In the recent Tax Court case of Vision Monitor Software LLC v. Commissioner (September 3, 2014), the Tax Court disallowed a taxpayer’s deduction for losses incurred by a partnership in which he was a partner because he did not have sufficient income tax basis in his partnership interest to deduct those losses. The taxpayer claimed that he obtained the needed basis by contributing his own promissory note to the partnership. The court denied the basis and pointed out that there is considerable previous case law that says a taxpayer does not have any tax basis in his own note.

The IRS also sought to impose the 20 percent substantial understatement penalty. One defense against the imposition of this penalty is the taxpayer’s reliance on professional advice. The partnership’s longtime attorney, who is a certified tax specialist, recommended the note contribution as a means of increasing the partners’ tax basis in the partnership. He gave this advice orally rather than in writing. In order to use reliance on professional advice as a defense against the substantial understatement penalty, the taxpayer must establish that (1) the advisor was a competent professional who had sufficient experience to justify reliance; (2) the taxpayer provided the advisor with the necessary and accurate information on which to base his advice; and (3) the taxpayer actually relied in good faith on the advisor’s judgment.

The court found all three of these conditions were satisfied and granted the taxpayer relief from the penalty. While there is no requirement that the relied-on advice be written, getting professional advice in writing is certainly the better practice. Whether the taxpayer acted reasonably in relying on this advice when several cases had already held that a taxpayer did not have any tax basis in his own note is a good question. The advisor made a weak argument that another case – one that granted the basis to the taxpayer – applied in this case, but the court held it was not applicable because the case was based on very different facts. The court nevertheless determined that the advice given by this advisor would seem reasonable to the taxpayer, who did not have deep knowledge of the tax law.