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Tom Talks Taxes - June 14, 2023
Reliance on a tax professional and the employee retention credit
The IRS has paid out tens of billions of dollars in COVID-19 employee retention credit refunds, and the statute of limitations on ERC refunds will generally expire on April 15, 2024 (for 2020 quarters) or April 15, 2025 (for 2021 quarters).
There has been a staggering proliferation of so-called “ERC mills” that submit unreasonable, perhaps even fraudulent, ERC refund claims. Examinations have begun; ethical practitioners will likely pick up the pieces to help taxpayers facing significant examination adjustments. While there is no way to avoid the tax increase and retroactive interest accruals in the case of a disallowed ERC claim, can the taxpayer avoid §6662(a) accuracy-related penalties using reliance on a tax advisor?
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As a reminder, in Neonatology Assocs., PA v. Comm., 115 T.C. 43 (2000), the Tax Court promulgated a three-prong test to determine if reliance on a tax advisor constitutes reasonable cause:
The advisor was competent with sufficient expertise to justify reliance,
The taxpayer provided necessary and accurate information to the advisor, and
The taxpayer actually relied in good faith on the advisor’s judgment.
Setting aside potential competence issues, many taxpayers may have difficulty showing that they relied in good faith on the ERC promoter’s judgment:
Some ERC promoters explicitly state that businesses self-certify that they qualify for the ERC and the promoter is not making an eligibility determination.
The taxpayer’s reliance on the ERC promoter’s advice may not be reasonable if the promoter has a conflict of interest because they charged a contingent fee. A contingent fee is one in which the promoter’s compensation, in whole or in part, is determined by either the credit received or the credit not challenged by the IRS. The IRS Office of Professional Responsibility explicitly mentioned this in relation to practitioner reliance on another practitioner’s work product in Office of Professional Responsibility Alert 2023-02.
The taxpayer sought the advice of their tax professional who advised them that they were not eligible for the ERC based on their facts and circumstances.
If a reasonable or prudent person would view the ERC claim as “too good to be true,” a taxpayer likely did not act in good faith unless they made reasonable attempts to ascertain its correctness.
In the Neonatology case, the taxpayer lost on the reliance on a tax advisor defense for several of the above-listed reasons:
We are unable to conclude that any of petitioners has met any of these requirements. First, none of petitioners has established that he, she, or it received advice from a competent professional who had sufficient expertise to justify reliance. The "professional" to whom petitioners refer is their insurance agent, Mr. Cohen. Mr. Cohen is not a tax professional, nor do we find that he ever represented himself as such. Petitioners' mere reliance on Mr. Cohen was unreasonable, given the primary fact that he was known by most of them to be involved intimately with and to stand to gain financially from the sale of both the subject VEBA's and the C-group product. Given the magnitude of petitioners' dollar investment in the C-group product and the favorable consequences which Mr. Cohen represented flowed therefrom, any prudent taxpayer, especially one who is as educated as the physicians at bar, would have asked a tax professional to opine on the tax consequences of the C-group product. The represented tax benefits of the C-group product were simply too good to be true. Such is especially so when we consider the fact that the physicians who testified admitted that they knew that term insurance was significantly less expensive than the premiums purportedly paid under the C-group product solely for term insurance.
In Gundanna and Viralam v. Comm., 136 T.C. 151 (2011), the taxpayer used a “tax reduction” promoter to set up a “family public charity” charitable donation vehicle. The promoter purported benefits that seem highly unlikely:
Doctor donors may direct the use of funds accumulated within their family public charity accounts to finance charitable projects including personal teaching, research, pro bono works, [and] college and graduate scholarship programs… Donors and their family members may work for and be compensated by their family public charities for good works (teaching, research, or providing pro bono services) they perform on behalf of their family public charities.
The Tax Court disallowed the charitable contribution deductions because the taxpayer retained dominion and control over the funds in the account. The taxpayers used funds in the account, in part, to fund family student loans.
The Tax Court upheld a §6662(a) negligence penalty with respect to the transactions at issue in the case:
We find that petitioners were negligent because petitioner failed to make a reasonable attempt to ascertain the correctness of a deduction which would seem to a reasonable or prudent person to be "too good to be true" under the circumstances. A reasonable or prudent person would have perceived as "too good to be true" a deduction for a supposed charitable contribution where the amounts deducted could be used to fund student loans for his own children. The same is true with respect to the avoidance of capital gains taxes on the sales of stocks where the proceeds remained under petitioner's control for use by his children. To the extent petitioner ascertained the validity of the charitable deduction or capital gains exclusion from [promoter]'s employees or its printed materials, there was an obvious conflict of interest on the part of persons promoting [promoter]'s programs…
Petitioner also testified that he consulted with his accountant regarding the deduction, but there is nothing in the record concerning the nature of those discussions or, importantly, establishing that the accountant was given complete information, including petitioner's intention to direct the use of the proceeds from the contribution for student loans for his children. Without some evidence that petitioner's discussions with his accountant covered his anticipated participation in the student loan program, there is no basis to conclude that petitioner made a reasonable attempt to ascertain the correctness of the deduction.
Before closing the conversation on ERC penalty assertion, it is important to discuss tax practitioners who were not involved in the ERC claim process but were ultimately charged with reporting the downstream tax consequences of receiving ERC funds. The various ERC statutory provisions all state that rules similar to §280C(a) apply to the ERC (see §3134(e) as an example). Both Treas. Reg. §1.280C-1 and Notice 2021-49 interpret §280C(a) as requiring reducing the wage deduction by the credit amount in the tax year in which the taxpayer paid the wages.
Therefore, as an example, a calendar year taxpayer receiving an ERC refund for a 2021 quarter must reduce the wage deduction on the 2021 return; if the reduction was not reflected on the original tax return, the taxpayer must amend it. There will also be interest accrual retroactive to the unextended due date of the return.
Some tax practitioners are failing to apply this rule and are reporting the ERC refund as income in the tax year in which it is received. In the author’s opinion, there is no reasonable basis for this position on a tax return; therefore, adequate disclosure of this position will not provide relief via §6662(d)(2)(B) from a §6662(a) substantial understatement of tax penalty.
However, since this is a technical ERC consequence that a reasonable person would not understand, it is likely that reliance on a tax professional would be an acceptable defense to an §6662(a) penalty in this situation. For example, in Evans v. Comm., T.C. Memo 2015-12, the Tax Court did not impose the §6662(a) accuracy-related penalty when it disallowed the taxpayer’s §911 foreign earned income exclusion, stating that “Although this advice was incorrect, this is a technical area of tax law, and we are satisfied that petitioners reasonably relied on the advice they were given.”
In closing, the simplest way to avoid §6662(a) accuracy-related penalties in these situations is to correct these problems via an amended return prior to the IRS’s initial contact for an examination. This is a qualified amended return under Treas. Reg. §1.6664-2(c)(2)(3) and avoids the §6662(a) accuracy-related penalty, which was discussed in detail in a prior edition of this newsletter.
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