You Have To Look At Your Return

I am looking at a case that covers relatively well-trod ground. It did however remind me of a client from around 20 years ago. I got a different result than the taxpayer did in this case, but I suspect part of the reason is the IRS becoming noticeably more overbearing with penalties over the last two decades.

Anna Walton is a psychologist. In 2014 the firm where she worked informed her that their interests had diverged. This of course is jargon for termination, and she transitioned to her own firm with multiple clients, including Brown University and the National Geographic Society.

 Having multiple clients meant that she received multiple Forms 1099 at the end of the year. It is a poor idea to blow these off, as the IRS uses the 1099s for computer matching of reported income. Report less income than the 1099s on file and you can anticipate an automated notice from the IRS.

Let’s roll to January, 2016 and Ms Walton was looking at her 2015 records. She e-mailed her accountant of approximately 20 years that the practice had approximately $525 grand in revenues. The accountant used that number to arrive at an estimated tax payment.

So far there is no big deal.

She later sent her tax stuff in. A staff accountant working at the firm noted that the 1099s she remitted only added-up to approximately $351 grand. Cross-referencing the $525 grand e-mail, the accountant asked whether Ms Walton had or was expecting other 1099s. She also asked about other stuff, such as contributions, tuition plans and whatnot going into the tax return.

COMMENT: In case you are wondering, it is quite unlikely that your accountant personally prepares your tax return. It is more likely that he/she hires someone to prepare your return, including questions, and then reviews the draft return once fully or mostly prepared. I for example prepare very few returns, but I review a ton. There are not enough hours in the day for me to work with as many returns as I do if I also had to prepare them.

Ms Walton responded to the accountant but blew-off the 1099 question.

The accountant asked again.

Ms Walton blew her off again.

I think you get the drift.

The accountant prepared the return with the information available. The IRS caught the underreporting of 1099 income. The IRS wanted tax. It also wanted penalties.

Ms Walton agreed to the tax, but she did not think she should owe penalties.

Off to Tax Court they went

Her argument was easy: she relied on her accountant.

Folks, there are prerequisites to the reliance argument. For example, one has to provide all necessary information to the accountant. Secondly, that reliance is moot if even the most cursory review of the return would alert the average person to errors on the return.

The Court was quite curious why Ms Walton did not inquire why the return showed approximately one-third less revenues than she herself had previously told the accountant.

I also suspect that the Court did not take kindly to Ms Walton repetitively blowing-off the staff accountant. The repeated questioning would have/should have alerted a reasonable person that more attention was required on the matter.

The Court decided that she did not have reasonable cause to abate the penalty.

I agree.

My client back in the antediluvian days?

He left $3.5 million off his return.

The IRS wanted tax and penalties.

I argued the penalties.

What was my argument?

The client reported so much income from so many sources that $3.5 million could reasonably have been overlooked on that year’s return.

I wish I had a personal tax return like that.

I got penalty abatement, by the way.

Our case this time was Walton v Commissioner, T.C. Memo 2021-40.

 

What Does It Mean To Rely On A Tax Pro?

You may know that permanent life insurance can create a tax trap.

This happens when the insurance policy builds up cash value. Nice thing about cash value is that you can borrow against it. If the cash value grows exponentially, you can borrow against it to fund your lifestyle, all the while not paying any income tax.

There is always a "but."

The "but" is when the policy terminates. If you die, then there is no tax problem. Many tax practitioners however consider death to be extreme tax planning, so let's consider what happens should the policy terminate while you are still alive. 

All the money you borrowed in excess of the premiums you paid will be income to you. It makes sense if you think of the policy as a savings account. To the extent the balance exceeds whatever you deposited, you have interest income. Doing the same thing inside of a life insurance policy does not change the general rule. What it does do is change the timing: instead of paying taxes annually you will pay only when a triggering event occurs.

Letting the policy lapse is a triggering event.

So you would never let the policy lapse, right?

There is our problem: the policy will require annual premiums to stay in effect. You can write a check for the annual premiums, or you can let the insurance company take it from the cash value. The latter works until you have borrowed all the cash value. With no cash value left, the insurance company will look for you to write a check.

Couple this with the likelihood that this likely will occur many years after you acquired the policy - meaning that you are older and your premiums are more expensive - and you can see the trap in its natural environment.  

The Mallorys purchased a single premium variable life insurance policy in 1987 for $87,500. The policy insured Mr. Mallory, with his wife as the beneficiary. He was allowed to borrow. If he did, he would have to pay interest. The policy allowed him two ways to do this: (1) he could write a check or (2) have the interest added to the loan balance instead.

Mallory borrowed $133,800 over the next 14 years - not including the interest that got charged to the loan.

Not bad.

The "but" came in 2011. The policy burned out, and the insurance company wanted him to write a check for approximately $26,000.

Not a chance said Mallory.

The insurance company explained to him that there would be a tax consequence.

Says you said Mallory.

The policy terminated and the insurance company sent him a 1099 for approximately $150,000.

It was now tax time 2012. The Mallorys went to their tax preparer, who gave them the bad news: a big tax check was due.

Tax preparer became ex-tax preparer.

The Mallorys did not file their 2011 tax return until 2013. They omitted the offending $150,000, but they attached the Form 1099 to their tax return with the following explanation:

Paid hundreds of $. No one knows how to compute this using the 1099R from Monarch -- IRS could not help when called -- Pls send me a corrected 1040 explanation + how much is owed. Thank you."

