Section 6662 imposes an accuracy-related penalty for various types of infractions in tax, including underpayments attributable to negligence or disregard of rules or regulations (§6662(b)(1)) or a “substantial understatement of income tax” (§6662(b)(2)). A substantial understatement of income tax exists where the amount of the understatement for a taxable year exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. For a regular or C corporation a substantial understatement of income tax is present where the amount of the understatement for the tax year exceeds the lesser of $10,000 or $10,000,000. The substantial understatement penalty is reduced by the portion of the understatement attributable to the tax treatment of any item contributing to the understatement for which there is or was “substantial authority”, or, alternatively where the questionable item was adequately disclosed on the tax return. This relief rule does not apply to “tax shelters” which term is broadly defined for purposes of this provision. Other accuracy-related penalties are imposed on valuation misstatements, substantial estate or gift tax valuation understatements or substantial overstatement of pension liabilities. More recently, Section 6662(b)(6) imposes a special accuracy related penalty of up to 40%, generally accuracy-related penalties are limited to 20% of the resulting tax caused by the violation, for claimed tax benefits that are undisclosed on the return which are disallowed by application of the economic substance doctrine under Section 7701(o). Penalties for the failure to comply with the reportable transaction rules also subjects a taxpayer to a separate penalty under Section 6662A.
Under Section 7491(c), the Commissioner bears the burden of production and must produce sufficient evidence that the imposition of the penalty is appropriate in a given case. Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner meets this burden, the taxpayer must come forward with persuasive evidence that the Commissioner's determination is incorrect. Tax Court Rule 142(a).
Mitigation of the Accuracy-Related Penalty
It is only natural that when the particular treatment of an item on a tax return runs the risk of being challenged by the Service, including the assertion of an accuracy-related penalty, the tax advisor will consult with its client and discuss the risks involved in taking what might be labeled as “aggressive” position and whether a penalty can be avoided if the item in question generates a deficiency in tax. As mentioned, in some cases the presence of “substantial authority” for the treatment of a particular item on the return (which treatment is ultimately determined to be incorrect) or the filing of an adequate disclosure statement giving the Service notice of the particular item in question and its treatment on the return, will, in many instances, avoid the imposition of the penalty. In addition, there is always the idea that the taxpayer’s reliance on its tax advisor(s) in taking the questionable position on the return provides a sufficient basis to avoid the penalty. More specifically, Section 6664(c)(1) provides that "[n]o penalty shall be imposed under section 6662 ... with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion." Under Treas. Reg. §1.6664-4(b)(1), reliance on professional advice can meet the requirements of “reasonable cause” and “good faith” provided, under all circumstances, such reliance was reasonable and the taxpayer in fact acted with good faith. Treas. Reg. §1.6664-4(c)(1) states that "[a]ll facts and circumstances must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer ... under Federal tax law.” The presence of actual reliance on a qualified professional tax advisor may not assure a successful defense to an accuracy-related penalty will be the outcome although dictum from the Supreme Court’s decision in Boyle might be persuasive that a “per se” rule is proper. In United States v. Boyle, 469 U.S. 241, the Supreme Court stated: "When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To 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 the very purpose of seeking the advice of a presumed expert in the first place.... ‘Ordinary business care and prudence’ does not demand such actions."
Under Treas. Reg. §1.6664-4(c)(2), “advice” is “any communication *** setting forth the analysis or conclusion of a person, other than the taxpayer”. (emphasis added). See §7701(a)(14). The determination of whether a taxpayer acted with reasonable cause and in good faith depends upon the facts and circumstances, including the taxpayer's efforts to assess its proper tax liability; experience, knowledge, and education; and reliance on the advice of a professional tax advisor. The Tax Court recently addressed the reasonable cause defense in Seven W. Enterprises, Inc. v. Commissioner, 136 T.C. No. 26 (2011) and in Woodsum v. Commissioner, 136 T.C. No. 29 (2011).
Seven W. Enterprises, Inc.
In Seven W. Enterprises, Inc., supra, the Service, in addition to asserting deficiences in corporate income tax and personal holding company tax for 4 years, also sought to impose, under Section 6662(b)(2), a 20% penalty for a substantial underpayment of tax. The case involved a family which controlled two closely-held companies, Highland Supply Corporation (HSC) and Seven W. Enterprises, Inc. (7W). HSC was the parent of a group of corporations which elected to file consolidated returns. HSC manufactured floral, packaging, and industrial wire products. The HSC Group included Highland Southern Wire, Inc., and Weder Investment, Inc. (WI). 7W, a corporation principally engaged in leasing nonresidential buildings, was the parent of a group of entities (collectively, 7W Group), which also filed a consolidated Federal income tax return. 7W owned an 89% limited partnership interest in Weder Agricultural Limited (WAL).
