The Accuracy-Related Penalty and the Reasonable Cause Defense

In Defenses, Penalties by Jason Freeman1 Comment

The Tax Court, in Kauffman v. Commissioner, (2017) TC Memo 2017-38, recently addressed a commonly-encountered issue in tax litigation: The application of the reasonable cause defense to the IRS’s assertion of the accuracy-related negligence penalty.  The case, while not breaking new ground, stands as a reminder of the limits of the reasonable cause defense and the need to present evidence that establishes each of the particular elements necessary to successfully invoke and rely on the defense.

The facts in the case are straightforward.  The IRS issued the taxpayer a notice of deficiency for $52,680 and an accuracy-related penalty of $11,592.80 under section 6662(a).  The IRS claimed that the taxpayer took several improper deductions and disallowed those deductions.  The only evidence that the taxpayer provided was accounting records and bank statements. However, while those items reflected expenses allegedly incurred by the taxpayer, the records and bank statements did not show why the alleged expenses were ordinary and necessary expenses that were properly deductible. The taxpayer did not testify or offer any other evidence explaining how the expenses were calculated or to support the positions.

Under section 6662(a), (b)(1) and (2), a taxpayer can be held liable for a penalty equal to 20% of the portion of an underpayment of tax due to: (1) “negligence” or “disregard” of rules or regulations or (2) a “substantial understatement” of income tax.  (Section 6662(b) provides a host of other categories giving rise to the 20% penalty as well.)   “Negligence,” in this context, is defined as any failure to make a reasonable attempt to comply with the provisions of the Code—and the government takes the position that negligence is established where there is a failure to keep adequate books and records or to substantiate items properly. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). It is also defined as the failure to exercise due care or the failure to do what a reasonable person would do under the circumstances. See Allen v. Commissioner, 92 T.C. 1, 12 (1989), aff’d, 925 F.2d 348, 353.

The term “disregard” means any careless, reckless, or intentional disregard. § 6662(c). “Understatement” means the excess of the amount of the tax required to be shown on the return over the amount of the tax imposed that is shown on the return, reduced by any rebate. § 6662(d)(2)(A). A “substantial understatement” of income tax is defined as an understatement of tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. § 6662(d)(1)(A).

Importantly, even where a taxpayer may be subject to the accuracy-related penalty under the definitions above, the Code provides a potential defense: reasonable cause. In other words, the accuracy-related negligence penalty does not apply to any portion of an underpayment for which the taxpayer can show that there was reasonable cause and that he or she acted in good faith. See § 6664(c)(1). Whether reasonable cause and good faith exist is determined on a case-by-case basis. See § 1.6664-4(b)(1). “Circumstances that may indicate reasonable cause and good faith include 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.” Id. “Reliance on a tax professional,” one of the common bases for a reasonable cause defense and one of the bases at issue in Kaufman, rises to the level of “reasonable cause when a taxpayer (1) selects a competent tax adviser, (2) supplies the adviser with all relevant information, and (3) relies in good faith on the adviser’s professional judgment.” Kauffman v. Commissioner, (2017) TC Memo 2017-38.  In order to successfully raise the defense of reasonable cause, the taxpayer must demonstrate the existence of these elements by a preponderance of the evidence.

While the IRS bears the initial burden of production to demonstrate that such an accuracy-related penalty applies, once the Commissioner satisfies that burden, the taxpayer bears the burden to prove that the IRS’s determination is either incorrect or that the taxpayer had reasonable cause or substantial authority for the position.

In the recent Kauffman case, the taxpayer put forward a reasonable cause defense, arguing reliance on his tax preparer. The Tax Court, however, ultimately determined that the taxpayer did not adequately prove reasonable cause, citing his failure to maintain adequate records and inability to demonstrate that he provided his tax return preparer with all relevant information.  The court succinctly stated its analysis of the reasonable cause issue in a brief paragraph:

Petitioner did not maintain sufficient records to substantiate most of the expenses underlying his deductions, and the disallowed deductions in this case are directly attributable to petitioner’s failure to maintain adequate records. Furthermore, petitioner has not proven he had reasonable cause for his return positions and his failure to maintain adequate business records. Although petitioner argues he relied on a return preparer, there is no evidence in the record that his return preparer was provided all relevant information. Petitioner testified that he provided his return preparer with his accounting records (which we find unreliable), but the record does not show that he provided his return preparer with the supporting evidence (or that the supporting evidence ever existed). It is also unclear from the record whether petitioner adequately explained the nature of the transactions his related business entities were purportedly engaged in . . . . We therefore hold that petitioner is liable for a section 6662(a) accuracy-related penalty on the ground of negligence.

The case is a reminder of the limits of the reasonable cause defense and the need to adequately present evidence that establishes the elements necessary to successfully invoke the defense.  Because the taxpayer bears the burden to demonstrate that the defense of reasonable cause applies, the taxpayer must approach the issue carefully and ensure that all relevant evidence is presented to the court in support of the defense.

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