Designated Orders: 4/2 – 4/6/2018

Reasonable Cause – Late/Incorrect 1099 Forms Insufficient for Penalty Avoidance

Docket No. 9285-17S, Zschau v. C.I.R. (Order Here)

Docket No. 6628-17S, Cusack v. C.I.R. (Order Here)

Judge Carluzzo issued bench opinions in two cases, Zschau and Cusack, where the sole issues for decision was whether the petitioners qualified for a reasonable cause exception to the substantial understatement penalty under section 6662. In both cases, the petitioners relied on third parties to properly and timely issue information returns; those third parties (Janus Investments and Chase Bank) failed their statutory obligations. Nevertheless, Judge Carluzzo sustained the penalties in both cases—though in Zschau, only by a hair.

These cases are eminently frustrating to me. They reflect what I consider to be a wholesale failure of federal tax administration, stemming, it seems, from the taxpayers’ basic lack of understanding of just what the federal income tax is and what their reporting obligations are. I see this among many (though not all) of my clients in the LITC; I’m sure my fellow bloggers have similar experiences.

Indeed, just the other day, I spoke with a new client. Since retiring on a small pension about 10 years ago, she hasn’t filed an income tax return, because—she believed—there’s no requirement to file a tax return or pay taxes after one is retired. I explained the very basic concepts of income taxation and withholding to her. Her eyes lit up. “I had no idea. That makes sense, but no one has ever explained that to me,” she said. Fortunately, after obtaining her information returns, I determined she owed no tax on the unreported income—but had missed out on nearly $10,000 in refunds over the past 10 years.

The issues in Zschau and Cusack are more complex, but I believe, derive from the very same ignorance of how federal income taxation works and what obligations the Code imposes on taxpayers. Most taxpayers that I encounter (and I admittedly self-select those who have run into issues with the Service) understand taxation through unsolicited experience; that is, at some point in their lives, their employer or a payor sends them an information return, which they do not understand. The taxpayer may ignore that form; or they may take it to a trusted friend or relative, who eventually points them to a tax return preparer.

Eventually, the understanding emerges that all taxpayers have an annual filing obligation, and such forms should be provided to a tax return preparer on an annual basis. Taxpayers thus rely on and presume the accuracy and timely delivery of those forms. And perhaps, at some point, taxpayers come to understand the notion that if they receive income—especially in cash—they’re required to pay taxes on that income. But I think (and I’d welcome research on this point) that the provision of an information return with respect to that income would satisfy the taxpayer’s perceived obligation, so long as it was timely delivered to a return preparer; that the absence of such a form, generally speaking, signals to the taxpayer that nothing needs to be provided to a return preparer; and that any error on the form or in delivering the form is the fault of either the third party or the tax return preparer.

In Zschau, the taxpayers didn’t “see” any income from their investment account in cash—and didn’t receive a 1099-B to boot. In Cusack, the taxpayers received a (very) incorrect 1099-R. Both taxpayers had invested with large investment or banking organizations, which presumably have sophisticated tax reporting operations. In both cases, we see errors of the type I describe above.

Zschau’s investment account custodian did not send a 1099-B until long after the petitioners’ return preparer filed the tax return. As such, it wasn’t included on the return. Further, the amounts distributed were reinvested into the account; thus, the Zschau’s didn’t intuit that they had received taxable income, as one might have, had the proceeds been converted to cash in a bank account. They didn’t know about the discrepancy until receiving correspondence from the Service, and then submitted an amended return to include the income (which was unprocessed, due to the outstanding Notice of Deficiency). They also paid the deficiency.

These taxable events that do not result in liquid income often confuse my clients in the Clinic, such that the income is not reported on the return. This is especially true if there’s a delay, like in Zschau, in issuing the 1099-B or other information return, as the tax preparer cannot catch that income either. Cancellation of debt income, pass-through income, reinvested taxable income, and improperly performed retirement account rollovers often lie at the heart of Automated Underreporter (and eventually, Automated Collection Systems) cases in my clinic, and reflect the general ignorance of federal income taxation that I describe above.

The amounts underreported clearly established a substantial understatement under section 6662(d), as the underreported tax exceeded 10 percent of the tax required to be shown on the return (and presumably also exceeded $5,000). Thus, the only legal issue was whether reasonable cause existed for the underreporting.

Before deciding the issue, Judge Carluzzo noted that this was “a very close case”, and that further he was “disappointed that the parties were unable to resolve it between themselves by splitting the penalty.” That short comment struck me and creates a fertile ground for a longer discussion. Notwithstanding the preferences of judges for private settlement, the Tax Court’s institutional interest in efficiency, and litigants’ interests in avoiding the cost and time of trial, surely it’s this very sort of case that the Tax Court exists to decide: a case where equities exist on both sides, are difficult to balance, and where cause the parties to hold seemingly strong views regarding their positions.

Of course, we can only speculate as to what happened before trial. We don’t know whether settlement negotiations occurred, and if so, what took place therein. Perhaps had the Zschaus retained counsel, they would have benefited from a more accurate analysis of litigation hazards. Or perhaps it was respondent who was intransigent.

Putting aside my speculation, Judge Carluzzo ultimately held for the Service. The decision hinged on the Zschaus having received a 2014 year-end summary from Janus before filing the tax return. While the summary didn’t indicate whether any gains were taxable, it did show a large amount of capital gains. Zschau noted that he had only ever provided his return preparer with his Forms 1099-B; Judge Carluzzo found this insufficient (which may surprise a number of tax return preparers). Not helping matters was Zschau’s ownership of an insurance brokerage agency, suggesting he should have known to provide the summary to his return preparer—though I submit that general financial literacy (if that can be imputed to Zschau from ownership of an insurance agency) does not substitute for tax literacy.

Bottom line: a cautionary tale for taxpayers with investment accounts and tax preparers who only require a 1099-B from their clients. To enable accurate reporting and penalty avoidance, taxpayers should provide their year-end summaries to their return preparers, in addition to their tax reporting forms.

The Cusack matter is more straightforward, though still frustrating to me and for the taxpayers. The Cusacks owned an IRA, from which they took distributions amounting to $36,500 due to financial hardship. However, Chase issued the Cusacks a 1099-R reporting only $2,780, which they provided to their return preparer and reported on their return. Chase did not issue a corrected or additional 1099-R for this year.

Judge Carluzzo noted that the taxpayers “were obviously aware that the distributions were made” and that “one or both of them must have known that the amount shown on the return as an IRA distribution was understated.” He concluded that, “we cannot excuse their failure to question the relatively low amount the return preparer included on the return as an IRA distribution.” As such, he upheld the penalty, as the Cusacks did not demonstrate reasonable cause.

We can indeed easily conclude that the Cusacks were aware of the distributions, given they compensated for the taxpayers’ difficult economic circumstances. But I do wonder: were the taxpayers afforded an opportunity to review their return before filing? Could the taxpayers effectively read and understand the items listed on a Form 1040? Did they presume that Chase had accurately reported taxable income from the IRA on Form 1099-R? Did they understand how an IRA works, in the first instance?

I realize that the answers to these questions are not necessarily determinative in the 6662(a) context. Yet the stated purpose of the accuracy penalties is to encourage voluntary compliance. I’d indeed bet that the Zschaus and the Cusacks now have a better understanding of their federal income tax obligations, and are therefore more likely to comply in the future (at least if similar issues arise).

But will these cases have any effect on taxpayers writ large, outside of those already tax-educated few who read this blog? I very much doubt it.