Follow up On Clean Hands Post: The Imposition of Penalties and How Using a Preparer Does Not Automatically Constitute Good Faith and Reasonable Cause

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In yesterday’s post I discussed the case of Key Carpets v Commissioner, involving one entity’s payment of business expenses that were unrelated to its business but which were related to the business of a separate corporation controlled by the same shareholder. In Key Carpets, the Tax Court disallowed the entity’s deduction under Section 162 and also found in the consolidated case of Johnson v Commissioner that the entity’s shareholder received a constructive distribution. On top of the disallowed deduction and constructive distribution, the Tax Court sustained the 20% substantial understatement penalty for both the individual and corporate adjustment, an issue I flagged but did not explain.

It is worth a bit more on the penalty issue as the taxpayer argued that his and the corporation’s use of a preparer insulated him from civil penalties. The Tax Court’s brief distinction between using a preparer and relying on a taxpayer for advice highlights that it is prudent to have some additional evidence of a preparer’s advice beyond the return itself if you want to ensure the possibility of penalty relief.

Here is some more on the issue.


For an individual taxpayer, there is a “substantial understatement” of income tax for any year if the amount of the understatement for the taxable year exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. For a C corporation, there is a “substantial understatement” of income tax for any year if the amount of the understatement for the taxable year exceeds the lesser of 10% of the tax required to be shown on the tax return (or, if greater, $10,000) or $10 million. In the opinion the Tax Court found that the understatements exceeded the threshold for applying the penalty.

There is a reasonable cause good faith exception to the penalty. In Key Carpets, both taxpayers argued that they qualified for that exception, having “provided all records to their accountant and had a reasonable basis for the business deductions.”

The Tax Court disagreed, finding that both “petitioners did not act in good faith, because their positions run contrary to established law.” As to whether they could avoid the penalty due to the presence of a qualified accountant preparing the corporate and individual returns, the Tax Court said no in large part because the record did not reflect if there was specific advice sought or received on the payments and the consequences of those payments:

Mr. Johnson testified that he provided all records to his accountant on whom he relied to prepare his corporate and individual returns, but petitioners did not offer any evidence about whether they sought advice from their accountant about the deductions or whether the Key Carpets payments to Clean Hands constituted constructive distributions.

When it was all said and done the opinion concluded that “[b]ecause petitioners’ positions run contrary to established law and petitioners have not shown that they reasonably relied on their accountant to do anything more than prepare tax returns, petitioners have not met their burden of proving that they acted in good faith with reasonable cause, and the Court sustains the section 6662(a) accuracy-related penalty.”

I have previously discussed the standard that the courts used in looking at reliance on an advisor in a small business setting. For example, in Tax Court Finds Reliance on Advisor in Messy Small Business Setting I discuss the three factor test set out in Neonatology v Commissioner:

  1. Was the adviser a competent professional who had sufficient expertise to justify reliance?
  2. Did the taxpayer provide necessary and accurate information to the adviser?
  3. Did the taxpayer actually rely in good faith on the adviser’s judgment?

The Key Carpets opinion is a little thin on the penalties issue. A threshold issue is whether a taxpayer receives advice from a preparer. In other cases courts have held that advice can take the form of conclusions and positions taken on the tax return itself. See for example my discussion of the Ohana case a few years back where the Tax Court distinguished cases where advice was contained in the return itself and found that where there was no real relationship between the preparer and the taxpayer (most interaction was between the taxpayer and a receptionist) and the preparer was essentially rubberstamping the numbers the taxpayer gave it, the positions on the tax return did not reflect advice.

In contrast, unlike Ohana there was nothing in the opinion that suggested Johnson did not have a true client/preparer relationship with his preparer. Perhaps the preparer might not have inquired about the ownership of the patent on the voice activated soap dispenser, and perhaps Johnson did not provide that information. I might add that this omission is somewhat understandable as in prior years it was legitimate (or at least unchallenged) for Key Carpets to incur and deduct expenses on the radio frequency hand washing venture. If the preparer were involved in the prior years or reviewed those returns he might have expected Key Carpets to incur costs associated with the voce activated hand washing venture.

It is hard to be too critical on such a fact-specific issue, as I do not fully know the record in the case. For example, the opinion does not discuss whether there was any testimony from the preparer or other evidence relating to the relationship between the preparer and the taxpayer. Yet the result here seems harsh, especially for Johnson individually, as his consequences stem from a deemed distribution that most taxpayers would not appreciate despite the court’s discussion of the outcome as running contrary to established law. In addition, one would expect perhaps that a preparer would make inquiries necessary to reach appropriate legal conclusions about the nature of the payments.

At the end of the day, the opinion is certainly a warning that merely hiring a preparer is not enough, and proving reliance on an advisor requires perhaps a bit more focus than a taxpayer’s testimony that the accountant prepared the return.

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Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.


  1. Barry Goldwater says

    I would like to see a law passed that provides that any IRS employee has an automatic penalty assessed against them personally anytime they open an audit, collection case, or take any official action against a taxpayer. At the conclusion of the case, they can apply to have the penalty abated if their actions during the case conformed to established law. (IRM, IRC, etc.). There can also be an offset provision that allows the IRS employee penalty to be offset by any penalty against the taxpayer. If the employee relied on a supervisor, they can provide written confirmation of that or have the supervisor come into court to testify to such.

    The purpose of a penalty is to reimburse the government for the cost of collecting, enforcing compliance, etc. But there is no offsetting compensation to the taxpayer for all of the extra work he must perform for his government such as defending an audit, collecting withholding tax and excise tax, reading and understanding 1000s of pages of regulations, dealing with idiot government workers (robots), costs for tax, accountant, lawyer, advisor fees, etc.

    Ted Cruz does not have authority to abolish the IRS, but we Americans have authority to take back this country and elect common sense representatives to repeal 95% of the nonsense we have to live with on a daily basis. Thomas Jefferson would not recognize this country. In fact, he is better off where he is, six fee under at Monticello.

    • Wow! Even the true Barry Goldwater never advocated penalizing IRS employees for performing (for better or for worse) their jobs.

      I prefer my idea that federal revenue be collected only by true voluntary compliance, i.e., the various branch and department heads would appeal to the public for contributions through several telethons or Web equivalent. Such a federal revenue system would reflect true public support.

      As for Jefferson not recognizing this country, I believe he would recognize “95% of the nonsense we have to live with on a daily basis.” Compliance with federal imposts, duties, and other excises was then (as now) no simple matter. Read some of the original revenue acts that Congresses in Jefferson’s time adopted. If you do, then you will learn that the Jefferson-era American people endured some harsh tax compliance methods.

      Also, Jefferson raised no protest when he learned that President Washington and Treasury Secretary Hamilton had personally led a militia to quell the so-called Whiskey Rebellion. After all, the whiskey tax was then, as the income tax is today, imposed with “the consent of the governed” through its elected representatives.

      You seem to hold the common, yet false, notion that the U.S. Constitution was framed and ratified to provide for “limited government.” The United States left that government behind when it jettisoned the Articles of Confederation–which provided for federal tax collection only by requisitions on the states.

  2. Bob Camden says

    “[O]ne would expect perhaps that a preparer would make inquiries necessary to reach appropriate legal conclusions about the nature of the payments.”

    Really? We must practice tax law in very different worlds. Through direct experience, I’ve learned not to expect that.

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