Ohana Means Penalty: Ordinary Prudence May be Lacking Even When Paying for Tax Return Preparation

Ohana Means Real Estate

In 2007 until late 2009 (the three years before the court), Ohana and his family lived in a house in Saratoga and rented a house to tenants in Palo Alto.  In those three years Ohana was executive vice president of a company that licensed patents to computer-chip manufacturers. He earned substantial income from his job, over $1.2 million in the years before the court. Originally from Israel, Ohana was based in California but traveled extensively. In addition to his day job, he also spent considerable time and money on his properties. He renovated the Saratoga house and after evicting his tenants tore down the Palo Alto house and built a new house and a guest cottage, eventually moving into the Palo Alto house and renting the Saratoga house in late 2009. As part of his real estate activities, he deducted hundreds of thousands of dollars in both rental and nonrental expenses over 2007-09.

The deductibility of the rental expenses turned on whether Ohana was a real estate professional under the passive activity loss rules of Section 469. The Tax Court found he was not. The deductibility of his nonrental expenses turned in part on whether Ohana was engaged in the trade or business of being a real estate developer. The Tax Court also found he was not engaged in a trade or business, and sustained sizeable tax liabilities. It also sustained a substantial understatement penalty, notwithstanding that the taxpayer was not American and had paid preparers to prepare the tax returns.

The Substantive Trade or Business Issue: In Brief

As to whether Ohana could deduct the nonrental expenses, Ohana argued that he was in the business of trying to flip houses. Judge Holmes sets the stage:

He said that he planned to make money by flipping houses–i.e., buying a house with the intent to fix it up and then sell it at a profit. Successfully flipping houses depends on several steps’ being executed gracefully, from choosing where to buy (ideally in a neighborhood that attracts deep-pocketed customers) to choosing the right people to do the renovations to keeping transaction costs low. But if something goes wrong, such as trying to flip after a market crash, the flip can flop and theflipper can be stuck with a piece of real estate. Ohana, however, claimed he had an “exit strategy:” He would move into the house and live there until the market was more favorable and then he’d try again to sell the property.

How did Ohana’s claim fit in with the law? To be engaged in a trade or business, a taxpayer must (1) be involved in the activity with continuity and regularity (2) the primary purpose of which is income or profit. The Tax Court found against Ohana with respect to both requirements. As to the first requirement, although there was testimony regarding the taxpayer’s continuous and regular renovating and decorating efforts, case law requires that a person be in the “business of buying and selling residential real estate.” (emphasis in original). Ohana neither bought nor sold houses in the year in question.

I will skip much of the discussion on what a taxpayer must show to have a primary profit purpose, but suffice to say Ohana came up short there too, also in large part because of the absence of any sales. That the years in question coincided with a downturn in CA real estate did not move Judge Holmes, who thought there should at least have been an attempt at a sale.

As is typical with Judge Holmes’ opinions, Ohana makes for good reading. The opinion describes facts that suggest the renovations were designed to turn the Palo Alto house into a family residence, including how it had a “custom-built door with a peephole low enough that the five-foot-four Ohana could reach it.”  It did not help Ohana that he failed to turn over to the IRS an email where he said he purchased the Palo Alto house to build a new residence for his family: “[w]e observe that this email–and only this email–was missing from the production set of emails that the Ohanas provided to the IRS.”

Ohana Means Penalties

In addition to losing the substantive issues (I am skipping the passive activity, substantiation, and capitalization issues that the opinion discusses—readers wanting more should turn to the opinion), Ohana faced the 20% substantial understatement penalty. Under Section 6662(d)(1)(A) a substantial underpayment exists if the understatement of tax exceeds the greater of 10 percent of the amount of tax required to be shown on the return or $5,000. Exceeding the threshold triggers the penalty automatically, though a taxpayer can avoid the penalty if he shows that he had a reasonable-cause-and-good-faith defense under Section 6664(c)(1) and the regulations under Section 6664. What does that require? The Tax Court summarized as follows:

This requires us to look at the relevant facts and circumstances, including the taxpayer’s efforts to assess his own proper tax liability, and, whether he had reasonable cause and showed good faith by relying on professional advice.

The opinion described a number of factors that contributed to the court’s lack of sympathy to a reasonable cause/good faith defense. As part of the evidence the taxpayer put on to attempt to establish he was in a trade or business, the record reflected Ohana as a detail-oriented businessman whose efforts would contribute to the venture’s eventual profitability. For example, Ohana micromanaged the work on his houses and monitored the work even when traveling through live camera feeds. A witness (a co-worker from his high-tech day job) testified that Ohana was methodical about “everything.”

Framing Ohana as methodical in his approach did not help when it came to penalties. Judge Holmes observed that Ohana’s methodical approach did not extend to taxes:

He says that he didn’t read or even look at his 2007, 2008, or 2009 individual or partnership tax returns before signing and submitting them to the IRS. He didn’t compare his Quickbooks accounting records to his tax return. And he didn’t provide receipts to the revenue agent during the examination to substantiate the business expenses claimed by Ohana Consulting and Zoop[two LLCs that Ohana claimed owned the properties though the properties were owned individually].

