When will reliance on a tax adviser avoid an accuracy-related penalty?

• Author: Oliva, Robert R.

One potential defense to a Sec. 6662 accuracy-related penalty is the taxpayer's reasonable cause, good faith reliance on a tax adviser under Sec. 6664(c)(1). Through the use of examples based on actual cases, this article explains when use of that defense may (or may not) be successful.

The IRS may penalize taxpayers for failing to meet specific standards prescribed by the Code and/or regulations. One potential defense to imposition of a Sec. 6662 accuracy-related penalty, blaming the inaccuracy on the taxpayer's adviser, is experiencing rapidly growing use among taxpayers. This article analyzes this defense and provides examples and needed guidance.

As summarized in the table on page 774, Sec. 6662(a) and (b) impose penalties for tax underpayments due to negligence or disregard of rules or regulations, substantial understatements of income tax, substantial valuation mis-statements or substantial overstatements of pension liabilities. Taxpayers may avoid these penalties by meeting standards prescribed in Secs. 6662 and 6664 and the regulations thereunder (e.g., under Regs. Sec. 1.6662-3(b)(1), the negligence penalty can be avoided if the return position has a reasonable basis or by disclosure if the position meets the realistic possibility standard).

However, as indicated in the last column of the table, when a taxpayer does not meet the Sec. 6662 standards or no standards are prescribed (e.g., for corporate understatements due to tax shelters and for valuation-related penalties), Sec. 6664(c)(1) and the regulations thereunder provide for a "reasonable cause/good faith" (RCGF) defense.(1) While RCGF may be based on any number of reasons, the most prevalent RCGF defense is that the taxpayer followed the advice of a tax adviser. Taxpayers have often raised the RCGF defense since its inception.(2)

Defining RCGF

Sec. 6664(c)(1) provides that no penalty will be imposed with respect to any portion of an underpayment if the taxpayer shows RCGF for such portion. Regs. Sec. 1.6664-4(b) states generally that RCGF depends on the facts and circumstances of each case; the most important factor is the extent of the taxpayer's effort in determining his proper tax liability. In determining whether a taxpayer's efforts have been sufficient to raise the RCGF defense, the taxpayer is deemed to know not only what he actually knows, but what he should have known after reasonable diligence.

Example 1:(3) Based on a recommendation from friends, A hires B, a CPA and professional tax adviser, to provide advice concerning the deductibility of payments A made to his state and local governments. After A provides B with full details about the payments, B states that A's payments are deductible state and local taxes. Everything else being equal, if A acts in good faith and deducts the payments based on B's recommendations, A has an RCGE defense if the deduction is later determined to be erroneous.

Example 2:(4) C procrastinates until the evening of April 15, 1998 to prepare his 1997 return. He hurriedly attempts to prepare the return and at 11:00 p.m. has questions about many deductions. C calls D, an acquaintance who is a CPA. In answer to C's questions, D replies that the items might be deductible, but that he would have to obtain more information and research the issue in the following week before being able to provide a definitive answer. Based on that conversation, C claims the items as deductions. C cannot use the RCGF defense if the deductions are later determined to be erroneous.

In considering the level of the taxpayer's efforts, Regs. Sec. 1.6664-4(b)(1) states that reliance on professional advice constitutes RCGF if, under all the circumstances, it was reasonable and the taxpayer acted in good faith. Similarly, Internal Revenue Manual (IRM) (20)331(2) states generally that each RC request must be evaluated on its own merit, which should be determined based on the events or parties involved and on whether or not the taxpayer exercised ordinary business care and prudence.

Because the regulations and the IRM refer to reasonable conduct under the circumstances and to ordinary business care and prudence respectively, the RCGF defense basically depends on the presence or absence of negligence. Further, 0every item subject to the RCGF defense is treated separately (e.g., a taxpayer may have RCGF for some items, but not for others).(5) Lastly, as indicated below, a review of the administrative and judicial interpretations shows that reliance on a tax adviser has two aspects--the taxpayer's responsibilities and the advise responsibilities.

Advice From Tax Advisers

Regs. Sec. 1.6664-4(c)(2) broadly defines "advice" as any communication (including the opinion of a professional tax adviser) setting forth the analysis or conclusion of a person (other than the taxpayer) provided to (or for the benefit of) the taxpayer and on which the taxpayer directly or indirectly relies. The use of "including" implies that others may be considered tax advisers; further, the advice at issue may be oral or written, from a paid or unpaid adviser in taxation or other field.

Example 3:(6) E and F filed for divorce; at their dissolution hearing, the judge ruled that one of the parties should bear all the tax consequences of the monthly separation payments. Based on the judge's order, E and F take appropriate positions in married filing separate returns. For Sec.6664(c)(1) purposes, the judge is a tax adviser.

Taxpayer's Responsibilities

IRM (20)331(1) provides that taxpayers have the burden of proving RC. Under Regs. Sec. 1.6664-4(c)(1) and IRM (20)333.7(1), RC does not exist when tax advice is tainted because the taxpayer intentionally failed to provide all the relevant information or negligently failed to confirm the adviser's qualifications.

Intentional actions may involve conspiracies between the taxpayer and the...