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.
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.”
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.”
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.
