Reliance and Omitted Income: Taxpayer Cannot Avoid Penalties Even When Using Longtime Preparer

0 Flares Filament.io 0 Flares ×

I do not prepare tax returns. But I feel for the long-suffering preparers who try their best to get the information from clients to prepare an accurate tax return.  For people with a variety of sources of income, like self-employed consultants with multiple clients, the process is burdensome—at least when compared to employees who more or less automatically get W-2s with withholding that tends to approximate liability.  I also feel for taxpayers who have income from a myriad of sources because collecting and insuring that the income from each source that gets reported can prove difficult.  Neither taxpayers nor preparers have a computer system akin to the IRS underreporter program that matches all of their third party returns against the amounts reported on the returns.  If such a program existed presubmission to the IRS, returns would be much more accurate.

read more...

The recent case of Walton v Commissioner involved a psychologist whose 2015 tax return failed to include almost $170,000 in compensation. Prior to 2015, Walton had been employed with a consulting firm. In 2015 she went out on her own and had multiple clients. When it came time to file her 2015 return, she attempted to give all her information to her preparer but, as we will see below, she may not have given all of her 1099’s and the preparer failed to include a sizable chunk of her income. The issue in the case involved substantial understatement penalties-namely whether the IRS satisfied the supervisory approval requirement under 6751(b) or whether her omission should be excused by good faith reliance on her longtime experienced CPA return preparer.

In this post I will discuss the latter issue though I note the opinion discusses that the 6751(b) approval was not necessary because of the exception to the supervisory approval requirement for a “penalty automatically calculated through electronic means.” The opinion discusses how Walton’s omission was flagged by the IRS’s Automatic Underreporting Program (AUR) and thus was “determined mathematically by a computer software program without the involvement of an IRS examiner” leading it to conclude that the penalty was “automatically calculated through electronic means.” (citing Walquist v Comm’r, which Keith discussed in Automatically Generated Penalties Do not Require Managerial Approval and which Bob Kamman also addressed in Some Facts About the Walquist Case, Along with Some Nuance).

After rejecting the 6751(b) defense the court turned to whether Walton had reasonable cause for the omission and whether she acted in good faith. In setting up the issue the opinion notes that reliance of a qualified and competent preparer is not enough; there must be evidence that the taxpayer acted with diligence and prudence. 

In evaluating whether she acted with both prudence and diligence, the opinion discusses the back and forth between Walton and her preparer. As a starting point the atmosphere here is bad: the return left off almost 1/3 of her total compensation. Yet the exchange showed she gave her preparer a starting point on income that was well in excess of the 1099’s she had sent over. In January of 2016 she sent an email to her preparer stating that “I am sure I need to pay taxes. If I did the math right, I earned about $525k in 1099 pay.” A month later Walton sent over a W-2 showing some income from her former employer as well as five 1099 MISC’s totaling over $350,000.  Fast forward to April 12: another CPA at the firm sent Walton an email asking a bunch of questions on unrelated issues as well as if she was sure that she had sent all the 1099’s as the total was well below the 525,000 estimate in her January email. 

Two days later Walton responded to the questions but did not answer the 1099 MISC question.  After that exchange the CPA firm obtained an extension to October 15th. On September 29 her preparer (who had done her taxes for twenty years and prepares over 1,000 returns a year) emailed Walton a list of things he needed to complete the return. That did not include a specific ask for 1099 MISC’s but instead focused on 1099- DIV, business and travel expenses and other issues. Walton responded and said that she “attached the 1099s to the last emails”, and the preparer replied that “I have all the 1099s and the kids accounts, … the taxes and interest on the house …[and] the charities as well.”

The opinion notes that it is the preparer’s practice when there is a discrepancy between a client estimate and documentation to rely on the numbers in the document. Unfortunately for Walton, she testified that she did not review the return before the preparer e-filed it as she trusted his expertise.  That admission was fatal to the defense—even though there was some uncertainty as to whether she gave all 1099 MISC’s to her preparer, the failure on Walton’s part to review the return led to a finding that she failed to act with the prudence and diligence necessary to avoid the penalty.

