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Follow up On Clean Hands Post: The Imposition of Penalties and How Using a Preparer Does Not Automatically Constitute Good Faith and Reasonable Cause

Posted on Mar. 3, 2016

In yesterday’s post I discussed the case of Key Carpets v Commissioner, involving one entity’s payment of business expenses that were unrelated to its business but which were related to the business of a separate corporation controlled by the same shareholder. In Key Carpets, the Tax Court disallowed the entity’s deduction under Section 162 and also found in the consolidated case of Johnson v Commissioner that the entity’s shareholder received a constructive distribution. On top of the disallowed deduction and constructive distribution, the Tax Court sustained the 20% substantial understatement penalty for both the individual and corporate adjustment, an issue I flagged but did not explain.

It is worth a bit more on the penalty issue as the taxpayer argued that his and the corporation’s use of a preparer insulated him from civil penalties. The Tax Court’s brief distinction between using a preparer and relying on a taxpayer for advice highlights that it is prudent to have some additional evidence of a preparer’s advice beyond the return itself if you want to ensure the possibility of penalty relief.

Here is some more on the issue.

For an individual taxpayer, there is a “substantial understatement” of income tax for any year if the amount of the understatement for the taxable year exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. For a C corporation, there is a “substantial understatement” of income tax for any year if the amount of the understatement for the taxable year exceeds the lesser of 10% of the tax required to be shown on the tax return (or, if greater, $10,000) or $10 million. In the opinion the Tax Court found that the understatements exceeded the threshold for applying the penalty.

There is a reasonable cause good faith exception to the penalty. In Key Carpets, both taxpayers argued that they qualified for that exception, having “provided all records to their accountant and had a reasonable basis for the business deductions.”

The Tax Court disagreed, finding that both “petitioners did not act in good faith, because their positions run contrary to established law.” As to whether they could avoid the penalty due to the presence of a qualified accountant preparing the corporate and individual returns, the Tax Court said no in large part because the record did not reflect if there was specific advice sought or received on the payments and the consequences of those payments:

Mr. Johnson testified that he provided all records to his accountant on whom he relied to prepare his corporate and individual returns, but petitioners did not offer any evidence about whether they sought advice from their accountant about the deductions or whether the Key Carpets payments to Clean Hands constituted constructive distributions.

When it was all said and done the opinion concluded that “[b]ecause petitioners’ positions run contrary to established law and petitioners have not shown that they reasonably relied on their accountant to do anything more than prepare tax returns, petitioners have not met their burden of proving that they acted in good faith with reasonable cause, and the Court sustains the section 6662(a) accuracy-related penalty.”

I have previously discussed the standard that the courts used in looking at reliance on an advisor in a small business setting. For example, in Tax Court Finds Reliance on Advisor in Messy Small Business Setting I discuss the three factor test set out in Neonatology v Commissioner:

  1. Was the adviser a competent professional who had sufficient expertise to justify reliance?
  2. Did the taxpayer provide necessary and accurate information to the adviser?
  3. Did the taxpayer actually rely in good faith on the adviser’s judgment?

The Key Carpets opinion is a little thin on the penalties issue. A threshold issue is whether a taxpayer receives advice from a preparer. In other cases courts have held that advice can take the form of conclusions and positions taken on the tax return itself. See for example my discussion of the Ohana case a few years back where the Tax Court distinguished cases where advice was contained in the return itself and found that where there was no real relationship between the preparer and the taxpayer (most interaction was between the taxpayer and a receptionist) and the preparer was essentially rubberstamping the numbers the taxpayer gave it, the positions on the tax return did not reflect advice.

In contrast, unlike Ohana there was nothing in the opinion that suggested Johnson did not have a true client/preparer relationship with his preparer. Perhaps the preparer might not have inquired about the ownership of the patent on the voice activated soap dispenser, and perhaps Johnson did not provide that information. I might add that this omission is somewhat understandable as in prior years it was legitimate (or at least unchallenged) for Key Carpets to incur and deduct expenses on the radio frequency hand washing venture. If the preparer were involved in the prior years or reviewed those returns he might have expected Key Carpets to incur costs associated with the voce activated hand washing venture.

It is hard to be too critical on such a fact-specific issue, as I do not fully know the record in the case. For example, the opinion does not discuss whether there was any testimony from the preparer or other evidence relating to the relationship between the preparer and the taxpayer. Yet the result here seems harsh, especially for Johnson individually, as his consequences stem from a deemed distribution that most taxpayers would not appreciate despite the court’s discussion of the outcome as running contrary to established law. In addition, one would expect perhaps that a preparer would make inquiries necessary to reach appropriate legal conclusions about the nature of the payments.

At the end of the day, the opinion is certainly a warning that merely hiring a preparer is not enough, and proving reliance on an advisor requires perhaps a bit more focus than a taxpayer’s testimony that the accountant prepared the return.

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