Avoiding an accuracy-related penalty through the reasonable-cause exception

By William A. Bailey, CPA, J.D., LL.M., and Ryan H. Pace, J.D., LL.M.

PHOTO BY MIGUELLPINK/ISTOCK
PHOTO BY MIGUELLPINK/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • Whether a taxpayer is subject to an accuracy-related penalty due to an understatement of tax is the most-litigated tax issue in recent years. Although the IRS wins a large majority of cases on this issue, some taxpayers avoid an accuracy-related penalty by arguing they are entitled to the Sec. 6664(c)(1) reasonable-cause exception to the penalty.
  • Whether the exception applies is a facts-and-circumstances question. Courts typically consider a number of common factors to determine whether the exception applies, the most important of which is the extent of the taxpayer's effort to determine the proper tax liability.
  • To determine if relying on professional advice establishes that the taxpayer acted with reasonable cause, courts generally apply a three-part test that looks at whether the person providing the advice is competent to do so, the taxpayer provided the person all the required information, and the taxpayer relied on the advice.
  • A taxpayer may be better positioned to argue the reasonable-cause exception by taking certain steps before filing the tax return.

According to the national taxpayer advocate's annual reports to Congress, the most-litigated tax issue between the IRS and taxpayers over the past several years has been the application of the accuracy-related penalty imposed by Sec. 6662.1 In fact, according to the national taxpayer advocate, federal courts have issued opinions involving the penalty in more than 260 cases between June 2015 and May 2017.2

The Code imposes penalties on taxpayers, of course, to encourage voluntary compliance with tax laws. A taxpayer may avoid the accuracy-related penalty, however, if the taxpayer has "reasonable cause" for a tax underpayment.3 This article briefly sets out the law relating to the imposition of accuracy-related penalties and the meaning of reasonable cause, but it primarily discusses the most common factors in recent cases where taxpayers argued the reasonable-cause exception. It also suggests actions a taxpayer and tax adviser can take to best position the taxpayer to avoid the accuracy-related penalty by meeting the reasonable-cause exception.

Imposition of the penalty

Sec. 6662(a) states:

If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies.

The accuracy-related penalty applies to:

  • Negligence or disregard of rules or regulations;
  • Any substantial understatement of income tax;
  • Any substantial valuation misstatement;
  • Any substantial overstatement of pension liabilities;
  • Any substantial estate or gift tax valuation understatement;
  • Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance;
  • Any undisclosed foreign financial asset understatement; or
  • Any inconsistent estate basis.4

Reasonable-cause exception

Notwithstanding the breadth of situations where the penalty may apply, Sec. 6664(c)(1) provides an exception:

No penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.5

As with many areas of the law, the applicability of the exception depends on the facts and circumstances of each case.6 Of particular importance, of course, is the definition of "reasonable cause." The Treasury regulations provide assistance in this regard.

Defining 'reasonable cause'

According to Regs. Sec. 1.6664-4, "the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Other factors the regulations state may be taken into account include:

  • Reasonable misunderstanding of fact or law;
  • Experience, knowledge, and education of the taxpayer;
  • Isolated computational or transcriptional error;
  • Reliance on an information return;
  • Reliance on advice of a professional tax adviser or appraiser; and
  • Reliance on erroneous information.

While reliance on an information return, a tax adviser, or information that (unbeknownst to the taxpayer) is incorrect does not necessarily indicate reasonable cause and good faith, the regulations state that such reliance can constitute reasonable cause and good faith where the reliance was reasonable and the taxpayer acted in good faith.7

Burden of proof

The Code imposes the burden of production on the IRS that a penalty is warranted.8 The IRS generally continues to have the burden of proof with respect to factual issues, but only if the taxpayer provides credible evidence, properly substantiates items, has maintained records, and cooperates with reasonable IRS requests.9

Illustrative recent court cases and taxpayer arguments

Because the accuracy-related penalty continues to be highly litigated, a survey of recent court cases yields a useful overview of the factors most likely to determine taxpayer success or failure in sustaining a reasonable-cause defense.

The Taxpayer Advocate Service notes in its most recent report that the IRS prevails in roughly 80% of accuracy-related penalty cases.10 Taxpayers appeared without representation in about 60% of cases and had a slightly lower success rate than taxpayers who were represented in court. Taxpayers who claimed they relied on a tax professional as part of their reasonable-cause and good-faith defense prevailed in over 30% of litigated cases, a noticeably higher success rate than taxpayers who did not rely on a tax professional for a tax return position.