In 1990, HSC Group and 7W Group, hired Mues, a CPA, to serve as their tax manager. He was familiar with the personal holding company rules, which would later be a critical issue before the Court, and had worked at Deloitte preparing various types of business tax returns, including consolidated returns, and also was employed in-house at another company preparing consolidated returns. In 1991, the petitioners made Mues VP of taxes. While employed by the petitioners, Mues drafted documents, performed general legal work, and prepared returns for petitioners and petitioners' shareholders. In December, 1995, a family trust (FT), which was unrelated to petitioners, issued a $4M interest note for the benefit of HSC. One year later, HSC assigned the promissory note to WI. In 1997, during an audit of the HSC consolidated group’s 1995-1997 returns, the Service and the taxpayers agreed to various adjustments including the disallowance of $450,000 of personal expenses of HSC’s president. The settlement was signed by Mues on behalf of the HSC group and also for both consolidated groups for 1998 and 1999. The HSC Group had recurring tax adjustments for research and development expenses.
After completing an MBA while working for HSC, Mues resigned as VP of taxes and went to law school on a full time basis. While an employee of petitioners and prior to 2001, Mues obtained a master's degree in business administration and began law school as a part-time student. He agreed with HSC and 7W to provide consulting services on tax matters although not subject to the petitioners supervision or direction. As a consultant, Mues prepared the 7W Group 2000 return and HSC Group’s 2001 return. In March 2002, after Mues completed law school, petitioners hired him again as VP of taxes and he subsequently prepared and signed, on behalf of petitioners, 7W Group's 2001, 2002, and 2003 returns and HSC Group's 2002, 2003, and 2004 returns, which later were the years in issue in the case.
The government imposed a personal holding company (PHC) tax on HSC per Section 541 on the HSC Group’s undistributed PHC income. As argued by the Service (and agreed by the Court) on HSC Group's 2003 and 2004 returns, Mues incorrectly concluded that interest income, relating to the promissory note held by WI, was income from a source within HSC Group and that WI was not liable for the personal holding company tax. As a result, HSC Group, whose consolidated return included WI, understated its 2003 and 2004 tax liabilities. On 7W Group's 2000, 2001, 2002, and 2003 returns, Mues made a similar mistake with respect to interest income received by WAL. During 2000, 2001, 2002, and 2003, WAL received interest income relating to an installment note issued by an entity outside 7W Group, and each year 7W, in determining its income, took into account a portion of that interest income equal to 7W's distributive share. For purposes of calculating the personal holding company tax, however, Mues did not take this income into account. In addition, Mues also misapplied the personal holding company tax rules relating to rental income under Section 543(a)(2), and, in doing so, incorrectly concluded on each year’s return that 7W's rental income was not subject to the personal holding company tax. As a result, 7W Group understated its 2000 through 2003 tax liabilities.
In March, 2008, the Service issued 7W Group a notice of deficiency relating to 2000, 2001, 2002, and 2003 and HSC Group a notice of deficiency relating to 2003 and 2004 (collectively, notices). In the notices, respondent determined that petitioners were liable for Section 6662(a) accuracy-related penalties for all years and returns. After the taxpayers filed petitions in the Tax Court, the taxpayer conceded it had incorrectly treated the interest payments and rental income as not constituting personal holding company income and that a substantial understatement of income tax existed. The petitioners’ defense to the accuracy-related penalties was reasonable cause and good faith under Section 6664(c)(1).
7W Group's 2000 Return. The argument advanced by 7W was it relied on Mues’ advice, as an independent, competent tax advisor. Petitioner noted that when Mues prepared 7W Group's 2000 return, he had resigned as VP of taxes and was working under a consulting agreement. The Service countered by arguing that since Mues performed the same activities before and after his resignation for 7W, the distinction drawn distinguishing working as an employee for 7W versus a consultant should be ignored and that Mues was not sufficiently independent for obtaining relief under Section 6664(c). The Court sided with the taxpayer based on the independent contractor status Mues had under the consulting agreement. He was also, in signing 7W’s Group 2000 return, a paid preparer and the consulting agreement specifically provided that he was not subject to petitioners' supervision. As precedent, the Court in its decision in Montgomery v. Commissioner, 127 T.C. 43, 67 (2006) (stating that it is reasonable to rely on an advisor's professional judgment if the taxpayer “selects a competent tax adviser and supplies him or her with all relevant information” and that “a taxpayer who seeks the advice of an adviser does not have to challenge the adviser's conclusions, seek a second opinion, or try to check the advice by reviewing the tax code himself or herself.” (citing United States v. Boyle, 469 U.S. 241, 250-251 (1985)).