The lack of tax qualifications of the preparers also hurt Ohana. Ohana retained a preparer from company called URS:

Instead of checking his returns, Ohana relied on the tax-preparation skills of URS–an organization that specialized in pitching services to Israeli immigrants.Many of URS’s employees were Israelis who would spend most of the year back home and come back to the United States just before tax season. Ohana’s friend Avny was cautious about using the firm, and he refused to allow anyone but the owner of URS, a man named Nadav, to do his taxes. Ohana was not as picky. His return preparer, Shalom Eyal Bitton, was neither an accountant nor a lawyer, though he was a former CFO of an Israeli company, and he came from an elite unit in the Israeli army–not particularly relevant experience when it came to tax preparation, but perhaps some indicator of trustworthiness to this particular expatriate community. Bitton assured Ohana that the software URS used should eliminate any concerns and would confine his role to data entry. As a bonus, Bitton promised that Nadav would review Ohana’s returns. Ohana sent Bitton all the information related to his income and deductions, including his real-estate activities, on documents entitled “Profit and Loss Details.” URS then entered this data into a computer and generated a tax return.

The description of URS also has a footnote. It is not the kind of footnote that helped Ohana:

There are several cases pending in our Court naming URS as the tax preparer. A great many of URS’s clients are being investigated by the IRS. Criminal charges have been filed against URS in the Central District of California on allegations that the firm deliberately aided, abetted, and assisted some of its clients in hiding money in Luxembourg after filing false tax returns. (We stress that Ohana is not one of these clients.)

Did Ohana Receive Any Advice?

Ohana argued that he relied in good faith on URS’s tax advice. An interesting threshold issue is whether Ohana received any advice from URS. The court noted that the regs under Section 6664 and case law define advice “as a communication that reflects analysis and conclusions of the tax adviser.” The interaction between Ohana and his preparer was not one that reflected a professional advising a taxpayer on the merits of his position on the tax return:

Ohana provided books and records to URS that stated he was in a real-estate trade or business. The documents are entitled “Profit and Loss Detail” for each year at issue. And while Ohana met with his tax preparer once during his initial interview with URS, his later meetings were with a receptionist who already had his returns prepared. Ohana himself testified that URS performed mainly data entry into software that would generate a tax return.

The opinion reflects a disapproval of a taxpayer/advisor relationship that minimizes contacts between the taxpayer and the preparer. Moreover, the availability of tax prep software can mask the deficiencies of a preparer. Punching numbers in to a program, without considering the underlying issues and advising the taxpayer as to the law in question and applying to the client’s facts, does not constitute advice. Tax law is challenging. Determining the deductibility of expenses relating to an individual’s real estate activities is not something you can buy at Staples. In light of the above, the court found that Ohana did not receive advice and thus could not rely on his commercial preparer to insulate him from penalties.

Even if Ohana Did Receive Advice The Advice was Not Reasonable

Despite finding that URS did not provide advice to Ohana, the opinion (citing to Neonatology v Commissioner) also describes the factors to determine if advice was reasonable:

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 opinion found for the taxpayer with respect to the first factor, but not the other two. The first factor was a close call. Ohana’s front-line preparer was not a CPA and was apparently one of the seasonal preparers that served the Israeli expat community. He assured Ohana that the tax prep software “was very sophisticated and would eliminate any of Ohana’s concerns because [his] main role would be reduced to mere data entry.” That alone would not have been enough. Ohana did more though; he arranged for URS’s CEO (a CPA) to review the return. That review led the court to conclude that Ohana had grounds to believe a competent professional was preparing his returns.

As to providing necessary information to URS and demonstrating reliance on the adviser’s judgment, the court found against Ohana. With respect to providing information, the opinion recounted discrepancies between the taxpayer’s Quickbook logs and the tax returns.

While finding that Ohana failed to give complete information to his adviser, the opinion also discussed why it felt there was not good-faith reliance even if he had given everything to the preparer. It was here where Ohana’s testimony about not looking at his returns and delegating all the tax responsibilities to his preparer hurt:

Given Ohana’s unusually focused attention to detail in other areas of his life, we do not find him credible when he says that he never once looked at his tax returns. And that he kept accounting records but never once made sure they tied with his Forms 1040 or Forms 1065, U.S. Return of Partnership Income, is telling. Claiming reliance on a tax preparer and choosing to maintain ignorance of the contents of his returns is not reasonable reliance in good faith, and we will not permit Ohana to avoid accuracy-related penalties for substantially understating his tax liabilities. While reliance on a professional tax preparer may save a taxpayer from accuracy-related penalties, it won’t where an intelligent and skilled taxpayer provided inaccurate information to the return preparer and claims improbably not even to have glanced at his returns to make sure they were satisfactorily prepared. (emphasis added).

Parting Thoughts

Some preparers are better than others when seeking to avoid penalties. Paying someone to prepare a tax return, even someone who has the best software on the market, does not insulate a taxpayer from a penalty. Even if the preparer is competent, and the taxpayer does in fact demonstrate that he received advice, a taxpayer who is sophisticated and highly educated cannot delegate responsibility when it comes to reviewing tax returns, especially when the items on the return reflect facts that differ from the taxpayer’s own records.

This case provides a nice contrast from a case I described last year, Anderson v Commissioner, where the Tax Court found the taxpayer had reasonable cause even after omitting a sizeable amount of income from an individual return. In that case, while the taxpayer also did not establish good faith reliance on an advisor, the Tax Court declined to impose accuracy-related penalties. Defense to penalty cases are very fact-specific and do not lend themselves to sweeping conclusions. Suffice to say it is harder to obtain relief from penalties when taxpayers are sophisticated and the facts suggest that the taxpayers exercised greater prudence in most other endeavors.