The reasonable-cause defense is a facts-and-circumstances test, which necessarily involves a comparison of the taxpayer's conduct with that of other similarly situated taxpayers.11 The courts look at multiple factors in sustaining reasonable cause.12 In agreement with the regulations, courts note that "the most important factor . . . is the extent of the taxpayer's effort to assess his or her proper tax liability."13 Courts also consider the following reasonable-cause factors (some court factors align squarely with Treasury regulation factors, while others supplement the regulations):

  • Experience, knowledge, and education of the taxpayer;
  • Complexity of the law — degree to which the tax law at issue is settled, clear, and unambiguous;
  • Whether the case is a novel issue or of first impression to the courts;
  • Whether there was nonreceipt of an information return or reliance on a third party;
  • Keeping adequate records;
  • Taxpayer credibility; and
  • Reliance on the advice of a tax adviser.

Taxpayers who assert that they relied on the advice of a tax adviser have a noticeably higher rate of success in showing reasonable cause.14 The courts generally use a separate analysis developed by the Tax Court to determine whether a taxpayer properly relied on a tax adviser's advice to establish reasonable cause. The taxpayer must demonstrate:

  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.15

Each of these reasonable-cause factors is analyzed below. However, it should be borne in mind that while these factors may indicate reasonable cause and good faith on the part of the taxpayer, the most important factor is the extent of the taxpayer's efforts to assess his or her proper tax liability.

Taxpayer's experience, knowledge, and education

Both court cases and the regulations find taxpayers' tax experience, knowledge, and education relevant in determining reasonable cause. While limited experience, knowledge, and education is often favorable to a taxpayer in a reasonable-cause and good-faith defense, professors John Cook and Alan Ocheltree note such limitations can be a double-edged sword: "[I]f taxpayers are relatively unsophisticated and inexperienced, they are generally held to a lower standard. But such lack of sophistication could also support a conclusion that the taxpayer's failure to consult a tax adviser was itself negligent. On the other hand, relatively sophisticated and experienced taxpayers are routinely held to a higher standard by courts."16

Complexity of the law

Several recent cases illustrate the interplay of taxpayer sophistication and complexity of the tax law at issue. If the law is complex, even relatively sophisticated taxpayers may be able to show reasonable cause; if, however, the law is well-settled, clear, and unambiguous, even relatively unsophisticated taxpayers will have difficulty showing reasonable cause.

The taxpayers in Simonsen17 prevailed in their reasonable-cause defense, due largely to the complexity of the law at issue, even though they were considered well-educated. In this case, the taxpayers engaged in a short sale of their previous residence so that their house was sold for less than their mortgage debt owed, and the bank forgave their excess debt. The taxpayers attempted to take the position that the sale and the bank's forgiveness of excess nonrecourse mortgage debt were separate transactions; they therefore claimed both a substantial deductible loss from the sale on the one hand and excludable COI (cancellation of indebtedness) income under Sec. 108(a)(1)(E) on the other.

The court walked through multiple steps of analysis and definitions to show the sale and debt forgiveness were part of the same transaction, which would effectively increase the amount realized on the sale by the amount of debt forgiveness and wipe out the deductible loss. In ruling on the accuracy-related penalty, the Tax Court addressed the interplay of taxpayer sophistication with the complexity of the tax law at issue:

We see nothing but reasonable cause and good faith here. The Simonsens are well educated — Christina (who prepared the return) is an attorney — but neither of them is a tax professional. Even to such intelligent people the information returns reasonably indicated that they should report their COI income separately from the sale. . . . As she'd done for almost a decade, Christina took to TurboTax. . . . The IRS hadn't issued regulations for section 108(a)(1)(E), and caselaw is scarce. . . . To make matters muddier, the IRS Instructions . . . and IRS Publications . . . are consistent with the Simonsens' view.18 . . . [I]f that weren't enough, the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers — so much so that we ourselves had to reason by analogy . . . and consider [a] puzzle . . . to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance.19

Thus, where the law is sufficiently complex or scarce or IRS guidance is misleading, a taxpayer is more likely to show reasonable cause.