Petitioners' 2001 Through 2004 Returns. The accuracy related penalties that the Service proposed to assess with respect to these, was agreed to by the Tax Court finding that the taxpayers did not exercise ordinary business care and prudence with respect on such returns. It specifically found “[I]t is unclear whether petitioners' myriad of mistakes was the result of confusion, inattention to detail, or pure laziness, but we are convinced that petitioners and Mues failed to exercise the requisite due care.” The fact that the taxpayers were sophisticated taxpayers cannot be ignored as well as the fact that Mues was a well-educated and experienced tax professional with full access to petitioners' records and personnel. Mues erroneously interpreted the PHC rules despite being familiar with the provision but “failed to apply some of the most basis provisions” contained in the rules. See §543(a)(2). He failed to identify the PHC income attributable to interest on the note issued by an “outside” debtor. Mues was petitioners' vice president of taxes both when the note was executed and when it was assigned. Furthermore, Mues testified that he knew at the time he prepared HSC Group's returns that the note's debtor was outside the group, yet he inexplicably treated the interest income as if it was derived from within HSC Group and not subject to the personal holding company tax. When asked by the Court whether this was reasonable, Mues made an admission when he stated: “it seemed reasonable at the time. It seems less reasonable now in hindsight.” Given Mues’ experience, expertise and education, the taxpayers did not exercise ordinary business care and prudence as to the disputed items. Petitioners further argued that the accuracy-related penalties should not apply because they reasonably relied on the advice of Mues— a competent tax advisor. Petitioners argued that, pursuant to Sections 7701(a)(1) and (14), the definition of a “taxpayer” is limited to petitioners (i.e., the persons subject to the tax) and, therefore, the “taxpayer” does not include Mues—petitioners' employee.
The Court had no trouble ruling against the petitioners on this line of advocacy. A corporation can act (e.g., sign the corporation's return) only through its officers. Petitioners authorized Mues to act as both the vice president of taxes and the taxpayer. Indeed, unlike the 2000 return, which Mues signed as a paid preparer, the 2001 through 2004 returns were signed by Mues on petitioners' behalf. Therefore, Mues does not qualify as “a person, other than the taxpayer” with respect to the returns which he signed on behalf of the taxpayer (i.e., petitioners). In upholding the bulk of the accuracy related penalties in this case, the Tax Court stated it need not and was not opining on whether reliance on an in-house professional tax-advisor may establish reasonable cause in other circumstances.”
The taxpayers-petitioners also were unsuccessful in asserting the reliance on competent tax advice defense to an accuracy related penalty in Woodsum v. Commissioner, 136 T.C. No. 29 (2011). Mr. Woodsum was the managing director of a private equity investment firm. He referred to himself in the joint stipulation of facts filed in the case as “financially sophisticated” and possessed of a “basic understanding of the taxation of interest income, dividend income, and income fom the sale of stocks and bonds”. The case, which was fully stipulated by the parties under Tax Court Rule 122, involved Mr. Woodsum’s investment in a “ten year total return limited partnership linked swap”. His lawyer advised him on the transaction and supervised the preparation of the tax return for 2006, the year in which the swap was entered into and then terminated by the taxpayer. The results from the taxpayer’s investment was that he had received a $3.4 million gain resulting from closing out his position. The taxpayer received a Form 1099-MISC that reported the payment.
Woodsum retained a “niche firm specializing” in rendering tax advises for private equity and hedge funds as well as such funds’ general partners. This firm, Venture Tax Services (“VTS”) employed a lawyer, Mr. Hopfenberg, who was the long time advisor to the petitioners, prepared the couple’s 2006 return. A VTS experienced CPA prepared the return and Hopfenberg supervised and served as reviewer. The taxpayers delivered to the firm all of some 160 plus information returns they received from third party payors, including the 1099MISC from the “swap” which were scanned by VTS into its records for use in preparing the returns. The 115 page federal income tax return filed for 2006 (along with 27 state income tax returns) reported $29.2M of adjusted gross income but somehow omitted the $3.4M from the swap transaction, which was the third largest long term capital gain that the taxpayers realized for such year.
