Penalties And Reliance On A Tax Professional

I am working a penalty appeal case. The owner was fortunate: the business survived. There was a time when his fate was uncertain.

The IRS is being … difficult. The IRS considers “reasonable cause” when considering whether to mitigate or abate many penalties. The idea is simple enough: would a “reasonable” person have acted the same way, knowing his/her responsibility under the tax law?

That is a surprisingly high standard, considering that there are professionals who spend a career mastering the tax law. There is stuff in there that no reasonable person would suspect. I know. I make a living at it.

Back to my appeal case: take an overworked and overstressed business owner. He is facing the more-than-unlikely possibility of bankruptcy. It is the end of the year and his accountant mails him W-2s for distribution to employees. He does so and puts the envelope on a stack of paperwork. He forgets to send the employer copies to the IRS. Granted, this is not as likely to happen today with electronic filing, but it did happen and not so many years ago.

The IRS nails him. Mind you, he distributed the W-2s to the employees. He filed all the quarterly reports, he made all the tax deposits. He had a bad day, a messy office and forgot to put a piece of paper in the mail.

Do you think he has reasonable cause – at least to reduce the penalties - considering all the other factors in his favor?  I think so. The IRS thinks otherwise.

Here is another one: you hire me to prepare an estate return. These things are rare enough. First of all, someone has to die. Second, someone has to have enough assets to be required to file. I tell you that the return is due next March. It turns out I am wrong, and the return is actually due in February.

The IRS sends a you a zillion-dollar penalty notice for filing the estate return late.

Do you have reasonable cause?

You might think this is relatively straightforward, but you would be wrong.

Let’s go through it:

(Q) Did you hire a professional?

(A) Yes

(Q) Was the professional qualified?

(A) I presume so. He/she had initials after their name.

(Q) Did you disclose all facts to the professional?

(A) I think so. Someone died. I presume the professional would prompt and question me on matters I would not know or have thought of.

(Q) Did you rely on the professional for matters of tax law?

(A) Uh, yes. Do you know what these accountants charge?

(Q) I mean, as opposed to something you can look up yourself.

(A) What do you mean?

That last one is alluding to a “ministerial” act. Think signing a return, putting a stamp on the envelope and dropping it in the mailbox. All the hard lifting is done, and it is time to break down and throw away the moving boxes.

Sounds easy enough.

Until someone pulls the rug out from underneath you by changing the meaning of “ministerial.”

That someone was the Supreme Court in Boyle, when it decided that a taxpayer’s reliance on a tax professional for an estate return’s due date was not enough. The taxpayer knew that a return was required. The taxpayer could not “delegate” the responsibility for timely filing by …. accepting the tax professional’s advice on when the return was due.

If that sentence makes no sense, it is because Boyle makes no sense outside the fantasy world of a tax zealot.

If you go to see a dentist, are you required to study-up on dental compounds, as the decision to use silver rather than composite could be deemed “ministerial?”

The IRS, sniffing an opportunity to ram even more penalties down your throat, has taken Boyle and characterized it to mean that reliance on a tax professional can never rise to reasonable cause.

As a tax professional, I take offense at that.

The IRS gets occasionally stopped in its tracks, fortunately, but not often enough.

I practice. I am only too aware that “it” happens. It is not a matter of being irresponsible or lacking diligence or other snarky phrases. It is a matter that one person – or a very small group of people – is multitasking as management, labor, owner, analyst, financier, ombudsman and so on. Perhaps you are a business owner thinking that you waited too long on replacing that employee who left…  did you call the insurance agent about the new business vehicle … you have to find time to talk to the banker about increasing your credit line… hey, did you see something from the accountant in the mail?

Yes, I get frustrated with the IRS and its unrealistic “reasonable” standard. Reasonable should be real-world based and not require pilgrimage to a Platonic ideal. Life is not a movie. “It” happens, even in an accounting firm. Yes, accountants make mistakes too.

Rounding back, though, there is one thing you must show if you are arguing that you relied on a tax professional.