Unlike the complexity of the law at issue in Simonsen, the Galloway20 case illustrates the impact of settled, unambiguous law as detrimental to a reasonable-cause defense. The taxpayers evidently attempted to take American opportunity tax credits for a fifth year, although the statute and rules clearly cap the credit at four years. Although the taxpayers claimed they were confused and made a "mistake" when they attempted to follow a program's instructions to self-prepare their returns, the court did not find reasonable cause:

In assessing the reasonableness of a taxpayer's misunderstanding of the law for the purpose of applying the reasonable cause exception to the accuracy-related penalty, we have placed significant weight on the degree of clarity of the applicable law. For example, we have accepted taxpayers' reasonable cause defenses when the relevant law was uncertain or ambiguous. . . . [Precedent, however,] stands for the proposition that a misunderstanding of settled, unambiguous law cannot be "honest" or "reasonable" within the meaning of section 1.6664-4(b)(1), Income Tax Regs.21 [Emphasis added.]

The court in Galloway therefore concluded that since "confusion" by the taxpayers could not have been attributed to uncertainty or ambiguity in the relevant law, their reasonable-cause defense failed, and the accuracy penalty was sustained.

Question of first impression

Just as a high degree of complexity of the law at issue favors taxpayers in a reasonable-cause defense, questions of first impression to the court are likewise a favorable factor to taxpayers. In Avrahami,22 a case dealing with a microcaptive transaction (a type of insurance structure under IRS scrutiny), the court observed: "This is a case of first impression — we have discovered no other case addressing microcaptives and the interplay among sections 162, 831(b), and 953(d). And we have previously declined to impose accuracy-related penalties when there is no clear authority to guide taxpayers" (emphasis added).23 Similarly, in Petersen,24 the court found "[t]he application of section 267(a) to employers and ESOP participants is a question of first impression. . . . We have previously declined to impose a penalty 'where it appeared that the issue was one not previously considered by the Court and the statutory language was not entirely clear' " (emphasis added).25

Issues of first impression are not always decisive, however — the taxpayer's first-impression case must actually be controversial to a degree. In Curtis Investment Co., LLC,26 the court observed an additional consideration in cases of first impression:

This Court has previously found that a taxpayer acted with reasonable cause and good faith when a deficiency is the result of an issue of first impression and the taxpayer's position is reasonably debatable. . . . [R]egardless of whether the legal issue is novel, the Court considers all of the facts and circumstances in determining whether a taxpayer acted with reasonable cause and in good faith. . . . [Here,] petitioners' position is not reasonably debatable.27 ­[Emphasis added.]

Because the taxpayers' position was not reasonably debatable, the court did not find reasonable cause.

Nonreceipt of information return

Generally, the fact that a taxpayer did not receive an information return, e.g., Form 1099, Schedule K-1, etc., does not by itself give rise to a reasonable-cause defense under Sec. 6662. Reasonable cause may be shown, however, when the taxpayer both did not receive an information return and (1) had no reason to know that he or she received taxable income, or (2) the taxpayer's liability was caused by a third party's failure to act.28

In McGuire,29 the taxpayers received from a state marketplace under the Patient Protection and Affordable Care Act advance premium tax credits that were paid to an insurance company. The taxpayers' income increased during the year, requiring them to pay back the advance premium tax credit (treating the amount owed as a tax liability). Although the taxpayers informed their state marketplace of the increase in their income, the marketplace did not adjust the advance premiums tax credit paid. The court found that the taxpayers never received Form 1095-A, Health Insurance Marketplace Statement, that would have instructed them they had excess advance premium tax credit leading to a deficiency. The court ruled that because the taxpayers did not receive their information return, did not have notice of the income because payments were received by the insurance company and not the taxpayers, and had reasonably relied on a third party (the marketplace) to adjust their eligibility for the tax credit, the taxpayers showed reasonable cause, and the accuracy-related penalty was not sustained.

Keeping adequate records

A review of recent years' cases addressing the accuracy-related penalty reveals that likely the most common weakness in taxpayers' reasonable-cause defense is a failure to keep adequate records. It is difficult for the court to find reasonable cause when the taxpayer does not do his or her part in keeping adequate documentation.

