Taxpayer’s reliance on tax preparer who erred was reasonable and in good faith; penalties abated

Editor: Mark G. Cook, CPA, CGMA

Under Sec. 6662, taxpayers are potentially subject to a variety of accuracy-related penalties. Two of these are the penalties for negligence or disregard of rules and regulations or any substantial understatement of income tax (Secs. 6662(b)(1) and (2)). In the case of the penalty for negligence or disregard of the rules and regulations, “negligence” includes any failure by the taxpayer to make a reasonable attempt to comply with the laws, and “disregard” includes any careless, reckless, or intentional disregard (Sec. 6662(c)). In the case of the penalty on substantial understatements of income tax, the understatement is “substantial” for an individual taxpayer if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return for the tax year (Sec. 6662(d)).

However, these penalties will not apply if the taxpayer had reasonable cause for the failure and acted in good faith (Sec. 6664(c)). One way the reasonable-cause and good-faith standard can be met and the application of the penalties avoided is to show that the taxpayer relied on a tax professional. In Whitsett, T.C. Memo. 2017-100, the Tax Court addressed how a taxpayer can show such reliance. In that case, the IRS determined Carolyn Whitsett was liable for an accuracy-related penalty because she reported income in the wrong year, but the Tax Court rejected the IRS’s claim because it found that she had reasonably relied on her tax preparer’s advice in determining which year to include the income.

Facts

Whitsett was a doctor specializing in blood transfusions. She and her husband purchased 4,000 shares of Immucor Inc. stock in 1982 for $11,000. After she and her husband separated in 1998, all the shares of Immucor stock were transferred to her, based on the terms of their divorce settlement.

In the year 2011, TPG Capital offered to buy all the shares of Immucor stock from Whitsett for $1,717,038. She notified her longtime tax return preparer, Joe Whittemore, that she intended to accept the offer from TPG Capital. In fact, she accepted the offer on Dec. 21, 2011, and submitted the required stock redemption form. During January 2012, TPG Capital’s agent, Computershare Trust Co., issued a check, dated Jan. 4, 2012, for $1,717,038. In the check payment package there was a document captioned “Corporate Action Advice” that showed the “payment date” as Aug. 19, 2011, and the “tax year” as 2012.

After discussing the issue with Whitsett and reviewing the documents she provided, Whittemore, the tax preparer, decided to report the gain on the sale of the Immucor stock in 2011. Whittemore determined the net long-term capital gain was $1,077,601, which he obtained by subtracting from the sale proceeds the original cost basis of $11,000 and the reinvested dividends of $628,437.

Whittemore needed additional time to prepare Whitsett’s 2011 return and prepared an extension request, which he provided to her. The extension request showed an estimated balance due of $154,776. The extension request was filed, and the IRS processed it as of April 11, 2012. Whitsett sent a check for the balance due to the IRS in May 2012. The IRS applied this payment to her account for 2011.

Although Whitsett had completed a 2011 tax organizer for Whittemore and submitted it along with all the requested documents to him, Whittemore did not file her 2011 tax return by the extended due date, Oct. 15, 2012, and, in fact, never filed her 2011 return. The IRS has no record of ever receiving that return. He completed the 2011 tax return during February 2013, and Whitsett paid the 2011 balance due of $5,393 on March 4, 2013.

Unaware that her 2011 return had not been filed, Whitsett retained Whittemore to prepare her 2012 return, which also was extended. On Oct. 7, 2013, Whitsett completed the 2012 tax organizer and provided all the supporting documents including a Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, from Computershare. The Computershare Form 1099-B indicated the Immucor stock was sold on Jan. 4, 2012, for $1,717,038. After reviewing all the documents, Whittemore determined that no capital gain attributable to the Immucor stock sale needed to be reported on Whitsett’s 2012 return because he had already reported it on her 2011 return. He filed her 2012 return late on Nov. 4, 2013.

