With Great (Tax) Knowledge Comes Great(er) Barriers to the Reasonable Cause Exception. Designated Orders, November 4 – 8, 2019

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It was a busy week at the Tax Court, with six designated orders. The orders that weren’t issued by Judge Buch were fairly unremarkable: a tax protestor avoiding (for now) an IRC 6673 penalty here and an order granting summary judgment to the IRS in a Collection Due Process case where the petitioner failed to submit information at the hearing here. Two of Judge Gustafson’s orders were essentially duplicates (same issue, different tax years) dealing with a partnership squabbling over tax settlement terms that are more beneficial to some partners than others (here and here). I was most interested by the lessons that could be found in Judge Buch’s orders, however, and thought that they provided an interesting lesson on the interplay of IRC 6662 and taxpayers of varying sophistication. Deep dive below the fold…

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Getting out of the IRC 6662 Accuracy Penalty: Being a Tax Preparer vs. Relying on a Tax Preparer: Jacobi v. C.I.R., Dkt # 17490-17 (here) and Atala v. C.I.R., Dkt. 9620-18 (here)

Both of Judge Buch’s orders were bench opinions, and both involved (among other things) whether an accuracy penalty should be imposed against the taxpayers. In one of the cases it is easy to sympathize with the taxpayer -in the other, not so much. And yet even the sympathetic taxpayer ends up no better off than the unsympathetic taxpayer with regards to the accuracy penalty… I found this result interesting (perhaps even incorrect) for reasons I will detail later. 

Let’s start with the easy case: Jacobi, where the taxpayer was a CPA that ran his own tax business. Mr. Jacobi’s return is a mess (as one example, he reported almost $60,000 in “cost of goods sold” for his accounting firm, $40,000 of which he tried to double-count as legal fees on a later amended return), and he should clearly know better. He also literally won a +$1M lottery and took a position that the winnings should be taxed at lower capital gains rates than what us working stiffs pay on our ordinary income. This is not a sympathetic taxpayer. But let’s run through his potential avenues for avoiding an IRC 6662 penalty anyway.

First, one may try to attack the penalty on purely procedural grounds -that is, the infamous requirement of supervisory approval under IRC 6751. This opinion doesn’t actually address whether there was supervisory approval for the penalty, and it is unclear whether it was raised or conceded as an issue. PT has covered these sorts of concerns here and here. For now, let’s just assume that there was supervisory approval and it was properly entered into evidence, thus denying the procedural attack for Mr. Jacobi.

Where the IRS asserts an IRC 6662 penalty for “substantial understatement” (6662(b)(2)) a second argument one can make is that their understatement simply wasn’t “substantial” to begin with. This “mistaken identity” argument is largely a numbers game, with the goal of getting the understatement under “the greater of” 10% of the total tax that should have been on the return, or $5,000, whichever is larger. IRC 6662(d)(1)(A).

Even if you can’t do this by prevailing on the merits, you can still do it if you show that a portion of your understatement had either “substantial authority” for your (wrong) position, or you adequately disclosed your position and had “reasonable basis” for it. IRC 6662(d)(2)(B). Basically, your error is removed from the size of your total “understatement” if you meet either of those exceptions. Because Mr. Jacobi’s tax return didn’t adequately disclose “the relevant facts” for his position that the lottery winnings were capital gains, he would need to show “substantial authority” (which is more demanding than “reasonable basis”) to avoid the IRC 6662(b)(2) penalty attributable to that error.

So what authority did Mr. Jacobi rely on for his lottery position, and is that authority “substantial?” You be the judge: for the novel idea that lottery winnings are capital, not ordinary, income Mr. Jacobi apparently relied on a passing conversation with a (now deceased) CPA. The Treasury Regulation on point (Treas Reg. 1.6662-4(d)(3)) provides a whole list of what sources taxpayers can rely on for substantial authority. Not surprisingly, “passing conversation with CPA” doesn’t make the list. Especially when, as Judge Buch notes, “even a cursory search (if one occurred) would have revealed that ““There is no question that lottery payments in the first instance were ordinary income.”” (Quoting Clopton v. C.I.R., T.C. Memo. 2004-95.)

