It’s easy to feel sorry for the people who invested in Son of Boss tax shelters. They really wanted to pay the right amount of taxes but were hoodwinked into investing into tax shelters that did not turn out like they hoped causing them to have significant problems with the IRS that they never intended.
If that’s your take on Son of Boss investors, you will love a case that came out earlier this summer. If that’s not your take, you might still find the situation amusing. I think the IRS found the situation just slightly less amusing than paying out attorney’s fees to tax shelter promoter BASR. In Ervin v. United States, the district court found that investors in a Son of Boss shelter were entitled to a refund of penalties paid to the IRS even though they recovered the penalties from their tax advisors who brought them into the tax shelter in the first place. How did we get there?
The investors brought a suit against the IRS to obtain a refund of the valuation misstatement penalty and penalty interest payments. They convinced a jury of their peers that they had reasonable cause for the tax positions they took. Now, they want the IRS to give them a refund of the penalties they paid.
In the meantime, the investors sued some of their tax advisors – BDO Seidman and Curtis Mallet – to recover the penalties asserted against them for investing in the Son of Boss shelter and they won that suit also. It came out in the tax refund suit that they had won the suit against their advisors and recovered a substantial amount of money. The IRS argued that it should not have to refund the penalties and interest to them because the recovery that the investors received from their advisors was intended to pay for the penalty. If the investors got to keep the recovery and did not have to pay the penalty, the investors would receive a windfall. The IRS argued that it should keep the money the investors paid to it because they were already made whole and the payments by the advisors represented the true payments of the penalties. The investors argued that they should receive the entire refund despite the private settlement. They also argued that the IRS does not have a claim of right with respect to the penalty payments.
The Court rejected the argument made by the IRS and rejected it without giving the IRS any further discovery. It finds that the investors did not fail to disclose a matter “bearing on the nature and extent of injuries suffered.” The suit was about their liability for penalties and the private suit against their advisors really had nothing to do with it. The Court said that it could not find a single instance in which a court has excused the IRS from its obligation to repay the improperly assessed and collected tax in a refund suit and ordered the IRS to pay here.
This case brings up an issue that Steve and I have debated before and he has written about. When a taxpayer argues reasonable cause based on the advice of tax advisor, the case is in many ways the malpractice case involving the advisor. If the taxpayer succeeds in fending off the penalty, maybe the taxpayer does not pursue the advisor. So, a victory for the taxpayer may be an economic victory for the party who caused the problem just as much for the taxpayer.
If taxpayers are going to defend against the IRS and sue their advisor in situations in which they can win both cases because they were reasonable in relying on the advisor and the advisor did give bad advice, maybe this feels bad to the IRS but it puts the economic loss in the right place, or maybe it misallocates the placement of the economic loss which is why the IRS was complaining.
The advisor who gives the bad advice should be liable and pay for the damages caused by the bad advice. The bad advice has really harmed both the IRS and the taxpayer. If the taxpayer pays the right amount of tax after the audit, the IRS is whole from the perspective of collecting the correct amount of tax but has still had to expend effort to collect that tax instead of having the self-reporting system work as it should. If the taxpayer pays the correct amount of tax in the end, should the taxpayer be freed from paying the advisor who caused the taxpayer to incur the problem in the first place? The taxpayer may have had to pay more money to fight with the IRS about the correct amount of tax and certainly did not get the value bargained for.
In cases where the taxpayer avoids an otherwise appropriate penalty because the taxpayer reasonably relied upon the advisor, should the system penalize the advisor so that the IRS recovers something akin to the appropriate penalty and so that the advisor feels the pain of causing the problem while also allowing the taxpayer to recover from the advisor at least the cost of the original bad advice plus perhaps the cost of the advice to fix the problem created? The IRS is right to complain here, in the sense that some penalty payment seems appropriate. It also seems right to allow the taxpayer to avoid paying the penalty to the IRS where the taxpayer reasonably relied on the advice of a professional and to allow the taxpayer to recover the cost the taxpayer paid for the bad advice. Maybe we should look at recasting the penalty scheme to bring all of the players to the table. Where I am particularly bothered, the advisor is continuing to represent the taxpayer in the reasonable cause litigation and I felt that the advisor was using the taxpayer’s more sympathetic case as a shield for the advisors’ less sympathetic one.