The IRS is quick to impose penalties. Many penalties are automatically imposed by the IRS’s computers. Even on audit, the IRS’s lead sheets direct IRS auditors to consider penalties before closing the audits.
Most penalties can be abated if the taxpayer can establish reasonable cause. This is a facts and circumstances analysis. The courts have accepted several types of arguments for not imposing penalties.
Reliance on a tax advisor is one such argument. The argument is that taxpayers should not be liable for penalties if they relied on tax advice from a competent and informed tax advisor. This argument is extended to tax reporting too. The taxpayer should not be liable for penalties if the tax preparer makes a reporting error on a tax return.
But what about obvious errors? Can the taxpayer avoid penalties if the tax return preparer makes an obvious error that would have been discovered if the taxpayer reviewed the tax return? Put another way, can taxpayers avoid penalties if they fail to adequately review their tax return? The court addresses this in Walton v. Commissioner, T.C. Memo. 2021-40.
Facts & Procedural History
The taxpayer was a psychologist. She operated as a sole proprietor in 2015. The taxpayer prepared a spreadsheet using her bank statements and determined that she earned $525,000 in 2015. She conveyed this message to her tax return preparer by email.
The tax return preparer responded by email noting that the Forms 1099 they were provided did not add up to $525,000. They added up to $351,026.
The taxpayer and her tax preparer addressed other issues, but did not address the discrepancy in the Forms 1099.
The tax return preparer then eFiled the return with the lower income amount.
The taxpayer reviewed the return and signed the eFile authorization form after the tax return was already filed.
Instead of an audit by the IRS, the IRS sent the taxpayer a notice of deficiency for the missing Form 1099 income. The notice included a $12,503 substantial understatement penalty.
The Substantial Understatement Penalty
The substantial understatement penalty is 20% of the amount of a “substantial understatement of income tax.” An understatement is substantial if it is more than $5,000 or 10% of the tax that should have been reported on the tax return.
A taxpayer can avoid a substantial understatement penalty if she can show that she had reasonable cause and acted in good faith. This requires a facts and circumstances analysis.
Generally, the courts have found reasonable cause if the understatement is attributable to tax advice from a competent and informed tax advisor. Even errors by a bookkeeper that lead to tax understatements can qualify.
Reasonable Cause Defense
The taxpayer asked that the IRS abate the substantial understatement penalty. Her argument was based on reliance on her tax advisor:
- She had used the same CPA to prepare her tax returns for 20+ years.
- The CPA was competent and in good standing.
- She provided the income amount to the CPA firm via email.
These facts would suggest that the penalty should not be imposed. This satisfies the three-factor test set out by the courts for the “reasonable reliance on an advisor” defense to penalties.
Failure to Review the Tax Return
There was one additional fact cited by the court, however. The court notes that the taxpayer failed to adequately review her tax return and she failed to do so before the tax return was filed:
Ms. Walton did not review her 2015 draft Federal income tax return before Mr. Milo’s firm efiled it on her behalf. She trusted in Mr. Milo’s expertise and experience and believed that he would be able to identify any issues related to the return. Ms. Walton skimmed over a copy of her return after filing and thought that the totals were correct.
Given these facts, the court concludes that:
As of January 2016 Ms. Walton was well aware that she had earned approximately $525,000 from her consulting work, and even a cursory review of her return would have revealed the omission of $169,426—over 32% of her total nonemployee compensation for that year.
The traditional three-factor analysis stated by the courts does not include this additional factor that the taxpayer actually reviewed the tax return. The conclusion in this case seems to add a fourth element to the traditional three-factor analysis for the defense of reasonable reliance on a tax advisor.
What Level of Review is Required?
This raises questions as to what level of review is required. How thoroughly does the review have to be? This case suggests that “skimming” a tax return is insufficient. On the other hand, a taxpayer does not have to study a tax return and trace items on it from different schedules.
It would seem that the review would need to rise to the level that large errors would be noticed. The courts have not imposed penalties where the amounts are smaller in comparison to the taxpayer’s overall income and/or the error is not evident on the face of the tax return (such as in the case of a complex tax position or voluminous tax return). This is even true if the taxpayer prepared her tax return herself and made a mistake in reporting the income.
The Elaine v. Commissioner, T.C. Memo. 2017-3, case provides an example of this. In Elaine, the taxpayer failed to report $11,000 of her IRA distribution. The court applied the “honest mistake” line of cases to conclude that no penalty was warranted.
Those seeking to have the substantial understatement penalties abated should document the level of and efforts to review their tax returns prior to filing. The larger the understatement, the more thorough the review should be. This should show that the taxpayer did more than “skim” the tax return. This review should also be done before the tax return is filed.