Because there (apparently) are no procedural issues and the understatement is “substantial” under IRC 6662(b)(2) the only remaining hope Mr. Jacobi has left is to argue “reasonable cause” for the mistake under IRC 6664(c). The opinion doesn’t actually address reasonable cause at all (it is unclear if it was raised by the taxpayer, which it would need to be as an affirmative defense). In any event, it’s probably safe to say that it doesn’t exist to excuse Mr. Jacobi’s errors: unsympathetic and sophisticated taxpayers face an uphill battle on reasonable cause.

To better understand the reasonable cause exception, it is instructive to look at the second bench opinion issued by Judge Buch: one that appeared to involve a (more) sympathetic and less-tax-savvy taxpayer: Atala v. C.I.R.

Ms. Atala’s tax situation in 2014 invokes a number of thorny issues: her filing status; community property income; substantiation issues with charitable donations; unreimbursed business expenses; and substantiation issues with her own side-business. This is close to a “greatest-hits” compilation from the National Taxpayer Advocate’s perennial “Most Litigated Issues” list.

This does not appear to be a case of the taxpayer creating the problem all on their own (for example, by just making up charitable donations). In this case, Ms. Atala appears to have lived with her husband until November 2014; frequently was required to travel for work; could substantiate cash contributions to charity (in the amount of $8050) but didn’t have an itemized receipt for her non-cash donations. For almost every issue that went against Ms. Atala there appeared to be at least some mitigating factor (or rationale) for why the mistake may have happened. And on top of all of that, Ms. Atala relied on a tax return preparer to sort these things out in filing her 2014 return. But apparently the return still got things wrong. So much so, in fact, that an IRC 6662 penalty for substantial understatement was imposed. 

But might Ms. Atala have a case for the “reasonable cause” exception where Mr. Jacobi, CPA, did not? One may be inclined to think so. 

“Reasonable cause” is essentially an equitable relief provision. The statute asks whether the taxpayer acted “in good faith” and the regulation provides that “Generally, the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.” Treas. Reg. 1.6664-4(b)(1)

As we are told ad nauseum “taxes are hard,” so innocent mistakes are likely to be made. It seems punitive to impose a penalty on mistakes made by taxpayers making a good faith effort to get it right. And to some degree you can find this intuitive notion taking hold in court decisions, where it appears judges are loath to penalize pro se petitioners appearing to be caught in the web of our tax code. I even recall at a previous ABA Tax Section conference one Tax Court judge providing a general rule where if it took two pages to explain the law at hand and why the taxpayers application of it was incorrect, the judge was less likely to uphold an accuracy penalty. 

Beyond general equitable notions of “trying your best,” a particular safety-valve has developed through court decisions where taxpayers rely on a tax return preparer. The leading case is Neonatology v. C.I.R., 115 T.C. 43 (2000), which provides a list of factors for when reliance on a tax professional might get you out of an IRC 6662 penalty, broken down generally as: (1) was the advisor competent enough to reasonably rely on, (2) did the taxpayer provide enough information to the advisor, and (3) did the taxpayer actually (in good faith) rely on the advisor? Mr. Jacobi probably didn’t do so in good faith… and there are perhaps questions whether this supposed conversation ever even occurred with the now-deceased CPA. So Neonatology is probably unavailing for him. What about for Ms. Atala?

The court’s analysis on that point is a bit confusing to me, and it never directly addresses Neonatology. In Judge Buch’s words, “Although Ms. Atala used a return preparer, the deficiencies principally relate to a failure to substantiate expenses, and she testified that she provided the information that was reported to the return preparer. Ms. Atala did not establish reasonable cause for her understatement.” I take Judge Buch’s reasoning to be that you don’t get a free pass by just giving numbers to a tax preparer without anything more. However, I think that may be a bit uncharitable. The facts show that the tax preparer never actually asked for any proof of the expenses -and that at least some of the expenses (the substantial cash charitable deductions) did end up being substantiated. Perhaps this is a way of saying “you gave some information, but not enough information to rely on the tax preparer in good-faith” (prongs 2 and 3 of Neonatology argument).