Taxpayer failures in this area include not keeping books or adequate records for a business,30 not keeping adequate records to compute beginning and ending inventories (for the calculation of cost of goods sold),31 failing to maintain books and records sufficient to calculate basis related to partnership distributions,32 and, perhaps most common, ignoring substantiation and documentation requirements of business expenses.33 Throwing records together before trial is obviously frowned on, as indicated by the court in Simonelli: "What few records [the taxpayers] did provide were cobbled together shortly before trial and lacked credibility."34 A taxpayer's assertion of a reasonable-cause and good-faith defense is more likely to succeed if the taxpayer maintained adequate business and tax records, especially before the tax return was filed.

Taxpayer credibility

In addition to other factors, the courts obviously value taxpayer credibility. Taxpayers taking opportunistic or "too good to be true" positions injure their reasonable-cause defense. Inconsistent and unverifiable testimony is also a problem. In Turan,35 the taxpayer did not report his stock sales but argued that his failure was due to an error in his broker's website that impeded him from making a FIFO/LIFO (first in, first out, or last in, first out) election for calculating his basis in the stock sold. The court found the taxpayer's testimony to be "not credible, uncorroborated, and controverted by the record," while noting that the taxpayer's understatement arose from his failure to report a year's worth of stock sales — not from a dispute over proper basis determination. The reasonable-cause defense failed, and the accuracy penalty was sustained.

In Ohde,36 the court denied a reasonable-cause defense, finding the taxpayers' assertion that they donated more than 20,000 items to Goodwill in a single year to be "implausible on its face" and "unsupported by any credible testimony or other reliable evidence," particularly since the taxpayers kept no contemporaneous records establishing the values or number of items donated.

Additionally, in Ankerberg,37 the court, in sustaining both accuracy-related and fraud penalties, found that the evidence in the case established that a CPA tax professional had a pattern of unreported income and overstated deductions. The taxpayer argued he had reasonable cause. The court rejected this argument, finding that the taxpayer's lack of credibility rose to the level of a "badge" of fraud because he asserted that his "mistakes" on his returns were attributable to his medical problems — particularly those affecting his eyesight — even though, during the years at issue, he continued to prepare scores of tax returns for clients and his own returns without seeking assistance and continued to drive a car.

Relying on a tax adviser

Regs. Sec. 1.6664-4(b)(1) states that relying on professional advice may ­establish reasonable cause if the reliance was reasonable and the taxpayer acted in good faith. To interpret the regulation, courts broadly rely on a test applied in Neonatology Assocs., P.A.,38 which requires a taxpayer to prove three elements to show that reliance on advice was reasonable: "(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."39 Since the taxpayer has the burden to prove each of these elements to signal reasonable cause, cases involving these elements are discussed further.

Competent adviser: The "competent adviser" prong of the tax-adviser-reliance factor requires that the adviser be competent, not necessarily an expert in the area of tax law on which he or she is giving advice — the adviser needs only "sufficient expertise to justify reliance."40 In Grecian Magnesite Mining,41 a Greek mining corporation decided to redeem a partnership interest it held in a U.S. mining partnership. The corporation failed to report its gain on the redemption, and the IRS asserted the accuracy penalty. The IRS argued that the taxpayer acted unreasonably because it failed to hire an expert who specialized in international tax law or an attorney with an LL.M. degree in taxation. However, the court reasoned that the tax return preparer — a licensed attorney and CPA with 40 years of tax preparation experience, including partnership returns — had sufficient credentials to justify the taxpayer's reliance. Reasonable cause was met, and the accuracy penalty was not sustained.

Reasonable cause is not found where the tax adviser is a promoter or otherwise has a conflict of interest regarding the tax position, since reliance on an adviser with a conflict of interest is not deemed reasonable. A promoter is an adviser who participates in structuring the transaction or is otherwise related to, has an interest in, or profits from the transaction.42

Information properly furnishedThe second prong of the tax-adviser-reliance factor in a reasonable-cause defense is that the taxpayer must provide necessary and accurate information to the adviser.43

In Smiling,44 the taxpayers' argument that they reasonably relied on their tax professional failed in part because there was no credible evidence the taxpayers provided receipts, promissory notes, or other information substantiating a disallowed business expense. However, the same taxpayers succeeded in showing reasonable cause for the portion of their tax return for which the taxpayers' accountant was provided canceled checks for claimed legal and professional expenses. Again, documentation is a critical foundation to a reasonable-cause defense.

