Tax preparer mistakes: taxpayer penalties and the tax treatment of indemnity payments.

• Author: Schnee, Edward J.

PREVIEW

* Penalties assessed by the IRS will sometimes be waived for reasonable cause where the taxpayer shows reliance on the advice of a tax professional.

* Where a taxpayer relies on the advice of a tax professional, and a penalty due to that reliance is not waived, the tax professional will frequently either voluntarily or involuntarily indemnify the taxpayer for the penalty.

* The IRS and the Tax Court do not always agree on the proper tax treatment of an indemnity payment made to a client to reimburse the client for penalties incurred due to an error by the tax professional.

Taxpayers are required to file income tax returns on set dates and to pay the tax liability on those dates. If they fail to file the return, file it after the due date, understate their tax liability, or simply fail to pay the tax due, the IRS can impose a penalty in addition to requiring the payment of the tax liability. Congress has adopted rules that allow taxpayers to request that a penalty be abated. One of the reasons for the abatement of a penalty is that the taxpayer relied on a tax professional. However, relying on a tax professional does not guarantee that the penalty will be removed.

This article discusses the basic penalty rules and then concentrates on the effect of a taxpayer's reliance on a tax professional. Since reliance does not guarantee that the penalty will be eliminated, this article then discusses the tax treatment of a payment by the professional to the taxpayer for mistakes made on the tax return.

Filing and payment penalties

Sec. 6651(a)(1) contains the penalty rules for the failure to file a tax return. The penalty is 5% of the tax liability if the late period is one month or less, increasing by 5% for each additional month the return is not filed up to a maximum of 25%. The penalty cannot be less than the lesser of $205 ($210 for tax years beginning in 2017) or 100% of the tax liability. (1)

Sec. 6651(a)(2) provides penalties for taxpayers who file their return on time but do not pay the tax liability. In this case, the penalty is 0.5% if the tax is unpaid for one month. The penalty increases by 0.5% for each additional month the tax is not paid up to a maximum of 25%.

The penalties for failure to file and failure to pay the liability are applied unless the failure is due to reasonable cause and not due to willful neglect. (2) The IRS evaluates the existence of willful neglect first. In the absence of willful neglect, the IRS considers whether the taxpayer had reasonable cause for the failure. (3)

The phrase "willful neglect" is not defined or discussed in the Code or congressional committee reports. The Supreme Court stated that it "may be read as meaning a conscious, intentional failure or reckless indifference." (4) The Court also stated that "it would be logical to assume that Congress intended 'willful neglect' to replace 'refusal'--both expressions implying intentional failure." (5)

Regs. Sec. 301.6651-1(c) explains the requirements for reasonable cause. Specifically, a taxpayer's failure to file is due to reasonable cause if he or she exercised ordinary business care and prudence but still is unable to file the return on time. The taxpayer's failure to pay the tax liability meets the requirement of reasonable cause if he or she exercised ordinary business care and prudence and was either unable to pay the tax or would suffer an undue hardship. For example, if the taxpayer suffers from mental illness, the penalty may be abated. (6)

The taxpayer will suffer an undue hardship if he or she will suffer a substantial financial loss. A mere inconvenience is not sufficient. (7) If the filing or payment penalty is assessed against a taxpayer for the first time, the taxpayer may request and receive an abatement of the penalty under the first-time-abatement procedures. (8)

Reasonable cause and willful neglect are determined by taxpayer actions. In Chief Counsel Advice 201637012, a taxpayer appointed a person with a durable power of attorney and granted that person the authority to sign and file a tax return. The return was filed late. The IRS stated it would look to the taxpayer and not the assigned agent when determining reasonable cause since under state law the person holding a power of attorney does not have the legal duty to file the return. The Service distinguished this case from Basseft, (9) where a minor's guardian did not file the tax return. Since the guardian is legally responsible for filing returns, the Bassett court ruled that the guardian's reason for not filing the return and not the taxpayer's reason determines whether a penalty may be abated. In other words, the person required to file the return must prove reasonable cause to have the penalty abated.

Accuracy penalty

If taxpayers do not correctly calculate their tax liability, the IRS can impose a 20% accuracy penalty under Sec. 6662. This penalty can be assessed because of negligence, disregard of rules and regulations, or a substantial understatement of the tax liability.

The term negligence includes failure to make a reasonable attempt to comply with the rules. The term "disregard" includes any careless, reckless, or intentional disregard of the rules, including those found in the Code, temporary and final regulations, and revenue rulings and notices. (10)

The penalty for negligence or disregard of a rule or regulation does not apply if the taxpayer discloses on the return the position taken and meets a specific standard. (11) The standard for a position contrary to a regulation is one in which a taxpayer has a good-faith challenge to the validity of the regulation. The standard for a position contrary to a revenue ruling or notice is if the position has a realistic possibility of being sustained on its merits. (12) Historically, a realistic possibility of being sustained on its merits means there is a one-in-three chance of success. (13)

Sec. 6662 imposes a 20% accuracy penalty on taxpayers whose returns have a substantial understatement of tax.

This penalty is imposed on taxpayers not guilty of negligence or disregard of rules or regulations. For individuals, a substantial understatement exists if the actual tax liability exceeds the liability on the tax return by an amount equal to the lesser of 10% of the actual liability or $5,000. For corporations, the substantial understatement is the lesser of 10% of the actual tax liability (or if greater, $10,000) or $10 million. Taxpayers can reduce the penalty by the amount of tax due on an item used to determine the tax liability for which they have substantial authority or for an item that was adequately disclosed and for which they have a reasonable basis. Substantial authority generally is considered as a 40% or higher chance of success, and reasonable basis is a 20% or higher chance of success. (14)

Avoiding penalties

A taxpayer has two ways to avoid an income tax penalty. The first is to prove that the IRS did not meet the requirement of Sec. 7491(c). The second is to qualify under Sec. 6664(c).

Sec. 7491(c) requires the IRS to meet the "burden of production" to assess a tax penalty. (15) If the IRS meets this requirement, the burden of proof shifts to the taxpayer. In Higbee, (16) the Tax Court noted that Congress used the term "burden of production" not "burden of proof. "The court also pointed out that Congress did not define this phrase. The court then referred to the legislative history, which states that the IRS does not have to provide evidence of elements such as reasonable cause or substantial authority. It only has to provide evidence of the appropriateness of the penalty. The court concluded that the Code's stating "burden of production" rather than the more common phrase "burden of proof" imposes a lower standard on the IRS than on the taxpayer. In Powell, (17) the Tax Court stated that the IRS meets this requirement if it shows that the substantial-understatement amount exists. In effect, the IRS will always meet the burden of production when it imposes the penalty.

The second, and probably the only realistic way, to reduce or eliminate penalties is contained in Sec...