Court: Complex Tax + Professional Advice = No Tax Penalty

We know that we can take steps to minimize our taxes. Our tax laws allow for this and, on review, the courts have made this clear.

Tax penalties are usually the problem with taking tax positions in situations that are not entirely clear. Taxpayers who find themselves having to make decisions in these gray areas have to either find substantial authority for their position or, if the IRS adjusts their returns, try to show reasonable cause.

Reasonable cause may be shown by getting a formal written legal opinion on a tax position or, absent that, showing that the taxpayer relied on the tax advisor or made an honest mistake. The recent Yaguda v. Commissioner, T.C. Summary Opinion 2022-21, case provides an example of when and how reasonable cause is established.

Facts & Procedural History

This case involves a taxpayer whose business was forced into bankruptcy. The business was an S corporation. The bankruptcy receiver took over the business, but later in the year, he abandoned the business. He wrote the taxpayer a letter explaining that the business was abandoned and was to be handled by the taxpayer.

The taxpayer hired a CPA to prepare his tax return for the year at issue. The taxpayer did not report the flow-through income from the business as he apparently believed that the business was part of the bankruptcy estate (which files its own tax return) and that the receiver had filed the tax return.

The IRS audited the taxpayer’s individual tax return and added the flow-through income from the S corporation to the taxpayer’s individual income tax return. It also assessed penalties. This is an interesting case as to whether the taxpayer abandoned his interest in the S corporation and should not report the S corporation income, but it is also noteworthy for how the court handled the penalties. We’ll just focus on the penalty aspect of this case.

About the Accuracy-Related Penalty

The accuracy-related penalty is equal to 20 percent of the understatement of tax. For example, if the IRS determines that an additional $100,000 of income tax should have been reported and paid, the IRS may assess a $20,000 accuracy-related penalty.

This penalty only applies if the understatement is due to negligence or the understatement is substantial (there are other less common instances that the penalty applies–you can read a more in-depth explanation of the penalty here).

The penalty should not be imposed, or should be removed if it is imposed, if the taxpayer had reasonable cause for the understatement.

Reliance on a Tax Advisor

There are a number of circumstances that establish reasonable cause for not imposing an accuracy-related penalty. The most common is reliance on a tax advisor.

The leading case on reasonable cause for avoiding penalties is United States v. Boyle, 469 U.S. 241 (1985). The Boyle case says that relying on advice provided by an attorney or accountant can qualify as reasonable cause. It even says that the taxpayer need not get a second opinion.

The Neonatology Associates v. Commissioner, 115 T.C. 43, 99 (2000) provides additional factors to consider for this defense. To qualify under this line of cases, the taxpayer has to show that:

• The adviser was a competent professional who had sufficient expertise to justify reliance,
• The taxpayer provided necessary and accurate information to the adviser, and
• The taxpayer actually relied in good faith on the adviser’s judgment.

The court has even extended these cases to reliance on bookkeepers whose work is incorporated into tax returns. There are scores of other cases that address other nuances, such as relying on an advisor who makes obvious errors, cases where the taxpayer did not even review the returns, and whether the advice has to be verbally communicated or a tax return form suffices.

Honest Mistake of Law

A mistake of law is another circumstance that has been found to be reasonable case.

The Higbee v. Commissioner, 116 T.C. 438, 446 (2001) case is the leading case for this proposition. It stands for the idea that an “honest misunderstanding of the law that is reasonable in light of the facts and circumstances” can qualify as reasonable cause.

This line of cases involves complex tax positions or tax reporting. As an example, Elaine v. Commissioner, T.C. Memo 2017-3, involved the reporting of IRA distributions. The court noted that taxpayers often fail to realize that there is no hardship rule that exempts these distributions from tax (there is a hardship rule that exempts the pre-59 1/2 addition to tax).

The Combined Reliance & Mistake Cases

Even though reliance on a tax advisor and the honest mistake of law cases provide a separate basis for avoiding penalties, the circumstances where both theories apply are often more difficult.

As it turns out, the IRS often does not agree that the taxpayer has established reasonable cause. This happens at the service center or IRS agent level and with IRS appeals officers and IRS attorneys. When both circumstances are presented, the IRS attorney has more ways to say “no” as each theory has its own nuances. The IRS is able to say that one theory does not apply for XXX reason and just end their analysis there.

This brings us back to the Yaguda case. The Yaguda case involved reliance on a tax advisor and an honest mistake. The court cites the rules for both theories. The court combines both theories as a basis for not imposing penalties:

Petitioners made a reasonable, good faith effort to correctly assess their tax liability. Petitioners timely filed their tax return, reported other passive income, and provided documentation in support. Further, they relied on the assistance of a CPA in preparing their return. It was not entirely clear from the proceedings in the California Superior Court and the bankruptcy court the tax treatment of the shares in EFI.

The court notes that “[g]enerally, the most important factor is the extent of the taxpayer’s efforts to assess his or her proper tax liability.” Taxpayers who have been or may be assessed penalties may cite this case for this proposition. This can be particularly useful to avoid IRS denials based on one theory or the other.

The Takeaway

Accuracy-related penalties can be substantial. A well-written and presented penalty abatement letter or request that the penalties not be imposed can help save taxpayers from having to pay this penalty. The circumstances that qualify are set out in case law. As this case shows, the nuances of these cases have to be considered in making this request. Marshaling the cases and presenting the cases based on the facts and circumstances can go a long way to convincing the IRS not to impose penalties or to remove them if they have already been imposed.