Actual reliance on adviser's judgment: The third prong of the factor to show reasonable adviser reliance requires the taxpayer to actually rely on the advice provided by an adviser but not on advice that raises too many "red flags" or is "too good to be true." If proper reliance is made, the reasonable-cause defense does not require taxpayers to challenge their adviser's advice or independently investigate its propriety; nor are taxpayers required to monitor the extent or sufficiency of their adviser's research on complicated tax issues.45 The reasonableness of any reliance depends on the quality and objectivity of the advice. Furthermore, the focus of the reasonable-cause defense is on the taxpayer's knowledge, not the adviser's knowledge.46

In Burke,47 the taxpayer attempted to take bad debt deductions for advances made to start a scuba diving business. The court determined the advances were not bona fide debt but capital contributions. In addressing the taxpayer's tax-adviser-reliance defense to the accuracy penalty, the court deemed the taxpayer's attorneys to have been competent and all documentation to have been properly provided. But the court took issue with the lawyers' recharacterizing the taxpayer's advances as loans after they had already been made and their "last-minute papering" to make it seem as if the advances were loans. The court reasoned there "were just too many red flags that a sophisticated businessman should have noticed,"48 and did not find reasonable cause.

In contrast, the court in Tucker49found that the taxpayer, the CEO of a large asset-management and financial-planning company, reasonably relied on his adviser, a Big Four accounting firm, for a disallowed tax strategy. The taxpayer did not initiate contemplation of the tax strategy, thought that the transaction was part of his adviser's services to keep the taxpayer in compliance with the tax law, consistently represented to his accounting firm adviser that he did not want to engage in a transaction that would subject him to IRS scrutiny or put his own reputation or career at risk, and did not believe the transaction would be abusive. The court found reasonable cause and did not sustain the accuracy penalty, noting that "[t]o find otherwise would require taxpayers to challenge their attorneys, seek second opinions, or try to independently monitor their advisers on the complex provisions of the Code."50 The reconciliation of Tucker and Burke on their faces is difficult — both taxpayers were sophisticated businessmen with different results — but Tucker's proactive effort to inform his adviser of his desire to avoid IRS scrutiny and protect his reputation likely played a part.

Other reliance considerations: Insufficient to rely on tax return preparation only: The courts find that relying on the actual judgment of a tax adviser means that the tax professional must have done more than merely prepare the tax return. Advice is defined as a communication that reflects the adviser's analysis or conclusion.51

In Russian Recovery Fund Ltd.,52 the court noted that there were no backup memos or records of conversations concerning the tax position taken:

We are simply asked to accept that, by signing off on the returns [the accounting firm] was giving its considered advice on whether it was appropriate to take the loss deduction. . . . However, tax returns are insufficient to demonstrate reliance on professional tax preparer advice for the reasonable cause exception.53

Furthermore, in Mileham,54 the court noted, "We have held that a taxpayer cannot escape a section 6662(a) accuracy-related penalty merely by providing raw numbers to a tax professional to prepare a return."55 The lesson evident in these cases is that taxpayers and their advisers should take extra effort in documenting tax advice given and received concerning the tax return, beyond its mere preparation.

No defense made

Aside from the lack of adequate documentation, perhaps the next-largest failure in the reasonable-cause defense is failing to provide any evidence to support a reasonable-cause finding. In case after case, taxpayers inexplicably do nothing to argue why reasonable cause applies to their case to avoid the accuracy-related penalty:

  • "At trial, petitioner presented no evidence, and made no argument, as to why he should not be liable . . . for the accuracy-related penalty";56
  • "In defense to the section 6662(a) penalty, [the taxpayers] rely only on their proving, which they have not, that there is no deficiency";57
  • "Petitioner did not address the accuracy-related penalty either in his pretrial memorandum or at trial";58 and
  • "Petitioners set forth no specific facts to show that the penalties should not apply."59

A lesson from these cases is that if the taxpayer is to raise the reasonable-cause defense, the taxpayer must actually provide facts and prepare arguments for that defense.

Defenses other than reasonable cause and good faith

It should be noted that in addition to the reasonable-cause defense involving the above factors, taxpayers can alternatively argue two other defenses to avoid the accuracy-related penalty: a substantial-authority defense and procedural defenses. The substantial-authority defense requires authority substantiating the taxpayer's position in the form of Code sections, regulations, revenue rulings and procedures, court cases, and certain other sources that are treated in the regulations as having authority.60 A review of recent cases shows that a substantial-authority argument typically is generally more difficult to prove than a reasonable-cause argument, and so it is not argued as often. That being said, if a substantial-authority defense applies in a taxpayer's case, it should be argued in concert with a reasonable-cause defense.