I am reading the recent Keenan case. This thing has to do with Section 419 plans, which are employee welfare plans that were unfortunately abused by charlatans. The abuse is simple enough. Set up a welfare plan, preferably just for you. Stuff the thing to the gills with life insurance. Deduct everything for a few years. Then close the plan, buy the insurance for a pittance and meet with a financial planner about retirement.

The IRS got cranky – understandably - and starting looking at these things as tax shelters.

Which means outsized penalties.

So Keenan was in a penalty situation. He points at the accountant and says “Hey, I relied on you to keep me out of trouble.”

Problem: the taxpayer did whatever the taxpayer was going to so. There was sweet money at the end of that rainbow. Accountant? Please.

Not that the accountant was without fault. He should have researched these things harder. If he then had reservations, he should have either insisted on the correct tax reporting or have fired Keenan as a client.

The correct reporting is not hard. You can take the deduction, but you have to flag it for the IRS. The IRS can then pursue or not, but you met your responsibility. I have done so myself when a partner has brought in a hyper-aggressive client. By doing so I am protecting both my license and the client from those outsized penalties.

That was not going to happen with Keenan.

Keenan lost the case for the most obvious reason: to argue reliance on a professional you have to actually rely on a professional.

Not Filing Because You Expect A Refund

I received a call from a client this past week. He is keen on getting his taxes caught-up.

Mind you, he is not a timely filer.  He files every two or three years, at best.

How does he get away with it?

He has the ultimate tax shelter: a net operating loss (NOL).

You have to have a business to have an NOL. It means a business loss so large that it overwhelms whatever other sources of income you may have. It leaves behind a net negative number, and you can use that negative to recoup taxes paid in a prior year (2 prior years, to be exact) or you can use it to reduce your taxes going forward (up to 20 years).

It makes tax planning easy.

Say you have a $1 million NOL carryforward. You anticipate earning $400,000 next year. What tax planning advice would you give?

Here’s one: stop the withholding on that $400,000, if you can.

Why?

$400,000 - $1,000,000 = ($600,000).

There is no tax on minus $600,000. There is no point in withholding.

And that is why my client is somewhat lackadaisical about filing his taxes.

Won’t there be penalties for late filing?

Most likely: No. Penalties are normally calculated on any taxes due. No taxes due = no penalties. This is not always true, but it is true enough in his case.

A more common variation on this theme is a taxpayer who always gets a refund. A refund = no taxes due = no penalties. One has to be careful with this, however, because once enough years go by (more specifically: 3 years), the government will keep your money.

I was looking at the Parekh case this week. Here is the Tax Court:

… we conclude that petitioners did not exercise ordinary business care and prudence and that they have not established reasonable cause for failing to file their 2012 tax return timely.”

COMMENT: if you see the words “ordinary business care and prudence” or “reasonable cause,” rest assured that someone is being penalized. Those are code words when one is trying to remove or reduce penalties.

What did Parekh get into?

Let’s see:

• Mr and Mrs Parekh filed 2009 only after the IRS prepared a substitute tax return for them.
• They were late in filing 2010 and 2011.
• They did not extend their 2012 return. They eventually filed it in 2014.

Wouldn’t you know the IRS decided to audit 2012?

Who cares, right? They are always overpaid.

There was something different in 2012: retirement plan distributions. The IRS determined that they owed over $8 grand of Alternative Minimum Tax (AMT).

Now that there was tax due the IRS also assessed a penalty.

Parekh went to Appeals. He wanted the penalty for late filing abated.

His reason?

He always had refunds. How was he supposed to know that 2012 was different?

Here is Parekh:

I figured, reasonably so I thought, that since I’d be getting a refund it was OK to file late ***. In fact, I had considered the de facto deadline for filing to be three years if one is getting a refund since after that the refund is forfeited. As I take a quick look at some tax advice websites that is pretty much what they say.”

Here is the IRS:

The Appeals officer noted that petitioners had also been delinquent in filing their 2009-2011 returns and that, as of […], they had not filed a return for 2013 or 2014 either.”

