No Tax Penalties for Obscure Tax Forms

Bad facts can create bad law. This describes the law for IRS penalties. The IRS abates or removes penalties at the administrative level for most taxpayers who have good facts. The rest of the cases are litigated–resulting in a lot of court cases where the government wins. It is somewhat rare for taxpayers to prevail in penalty abatement cases, so it is always good to read cases where taxpayers win. Thrane v. Commissioner, T.C. Memo. 2006-269, is one of those cases.

Facts & Procedural History

Thrane was in the mortgage business. He was the sole owner of a Subchapter S corporation.

Thrane employed an accountant to prepare his business tax return and a business bookkeeper and he had his individual tax return prepared by an accountant.

An accountant error on the business tax return resulted in Thrane underreporting income received on his personal tax return to the tune of $173,093.

The IRS imposed a Section 6662 substantial understatement penalty given that the amount of the tax that was not reported exceeded $5,000. Litigation ensued.

Reasonable Cause Accepted?

In court, Thrane argued that he had reasonable cause for the understatement and that he acted in good faith. The IRS rejected this argument.

The tax court noted the difference between relying on an advisor to file a tax return and relying on an advisor to prepare a correct tax return. The first type of reliance is not a defense to penalties, generally, as one is expected to know the due dates for tax returns. But the second can establish reasonable cause.

The court noted the factors for reasonable cause based on reliance as follows:

• 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 tax court held that Thrane did in fact have reasonable cause and he acted in good faith. The court reasoned that the error was one that was not obvious from the face of the tax return–it was an error that would require a thorough examination of the taxpayer’s Schedule E. Given the obscure nature of the error and that Thrane employed accountants, he was entitled to rely on the accountant’s faulty work.

Citing Thrane in Penalty Abatement Cases

This is consistent with Neonatology Associates, P.A. v. Commissioner,115 T.C. 43, 98 (2000). Neonatology is the leading case for the reliance-on-an-advisor defense. The Thrane case adds the obscurity element, which taxpayers may find helpful to cite in cases where the error is not obvious on the face of the tax return. With the right facts, citing Thrane could help convince the IRS to remove penalties at the administrative level.