Additionally, a notable procedural defense that has gained traction over the past year is the Second Circuit's interpretation that the IRS needs to show the court that the accuracy-related penalty was approved in writing by the IRS examiner's immediate supervisor no later than the date the Service issued the notice of deficiency (or files an answer or amended answer) asserting the penalty, as required by Sec. 6751(b)(1).61 The IRS generally — but not always — has met this procedural burden. Where the IRS fails to meet its procedural burdens, the taxpayer can avoid the accuracy-related penalty.

Building a defense

The accuracy-related penalty and the applicability of the reasonable-cause exception may likely continue to be the most-litigated issue each year. Depending upon the facts and circumstances, a taxpayer may wish to prepare for the potential imposition of an accuracy-related penalty by building the best arguments possible in advance of filing the return. Then, if the return position is later challenged, the taxpayer will not have the task of going back to gather facts supporting a reasonable-cause argument.

Key preparations include keeping adequate records and documentation both to record any written or verbal professional advice and to substantiate all material underlying transactions. Where information returns appear to be missing or are inaccurate, the taxpayer should be proactive in reconciling the records. Taxpayers clearly insulate themselves to a greater degree by relying on the advice of a competent tax professional, as long as the taxpayer is providing necessary and accurate documentation and the taxpayer actually relies on the advice. Mere preparation of a tax return is insufficient to show reliance on a tax adviser's advice. Any substantial tax authority relied on for a tax position should be documented as well.

If assessed an accuracy-related penalty, a taxpayer can gauge the probability of a successful reasonable-cause defense by taking into account his or her sophistication, the complexity of the law, and whether the tax issue is of first impression to the courts, all while recognizing the court will prioritize the extent of the taxpayer's efforts in complying with the tax laws and, of course, the taxpayer's credibility. The taxpayer should be sure to actually make reasonable-cause arguments, understanding that the court needs facts and arguments favorable to the taxpayer under the law before it can sustain a reasonable-cause defense.

By reviewing the taxpayer successes and failures in recent court cases as summarized in this article, a tax adviser will have a head start helping a taxpayer avoid the accuracy-related penalty.   

Footnotes

1Taxpayer Advocate Service, 2017 Annual Report to Congress, Volume 1, pp. 378, 515-22 (January 2018).

2Taxpayer Advocate Service, 2017 Annual Report to Congress, Volume 1, Appendix 3, Table 1, pp. 515-22 (January 2018); and 2016 Annual Report to Congress, Volume 1, Appendix 2, Table 1, pp. 555-61 (January 2017).

3Sec. 6664(c)(1). As the Supreme Court has recognized, "the [tax] law is complicated, accounting treatment of various items raises problems of great complexity, and innocent errors are numerous. . . . It is not the purpose of the law to penalize frank difference of opinion or innocent errors made despite the exercise of reasonable care" (Spies, 317 U.S. 492, 496 (1943)).

4Sec. 6662(b).

5The Treasury regulations combine the reasonable-cause defense with good faith; i.e., taxpayers must show "reasonable cause and good faith." "Reasonable cause" is an objective standard (Was the taxpayer's conduct objectively reasonable compared with that of other similarly situated taxpayers?), while "good faith" is a subjective standard (Was the taxpayer honest in purpose?). Professors John Cook and Alan Ocheltree note, "It should be borne in mind that these are two distinct requirements, although the IRS and the courts often appear to treat the two concepts as one" (Cook and Ocheltree, "The Accuracy-Related Penalty (Part II)," 41 The Tax Adviser 338, 339—40 (May 2010)). Because most cases devolve to an analysis of an objective standard of reasonableness, this article focuses on reasonable cause.

6Regs. Sec. 1.6664-4(b)(1).

7Regs. Sec. 1.6664-4(b).

8Sec. 7491(c).

9Sec. 7491(a)(2).

10Taxpayer Advocate Service, 2017 Annual Report to Congress, Volume 1, p. 371 (January 2018).

11Cook and Ocheltree, "The Accuracy-Related Penalty (Part I)," 41 The Tax Adviser 248 (April 2010).

