Andersen v Comm’r, a summary opinion from last week, caught my eye. The case is not precedential, and involves a relatively modest accuracy-related penalty. The case stands out to me because it is a rare case where taxpayers leave off a significant amount of W-2 income (about $28,000) from the return, but the court still found that they should not be subject to civil penalties. Most taxpayers leaving off a big slug of income are going to face a bill of back taxes, interest, and a 20% civil penalty. Yet, Andersen suggests that an isolated mistake combined with a history of past compliance can insulate a taxpayer from penalties.
I will briefly describe and give some context.
read more...Background
Mr. and Mrs. Andersen had been married 47 years; the opinion tells us that they had a history of timely filing their returns, and their returns had always been accepted as filed. Mr. Andersen worked for a window furnishing company, receiving a salary with the potential for bonuses. Mrs. Anderson was a part-time nurse with somewhat irregular shifts. The taxpayers also had some S Corporations that held and leased farmland. In 2010, Mrs. Anderson’s income was about $28,000. Mr. Andersen’s wages were about $87,000, and there was about $70,000 of other income, presumably investment or rental income. To prepare their returns, the Andersens had for many years used a CPA.
The opinion describes how the Andersens had kept track of their tax documents in a dedicated tax folder, and in February or March they would meet with the CPA/return preparer, and then again meet with the CPA to review the return before filing.
In 2010, the Andersens used the same system—they had collected their tax documents throughout the year, and met in February with their CPA, Curtis Trader, who had prepared their returns since 2005. Trader was a CPA with 20 plus years experience. He had a masters in accountancy. In 2010, Mrs. Anderson’s employer’s payroll agent discontinued issuing paper W-2s, though neither her employer nor the payroll agent told her about the switch. So, when they met with Trader, they did not give any information about Mrs. Andersen’s wages. Trader, as he testified, was under the impression that Mrs. Andersen had retired, based on past talks he had with the couple and the presence of a 1099-R.
An Unexpected Letter from the IRS –Penalty and Applicable Law
After filing their return that reflected a modest overpayment, IRS through I suspect its correspondence exam process issued a notice of deficiency, proposing a deficiency of $7,907 due to the wife’s unreported wages. The IRS also determined an accuracy-related penalty of 20% of the $7,907 understatement on the basis that the understatement was substantial (discussed below). After getting the notice, the taxpayers immediately faxed the notice to Trader in an effort to determine why the IRS contacted them, realized their mistake, paid the tax and interest within a week of the notice, and filed a petition challenging the penalty.
What was the penalty about? For individuals, an understatement is substantial and will trigger a 20% civil penalty if it is more than the larger of 10 percent of the correct tax or $5,000 (a different trigger applies for corporate taxpayers). Taxpayers can avoid the penalty if they adequately disclose the position and there is at least reasonable basis for the treatment, or if there is substantial authority for the treatment. Absent disclosure or substantial authority, (each of which has nuances that I will not describe here, though readers can look at revised Saltzman and Book Chapter 7B for a thorough discussion of both) the taxpayer can avoid the 20% penalty if she can show that she had reasonable cause for the mistake and acted in good faith, under Section 6664(c).
This case turned on the reasonable cause and good faith exception. The taxpayers have the burden of showing that they are not liable for the penalty, once the IRS establishes that the understatement was substantial, i.e., the numerical threshold is hit and there was no disclosure or substantial authority. In most cases, if a taxpayer leaves off wage income of $28,000, it means that they will not be able to show that the taxpayer had reasonable cause and acted in good faith—both of which are necessary to avoid the penalty.
So, how did the Andersens prevail in this case?
The case lays out the 6664(c) standard, looking to the regs and caselaw:
The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account the pertinent facts and circumstances, including the taxpayer’s knowledge, education, and experience, as well as the taxpayer’s reliance on professional advice. Thomas v. Commissioner, T.C. Memo. 2013-60; sec. 1.6664-4(b)(1), Income Tax Regs. Generally, the most important factor is the extent of the taxpayer’s effort to assess his or her proper tax liability. Humphrey, Farrington & McClain, P.C. v. Commissioner, T.C. Memo. 2013-23; sec. 1.6664- 4(b)(1), Income Tax Regs.