Conclusion

In reading this opinion I was reminded of one of my early blog posts back in 2013,  Omitted Income, Accuracy-Related Penalties and Reasonable Cause. That post discussed Andersen v Comm’r, a summary opinion where a taxpayer also used a longtime preparer and left 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. The opinion found that the taxpayer acted with reasonable cause and good faith, looking to an almost 50 year record of taxpayer compliance, only a slight difference in income from the year in question and the prior year’s return and circumstances that showed how the preparer mistakenly believed that he had all the information returns from the taxpayers. 

All of these cases are fact specific. Walton does reveal how burdensome our filing system is. The amount of time necessary to fish for all information returns is wasteful and prone to error. Taxpayers can set up online accounts with the IRS so that they (and their preparers) can see what information returns IRS has received, but that system is not easily accessible. While I understand the court’s conclusion in Walton, we would all be better off if taxpayers and their preparers could easily see all information returns on file. Our system does not make it easy. I am glad I do not prepare tax returns for a living.

About Leslie Book

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

Comments

  1. Bill Nemeth, EA says

    Comment on your statement:
    Neither taxpayers nor preparers have a computer system akin to the IRS underreporter program that matches all of their third party returns against the amounts reported on the returns. If such a program existed presubmission to the IRS, returns would be much more accurate. True Statement.

    For reference, there is a commercially available program today which will compare the FILED return with the taxpayer (and spouses) reported IRS Wage & Income and generate an exception report. This year the IRS will open Wage & Income Transcripts on May 23. If a tax professional with an IRS e-Services Account that includes Transcript Delivery System and has an 8821 or 2848 on file with the CAF unit, he can use this program to pull the transcripts (filed return; wage and income) and do the matching on the FILED return.
    This program will generate an exception report showing omitted income.

    The tax professional can make a judgement on whether to file a voluntary amended return. (Assume $1,000 1099-INT is omitted and taxpayer is in the 12% Tax Bracket, the additional tax would be $120; AUR unit would NOT flag this mismatch as it does not meet the trigger threshold. With the introduction of e-Filing Amended Returns in the summer of 2020, an amended return could be e-Filed and NOT clog up the IRS return processing system.

    There is another interesting aspect. The IRS AUR unit runs its matching program later in the year and if a reasonable mismatch is discovered, will put a “flag” in the account transcript (Code 922 – Review of Unreported Income) about 5 months before the AUR unit sends the CP2000. This program can “monitor” account transcripts for the code 922 and if one is discovered, the tax professional can analyze the situation and, if required, file a voluntary amended return (called a QAR – Qualified Amended Return) which will eliminate the potential accuracy-related penalty if the QAR is received BEFORE AUR sends the CP2000 (or CP2501) Notice.

    Interesting Trivia Question – How much income can be omitted from a return before it is flagged by the AUR Unit ?

    Answer: It is NOT the amount of income – it is the amount of ADDITIONAL TAX on the omitted income. From observation, the threshold seems to be in the $500 additional tax range.
    CP2000 threshold on erroneously reported AOC (American Opportunity Credit – Think 1098-T) appears to be in a similar range.

    • Why isn’t this process built into the tax filing program? Because these penalties generate massive increases in Revenue. How much of the penalty collected is allowed to be kept by the IRS? Can we say
      C O N F L I C T O F I N T E R E S T ?

    • Bob Kamman says

      Electronic filing of amended returns still clogs up the IRS system, because there is review by at least one and often two examiners, just as there is with paper returns. At best, the mail room delay of a day or two (in normal times) is avoided. If the taxpayer is not expecting a refund, what’s the hurry?

      As I often point out to the annoyance of other preparers, we have a tax on income, not on pieces of paper. The cult of the 1099 disciples is the intended consequence of the information-reporting regimen that IRS has managed to install over several decades. However, in many cases it discourages voluntary compliance, because of the taxpayer attitude “if I didn’t get a 1099 for it, it’s not taxable.”

      The key but overlooked fact here is that the taxpayer had a business bank account, and neither she nor the preparer bothered to add up 12 monthly totals for deposits to match them with the 1099’s. “Ms. Walton’s clients paid her by direct deposit into her Citibank business account.”

