Assessing professional tax advice and taxpayer sophistication.

• Author: Morris, Donald

EXECUTIVE SUMMARY

* Sec. 6662 imposes an accuracy-related penalty for any portion of a taxpayer's underpayment that is attributable to negligence or substantial understatement of income tax. However, an exception is provided in Sec. 6664(c) for taxpayers that show there was a reasonable cause for their underpayments and that they acted in good faith with respect to them.

* One way a taxpayer may be able to prove reasonable cause and good faith is to show that he or she relied on the advice of a tax professional regarding the underpayment after providing the tax professional with all the pertinent information regarding his or her situation.

* The regulations state that whether reliance on professional tax advice is reasonable is based on the taxpayer's facts and circumstances, including his or her experience, knowledge, and education. The regulations do not make clear how the taxpayer's experience, knowledge, and education are to be taken into account. The courts addressing the issue have come to varying conclusions, thus leaving taxpayers without a coherent standard for determining when reliance is reasonable.

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A taxpayer is liable for an accuracy-related penalty for any portion of an underpayment attributable to negligence or substantial understatement of income tax. The law provides a good-faith and reasonable cause defense against the negligence and substantial understatement penalty. In determining the applicability of the penalty, the taxpayer's reliance on professional tax advice is relevant. However, in evaluating the authority and circumstances of the advice and the adviser, the standards applied by the I RS in the regulations are more stringent than those imposed by the courts. The IRS requires taxpayers to evaluate the expertise of their tax advisers as well as the quality of the advice. The courts generally excuse taxpayers from negligence if they follow the advice of a tax adviser in good faith.

This article investigates the courts' interpretation of reasonable cause and good faith in circumstances where the IRS has imposed a negligence penalty. By examining cases addressing a similar tax issue, it is possible to contrast the respective reasoning of the IRS and the courts in measuring the reasonable cause and good-faith exception. To reduce the disparity between the IRS and the courts, potential modifications to the regulations are suggested.

The Negligence Penalty and the Reasonable Cause Defense

A taxpayer is liable for an accuracy-related penalty for any portion of an underpayment attributable to, among other things, a substantial understatement of income tax. A substantial understatement of income tax under Sec. 6662(d) occurs if the amount of the understatement exceeds the greater of either 10% of the tax required to be shown on the return or $5,000 ($10,000 for corporations). The Sec. 6662 penalty applies to five distinct taxpayer abuses, the most frequently cited being substantial understatement of income (Sec. 6662(b)(2)) and negligence or disregard of rules or regulations (Sec. 6662(b)(1)). The term "negligence" is defined to include any failure to make a reasonable attempt to comply with the provisions of the Code, and "disregard" includes any careless, reckless, or intentional disregard (Sec. 6662(c)).

A taxpayer may contest the imposition of a negligence penalty by showing that he or she acted reasonably and in good faith (Sec. 6664(c)). Congress left it to the IRS to specify criteria for determining reasonableness and good faith. Unfortunately, the IRS's response was to impose regulatory standards for reasonableness and good faith that are at least as subjective and difficult to administer as the statutory benchmarks they are meant to define. One involves assessing the level of professionalism of the taxpayer's tax adviser, and the other involves assessing the level of sophistication of the taxpayer. The application of these criteria is explained in Regs. Sec. 1.6664-4, "Reasonable cause and good faith exception to section 6662 penalties."

Regs. Sec. 1.6664-4(b)(2) distinguishes between a professional tax adviser and others who provide tax advice. The taxpayer is responsible for determining the difference. If a taxpayer seeks tax advice from "someone that he knew, or should have known, lacked knowledge in the relevant aspects of Federal tax law," even though the taxpayer sought tax advice, he or she would have "failed to act reasonably or in good faith." The IRS provides no further guidance on how a taxpayer is to make this determination. For example, there is no specification that the tax adviser must be qualified to practice before the IRS, as set out in IRS Circular 230, (1) which would limit the selection to CPAs, attorneys, or enrolled agents. The purpose of this article is to set out what guidance the courts offer for making the determination that an individual is a professional tax adviser.

The scope of the article is limited to individual taxpayers, and the examination of the Sec. 6662 penalty is limited to Sec. 104 cases in which the taxpayer has received an award or settlement in connection with a personal injury. In such cases, the IRS frequently asserts both negligence and substantial understatement penalties. The discussion is limited in this manner primarily to control for variables that may affect the law's application; focusing on one legal issue also avoids multiple explanations of the law in connection with each new case. The law controlling the taxability of personal injury awards was selected because its application is generally clear and settled, allowing the discussion to focus on measuring the taxpayer's reasonableness and good faith in following tax advice.

Negligence Penalty Assessments

In 2008, the IRS reported assessing 391,621 accuracy-related (including negligence) penalties totaling $904,206,000. Of that number, however, it subsequently abated 48,326 (12%) of the penalties totaling $216,870,000 (24%). (2) According to the "Post-Assessment Abatement Consideration of the Accuracy-Related Penalties" section of the Internal Revenue Manual: (3)

If a taxpayer receives notice and demand for payment and then makes his/her first response to the Service requesting abatement of the accuracy-related penalties (while not disputing the tax liability and not requesting or not being eligible for audit reconsideration procedures), abatement should be considered based on the evidence provided. The same guidance continues:

If the evidence is not sufficient to support a reasonable cause claim for the penalty abatement, the taxpayer should be issued the appropriate letter to indicate that the abatement request is denied and the remaining recourse is to pay the tax, penalties and interest and file a claim for refund on Form 843, Claim for Refund and Request for Abatement. (4) The "reasonable cause claim" in the context of Sec. 6664 refers to good-faith reliance on a professional tax adviser, (5) If a taxpayer faced with a negligence penalty can demonstrate that the reason for the tax underpayment or negligence was advice sought, received, and followed from a professional tax adviser, he or she may be entitled to the relief provided by the Sec. 6664 reasonable cause exception.

The Courts

The courts are the final arbiter in determining if an IRS-imposed negligence penalty is appropriate. Therefore, it is useful to review a number of decisions in which the court has explained its reasons for upholding the IRS or overturning its imposition of the penalty.

Personal Injury Awards and Sec. 104 Exemption

In an effort to ensure comparability of cases, this article limits its examination of the penalty assessment and its appropriateness to taxpayers receiving personal injury awards that they claimed were exempt under Sec. 104. This is a commonly litigated issue, in part due to taxpayer confusion in interpreting the law and in part because the amount in question is frequently significant. Before the law was modified by the Small Business Job Protection Act of 1996, (6) the personal injury exemption was broadly available for tort-type personal injuries and sickness but not for damages intended to replace income. For amounts received after August 20, 1996, the law was narrowed and now requires the injury to be a physical personal injury to qualify for exemption. However, this change did not affect the criteria for applying the Sec. 6662 penalty or its relief under the Sec. 6664 good-faith and reasonable cause exception and therefore does not...