One interesting part of the case is the candor that the opinion takes in addressing applying the standard to the facts of the case. The opinion states that this is “an exceptionally close case” though in light of the evidence it found that the penalty should not be imposed:
Clearly, petitioners made a mistake. But we think it was an honest mistake and not of a type that should justify the imposition of the accuracy-related penalty. In short, we think that petitioners’ diligent efforts to keep track of their tax information, hiring a C.P.A. to prepare their tax return, reviewing their return with the C.P.A. when it was completed, and prompt payment of the deficiency upon receipt of the notice of deficiency, together with the other facts and circumstances discussed above, represent a good-faith attempt to assess their proper tax liability. Accordingly, we hold that petitioners have carried their burden with respect to the reasonable cause and good faith exception under section 6664(c)(1) and that petitioners are therefore not liable for the accuracy-related penalty under section 6662(a).
Some of the “other facts and circumstances discussed above” included the following:
- That the Andersens had a close to 50 year or so record of filing returns, and there were no prior problems.
- They testified credibly about how the mistake arose, and the opinion notes that the taxpayers were direct and accepting of their responsibility, and were not defensive.
- The accountant testified, indicating he thought Mrs. Anderson had retired, based on prior conversations with the husband and an information return showing a distribution from a retirement account.
- The accountant was credible and a “highly credentialed tax professional.”
- The prior year return’s income was only $1,000 higher than 2010, the year where Mrs. Anderson’s W-2 income was omitted.
Some Parting Thoughts
Whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, and it is hard to draw general conclusions, especially from a nonprecedential S case.
Steve’s recent posts on penalties have shown that reliance on an advisor may not be enough to get penalty relief. Here, the Andersens did not avoid the penalty based on reliance on professional advice (after all they failed to provide the information to the CPA, a necessary element for a reliance defense). Yet, the presence of a competent professional was a crucial element in the Andersons’ victory.
In addition, way back in the early days of the blog, Steve discussed how in the IRM “under the reasonable cause penalty abatement provisions for the failure to file and failure to pay penalties, is an underutilized provisions for penalty abatement called the first time abate program.” Even though the taxpayers were not able to use that program here—the penalties in the first time abate are for delinquency and not accuracy-related penalties, the case suggests that past tax compliance history can be relevant in assessing whether a taxpayer made a sufficient effort to determine the tax liability in the year in question.
Sometimes when I read penalty cases involving individuals I am struck by how the penalties are inappropriate. Here, I understand why IRS counsel stuck to its guns and tried the case, but I also agree with the court’s conclusion on these facts. I suspect that very few taxpayers leaving off this amount of income would get relief from the penalties, though wonder if the IRM should extend the first time abatement relief to penalties other than failure to file or failure to pay, so that perhaps Counsel or Appeals will feel more comfortable in exercising discretion if there are facts suggestive of an isolated and understandable mistake.
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Thanks for reporting this, as an example of IRS practice and a judge’s response. The case doesn’t seem close to me. Clearly the taxpayer acted in good faith, and made a big effort to comply. The mistake is a big one, but it’s akin to a scrivener’s error in a contract— the kind of slip that can happen even if someone is taking reasonable care.
Thus, this case shows very bad judgement on the part of IRS management. I wouldn’t blame whoever was the lowest-level human IRS decisionmaker, but to get to a court decision, it had to be approved by a manager and the Chief Counsel’s office (if not, lack of such an approval procedure is a management problem in itself). First, the IRS was being unjust. Second, they were unjust publicly, thus hurting their image at a time when it’s in trouble already. Third, they should have known they’d lose in court, and compromised and avoided the litigation cost. Fourth, they hurt IRS credibility with Tax Court judges—it’s unwise to bring weak cases if you’re a repeat player who repeatedly asks a given court for deference to your good judgement. Fifth, this is a case where mercy was justified based on the facts, but there will be roughly similar cases where mercy is NOT justified or the taxpayer is even abusing the possibility of mercy, and even tho this case isn’t precedential— is not binding on future judges— it still make prominent in the minds of whoever reads it the possibility of getting out of taxes this way.
I hadn’t intended to write an essay, but this case is inspiring. And now I think of a sixth reason why the manager was unwise to press the taxpayer here: maybe *his* manager will read my comment and send him to be an auditor in the Texas Panhandle.
Thanks for your comment Eric. I would like to think that I would not have tried this case if I were IRS counsel. Yet I can see why counsel pushed ahead, and why the judge viewed this as a close case. There is a nondelegable duty to review the return. While the omission is understandable in light of the facts I describe, the amount that is omitted relative to the total income reported is significant. And a more than cursory review should alert someone to leaving off the entire amount of someone’s wages.
I do wonder if and to what extent counsel and taxpayer communicated prior to trial. Perhaps counsel did not have the opportunity to reflect or gauge credibility prior to trial.