One they got to Tax Court – and hired an attorney - the Parekhs added another reason for filing late: his mom was ill and he was routinely travelling to India in 2013 and 2014 to help his father care for her.

The Court did not like the attorney slapping the India thing into the record at the last minute.

Even if we were to credit petitioner husband’s testimony about his heavy travel schedule, it is inconceivable that he could not have found two days in which to fulfill petitioners’ filing obligation, as opposed to filing that return 15 months late.”

The Court said no reasonable cause for not extending and not filing on time. They had to pay the penalty.

Did Parekh’s track record with the IRS hurt him with the Court?

No doubt.

And there is the risk if you routinely file your returns late – perhaps because you expect a refund or because you have always gotten refunds. Have your taxes spike unexpectedly, and it is unlikely you will avoid the penalties that will come with them.

What Does It Take To Get Reasonable Cause Around Here?

My partner has a difficult IRS penalty issue.

He expects a client to be penalized for more than one year. This complicates how we handle the first year.

The IRS has reorganized its penalty review function to a system called the Reasonable Cause Assistant (RCA). There however is a problem: the system does not work well. The Treasury Inspector General for Tax Administration (TIGTA) reported that RCA was inaccurate 89% of the time in 2012.

Step away from RCA and you still have the following:

 * It used to be that penalties were assessed as a means to encourage voluntary compliance. Many tax pros feel that is no longer the case, and penalties are being used as a means to raise revenue.  An example is the penalty assessed for late filing of a partnership return: $195 per month per partner. Take a 10-person partnership, file a week late and face a $1,950 penalty. There is little consideration for the size of the partnership, its total assets or revenues - or the fact that partnerships do not pay federal taxes.            

* Penalties are assessed even when taxpayers are trying to do the right thing. For example, enter into a reportable transaction, disclose it on your tax return but forget to file a copy with a second office and you will be assessed a penalty. Fail to disclose the transaction at all and you will be subject to the same penalty.

 * The IRS is automatically asserting penalties. For example, for fiscal year 2015, the IRS assessed over 40 million penalties on individuals and businesses. To put that in context, there were approximately 243 million returns filed for the period.

* Many penalties can be waived if the taxpayer can show "reasonable cause," but many tax professionals believe the IRS has so narrowed the definition as to be almost unreachable, unless you are willing to die. To aggravate the matter, the IRS has also instructed its personnel to substitute "first time abatement" (FTA) for reasonable cause as a matter of policy. While the IRS argues that FTA is easier to review and administer than reasonable cause, there exists a high degree of skepticism. Why would a taxpayer automatically burn a "get out of penalty-jail free" card if the taxpayer otherwise has reasonable cause? Wouldn't a taxpayer want to keep that card available just in case?

My partner - by the way - has that last situation: burning his FTA chip without a reasonable-cause backup for the second year. Ironically, he may have reasonable cause for the first year, but that sequence does not follow IRS policy. I anticipate going to Appeals to obtain reasonable cause and preserve the FTA for the second year.

Let's talk about the Carolyn Rogers (Rogers v Commissioner) case.

Carolyn lived in New York. In 2006 she had a small business (Talk of the Town Singles) which she operated from her cooperative. In 2006 there was a fire which rendered the place uninhabitable.

She moved. In 2007 there was another fire, one she appears to have caused herself. The local newspaper called her out, and she was thereafter harassed by people in her neighborhood.

She moved to the YWCA until 2010. She did not have a pleasant time there, and in 2009 she fell off a subway platform and fractured her skull on the rails. She was in the hospital for days, and she continued to suffer from dizzy spells thereafter.

Prior to this period, she had a record of filing timely returns. She also made significant efforts to correctly prepare her tax returns, consulting books and references and more than once contacting the IRS. She did not use a paid preparer.

The IRS penalized her for not filing a 2009 return.

She explained that the insurance company settled the second fire in 2009, and she lost a bundle. According to her research, the casualty loss would wipe out her income, and she was therefore below the filing threshold. She did not need to file.

