Reliance on an Incompetent Tax Advisor

Published Categorized as IRS Penalties, Reasonable Cause, Tax Procedure
Qui Tam Settlements And The Tax Benefit Rule, Houston Tax Attorney

The IRS often imposes penalties for various tax return errors and omissions. Taxpayers may defend against certain penalties by showing reasonable reliance on professional tax advice. However, the competence and expertise of the advisor are key, as highlighted in a recent U.S. Tax Court case, Wilson v. Commissioner, T.C. Summary Opinion 2008-91. The case considers a situation where the tax advisor was incompetent and the question was whether the taxpayer could rely on an incompetent tax advisor to avoid the imposition of penalties.

Facts & Procedural History

The taxpayers in this case had their return prepared by a tax services company, which omitted their Social Security income. After the IRS sent a notice based on its income matching system, the taxpayers filed an amended return and paid the additional tax.

The IRS also assessed an accuracy penalty. The taxpayers contested the penalty, arguing they reasonably relied on the tax preparer. When the return position was not accepted, the taxpayers filed a petition with the U.S. Tax Court specifically to contest and redetermine the penalty.

Accuracy-related penalties are a specific type of penalty the IRS can assess when a taxpayer’s return contains certain errors or misstatements resulting in underpayment of tax.

Some triggers for these penalties include:

  • Negligence or disregard of tax rules
  • Substantial understatements of income
  • Misvaluation of property for claiming excessive deductions
  • Omission or misreporting of income sources

The penalty is generally 20% of the additional tax owed. The IRS often imposes this in conjunction with assessing the additional tax liability.

Accuracy penalties apply to various tax return mistakes and underpayments. But the reasonable cause defense, if applicable, can rescue taxpayers from accrued penalties.

Reasonable Cause for Penalties

There are several defenses that taxpayers may assert to ward off accuracy-related penalties. Reasonable cause is a common defense. It is not available for all penalties, such as the trust fund recovery penalty.

Reasonable cause can include the good faith reliance on tax advice from a reputable tax advisor. Neonatology Associates P.A. v. Commissioner, 115 T.C. 43 (2000) is the most often cited case for this defense.

In Neonatology, which involved a deduction from an employee benefit plan, the U.S. Tax Court concluded that penalties should be imposed given that the taxpayers only relied on an insurance agent who stood to profit considerably from the transaction rather than from a competent, independent tax professional with sufficient expertise to warrant reliance.

This reliance on advice differs from reliance on a tax advisor for knowing the tax filing deadlines. It is more substantive than just a date that was missed.

Thus, taxpayers can often avoid penalties for an incorrect position by showing:

  • They made a good-faith effort to determine the proper tax treatment.
  • They reasonably relied on the advice of a competent, independent tax professional.
  • They provided necessary and accurate information to the advisor.

However the advisor must have sufficient expertise in the issue. Reliance on promoters of questionable tax schemes or advisors with conflicts of interest is given less weight. There is also the issue of waiver of privilege as raising this defense can void any tax practitioner or attorney-client privilege for the advisor who provided the advice.

Reliance on an Incompetent Tax Advisor

In this case, the taxpayers relied on a tax advisor employed by the return preparation firm. The court noted:

  • The tax advisor advanced frivolous arguments indicating doubtful competence.
  • As an employee of the firm, his independence was questionable.
  • He showed limited expertise on the reporting issue by overlooking the omitted income.

This is not sufficient to avoid accuracy-related penalties.

The Takeaway

This case illustrates the heavy burden taxpayers face in proving reasonable cause based on professional tax advice. Competence and impartiality are key for any advisor. Taxpayers should thoroughly research an advisor’s qualifications and expertise before relying on their guidance. If penalties arise, the strength of the reliance defense hinges on the caliber of the expert consulted. Be sure to consult a trusted tax advisor if you have any concerns about penalties.

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