12Some cases note that the reasonable-cause and good-faith defense is a "narrow defense" to the accuracy-related penalty. See Russian Recovery Fund Ltd., 851 F.3d 1253 (Fed. Cir. 2017), quoting Stobie Creek Invs. LLC, 608 F.3d 1366, 1381 (Fed. Cir. 2010).

13See, e.g., Alterman,T.C. Memo. 2018-83 at *42. In Alterman, medical marijuana business owners failed to ask whether businesses that sell marijuana or violate federal drug trafficking laws are taxed differently from other types of businesses. The court ruled that such a basic lack of inquiry by the taxpayers showed such a weak effort to assess proper tax liability that their reasonable-cause defense failed, and the court upheld an accuracy-related penalty.

14The Seventh Circuit in Hexum, 721 Fed. Appx. 512 (7th Cir. 2018), stated, with regard to the reasonable-cause and good-faith defense, that, "[g]enerally a taxpayer seeking to apply this exception must have obtained an opinion from an accountant or lawyer." But see, e.g., Davidson, T.C. Memo. 2018-38 at *14 ("Reliance upon the advice of a tax professional . . . does not serve as an 'absolute defense'; it is merely 'a factor to be considered'" (citing Freytag, 89 T.C. 849, 888 (1987), aff'd, 904 F.2d 1011 (5th Cir. 1990), aff'd, 501 U.S. 868 (1991))).

15Neonatology Assocs., P.A., 115 T.C. 43, 99 (2000), aff'd, 299 F.3d 221 (3d Cir. 2002).

16Cook and Ocheltree, "The Accuracy-Related Penalty (Part I)," 41 The Tax Adviser 248, 250 (April 2010). Thus, a Goldilocks problem presents itself — a taxpayer's acquaintance with tax law imposes a high standard of conduct, but too much ignorance suggests the taxpayer failed to reasonably seek help; thus, the courts appear to reward just the right amount of understandable ignorance as a favorable factor in a taxpayer's reasonable-cause and good-faith defense.

17Simonsen, 150 T.C. No. 8 (2018).

18A clear reminder that IRS instructions are not tax law and cannot be relied on.

19Simonsen, slip op. at 27-29.

20Galloway, 149 T.C. No. 19 (2017). When assessing the factor of complexity of the law in reasonable-cause cases, courts have found the areas of alimony and certain expense capitalization rules to be complex (see, respectively, Davidson,T.C. Memo. 2018-38, and Wells, T.C. Memo. 2018-11), while the moving expense deduction rules were not deemed complex (see Benjamin,T.C. Memo. 2018-70).

21Galloway, slip op. at 25, citing Remy, T.C. Memo. 1997-72.

22Avrahami, 149 T.C. No. 7 (2017).

23Id., slip op. at 103, citing Petersen, 148 T.C. No. 22, slip op. at 29 (2017); Williams, 123 T.C. 144, 153 (2004); and Hitchins, 103 T.C. 711, 719-20 (1994).

24Petersen, 148 T.C. No. 22 (2017), citing Hitchins, 103 T.C. 711, 719-20 (1994).

25Petersen, 148 T.C. No. 22, slip op. at 29, quoting Hitchins, 103 T.C. 711, 719-20 (1994).

26Curtis Investment Co., LLC, T.C. Memo. 2017-150.

27Id., T.C. Memo. 2017-150 at *39, citing Williams, 123 T.C. 144, 153-54 (2004).

28See, e.g., McGuire,149 T.C. No. 9 (2017); Frias, T.C. Memo. 2017-139.

29McGuire, 149 T.C. No. 9 (2017).

30Vallejo, T.C. Memo. 2018-39.

31Alterman, T.C. Memo. 2018-83.

32Sarvak, T.C. Memo. 2018-68.

33Wax, T.C. Memo. 2018-63; Velez, T.C. Memo. 2018-46; Huzella, T.C. Memo. 2017-210; Pokawa, T.C. Memo. 2017-186; Busch, T.C. Memo. 2017-169; and Knowles, T.C. Memo. 2017-152. Cai, however, is perhaps an exception to the rule. Although the taxpayer failed to satisfy a heightened substantiation requirement of documentation, the court found that, on balance, reasonable cause was shown through the taxpayer's lack of a tax background and reliance on his tax return preparer and that the reliance was justified, as shown by the professional quality and completeness of the taxpayer's returns (Cai, T.C. Memo. 2018-52).

