According to the national taxpayer advocate's annual reports to Congress, the most-litigated tax issue between the IRS and taxpayers over the past several years has been the application of the accuracy-related penalty imposed by Sec. 6662. (1) In fact, according to the national taxpayer advocate, federal courts have issued opinions involving the penalty in more than 260 cases between June 2015 and May 2017. (2)
The Code imposes penalties on taxpayers, of course, to encourage voluntary compliance with tax laws. A taxpayer may avoid the accuracy-related penalty, however, if the taxpayer has "reasonable cause" for a tax underpayment. (3) This article briefly sets out the law relating to the imposition of accuracy-related penalties and the meaning of reasonable cause, but it primarily discusses the most common factors in recent cases where taxpayers argued the reasonable-cause exception. It also suggests actions a taxpayer and tax adviser can take to best position the taxpayer to avoid the accuracy-related penalty by meeting the reasonable-cause exception.
Imposition of the penalty
Sec. 6662(a) states:
If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies. The accuracy-related penalty applies to:
* Negligence or disregard of rules or regulations;
* Any substantial understatement of income tax;
* Any substantial valuation misstatement;
* Any substantial overstatement of pension liabilities;
* Any substantial estate or gift tax valuation understatement;
* Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance;
* Any undisclosed foreign financial asset understatement; or
* Any inconsistent estate basis. (4)
Notwithstanding the breadth of situations where the penalty may apply, Sec. 6664(c)(1) provides an exception:
No penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion. (5) As with many areas of the law, the applicability of the exception depends on the facts and circumstances of each case. (6) Of particular importance, of course, is the definition of "reasonable cause."The Treasury regulations provide assistance in this regard.
Defining 'reasonable cause'
According to Regs. Sec. 1.6664-4, "the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Other factors the regulations state may be taken into account include:
* Reasonable misunderstanding of fact or law;
* Experience, knowledge, and education of the taxpayer;
* Isolated computational or transcriptional error;
* Reliance on an information return;
* Reliance on advice of a professional tax adviser or appraiser; and
* Reliance on erroneous information.
While reliance on an information return, a tax adviser, or information that (unbeknownst to the taxpayer) is incorrect does not necessarily indicate reasonable cause and good faith, the regulations state that such reliance can constitute reasonable cause and good faith where the reliance was reasonable and the taxpayer acted in good faith. (7)
Burden of proof
The Code imposes the burden of production on the IRS that a penalty is warranted. (8) The IRS generally continues to have the burden of proof with respect to factual issues, but only if the taxpayer provides credible evidence, properly substantiates items, has maintained records, and cooperates with reasonable IRS requests. (9)
Illustrative recent court cases and taxpayer arguments
Because the accuracy-related penalty continues to be highly litigated, a survey of recent court cases yields a useful overview of the factors most likely to determine taxpayer success or failure in sustaining a reasonable-cause defense.
The Taxpayer Advocate Service notes in its most recent report that the IRS prevails in roughly 80% of accuracy-related penalty cases. (10) Taxpayers appeared without representation in about 60% of cases and had a slightly lower success rate than taxpayers who were represented in court. Taxpayers who claimed they relied on a tax professional as part of their reasonable-cause and good-faith defense prevailed in over 30% of litigated cases, a noticeably higher success rate than taxpayers who did not rely on a tax professional for a tax return position.
The reasonable-cause defense is a facts-and-circumstances test, which necessarily involves a comparison of the taxpayer's conduct with that of other similarly situated taxpayers. (11) The courts look at multiple factors in sustaining reasonable cause. (12) In agreement with the regulations, courts note that "the most important factor... is the extent of the taxpayer's effort to assess his or her proper tax liability." (13) Courts also consider the following reasonable-cause factors (some court factors align squarely with Treasury regulation factors, while others supplement the regulations):
* Experience, knowledge, and education of the taxpayer;
* Complexity of the law--degree to which the tax law at issue is setded, clear, and unambiguous;
* Whether the case is a novel issue or of first impression to the courts;
* Whether there was nonreceipt of an information return or reliance on a third party;
* Keeping adequate records;
* Taxpayer credibility; and
* Reliance on the advice of a tax adviser.
Taxpayers who assert that they relied on the advice of a tax adviser have a noticeably higher rate of success in showing reasonable cause. (14) The courts generally use a separate analysis developed by the Tax Court to determine whether a taxpayer properly relied on a tax adviser's advice to establish reasonable cause. The taxpayer must demonstrate:
The adviser was a competent professional who had sufficient expertise to justify reliance; 2. The taxpayer provided necessary and accurate information to the adviser; and
The taxpayer actually relied in good faith on the adviser's judgment. (1)
Each of these reasonable-cause factors is analyzed below. However, it should be borne in mind that while these factors may indicate reasonable cause and good faith on the part of the taxpayer, the most important factor is the extent of the taxpayer's efforts to assess his or her proper tax liability.
Taxpayer's experience, knowledge, and education
Both court cases and the regulations find taxpayers' tax experience, knowledge, and education relevant in determining reasonable cause. While limited experience, knowledge, and education is often favorable to a taxpayer in a reasonable-cause and good-faith defense, professors John Cook and Alan Ocheltree note such limitations can be a double-edged sword: " [I]f taxpayers are relatively unsophisticated and inexperienced, they are generally held to a lower standard. But such lack of sophistication could also support a conclusion that the taxpayer's failure to consult a tax adviser was itself negligent. On the other hand, relatively sophisticated and experienced taxpayers are routinely held to a higher standard by courts." (16)
Complexity of the law
Several recent cases illustrate the interplay of taxpayer sophistication and complexity of the tax law at issue. If the law is complex, even relatively sophisticated taxpayers may be able to show reasonable cause; if, however, the law is well-settled, clear, and unambiguous, even relatively unsophisticated taxpayers will have difficulty showing reasonable cause.
The taxpayers in Simonsen (17) prevailed in their reasonable-cause defense, due largely to the complexity of the law at issue, even though they were considered well-educated. In this case, the taxpayers engaged in a short sale of their previous residence so that their house was sold for less than their mortgage debt owed, and the bank forgave their excess debt. The taxpayers attempted to take the position that the sale and the bank's forgiveness of excess nonrecourse mortgage debt were separate transactions; they therefore claimed both a substantial deductible loss from the sale on the one hand and excludable COI (cancellation of indebtedness) income under Sec. 108(a)(1)(E) on the other.
The court walked through multiple steps of analysis and definitions to show the sale and debt forgiveness were part of the same transaction, which would effectively increase the amount realized on the sale by the amount of debt forgiveness and wipe out the deductible loss. In ruling on the accuracy-related penalty, the Tax Court addressed the interplay of taxpayer sophistication with the complexity of the tax law at issue:
We see nothing but reasonable cause and good faith here. The Simonsens are well educated--Christina (who...