Policemen and prosecutors exercise discretion all the time, choosing not to pursue winnable cases. It’s part of the job. This case was a closer one for the judge than it should have been for the IRS, because a judge usually doesn’t have the option to decide that a violator is technically guilty but ought not to be punished— that’s executive branch stuff, and all the judge can do is scold. But what reason do you see for IRS counsel pushing ahead with this? Not justice, certainly. Revenue?—doubtful, even if he’d won, given the cost. Deterrence? — the message is that the IRS cares about technical compliance more than honest effort, and it looks to me as if the taxpayer and accountant took reasonable care here, even though they did make a big mistake. Moreover, the only harm done by the kind of mistake they made is that the IRS computer which inevitably catches it has to send them a letter asking for the unpaid tax plus interest. There’s no way anybody’s going to get out of their taxes by filing a return that omits employer-reported wage income, so there’s no need to try to punish honest mistakes in order to scare the dishonest.
As a given, any CPA/Tax Preparer should know that the IRS has the records of W-2 information on file and would not leave this income off of a client’s tax return. Obviously there was a misunderstanding between the taxpayer and CPA in this case as the taxpayers was not notified of the employer’s change of reporting the W-2 income to the employee. The judges decision was wholly correct in this instance, and I can’t see why the IRS itself didn’t recognize the facts and cancel the penalty. The IRS does have the discretion to reduce or negate penalties.
I, too, wonder what the communication was like between the taxpayers and the IRS. I have found that more times than not, appeals officers and IRS counsel are very willing to reduce/waive penalties when you are making good-faith efforts to resolve the matter. It does appear that this matter was done on more of a correspondence level instead of any face-to-face meetings. It has been my experience, these types of correspondence matters are done in a very technical manner and have less discretion than an office audit or local appeals officer.
I am glad they got it waived. I cannot imagine working and forgetting my W2. Especially if I only had one job. The CPA should not have assumed she retired but asked about it.
I realize I’m a little late to the party, but I came across this blog entry via a partner at my firm who was presenting on abatement and I felt that I had to voice an opinion. Full disclosure I have only been a tax professional for 2 years now so take my opinion for what it is (a little green).
As a client service industry we have a fiduciary duty to represent our clients to the best of our abilities and to their benefit (within the confines of the law and professional standards). The decision was an obvious win for the taxpayers and I’m happy for both them and their CPA that they were successful. However, as an outside and objective observer I could not disagree more with the decision.
No competent tax preparer/CPA submits a return without reconciling substantial differences from the prior year through a client interview or bona-fide documentation. Relying on a 1099-R to support an assumption that the wife had retired is minor negligence in my opinion. There are dozens of reasons why someone would receive such a document that have nothing to do with retiring. In fact, the IRS neatly groups and codes these reasons for you in the 1099-R instructions. Even if the 1099-R was coded 7, preparers screw these up ALL THE TIME. I get at least one or two every season.
The taxpayers in question have decades of experience reviewing their own personal tax returns. Obviously this does not make them tax professionals, but it makes them familiar with their situation. All it takes is to look at line 7 of the 1040 to see that something doesn’t look right and if they didn’t catch it they should have. In the opinion it mentions that AGI was only $1,000 off from last year. If that’s all that was looked at during the review, it’s not good enough.
Anyways, good read. I’m glad I found your blog because I’m always looking for solid writers on the subject especially ones that focus on case law.
Thanks for your thoughtful comments Joe.
As someone who does not prepare returns for a living, I have been mildly surprised at the popularity of this post (it is the most widely viewed post on our site). I suspect that the situation of a preparer leaving off some W/2 1099 income is quite common. I leave to others with more practical experience as to what is negligence in preparing a return but I am somewhat dismayed that our tax system does nor readily have a way for a preparer to check in one secure location/taxpayer the issuance of all information returns. It seems that our system is a recipe for mistakes and that even careful preparers and taxpayers may foot fault at times.
Les
A belated thank you for your article on “Omitted Income, Accuracy-Related Penalties and Reasonable Cause”. I have a situation very close to the fact pattern mentioned in your article. However, the link for “Anderson v Comm’r” does not work and I can’t find any 2013 summary cases under the Anderson name. Do you have another cite to get me to the case?
Thanks for your continued commitment to tax education for the profession.
Dennis, thanks for the kind words. We have fixed the link to the case and it is now working. The cite to the case is Andersen v Comm’r, TC Summ. Op 2013-100