Taxpayers are liable for every position taken on their tax return. You take a position on the return by reporting certain items of income and taking some deductions. When a taxpayer signs the return, the taxpayer attests under penalty of perjury that the statement made or the position taken on the return is accurate to the best of his or her ability. The IRS will not process a tax return without a taxpayer’s signature. However, the code and regulations allow taxpayers to shift the liability for the assessed penalty to others when the taxpayer could prove there was a reasonable cause.
Under the IRS code and regulations, no accuracy-related or fraud penalty may be imposed with respect to any portion of an underpayment if the taxpayer can show there was reasonable cause for, and the taxpayer acted in good faith with respect to such portion.
The Internal Revenue Code in section 6662 states that with respect to the accuracy-related penalty on tax underpayments, no penalty is imposed under Code Section 6662 with respect to any portion of an underpayment upon a showing by the taxpayer that there was reasonable cause for, and the taxpayer acted in good faith with respect to, such portion (Code Sec. 6664(c)(1); Reg. Sec. 1.6664-4(a)).
Reasonable cause and good faith exception could be indicated by an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.
The Tax Court in Neonatology Associates, P.A. v. Comm’r, 115 T.C. 43 (2000), aff’d, 299 F.3d 221 (3d Cir.2002) stated that for a taxpayer to rely reasonably upon advice so as possibly to negate an accuracy-related penalty, the taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three-prong test:
(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.
As per Reg. Sec. 1.6664-4(b)(1), reliance on an information return, professional advice, or other facts, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.
The reasonable cause and in good faith exception is determined on a case-by-case basis, taking into account all pertinent facts and circumstances.
- The Court held in Tsai v. Comm’r, T.C. Summary 2013-26 that the taxpayer, whose command of the English language was limited, made a good-faith effort to determine his proper tax liability with respect to legal fees and dependency exemptions and that his underpayment attributable thereto was from an honest misunderstanding of law that was reasonable under the circumstances.
- In Tsehay v. Comm’r, T.C. Memo. 2016-200, the court found reasonable cause for not enforcing the accuracy-related penalty where among other things, the taxpayer had a language barrier and had sought and relied on professional advice.
- The Court in Argyle v. Comm’r, T.C. Memo. 2009-218, aff’d, 397 Fed. Appx. 823 (3d Cir. 2010) upheld a penalty against a certified public accountant (CPA) who held a master’s degree in accounting with a major in tax. According to the court, the taxpayer’s training and experience were relevant factors in considering whether he was liable for the penalty.
- In Tucker v. Comm’r, T.C. Memo. 2017-183, aff’d 2019 PTC 116 (5th Cir. 2019), even though the taxpayer was a CPA, a lawyer, and a former partner at KPMG, the court held that he was not liable for an accuracy-related penalty because he had made a sufficient good-faith effort to assess the tax liability at issue and had reasonably relied on professional advice.
- The Tax Court in Babu, TC Memo. 2020-121, rejected a tax attorney’s plea to escape penalties. After the IRS assessed a substantial understatement penalty against the lawyer, he claimed the penalty was erroneous because he relied in good faith on the advice of a qualified tax professional. The Court rejected the argument for multiple reasons, one of them is his experience in tax.
The reasonable cause exception does not apply to certain cases and transactions as detailed in the code sections 6664(c)(2) and 6664(c)(3). Examples include but not limited to: transactions lacking economic substandard, underpayment attributable to a substantial or gross valuation under the income tax rules.
Some taxpayers could qualify for abatement of penalty relief (called FTA or First Time Abatement) when certain conditions are met.
Hiring a tax resolution expert is the best action a taxpayer could take in a tax matter before the IRS or a state tax authority.
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