The IRS then trotted technical guidance on a casualty loss. While the layperson might think that the loss would be deferred until the insurance is settled, the tax Code uses a different test:

* If an insurance claim is not paid in the year of casualty AND there is a reasonable prospect of recovery, then the loss is deferred until one can determine the amount of recovery.

* If there is no hope for insurance - or the prospect of recovery is unreasonable - then the loss is deductible in the year of the casualty.

 The IRS said that she came under the second rule. She knew that insurance would not cover the full loss from the 2007 fire. The loss was therefore deductible in 2007.

COMMENT: There is enough "what if" to this rule that even a tax professional could blow it.

The IRS wanted penalties for not filing that 2009 return.  

The Tax Court reviewed her filing history and her chaotic life. It noted:

Petitioner's error (regarding the proper year of deduction of the portion of a casualty loss for which there is no reasonable prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic. Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique ..."

Ouch. The Court did not appreciate the IRS wasting its time.

Taking into account all of the facts and circumstances, we conclude that petitioner exercised ordinary business care and prudence under the difficult circumstances in which she was living at the time leading up to the due date of her 2009 return...."

The Court found reasonable cause. She owed the tax, but she did not owe the penalties.

The IRS should have found reasonable cause too. It is troubling that it didn't.

Olsen v Commissioner

You may recall that there is a”super” penalty that the IRS can assess if one understates his/her tax by too much. This penalty is not trivial: it is 20% and is called the accuracy-related penalty. In many cases the IRS assesses the penalty as a mathematical exercise. You can however request that the penalty be abated by providing a reasonable cause for doing so. A long illness or the death of a close family member, for example, has long been considered as reasonable cause.

We now have a new reasonable cause. I suspect that it will enter the tax lexicon as the “Geithner” defense, for the secretary of the Treasury under President Obama.

Here is what happened.

Kurt Olsen (KO)’s wife received interest income for 2007 from her mother’s estate. This means that she received a Schedule K-1, an unfamiliar form to the Olsens. KO normally prepared the tax returns, and he liked to use TurboTax. Upon receipt of the K-1, he upgraded his version of TurboTax as a precaution in handling this unfamiliar tax form.

TurboTax uses an interview process to obtain information. Using this process, KO entered the name and identification number of the estate. He also took a swing at entering the interest income, but something went wrong. The interest income did not show up on the return. KO was quite responsible and used the verification features in his upgraded software, but he did not discover the error.

The IRS did, though. They sent him a notice requesting an additional $9,297 in tax. The change in tax was large enough to trigger the “super” penalty of $1,859 ($9,297 times 20 percent).

KO knew he owed the tax, but he felt that the penalty was unfair. He felt strongly enough about the penalty that he pursued the issue all the way to the Tax Court. He represented himself under a special forum for small cases.

                Note: The tax term for representing yourself is “pro se.”

Now, the Tax Court has not been forthcoming in considering “tax software” as a reasonable cause. The Court has long expected one to use the software properly. In fact, a famous case (Bunney v Commissioner) has the Court stating that “tax preparation software is only as good as the information one inputs into it.”

The Court however took pains to distinguish KO, commenting that…

·         “We found petitioner to be forthright and credible.”

·         “It is clear that his mistake was isolated as he correctly reported the source of the income.”

·         “He did not repeat any similar error in preparing his tax return.”

·         “Petitioner acted reasonably in upgrading his tax preparation software to a more sophisticated version.”

The Court found reasonable cause to abate the penalty.

The key thing is that the taxpayer had an unusual source of income. He did not know where to look to check that the income had been properly included on his return. He did however meticulously follow the verification features in the software, and he relied – not unreasonably – on the software to report this transaction correctly.

This type of case unfortunately cannot be used as precedent. Tax Court Judge Armen also took care to cite the “unique facts and circumstances of this case.” Nonetheless, as more and more taxpayers use software to prepare their returns, it is expected that we will see more and more instances of the “Olsen” defense.