Procedure & Administration
The Tax Court held that a taxpayer did not have reasonable cause for omitting from income $3.4 million from the termination of a swap transaction that was reported to him on a Form 1099.
Stephen Woodsum is the founding managing director of a private equity firm. In 1998, he undertook a financial transaction called a 10-year total return limited partnership linked swap with Bankers Trust Company, which was later succeeded in its interest in the swap transaction by Deutsche Bank. The swap transaction was scheduled to end in 2008, but Woodsum decided to terminate the transaction in 2006. The net payout to Woodsum on the termination of the swap was $3,367,611, which was taxable to him.
As a result of the termination payout, Deutsche Bank issued Woodsum a Form 1099-MISC reporting $3,379,611 as “Other Income” and a Form 1099-INT reporting interest income of $60,292. Woodsum also earned large amounts of income from other sources in 2006. All told, he received almost $33 million in 2006 (including the income from the termination of the swap transaction) that the payers reported to Woodsum on over 160 different information returns.
A tax firm that specialized in part in preparing the individual income tax returns of private equity and hedge fund partners prepared Woodsum’s 2006 return. The firm employees who prepared the return had extensive experience in return preparation, and Woodsum gave them all the information returns he received for 2006 (including the Deutsche Bank 1099s). However, for unknown reasons, the approximately $3.4 million of income reported to Woodsum on the Deutsche Bank 1099-MISC was not included in the 115-page individual return the firm prepared for Woodsum. If it had been included, it would have appeared as long-term capital gain on a separate line item in part II of Schedule D, Capital Gains and Losses.
On October 15 (the extended due date of the return), Woodsum met with a representative of the tax firm to review the return and discuss other matters. During the discussion of the return, Woodsum did not compare or match the items of income reported on the Form 1040 and its schedules with the information returns that the third-party payers had provided. He signed the return the same day.
The IRS determined a deficiency of $521,473 based on the omitted income from the termination of the swap transaction and also assessed an accuracy-related penalty under Sec. 6662(a) of $104,295. Woodsum agreed to pay the amount of tax due on the income but challenged the imposition of the accuracy-related penalty in Tax Court. Woodsum argued that under Sec. 6664(c)(1) he was not liable for the penalty because he had a reasonable cause for the omission and had acted in good faith, based on his reliance on a professional tax firm to prepare his return.
The Tax Court’s Decision
The Tax Court held that the Sec. 6664(c)(1) reasonable cause and good-faith defense did not apply to Woodsum and that he was liable for the accuracy-related penalty based on the omission from his return of the income from the swap transaction. In coming to its decision, the court considered the two ways that a taxpayer can establish reasonable cause and good faith for purposes of the accuracy-related penalty: by showing that he or she relied on the advice of a competent tax professional or by showing that an underpayment was due to an isolated computational or transcriptional error.
Regarding the first method of proving reasonable cause and good faith, the Tax Court agreed that Woodsum had employed a competent and experienced tax firm and that he had provided them with all the information necessary to complete the return properly. However, the court further found that the omission of income from the return was not due to Woodsum’s reliance on any advice that he received from the tax firm. According to the Tax Court, to constitute “advice” within the definition of the regulations, the communication must reflect an analysis or conclusion of the professional or the professional’s judgment. In Woodsum’s case, the Tax Court found that the omission of income on his return was not due to any analysis or conclusion or judgment by the tax firm. Therefore, Woodsum had not relied on professional advice.
The Tax Court concluded that Woodsum could not rely on the omission’s being due to an isolated computational or transcriptional error because while it appeared to be such an error, Woodsum provided no evidence that it was. Thus, the omission remained unexplained, and Woodsum had failed to prove that there was a reasonable cause for the omission and that he had acted in good faith.
The Tax Court further explained that even if Woodsum had provided proof of such an error as the cause of the omission, his reasonable cause defense would fail. Citing Magill, 70 T.C. 465 (1978), the Tax Court noted that even if a taxpayer gives a preparer all the necessary information, the taxpayer still has a duty to read his or her return and make sure that all income items are included on it. The Tax Court stated that the taxpayer did not need to replicate the work done by the preparer but that he must conduct a reasonable review of the return under the circumstances. It found that a reasonable review should have revealed the omission of the income. The court also noted that under Regs. Sec. 1.6664-4(b)(1), the most important factor in evaluating reasonable cause was the extent of the taxpayer’s efforts to assess the proper tax liability, and the evidence showed that Woodsum had made little effort to ensure that his liability on his return was correct.
As the Tax Court stated in its opinion, “the duty of filing accurate returns cannot be avoided by placing responsibility on a tax return preparer.” However, a client will almost certainly hold a practitioner responsible for the results of an error in a return and will probably expect the practitioner to reimburse him or her for a penalty assessed because of the error. While it may be difficult or impossible for a practitioner to make a taxpayer perform a meaningful review of a return, as the Tax Court makes clear in this case, it may save the taxpayer from an accuracy-related penalty and ensure that the practitioner does not end up in a dispute over reimbursing the taxpayer for the penalty.
Woodsum, 136 T.C. No. 29 (2011)