But I am also surprised at the penalty for another reason. At least some of the underlying deficiency results from the Court’s finding that Ms. Atala was not entitled to claim her minor niece and nephew as dependents.

Normally this would be unremarkable. Except that this is not a case where a taxpayer just puts a related individual on their return that they have had nothing to do with. Rather, the facts here show that Ms. Atala lived with her niece and nephew in the tax year and provided their housing. Those facts show (or strongly suggest) all of the key tests met to be a qualifying child: age (the niece and nephews are minors), relationship (niece and nephew suffices), and residency. The only test remaining is support… and here I actually think Judge Buch gets the law wrong. 

Judge Buch finds the elements I quoted to be met, but nevertheless does not find that the niece and nephew are qualifying children. This is because Ms. Atala “did not show that she provided support for her niece and nephew aside from providing housing, as required by section 152(c)(1)(D).”

The problem is that section 152(c)(1)(D) says something quite different than that the taxpayer must show they supported their qualifying child. What it actually says is that a qualifying child is an individual that “has not provided over one-half of such individual’s own support[.]” [emphasis added]. In other words, the test is whether the child supported themselves. It is (mostly) immaterial who the support came from so long as it wasn’t the minor supporting themselves. Over half the support could have been provided by Santa Claus, Ms. Atala, or a friendly neighbor. In all cases the support test would be met with regards to Ms. Atala. Minors don’t usually support themselves, so I rarely have to quibble with the IRS on this point. But here it appeared to be a difference-maker. 

This is particularly important because one of the main benefits Ms. Atala was seeking was the Child Tax Credit, which (unlike the Earned Income Credit)  you can receive even if Married Filing Separate (which is what Ms. Atala’s filing status would be, since she appears ineligible for Head of Household). In 2014, this could have shaved off a solid $2,000 of tax. Or at the very least, shave off the accuracy penalty associated with that understatement.

Finally, recall that this was a bench opinion -which, being non-reviewed and non-precedential, would seem to be ideal for equitable arguments and sympathetic taxpayers. And though I am not privy to all of the facts and circumstances of the case, that the penalties were upheld in a bench opinion contributed to my surprise. To me, it looked like an instance where with the right advocacy Ms. Atala may have had a strong case to get out of the penalty -or even get some of the credits related to her niece and nephew that she originally claimed.

About Caleb Smith

Caleb Smith is Visiting Associate Clinical Professor and the Director of the Ronald M. Mankoff Tax Clinic at the University of Minnesota Law School. Caleb has worked at Low-Income Taxpayer Clinics on both coasts and the Midwest, most recently completing a fellowship at Harvard Law School's Federal Tax Clinic. Prior to law school Caleb was the Tax Program Manager at Minnesota's largest Volunteer Income Tax Assistance organization, where he continues to remain engaged as an instructor and volunteer today.

Comments

  1. Bob Probasco says

    Caleb,

    Nice post.

    I think Atala is another example of an underlying confusion about penalty defenses. Substantial authority is, of course, based on *legal* authority. But reasonable basis may be as well. See Treas. Reg. 1.6662-3(b)(3), which suggests looking at the same types of “authority” as defined for purposes of “substantial authority” when determining whether the taxpayer had reasonable basis. What about *factual* authority? What if you have some factual support but not enough to win on the merits of the tax? Can that be sufficient for a penalty defense? See Osteen v. Comm’r, 62 F.3d 356 (11th Cir. 1995).

    And I suspect reliance of a tax return preparer is also probably seen as important to a penalty defense *primarily* because you’re relying on his/her expertise as to the *legal* standard rather than confirmation of the underlying facts. We’re starting to move away from that in some instances, such as Form 8857, the due diligence checklist for claiming EITC. But we’re not all the way there yet and with respect to substantiation, a tax return preparer wouldn’t necessarily carry much weight for a reasonable cause defense. I’m not sure we can really expect tax return preparers to ask for proof of expenses.

    So – with respect to general substantiation, I’m not surprised by the decision. But with respect to whether the kids are “qualifying children,” that’s where it might make sense.

    And mistaking the support requirement for “qualifying child” with the support requirement for “qualifying relative” confuses things further.

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