After obtaining an extension to file their 2006 return until October 15, 2007, on that morning the taxpayers met with Hopfenberg to go over various matters, including the voluminous federal income tax return. The taxpayers stipulated that their review of the return was more than “cursory” but did not recall which specific items of income or deduction were discussed and were unaware that the $3.4M gain from the swap was not included in gross income. The Service subsequently issued a notice of deficiency for the tax attributable to the $3.4M omitted from the return, i.e., approximately $521,500, and imposed a 20% accuracy-related penalty of $104,300 under Section 6662(a).
Not surprisingly, the taxpayers objected to the penalty based on “reasonable cause” based on reliance on a competent tax advisor, here the attorney and CPA for VTS who prepared the returns. The Court stated that for the petitioners to prevail, they must prove by a preponderance of the evidence that: (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. The taxpayer argued it met all three conditions. First, VTS, its attorney and CPA were competent and experienced. Second, he provided VTS with the necessary and accurate information, i.e., the Form 1099-MISC for $3.4 from the swap. Third, the taxpayers relied on VTS to prepare the returns correctly and include the $3.4M in gross income (capital gains).
The Tax Court was not easily persuaded by the taxpayers’ argument. It first examined Treas. Reg. §1.6664-4(c)(2) as to the meaning of the term “advice”, i.e., “…any communication, including the opinion of a professional tax advisor, setting forth the analysis or conclusion of a person, other than the taxpayer, provided to (or for the benefit of) the taxpayer and on which the taxpayer relies, directly or indirectly, with respect to the imposition of the section 6662 accuracy-related penalty. Advice does not have to be in any particular form.” Here the taxpayer essentially proffers that the failure by VTS and its employees to include the $3.4M on the return constituted “advice” und Treas. Reg. §1.6664-4(c)(2). While the regulation is broadly defines “advice”, it does not include a return preparer’s unexplained omission which Woodsum knew was substantial and includible in gross income. As support the Tax Court invoked the holding of the Supreme Court in United States v. Boyle, supra, that where the taxpayer knew or should have known of the applicable filing deadline, he lacked reasonable cause for his attorney's untimely filing of his return. In this case, since petitioners knew their Form 1099 income should have been included, they lack reasonable cause for their preparer's failure to include the income.
The Court continued to drive home the meaning of the term “advice” under the regulations. The communication needs to reflect the tax adviser’s “analysis or conclusion” and that the taxpayer relied, in good faith, on the adviser’s judgment. Here, there was no evidence in the record to show that the omission of the $3.4M was the product of an “analysis or conclusion” by VTS that the income was not taxable. Indeed, in echoing the analysis in Boyle, the Court stated that no special knowledge was required for the taxpayer to know that the $3.4M capital gain was includible in gross income as reflected on the Form 1099MISC that he had received from the third party payor. Therefore the erroneous preparation of the returns did not involve the taxpayers knowingly following the substantive professional advice of the tax adviser. It was in reality a clerical mistake and reliance on professional advice has no application in such instance. Still, the Court suggested that the taxpayers’ might be rescued by application of Treas. Reg. §1.6664-4(b)(1), which provides that “[a]n isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith.”. Based on the record, however, no actual evidence supports that characterization. The omission is unexplained and does not meet the taxpayers burden of persuasion although in some instances an accuracy related penalty may be avoided by a return preparer’s error. Compare Thrane v. Commissioner, T.C. Memo. 2006-269 with Metra Chemical Corp. v. Commissioner, 88 T.C. 654, 662 (187); Magill v. Commissioner, 70 T.C. 465, 479-480, aff’d 651 F.2d 1233 (6th Cir. 1981)(“Even if all data is furnished to the preparer, the taxpayer still has a duty to read the return and make sure all income items are included.”). In other words, the Tax Court in Woodsum, supra, stated that it would uphold a reasonable cause defense where a taxpayer conducts a review of his third-party prepared return with the intent of ensuring that all income items are included, and who exerts effort that is reasonable under the circumstances, but who nonetheless fails to discover an omission of an income item. Treas. Reg. §1.6664-4(b)(1)(“most important factor” in evaluating reasonable cause is the “taxpayer’s effort to assess…the proper tax liability”. That effort was not present in this case. See also Bailey v. Commissioner, 21 T.C. 678, 687 (1954) (duty of filing accurate returns cannot be avoided by placing responsibility upon an agent.....taxpayer failed to review and read the return to check its accuracy). The lesson of Woodsum, supra, is that a taxpayer’s failure to review the return to ensure that the income has not gone unreported can demonstrate a lack of reasonable cause, even if the taxpayer provided full and accurate information to the return preparer.