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Tom Talks Taxes - May 15, 2023
Can a taxpayer avoid penalties by relying on a tax professional's advice?
This article is the first in a series on how a taxpayer can use reliance on a tax professional to escape federal tax penalties.
If a taxpayer has a tax underpayment due to negligence, a substantial understatement of tax, or other misrepresentation, the IRS can impose a 20% accuracy-related penalty under §6662(a). However, §6664(c)(1) states this penalty will not apply if there was a reasonable cause for such underpayment and the taxpayer acted in good faith with respect to the underpayment.
Treas. Reg. §1.6664-4(c)(1) states that reliance on an opinion or advice can constitute reasonable cause. All facts and circumstances must be considered when determining if a taxpayer reasonably relied in good faith on that advice, including advice from a tax advisor.
Treas. Reg. §1.6664-4(c)(2) defines advice as follows:
Advice is any communication, including the opinion of a professional tax advisor, setting forth the analysis or conclusion of a person, other than the taxpayer, provided to (or for the benefit of) the taxpayer and on which the taxpayer relies, directly or indirectly, with respect to the imposition of the §6662 accuracy-related penalty. Advice does not have to be in any particular form.
According to the regulation, factors that should be considered include:
The taxpayer's education, sophistication, and business experience will be relevant in determining whether the taxpayer's reliance on tax advice was reasonable and made in good faith.
The advice must be based upon all pertinent facts and circumstances and the law related to those facts and circumstances. This is not satisfied if the taxpayer fails to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item.
The advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events). It must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.
A taxpayer may only rely on an opinion or advice that a regulation is invalid if the taxpayer adequately disclosed that position.
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There is an example of reliance on the advice of a tax advisor in Treas. Reg. §1.6664-4(b)(2), Ex. 1:
A, an individual calendar year taxpayer, engages B, a professional tax advisor, to give A advice concerning the deductibility of certain state and local taxes. A provides B with full details concerning the taxes at issue. B advises A that the taxes are fully deductible. A, in preparing his own tax return, claims a deduction for the taxes. Absent other facts, and assuming the facts and circumstances surrounding B's advice and A's reliance on such advice satisfy the requirements of Treas. Reg. §1.6664-4(c), A is considered to have demonstrated good faith by seeking the advice of a professional tax advisor, and to have shown reasonable cause for any underpayment attributable to the deduction claimed for the taxes.
However, if A had sought advice from someone that A knew, or should have known, lacked knowledge in the relevant aspects of Federal tax law, or if other facts demonstrate that A failed to act reasonably or in good faith, A would not be considered to have shown reasonable cause or to have acted in good faith.
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 taxpayer must prove by a preponderance of the evidence that:
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.
A taxpayer challenging a penalty based on reliance on a tax advisor must have evidence supporting this assertion. In Gladys L. Gerhardt et al. v. Comm., 160 T.C. 9 (2023), the petitioners argued they had reasonable cause for the underpayment of tax because they lacked relevant legal training and relied on tax advisers both in pursuing the charitable remainder annuity trust (CRAT) transactions discussed and in preparing their 2016 tax return. The taxpayer provided no evidence to show they met the Neonatology Associates factors, so they lost on the penalty issue:
Based on the record before us, we are unable to determine that Tim and Pamela reasonably relied on tax advisers in preparing the return or pursuing the positions reflected in the return. The record does not demonstrate the qualifications of the advisers, the nature of Tim and Pamela's communications with them, or the quality or objectivity of the advice Tim and Pamela received. These facts are necessary to our analysis, and it was Tim and Pamela's burden to provide them. This they did not do.
Hussey v. Comm., 156 T.C. 12 (2021) provides an excellent example of the analysis the Tax Court undertakes when analyzing whether a taxpayer meets the Neonatology Associates factors. The taxpayer and the IRS agreed that the advisor was competent and received all relevant information from the taxpayer. The IRS’s position was that the taxpayer did not rely in good faith on the advisor’s judgment.
The taxpayer was held not liable for the §6662 penalty. In this case, the IRS made assertions concerning the penalty that did not have an evidentiary basis. Here is the Tax Court’s analysis of the issue:
We decide whether a taxpayer relied in good faith by considering all of the facts and circumstances, including the taxpayer's "experience, knowledge, and education"… Petitioner, suspecting that his 2012 tax return was prepared incorrectly, consulted his financial adviser who agreed with petitioner that his return seemed incorrectly prepared. The financial adviser arranged for petitioner to meet with a C.P.A. at a large accounting firm, who also agreed that petitioner's 2012 tax return was not prepared correctly. The C.P.A. referred petitioner to Mr. Kohn, who also told petitioner that he believed that his 2012 tax return was incorrect, and described what he thought the errors were.
Petitioner has no background in tax or accounting, and, therefore, sought the advice of individuals he believed would have the knowledge needed to provide help. Petitioner reasonably believed Mr. Kohn's explanation was correct, and he relied on Mr. Kohn's advice in good faith…
Respondent suggests, with no basis in the record and contrary to petitioner's undisputed testimony, that petitioner's description of how he was referred to Mr. Kohn was untrue and that he was shopping for a favorable tax result. We disagree and find petitioner's testimony credible.
Respondent contends that petitioner did not rely upon Mr. Kohn's advice in good faith because he knew or should have known that the tax result was "too good to be true". While that phrase has been applied in appropriate situations, we believe it does not apply here because of the extensive steps petitioner took to ensure he was receiving adequate professional advice.
Respondent points out that there are errors on petitioner's returns prepared by the Kohn Firm… Respondent contends these errors show that petitioner was not acting in good faith. We disagree. We do not believe petitioner is responsible for detecting errors of this nature in reporting complicated tax transactions. Taking into account all of the facts and circumstances, we conclude that petitioner relied in good faith on the Kohn firm to prepare his amended 2012 and his 2013 and 2014 tax returns, and that he is not liable for penalties under §6662.
If a taxpayer worked with a tax advisor and the IRS proposes a §6662 penalty with respect to a position taken on that tax return:
Always raise reliance on a tax professional as reasonable cause,
Cite the Neonatology Associates three-factor test, and
Explain, with evidence, why the taxpayer meets each prong of that test.
In almost every circumstance I did this in an examination or Tax Court case, the IRS has conceded the §6662 penalty. If you are the tax advisor that provided the advice in question, you may have a conflict of interest in representing the client with respect to the penalty, which I will discuss in the next article on this topic.
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