Procedure & Administration
In five recent cases, the Tax Court tested the defenses of various taxpayers to the imposition by the IRS of accuracy-related penalties for substantial understatements of income tax. In each case, the court weighed the facts to decide whether a 20% accuracy-related penalty applied, considering the taxpayers’ efforts to properly determine their correct income tax liability. A review of these cases provides relevant and timely insight into the defenses available against an accuracy-related penalty.
Secs. 6662(a) and (b)(2) impose a 20% penalty on an underpayment attributable to a substantial understatement of income tax. For an individual, an understatement is considered substantial if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return (Sec. 6662(d)(1)(A)). For a corporation, an understatement is considered substantial if it exceeds the lesser of $10 million or 10% of the tax required to be shown on the return (or, if greater, $10,000) (Sec. 6662(d)(1)(B)).
Before applying the mechanical test for determining whether an underpayment is deemed substantial, the taxpayer excludes any portion of the underpayment for which (1) there is substantial authority for the treatment of the position, or (2) the position was adequately disclosed in the tax return and there is a reasonable basis for the treatment of the item (Sec. 6662(d)(2)(B)).
For underpayments arising from circumstances for which there is neither substantial authority nor adequate disclosure, taxpayers are forced to rely on the more subjective standard in Sec. 6664(c), i.e., the reasonable-cause and good-faith exception. Generally, a penalty under Sec. 6662 will not be imposed for the portion of an underpayment for which it is adequately demonstrated that there is reasonable cause and that the taxpayer acted in good faith. Regs. Sec. 1.6664-4 provides guidance on whether taxpayers acted with reasonable cause and in good faith. It requires assessing taxpayers’ efforts to determine the proper tax liability as well as their experience, knowledge, and education, and whether they relied on the advice of a professional tax adviser.
Seve n W. Enterprises, Inc.
In Seven W. Enterprises, Inc., 136 T.C. 539 (2011), the IRS assessed substantial underpayment penalties on two commonly controlled corporations that failed to self-assess the personal holding company tax. The Tax Court allowed a reasonable-cause exception to overcome the penalties for tax returns for one tax year, based on the corporations’ reliance on a CPA tax professional who prepared them as an independent consultant. The tax preparer incorrectly concluded that the personal holding company tax did not apply. However, for subsequent years in which the corporations employed the tax preparer as their vice president of tax and he prepared returns in a similar manner, the Tax Court denied the reasonable-cause/reliance defense and upheld the penalties. The court found that, as an employee, the tax preparer did not qualify as “a person, other than the taxpayer,” under Regs. Sec. 1.6664-4(c)(2). The court further found that the taxpayers failed to exercise ordinary business care and prudence with respect to the items at issue.
This case should put in-house tax professionals on alert that the advice they provide may not shield their employer from an accuracy-related penalty based on the reasonable-cause/reliance defense.
In Woodsum, 136 T.C. 585 (2011), the IRS assessed a substantial underpayment penalty on a private-equity managing director and his wife for omitting a $3.4 million gain upon the termination of a swap transaction. The taxpayers argued that they had given their CPA firm all of the 160-plus information returns received from payers, including the Form 1099-MISC, Miscellaneous Income, that reported the omitted gain. The Tax Court rejected the taxpayers’ argument that they had reasonable cause and had relied on the tax return preparer because the omission did not involve professional “advice” as defined in Regs. Sec. 1.6664-4(c)(2)—the item of income was apparently inadvertently overlooked by the preparer and there was no dispute that the income was taxable.
The court also cited Regs. Sec. 1.6664-4(b)(1), which states that, in evaluating whether reasonable cause exists, the extent of the taxpayers’ efforts to determine the proper tax liability is the most important factor. The court found that the taxpayers had not made an adequate effort to determine the proper tax liability because they did not establish that they had adequately reviewed the return that was prepared for them.
Tax preparers should be alert to the fact that, where their efforts are limited solely to tax preparation and data presentation and do not rise to the level of professional advice on a material item, such efforts may not shield clients from an accuracy-related penalty if their clients do not exercise due care in reviewing the tax preparer’s work product.
In McGowen, T.C. Memo. 2011-186, the IRS assessed a substantial underpayment penalty against a financial analyst who was awarded a settlement for workplace discrimination. The taxpayer argued that the payment she received was partly an award for personal physical injuries excludable under Sec. 104(a)(2). The court held against the taxpayer based on the facts, finding that the payment was for her emotional distress and not for any physical injury or sickness. However, the court granted a reprieve from the imposition of the penalty, noting that the taxpayer “lacked knowledge and experience in tax law, reasonably believed that a portion of her settlement payment was not taxable and in good faith did not report that portion of the settlement payment on her 2006 return.”
While this case could have gone either way, considering that the taxpayer was a financial analyst and at least somewhat sophisticated, the court viewed her efforts in assessing the proper income tax liability as sufficient, albeit inaccurate.
In Campbell, 658 F.3d 1255 (11th Cir. 2011), an employee of a government contractor received an $8.75 million whistleblower award from the government as a result of two lawsuits against his employer. The employee/taxpayer paid attorneys $3.5 million for their assistance in his case but, without seeking any professional tax advice, excluded the entire award from his taxable income. The taxpayer disclosed the award on a Form 8275, Disclosure Statement, attached to his return but cited no authority for his assertion that the award was not taxable income.
After holding that the entire award was taxable income, the Tax Court, later affirmed by the Eleventh Circuit, upheld a substantial underpayment penalty. The Eleventh Circuit reasoned that the taxpayer was “sophisticated” and chose not to consult a tax professional. Further, the court held that the taxpayer did not make the tax return disclosure with reasonable cause or in good faith. Rather, the omission of income was “an overt and intentional act to underpay,” the court said. The Form 8275 he included with his tax return was ineffective, since Regs. Sec. 1.6662-4(e)(2) states that disclosure will have no effect in reducing an understatement if the position, even if disclosed, does not have a reasonable basis.
In Fuhrman, T.C. Memo. 2011-236, the Tax Court upheld substantial underpayment penalties against a taxpayer whose single-member LLC truck-leasing company deducted management fees paid to the taxpayer’s wholly owned corporation. The LLC was invoiced a flat $9,000 per month in management fees from the related trucking company operator. The IRS disallowed a significant portion of the management fees due to a lack of a written contract between the two entities and a failure by the taxpayer to establish how the fees were determined. A noncontemporaneous analysis was presented by the taxpayer’s accountants during the examination. However, the court noted that the noncontemporaneous analysis differed from testimony “in notable respects.” In upholding the accuracy-related penalties, the court noted that the taxpayer neither established nor expressly alleged that he had reasonable cause or had acted in good faith.
The outcome of this case is not surprising, given the scrutiny applied to transactions between related parties. In this situation, the lack of reasonable care in sufficiently documenting the related-party transactions was fatal to the taxpayer’s defenses against both the disallowance of a significant portion of the deductions and the imposition of accuracy-related penalties.
A review of these cases is instructive for tax professionals to understand how the accuracy-related penalties are determined, but more important, to understand how the various defenses available to taxpayers are tested by the courts. In the event of a substantial understatement of income tax, and in the absence of substantial authority or the disclosure of a material tax return position or positions, the most important factor in whether accuracy-related penalties apply is whether the taxpayer put forth a sufficient effort to properly determine the tax liability.
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.