Taxes are computed based on accounting records. Accounting records are often complied by bookkeepers who have no tax training or experience.
The bookkeepers may not intend to provide tax advice. Their work product may be used to prepare tax returns, however. The tax return preparer may move the numbers from the bookkeeper’s profit and loss statement directly over to the tax return.
This raises the question as to whether work performed by bookkeepers can be relied on when preparing tax returns? Say the IRS audits the return and concludes that the bookkeeper made mistakes? Can the taxpayer avoid penalties for the bookkeeper’s mistakes? The court recently answered these questions in Pankratz v. Commissioner, T.C. 2021-26.
Facts & Procedural History
The taxpayer owned several small businesses. This included hotels, gas stations, etc.
The taxpayer hired a CPA firm to do the bookkeeping for most of the businesses. The bookkeeper was a CPA. She performed the following tasks:
she recorded income and expenses in QuickBooks from invoices she received. She sorted the invoices by entity and got her manager’s approval to pay them if needed. Gerlach would then enter expenses into QuickBooks and print the checks. She also did the payroll for some of these businesses.
For his ranching operations, the taxpayer used a long-term employee to perform the bookkeeping. The employee had an accounting degree. The employee performed the following tasks:
his role grew to include paying and filing invoices, depositing checks, reconciling bank statements, and compiling and collecting other financial information. He also prepares information for Pankratz’s income-tax return every year.
The taxpayer used a different bookkeeper for two of the gas stations. The bookkeeper was the ex-wife of the on-site manager. It does not appear that this bookkeeper had any accounting education or experience.
The taxpayer’s CPA used these books to prepare the tax returns.
The IRS audited the taxpayer’s returns and made several adjustments. Tax litigation ensued. Most of the issues were settled with the IRS. One of the remaining issues was whether the taxpayer was liable for accuracy related penalties.
The taxpayer argued that he should not be penalized for bookkeeping mistakes when he had a good bookkeeping system in place.
Accuracy Related Penalties
The IRS usually imposes accuracy-related penalties after an audit if there are any adjustments to tax proposed by the auditor. This is almost automatic.
In many cases, penalties are imposed with based on the thought that it provides the IRS Office of Appeals something to give away if the taxpayer files an appeal. The hope by the IRS audit function is that Appeals will not settle the tax liability if it has already given away something substantial.
This is not the reason why Congress provided for penalties, but it is the reason why many penalties are imposed. The rules say that the penalty can only be imposed if there is negligence, disregard of our tax rules, substantial understatement of income tax, or certain over-and undervaluations.
The amount can be substantial. The penalties are 20% of any underpayment of federal tax. This is why penalties are often disputed in tax court litigation.
Accuracy-related penalties do not apply if the taxpayer can establish reasonable cause for the failure.
There are several theories that can establish reasonable cause. One theory can be reliance on advice from a tax advisor.
The courts have created a three factor test for the reliance on tax advice defense. Namely, the tax advisor has to be competent, they have to provide information, and the taxpayer has to rely in good faith on the advice.
Can a Bookkeeper Be a Competent Tax Advisor?
The court noted that a bookkeeper can be a competent tax advisor in some cases.
It did find that the long-term employee was not a competent tax advisor, however:
When we apply this practical test, we find that Horning was not a competent tax adviser. He is not a CPA. He is not an attorney. He is not a full-time return preparer. He has no professional license of any kind. He is just a longtime employee who provides financial-related support to Pankratz and has a bachelor’s degree in accounting. We are specifically not saying that a professional license is always required for a reliance defense to penalties, only that Horning’s experience is not enough to make him competent to prepare a large and complex tax return which included information from over a dozen businesses and farms. Pankratz himself knew that his usual way of preparing returns for his businesses had led to understatements of tax in the past. And it leads us to find again, as we did in Kirman v. Commissioner, T.C. Memo. 2011-128, 101 T.C.M. (CCH) 1625, 1633 (2011), that a longtime preparer may not be a competent adviser on whom a taxpayer could reasonably rely.
This shows that the bookkeeper has to have some tax training or experience or the return has to be relatively simple.
Does a Bookkeeper Provide Advice?
The providing information factor usually involves providing tax advice. But, as in this case, providing information can also include compiling books and records that feed into the tax return. The compilation of books and records can satisfy this factor.
The regulations confirm that this is the case:
“erroneous information * * * inadvertently included in data compiled by the various divisions of a multidivisional corporation or in financial books and records prepared by those divisions generally indicates reasonable cause and good faith, provided the corporation employed internal controls and procedures, reasonable under the circumstances.”
The court noted that reliance on records is sufficient:
There are at least some cases that analogize bookkeepers to more obviously professional tax advisers, like CPAs or lawyers. When we do this, we apply the usual Neonatalogy test and look for professional competence, provision of information, and reasonable reliance on advice in good faith. See, e.g., Isaacs v. Commissioner, T.C. Memo. 2015-121, 109 T.C.M. (CCH) 1624, 1640 (2015). Then there are the cases where we trace underpayments on returns to faulty bookkeeping and ask whether the taxpayer was reasonable and acted in good faith in relying on his bookkeeper or the system of bookkeeping that he set up. See, e.g., Bigler v. Commissioner, T.C. Memo. 2008-133, 95 T.C.M. (CCH) 1525, 1528 (2008).
Thus, the providing information factor was satisfied.
Is Reliance Reasonable?
The first question the court considered is whether a taxpayer can reasonably rely on a bookkeeper. The court considered each bookkeeper and agreed that reliance on two of the three was reasonable.
The court had little difficulty finding that the reliance on the bookkeeper from the CPA firm was reasonable. The court noted that the IRS allowed most of the deductions based on this CPAs records. The IRS only disputed the allocation of expenses between different Schedule C businesses, apparently.
For the ranching operations, the court found that the reliance on the long term employee was reasonable. This was based on the employee’s track record of keeping the books over time. That the employee had an accounting degree probably helped too.
For the two gas stations, the court did not find that reliance on the bookkeeper was reasonable. There was no evidence that this bookkeeper had any accounting education or training. She was merely the ex-wife of the on-site manager. For this type of unlicensed bookkeeper, the court cited Embroidery Express, LLC v. Commissioner, T.C. Memo. 2016-136, 112 T.C.M. (CCH) 76 (2016).
According to the court, Embroidery Express requires the books prepared by an unlicensed bookkeeper to be reviewed by the experienced or credentialed tax preparer. In this case, the tax return preparer did not review the bookkeeping records. He merely used the records for inputs into the tax return.
This case confirms that compiling books and records can count as providing tax advice for the reasonable cause defense to penalties.
This case also cautions taxpayers that if they use unlicensed and inexperienced bookkeepers, they should have the books reviewed by an experienced tax preparer. This can help satisfy the reasonable reliance factor.