The IRS in turn replied that they wanted $40,000 in tax, a penalty of approximately $10,000 for filing the return late and another penalty of over $8,000 for omitting the 1099 in the first place.

The Mallorys countered that they had no debt with the insurance company. Whatever they received were just distributions, and they were under no obligation to pay them back.

In addition, since they received no cash from the insurance company in 2011, there could not possibly be any income in 2011.

It was an outside-the-box argument, I grant you. The problem is that their argument conflicted with a small mountain of paperwork accumulated over the years referring to the monies as loans, not to mention the interest on said loan.

They also argued for mitigation of the $8,000 penalty because no one could tell them the taxable portion of the insurance policy.

The Mallorys had contacted the IRS, who gave them the general answer.  It is not routine IRS policy to specifically analyze insurance company 1099s to determine the taxable amount.

They had also called random tax professionals asking for free tax advice.

COMMENT: Think about this for a moment. Let's say you receive a call asking for your thoughts on a tax question. The caller is not a client. Your first thought is likely: why get involved? Let's say that you take the call. You are then asked for advice. How specific can you be? They are not your client, and the risk is high that you do not know all the facts. The most you can tell them - prudently, at least - is the general answer.

This is, by the way, why many practitioners simply do not accept calls like this.                            

The Court did not buy the Mallory's argument. It was not true that the Mallorys were not advised: they were advised by their initial tax preparer - the one they unceremoniously fired. After that point it was a stretch to say that they received advice - as they never hired anyone. A phone call for free tax advice did not strike the Court as a professional relationship providing "reasonable cause" to mitigate the $8,000 penalty. 

The Mallorys lost across the board.

Your Accountant Makes the Mistake. Do You Owe Penalties?

If your accountant omits some of your income on your personal income tax return, is it fair that you should be penalized by the IRS?

Generally speaking, reliance on a tax preparer is “reasonable cause” to request penalty mitigation from the IRS. Generally, but not always.

Enter Stephen Woodsum (SW). SW has a bachelors degree from Yale and a masters from Northwestern. He was a founding director of Summit Partners, a private equity firm.

Note: Mr. Woodsum is financially savvy.

In 1998 SW entered a transaction described as a “ten year total return limited partnership linked swap.” This transaction involved Bankers Trust Company and Deutsche Bank and included a reference to paying interest at the “LIBOR rate” upon the “notional amount” of the “reference fund.”

        Note: Financially unsavvy people do not use these words.

So, the swap was to expire in 2008 – ten years. SW was unhappy with the performance of the swap and ended it in 2006. He received at that time a Form 1099 reporting the $3.4 million Deutsche Bank paid him and another 1099 for $60,291 of interest income.

SW gave all of his tax documents to his accountant. There were over 160 such documents. SW must have had a good year, as the $3.4 million was not the largest number on his tax return. It would however had been the third largest capital gain had the $3.4 million in proceeds been reported.

The accountant prepared the return, including the interest but excluding the $3.4 million.  Some accountant. SW and his wife met with the accountant on October 15, the day the return was due. They had to go over the federal return and 27 state income tax returns. The federal return alone was 115 pages.

Mr. and Mrs. Woodsum did not notice that the accountant had left out the $3.4 million.

The IRS did notice, of course, and wanted the tax and interest, as well as penalties.

Mr. Woodsum felt he did not have to pay penalties because… well, he relied on his accountant. I agree with SW.

The court made an interesting comment. It observed that courts have previously mitigated the penalties, but it continued …

It may be (and petitioners seem to expect the Court to assume) that the omission was the result of the C.P.A.'s oversight of one Form 1099 amid 160 such forms, but no actual evidence supports that characterization. The omission is unexplained, and since petitioners have the burden to prove reasonable cause and good faith, this evidentiary gap works against their defense.”

No actual evidence supports that characterization? I would have gotten a statement from the accountant clarifying that the accountant was provided but failed to include the 1099 on my return.

The court seemed unwilling to give SW as much latitude because of his financial sophistication. The court goes on…

Mr. Woodsum, however, makes no showing of a review reasonable under the circumstances. He personally ordered the termination that gave rise to the income; he received a Form 1099-MISC reporting that income; that amount should have shown up on Schedule D as a distinct item; but it was omitted. The parties stipulated that petitioners' “review” of the defective return was of an unknown duration and that it consisted of the preparer turning the pages of the return and discussing various items. Petitioners understated their income by $3.4 million—an amount that was substantial not only in absolute terms but also in relative terms (i.e., it equaled about 10 percent of petitioners' adjusted gross income). A review undertaken to “make sure all income items are included” (in the words of Magill)—or even a review undertaken only to make sure that the major income items had been included—should, absent a reasonable explanation to the contrary, have revealed an omission so straightforward and substantial.”

I have had clients who did the same as Mr. Woodsum. It did not occur to me that they were conducting an unreasonable review. They provided all documents, answered all questions, met with me and complained about the amount I told them they owed. These are wealthy people. This is not you or I, where the absence of our salary would be immediately noticeable on our return. Mr. Woodsum reported approximately $33 million of income on his return. Note that the sale was not even the largest number on a schedule to Mr. Woodsum’s return.

The court upheld the penalties.

Perhaps this is what happens when a private equity manager gets into a complex financial transaction with names like “ten year total return limited partnership linked swap.” This court was not willing to bend much on the reporting of a “Wall Street” transaction that requires a tax seminar to understand.
The penalties were over $100 thousand.

I wonder whether Mr. Woodsum is suing his accountant for malpractice.