The IRS is empowered to impose penalties upon taxpayers for various taxpayer deficiencies. For example, failure to timely file tax returns, failure to pay taxes, and for substantial underreporting of income. However, the IRS or the Tax Court can abate penalties upon a showing up reasonable cause and that the taxpayer acted in good faith. One ground the taxpayer may assert is reliance on the advice of a tax professional.
The 10th Circuit Court of Appeals recently denied a penalty abatement for a taxpayer with a substantial underreporting penalty who asserted a defense of reliance on the advice of a tax professional, namely the tax preparer. In Langston, v. Commissioner of Internal Revenue, the taxpayer owned a house that it attempted to depreciate as rental property despite having de minimus renters and to depreciate a boat and RV as business equipment. Instead, the Tax Court determined the properties were non-deductible personal assets. The denial of these deductions gave rise to a substantial underreporting penalty.
The taxpayers asserted a defense of reliance on the advice of a tax professional. The 10th Circuit instructed on the law that must be shown for such a defense, ruling as follows:
- Taxpayer must act reasonably and in good faith. “Reliance on the advice of a professional tax adviser ‘constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.’ Treas. Reg. § 1.6664-4(b)(1). But the exception does not apply ‘if the taxpayer fails to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item.’ Id. § 1.6664-4(c)(1)(i).”[1]
- Three part test to determine reasonable, good faith reliance on tax professional. The Court set forth a three part test to determine if the taxpayer reasonably relied in good faith on tax professional:
(1) [t]he 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. [citation omitted].[2]
The 10th Circuit ruled that the taxpayers failed to meet the second element because they had not provided necessary and accurate information to the tax advisor. The taxpayers had not shown that the RV and boat had been transferred to the taxpayers’ LLC and had not provided documents showing business purpose. Rather, the tax preparer relied on oral and implied information from the taxpayers. The assets at issue required written substantiation for deductions, which the taxpayers had failed to provide.
Moreover, the Court ruled that the taxpayers “cannot avail themselves of a reasonable-cause defense because they must show that the advice of a qualified adviser took into account all facts and circumstances and was ‘not based on unreasonable factual or legal assumptions.’ Treas. Reg. § 1.6664-4(c)(1)(i)-(ii).”[3] This additional element was not met because the tax preparer had advised the taxpayers to take the deduction even though the tax preparer knew the property required a higher level of substantiation. Further, the tax preparer wrongfully advised to take the deduction on the property without any evidence of fair market value, which was contrary to law. Because the tax preparer failed in taking reasonable factual or legal assumptions, the taxpayers were barred from asserting the defense.
This last ground for denying the defense is curious. If the taxpayer had no reason to know that the deductions were wrongful and took the deduction in good faith reliance on the advice of the tax professional, the 10th Circuit’s ruling seems to indicate that the penalty abatement can’t be taken if the tax professional gave tax advice that is contrary to a reasonable assumption of law. This begs the question: how is the taxpayer supposed to know if the tax preparer is making unreasonable assumptions of law or fact?
This tacked-on requirement will need to be carefully examined by courts to insure that it is not too broadly construed to deny the tax abatement to worthy taxpayers who rely in good faith on erroneous tax advice.
Taxpayers with penalties may contact Jared Le Fevre to determine if their tax penalties may be able to be abated.
Jared M. Le Fevre is a tax attorney and partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal and state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.
[1] Langston, v. Commissioner of Internal Revenue, 2020 WL 5869468 (10th Cir. Oct. 2, 2020)
[2] Id.
[3] Id.