34Simonelli, T.C. Memo. 2017-188.

35Turan, T.C. Memo. 2017-141.

36Ohde, T.C. Memo. 2017-137.

37Ankerberg, T.C. Memo. 2018-1.

38Neonatology Assocs., P.A., 115 T.C. 43 (2000).

39Id.at 99.

40Id.

41Grecian Magnesite Mining, Industrial & Shipping Co., S.A., 149 T.C. No. 3 (2017).

42See Avrahami, 149 T.C. No. 7 (2017), citing 106 Ltd., 136 T.C. 67, 79 (2011), in turn citing Tigers Eye Trading, LLC, T.C. Memo. 2009-121. See also Tucker, T.C. Memo. 2017-183 at *79: "An adviser is not a promoter when he has a long-term and continual relationship with the client-taxpayer, does not give unsolicited advice regarding the tax shelter, advises the client only within his field of expertise and not because of his regular involvement in the tax shelter transactions, follows his regular course of conduct in rendering his advice, and has no stake in the transaction besides his regular hourly rate. . . . There is no bright-line test for determining whether an adviser is a promoter" (citing 106 Ltd., 136 T.C. at 80 (citing Countryside Ltd. P'ship, 132 T.C. 347, 352-55 (2009))).

43The Tax Court found in Lopez, T.C. Memo. 2017-171, that errors in information that the taxpayers provided to their return preparer that were attributable to the taxpayers' former accountants that would have not been readily apparent to them did not negate reasonable cause.

44Smiling, T.C. Memo. 2017-196.

45Full Circle Staffing, LLC, T.C. Memo. 2018-66, citing Streber, 138 F.3d 216, 219 (5th Cir. 1998), rev'g T.C. Memo. 1995-601, and Stanford, 152 F.3d 450 (5th Cir. 1998), aff'g in part, vacating in part 108 T.C. 344 (1997).

46Tucker, T.C. Memo. 2017-183, citing Southgate Master Fund, 659 F.3d 466, 494 (5th Cir. 2011).

47Burke, T.C. Memo. 2018-18 (accuracy-related penalty not sustained on procedural grounds).

48Id.

49Tucker, T.C. Memo. 2017-183.

50Id., T.C. Memo. 2017-183, at *86.

51Williams, T.C. Memo. 2018-48, citing Woodsum, 136 T.C. 585, 593 (2011).

52Russian Recovery Fund Ltd., 851 F.3d 1253 (Fed. Cir. 2017).

53Id., slip op. at 27, quoting Russian Recovery Fund Ltd., 122 Fed. Cl. 600, 623 (2015), and citing Richardson, 125 F.3d 551, 558 (7th Cir. 1997) (finding no reasonable cause where, "other than the fact that a tax preparer signed [the taxpayer's] returns, there [was] no evidence in the record that [the taxpayer] received any advice from professionals"). See also Neonatology Assocs., P.A., 115 T.C. 43, 100 (2000), aff'd, 299 F.3d 221 (3d Cir. 2002): "The mere fact that a certified public accountant has prepared a tax return does not mean that he or she has opined on any or all of the items reported therein."

54Mileham, T.C. Memo. 2017-168.

55Id., T.C. Memo. 2017-168 at *48, citing Minchem Int'l, Inc., T.C. Memo. 2015-56, at *58.

56Vallejo, T.C. Memo. 2018-39 at *9.

57Pourmirzaie,T.C. Memo. 2018-26 at *17.

58Logue, T.C. Memo. 2017-234 at *15.

59Barrett,T.C. Memo. 2017-195 at *17.

60Regs. Sec. 1.6662-4(d)(3)(iii).

61Graev, 149 T.C. No. 23 (2017); Chai, 851 F.3d 190 (2d Cir. 2017).

 

Contributors

William A. Bailey, CPA, J.D., LL.M., is an assistant professor of accounting at Bradley University in Peoria, Ill. Ryan H. Pace, J.D., LL.M., is a professor of taxation, director of the Master of Accounting and Master of Taxation programs, and director of the Center for Tax Education and Research at Weber State University in Ogden, Utah. For more information on this article, contact thetaxadviser@aicpa.org.

 

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