On Dec. 9, 2013, Whitsett received an IRS notice CP80 stating her 2011 account had a credit of $165,562 but that no 2011 return had been filed. She promptly sent the IRS a letter expressing her understanding that Whittemore had filed her 2011 return electronically. She enclosed with this letter a copy of the 2011 return that he had provided to her and a letter Whittemore had sent her with the copy of her return stating that he had filed it electronically.

On Oct. 27, 2014, the IRS sent Whitsett a CP2000 notice for her 2012 tax year stating she had a balance due of $680,086. Immediately, she contacted Whittemore again to discuss those IRS notices. Whittemore informed her by email that the 2011 return and 2012 return needed to be amended, but he did not file the amended returns.

After receiving no response to the CP2000 notice, the IRS issued Whitsett a notice of deficiency for 2012 of $541,552 and an accuracy-related penalty under Sec. 6662(a) of $107,995, attributable chiefly to the unreported proceeds from the Immucor stock sale.

At this point, realizing that something had gone seriously wrong, Whitsett sought new assistance and hired a tax lawyer to represent her. The lawyer prepared and filed a correct 2011 return that did not include the proceeds from the Immucor sale and requested a refund of $174,359, which was designated to be applied to Whitsett’s 2012 liability.

In addition, Whitsett filed a petition in Tax Court challenging the IRS’s deficiency determination. Before trial, Whitsett and the IRS agreed that a reduced amount of tax was due for 2012, leaving the question of whether a penalty was due on the reduced deficiency amount as the only issue before the Tax Court.

Avoiding penalties: Reliance on tax professional’s advice

The Tax Court held that Whitsett was not liable for an accuracy-related penalty under Sec. 6651(b)(1) or (b)(2) because she acted with reasonable cause and in good faith in failing to report the proceeds from the stock sale on her 2012 return. The Tax Court found that she met this standard because she relied on the advice of a tax professional regarding the treatment of the stock sale.

The Tax Court has created a three-prong test to determine whether a taxpayer relied in good faith on the advice of a tax professional. The three elements the taxpayer must show are: (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(Neonatology Assocs., P.C., 115 T.C. 43, 99 (2000)).

The adviser is considered a competent professional based on whether he or she has the requisite experience and knowledge regarding the relevant tax law. The court observed that Whittemore was considered a competent professional, with more than 25 years of tax return preparation experience, during which he prepared about 100 to 125 tax returns each year, mostly for doctors and dentists. Also, although Whittemore made some mistakes during the process of filing Whitsett’s returns, because Whitsett was completely unaware of his errors, the court found that these errors could not be used to retroactively demonstrate Whittemore’s lack of competence. Therefore, the court concluded that she had demonstrated she relied on the tax adviser as a competent professional.

Regarding the second element of the test, the Tax Court found that Whitsett did provide all the available information on time and accurately to Whittemore. The court pointed out that she communicated clearly and extensively with Whittemore about all the facts and correspondence, including the Computershare Form 1099-B and IRS notices over the entire period. Accordingly, Whittemore made his decision on when to report the stock sale after reviewing all the sufficient tax supporting documents, and Whitsett could not be blamed for this erroneous decision.

Last, to determine whether the final element of the test is met, the court determines the taxpayer’s good faith by looking at all of the facts and circumstances, including the taxpayer’s experience, knowledge, and education. The Tax Court noted that Whitsett was a medical doctor and had no training in tax return preparation. Whittemore had been her tax preparer for many years, and none of the prior returns had been subject to a serious IRS challenge. Furthermore, the court found that she “indisputably” relied on Whittemore’s advice about the stock sale reporting, which was reasonable, given the confusing documentation regarding it. Furthermore, she willingly accepted Whittmore’s advice to report the sale in 2011 rather than 2012, even though this was against her economic interest. Consequently, the court determined that Whitsett actually relied in good faith on the adviser’s judgment.

Conclusion

As Whitsett shows, a taxpayer can establish the reasonable-cause and good-faith requirement if he or she reasonably relied on the advice of a tax adviser to file the return. Thus, when a client is facing accuracy-related penalties, practitioners should consider whether the facts in the client’s case support relief from the penalties on this basis.

EditorNotes

Mark G. Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.