Taxpayers seeking abatement from the accuracy-related penalty imposed under section 6662(a) of the Code often argue reasonable cause based upon reliance on the advice of a professional tax adviser.1 As explained by the Supreme Court, reliance upon the advice of a tax professional may, but does not necessarily, establish reasonable cause and good faith for the purpose of avoiding a section 6662(a) penalty.2 In Neonatology Associates, P.A., the Tax Court explained that for a taxpayer to rely reasonably upon advice to potentially negate a section 6662(a) accuracy-related penalty the taxpayer must prove “(1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.”3
Several recent Tax Court cases have examined the reasonable cause defense for penalty batement based on reliance on a tax professional, focusing on the eonatology factors and, in more general sense, whether the tax consequences of the transaction were “too good to be true.”4
Giovacchini, et al. v. Comm’r
Most recently, the Tax Court considered whether penalty abatement was appropriate where an estate substantially understated the value of real property for estate and gift tax purposes.5 The estate argued that it was not liable for penalties because the estate relied on professional advisers in valuing the real property. The IRS argued that the estate could not establish the reasonable reliance defense because the estate failed to provide the professional advisers the information that was needed to accurately report the value of the real property.
With respect to the first prong of the Neonatology test, the Tax Court concluded that the estate had established that its tax advisers “were competent professionals who had sufficient expertise to justify reliance.” With respect to the second prong, the Tax Court was “satisfied that the evidence of record reflects that [the tax professionals] were provided the information that they needed to accurately and appropriately advise the family as to the [real property’s] value. Further, one of the tax professionals testified that the Giovacchinis were “always forthcoming, never misstated anything, and provided him with sufficient information to prepare the returns.”
With respect to the third prong, the Tax Court explained that the Giovacchinis had no tax expertise and relied on their advisers in good faith.
The IRS argued that the estate’s reliance was unreasonable because an initial appraisal received by the estate put the taxpayers on notice that the relevant real property was worth at least $26 million. In response, the Tax Court noted that the estate had no reason to believe that such a high figure reflected reality, especially in light of the conflicting advice given by their tax adviser. Quoting Boyle, the Tax Court explained “[t]o require the taxpayer to challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify every purpose of seeking the advice of a presumed expert in the first [place].” Thus, the Tax Court held that the estate demonstrated reasonable cause and good faith for the underpayment and was not liable for the accuracy-related penalties under section 6662(a).
Gaggero v. Comm’r
In Gaggero, the Tax Court analyzed whether the taxpayer properly reported the tax consequences of transactions involving the acquisition, improvement and resale of the taxpayer’s principal residence, and whether the taxpayer was liable for accuracy-related penalties under section 6662(a).6
In 1990, the taxpayer purchased land with a rundown house in a relatively depressed market for approximately $3 million. The taxpayer planned to make improvements to the home and sought the advice of his longtime accountant in structuring the purchase and development of the property. In accordance with the accountant’s advice, the taxpayer executed a Land Contract Purchase and Sale Agreement and Development Contract with the taxpayer’s development corporation (“BCC”). Under this contract, BCC agreed to develop the property in exchange for an interest equal to half the increase in its value, less the costs of sale. The taxpayer then moved into the house and used the house as his primary residence as BCC performed the development work. When the house later sold for $9.6 million, the taxpayer reported $6.6 million on Form 2119, Sale of Your Home, while BCC reported over $3 million in ordinary income. The taxpayer then bought a replacement principal residence for $6.7 million within two years and deferred his gain on the sale of the original residence under section 1034 of the Code. The Tax Court held that the taxpayer’s adjusted sales price in his “old residence” was in fact $9.6 million, rather than the $6.6 million reported by the taxpayer. Accordingly, the taxpayer recognized an additional gain of $2.9 million in the year of the sale because the amount by which the adjusted sales price of his “old residence” exceeded the cost of his “new residence” could not be deferred under section 1034 of the Code.
In evaluating whether the taxpayer had a defense based on his reasonable reliance on the advice of his accountant, the Tax Court noted that the taxpayer’s accountant was “a thoroughly qualified professional adviser . . . . [with] extensive experience with these type [sic] of owner developer real-estate transactions.” The Tax Court also acknowledged that the taxpayer had provided his accountant “with all the information they needed or asked for and that he actually followed their advice.”
The IRS claimed that even if the taxpayer proved reliance the taxpayer failed to act in good faith, arguing that the taxpayer had a “worldly understanding . . . [which] made him consciously aware that the tax consequences of the transaction were ‘too good to be true.’”7 The Tax Court flatly disagreed, explaining its impression of the taxpayer as “an honest craftsman who followed professional advice of his long-term consultants, a man who had to fight the IRS and then learn the case well enough to be familiar with the terms of the somewhat obscure issues that it raised.” The Tax Court agreed with the IRS as to the amount of gain to be recognized but overturned the accuracy-related penalty under section 6662(a).
The IRS frequently asserts that a taxpayer’s reliance was unreasonable because the taxpayer failed to disclose sufficient facts to allow the professional adviser to form a reasoned opinion. Further, the IRS often argues that a taxpayer’s reliance lacked good faith because, based on the education, experience, and sophistication of the taxpayer, or due to the taxpayer’s knowledge of a conflict of interest with the professional adviser, the taxpayer was aware that the tax consequences of a transaction were “too good to be true.”8 Taxpayers are generally “expected to ascertain the independence and qualification of their advisers, and are expected to provide the tax advisor with all relevant facts.”9 But, as we have seen in Gaggero, the fact that the IRS believes a taxpayer’s experience and sophistication puts the taxpayer on notice that the tax consequences are “too good to be true,” it is not necessarily fatal to the taxpayer’s reasonable and good faith reliance on the advice of a tax professional.