How one taxpayer argued and lost at Tax Court. Moral: you really have to take some responsibility for your taxes. Have you ever wondered if you could blame your tax preparer in order to avoid an IRS penalty of 20%? Come up with a new version of “The Dog Ate My Homework”, or “The Devil Made Me Do It”? If your tax return gets audited, and you “lose”, the IRS is very quick to impose its negligence penalty on top of back taxes, plus interest. The additional tax you owe is called a “deficiency” and the penalty is the “accuracy related penalty”, and is imposed at a flat 20% of the deficiency: if you owe $5,000 because you lost the audit, the penalty is $1,000.
“Hold on!” you may cry. “I gave all my stuff to the preparer. Just because he made errors should not be a reason to penalize me. I’ve got enough problems with coming up with the deficiency. I’m a victim here. Not fair. I’m going to Tax Court.” Which is precisely what a California woman did when faced with a penalty of $1,059.20. Not wanting to pay the big bucks for a tax lawyer, she represented herself [Pro Se] before the Tax Court [T.C. Memo 2009-278]. And she lost.
What happened? She asked her long time tax preparer to prepare her 2005 Form 1040. She gave the preparer financial documents, including a 2005 Form SSA-1099 Social Security Benefit Statement, indicating that she and her late husband had received $21,445 of Social Security benefits in 2005. She did not, however, provide the Preparer a 2005 Form 1099-DIV, Dividends and Distributions,indicating that she had received $216 of dividend income, or a Form 1099-INT, Interest Income, indicating that she had also received $24 of interest income.
Now, the Preparer, in the language of the Tax Court, “failed to consider or include” these three taxable items when he prepared the 2005 Form 1040: Social Security income $21,445, Dividends $216 and Interest $24. He forgot to put down the $21,445, and of course couldn’t put down the dividend and interest income, because he didn’t know about them. The Preparer did, nonetheless, give the Taxpayer a summary of the items which would be included on the tax return, but no copy of the return was provided to the Taxpayer until the return had been electronically filed, and the filing had been acknowledged by the IRS. (This is not considered to be acceptable practice by any tax preparer.)
The Taxpayer was well aware of the receipt of taxable Social Security Benefits in the 2002, 2003 and 2004 tax years. Nonetheless, she did not detect any errors in the summary of income items considered by the Preparer both in preparing the return, nor in the return itself when delivered after receipt of electronic filing.
The IRS, using its document matching programs, noticed the under-reported income and generated a letter calculating the deficiency of $5,296, and imposing the accuracy related penalty of $1,059.20. A straight calculation of 20% multiplied by $5,296. [IRC Sec. 6662(a)].
The legal framework is as follows:
The Internal Revenue Code, subsection (a) of section 6662 imposes an accuracy-related penalty of 20 percent of any underpayment that is attributable to causes specified in subsection (b).
Among the causes justifying the imposition of the penalty is
o any substantial understatement of income tax as defined in section 6662(d)
o a substantial understatement occurs where the amount of the understatement exceeds the greater of
–  10 percent of the tax required to be shown on the return for the taxable year, or
–  $5,000.
– In this case, the deficiency is $5,296 which is greater than $5,000 and fulfills the second condition.
Exceptions to the Penalty
The section 6662(a) penalty is not imposed if a taxpayer can demonstrate
o (1) reasonable cause for the underpayment and
o (2) that the taxpayer acted in good faith with respect to the underpayment. Sec. 6664(c)(1).
Regulations promulgated under section 6664(c) further provide that
o the determination of reasonable cause and good faith “is made on a case-by-case basis, taking into account all pertinent facts and circumstances.” Sec. 1.6664-4(b)(1), Income Tax Regs.
o Reliance on the advice of a tax professional may, but does not necessarily, establish reasonable cause and good faith for the purpose of avoiding a section 6662(a) penalty.
Based upon the this, the Taxpayer, of course, tried to fit her case into the Exceptions noted above by pleading special facts and circumstances, as well as reliance on the advice of her tax professional. A Taxpayer can really not accomplish more than that.
The Tax Court has set forth the following three requirements in order for a taxpayer to use reliance on a tax professional to avoid liability for a section 6662(a) penalty:
o (1) the adviser was a competent professional who had sufficient expertise to justify reliance,
o (2) the taxpayer provided necessary and accurate information to the adviser, and
o (3) the taxpayer actually relied in good faith on the adviser’s judgment.” See Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd. 299 F.3d 221 (3d Cir. 2002).
These requirements are also known as “prongs”, a Three Prong Test. Unconditional reliance on a preparer or adviser does not always, by itself, constitute reasonable reliance. The Tax Court has set forth additional guidelines based upon facts and circumstances. [Such guidelines are called dicta]
o The taxpayer must also exercise “Diligence and prudence”.Marine v. Commissioner, 92 T.C. 958, 992-993 (1989), affd. without published opinion 921 F.2d 280 (9th Cir. 1991).
o “The general rule is that the duty of filing accurate returns cannot be avoided by placing responsibility on an agent.” Pritchett v.Commissioner, 63 T.C. 149, 174 (1974).
o Taxpayers have a duty to read their returns to ensure that all income items are included.
– Reliance on a preparer with complete information regarding a taxpayer’s business activities does not constitute reasonable cause if the taxpayer’s cursory review of the return would have revealed errors. Metra Chem Corp. v. Commissioner, 88 T.C. 654, 662-663 (1987).
o “Even if all data is furnished to the preparer, the taxpayer still has a duty to read the return and make sure all income items are included.” Magill v.Commissioner, 70 T.C. 465, 479-480 (1978), affd. 651 F.2d 1233 (6th Cir. 1981).
The Court started off with a consideration of the Third Prong, the reliance in good faith on the Preparers judgment. In a display of common sense which is rarely seen in any federal court, the Tax Court delivered its opinion that
o “We conclude that petitioners did not rely in good faith on [the Preparer] to accurately prepare their return. We conclude that petitioners did not rely in good faith on [Preparer’s] advice because they did not examine their return before it was submitted to the IRS. [Emphasis added]
– There you have it! If you don’t read the return, you are not really relying upon someone, are you?
– “Thus, petitioners’ unconditional reliance on [The Preparer] does not, on these facts, constitute reasonable reliance and does not excuse their failure to closely examine their return.”
What about the Second Prong? That the Taxpayer must provide necessary and accurate information to the Preparer.
o The Tax Court noted that the “reliance defense is also undercut by the fact that [Taxpayer] did not provide [Tax Preparer] with necessary Form 1099 documentation regarding their dividend and interest income in 2005.
– Sure, the amounts are insignificant, $216 in dividend income, and $24 interest income. But the failure to hand these over shows sloppiness, and causes the taxpayer to not meet the Second Prong.
After considering the Second and Third Prongs, the Tax Court did not even bother with the First Prong, whether the tax adviser was a competent professional. It concluded that the Taxpayer had “not demonstrated good faith and reasonable cause for their underpayments for 2005. Accordingly, the Court sustains [the IRS] determination that petitioners are liable for the section 6662(a) accuracy-related penalty for substantial understatements of income tax for the 2005 tax year.”
That’s it. The 20% penalty is kept. Obviously, the Taxpayer was protesting the principle of the penalty, as $1,059.20 is not a lot of money, and not worth the work of filing a Petition to hear the case in Tax Court. We have discussed this particular case because it illustrates rather clearly the principles involved in protesting the penalty, as well as the burden of proof required by the taxpayer.