      Meanwhile, the Internal Revenue Manual section from 2012, cited by the opinion, has been removed. The source to use now is the following 2020 revision. The take-away is the legal fiction that if there is (as here) no taxpayer response to the initial notice, the penalty is assumed to have been assessed without human involvement, even though an IRS employee reviewed the case before the first notice was issued.

      IRM 20.1.1.2.3.2 (10-19-2020)
      Automated Underreporter and Correspondence Examination Automation Support Programs
      (1) When the IRC 6662 accuracy-related penalties are systemically assessed under the Automated Underreporter (AUR) Program or Correspondence Examination Automation Support (CEAS) Program without a human employee independently determining the appropriateness of the penalty, the penalty is considered automatically calculated through electronic means. For example, when the taxpayer does not submit a response to the 30-day letter that proposes the penalty, the penalty is automatically calculated through electronic means and may be assessed without written supervisory approval.

      (2) However, if a taxpayer submits a response, written or otherwise, that challenges the penalty or the amount of tax to which the penalty is attributable, and an examiner reviews the case, written supervisory approval under IRC 6751(b)(1) is required before any subsequent written communication that includes the penalty. The exception for penalties automatically calculated through electronic means no longer applies once a Service employee makes an independent determination to assert a penalty or to assert adjustments to tax on which a penalty is applicable.

  2. This automatic penalty calculation is to be automatically turned over to a live auditor the moment the taxpayer makes a formal inquiry by phone or by letter to the Audit department about the AUR. Due to the fact that the penalty was determined mathematically by a computer software program without the involvement of a human IRS examiner, we conclude that the penalty was ‘automatically calculated through electronic means,’ sec. 6751(b)(2)(B), as the plain text of the statutory exception requires and pursuant to tax statute and due process the live auditor must determine if the cause was without intent, a human mistake or a wrongfully filed information return. Something AUR programs cannot do. It really screams that the AUR is completely unconstitutional and should be canned like the Substitute for Return program finally was. Too many good Americans’ financial lives are being destroyed by bad, archaic programs.

  3. Hi Cindy,
    I admire your spirit (of the law). The question I ask myself, after MANY governmental requests to follow the law, is, who is paying who for tax administration? The Tax Court and the DOJ are most always in agreement, the District Courts and the DOJ are most always in agreement. Though you make a logical argument, I’m confident that more likely than not, your argument will fall on deaf ears, and your client will lose, and the Tax Court will uphold the IRS’s position, in the name of revenue. ‘The truth is what I say it is’ ! Good luck and Be Well.

  4. Ruth Rowlette says

    I am a long time EA and a tax attorney in Northern California having worked for IRS in Exam and Chief Counsel’s office prior to private practice. Even tho an, EA I do not prepare my clients returns and I do not even prepare my own tax returns.

    I am completely appalled at taxpayers who take the position that if there is no 1099, then the income does “not exist”. If the taxpayer has that level of income, she certainly has the financial wherewithal to hire a monthly book keeping service to prepare a complete and accurate set of books and records and accurately report her income. Reliance on her CPA is no excuse for that level of under reporting. It is not the job of the tax preparer to anticipate the tax payer’s nature or amount of income. That is and remains the taxpayer’s responsibility. To understate her income by 1/3rd is simply irresponsible and in my opinion, she deserves to pay the penalty and not shuffle the blame off to her CPA.

Comment Policy: While we all have years of experience as practitioners and attorneys, and while Keith and Les have taught for many years, we think our work is better when we generate input from others. That is one of the reasons we solicit guest posts (and also because of the time it takes to write what we think are high quality posts). Involvement from others makes our site better. That is why we have kept our site open to comments.

If you want to make a public comment, you must identify yourself (using your first and last name) and register by including your email. If you do not, we will remove your comment. In a comment, if you disagree with or intend to criticize someone (such as the poster, another commenter, a party or counsel in a case), you must do so in a respectful manner. We reserve the right to delete comments. If your comment is obnoxious, mean-spirited or violates our sense of decency we will remove the comment. While you have the right to say what you want, you do not have the right to say what you want on our blog.

Speak Your Mind

*