see Oliva, supra note 11.

³⁹ AICPA, Statements on Standards for Tax Services (SSTS), No. 1, Tax Return Positions (August 2000), Statements on Standards for Tax Services

⁴⁰ In 2008 the AICPA released an exposure draft revising SSTS No. 1 with a comment due date ending May 15, 2009. The exposure draft makes significant changes and revisions to the statement, including removal of the term “frivolous” and replacing it with a reasonable basis standard.

⁴¹ AICPA, Code of Professional Conduct, Section 54, Article III, Integrity, available at ET Section 54 – Article III – Integrity

⁴² Whether tax professionals are CPAs, enrolled agents, attorneys, certified financial planners, or other, their respective code of professional conduct establishes a basis for reasonableness.

⁴³ Murfam Farms LLC, 83 Fed. Cl. 635 (2008).