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IRS Inaction in Prior Years Provides Path to Penalty Relief for Substantial Understatement Penalty – Fire and Rain

Posted on Sep. 10, 2015

I went to college just as singer James Taylor became very popular.  One of his most popular early songs was Fire and Rain.  He talked about what he had seen.  The recent decision in James Taylor v. Commissioner involving someone else with that rather common name reminded me of things I had seen many taxpayers argue.  In this case, a tired argument on the income side of the case turned into a winner on the penalty aspect.  As the IRS budget cuts cause it to become more and more overwhelmed, a greater number of cases will occur in which it has failed to catch an incorrect tax position in earlier years.  Mr. Taylor’s case points out how the failure of the IRS to act can provide a significant benefit to a taxpayer (aside from years of getting by with paying less tax than should have been paid) when the IRS seeks to impose an accuracy related penalty as it often does based simply on the dollar amount of the deficiency without any thought to the taxpayer’s reason for underreporting the tax.  In the case of Mr. Taylor, when “You’ve Got a Friend” who is not a tax professional who gives you advice on how to avoid taxes by not reporting your pension, “You can Close Your Eyes” and think about “How Sweet It Is” or you can check it out with someone who might have a more reliable opinion. Mr. Taylor apparently closed his eyes and moved forward.

Taxpayers who get audited for the first time after several years of incorrect filing regularly want to argue that the IRS allowed a particular tax treatment in the past.  This argument always loses and should lose when it focuses on the effect of the IRS previous failure to act upon the tax liability for the year at issue.  While IRS inaction cannot create a right for a taxpayer to claim a certain tax benefit not otherwise allowed by the Internal Revenue Code, it can lull the taxpayer into thinking that his or her tax treatment of an item on the return is correct and that for the taxpayer it’s Enough to Be On Your Way.  The longer the activity goes on without action from the IRS the more the taxpayer is likely to rely on the position taken in the prior return and the more reasonable that reliance becomes.  This appears to have happened in Mr. Taylor’s case.

Mr. Taylor retired after 26 years of active duty service in the Army during which time he achieved the rank of Lt. Colonel.  In the same year he retired, he also was divorced.  As a result of the retirement, he began receiving a pension.  As a result of the divorce, he received less of the pension than he might have had he remained married.  He originally reported the pension on his returns for 2006-2008 but an acquaintance told him he could exclude these amounts.  He filed amended returns treating the pension amounts as excludable and the IRS sent him a Letter in the Mail with the refunds prior to his filing the 2009 return at issue in this case.  Getting the money back based on amended returns is an even more positive affirmance by the IRS of the correctness of the position taken than it would have been had he taken this position on his original returns.  Usually, we think of the IRS glancing at, if not taking a hard look at, refund claims and giving much more scrutiny to them than it does to original returns even if the original returns contain refund requests.

Mr. Taylor’s determination that the reduced pension he received was not taxable was wrong.  The IRS figured this out in looking at his 2009 return and sent him a notice of deficiency increasing his tax liability; the IRS told Mr. Taylor they would spend a Little More Time with You.  Judge Carluzzo, after describing the facts, spent on sentence determining that Mr. Taylor’s position on the income tax treatment of the pension was wrong.

The notice also contained the accuracy related penalty.  Here things got more interesting because of the amended returns the IRS had allowed.  These returns contained the same wrong argument for excluding the pensions that he used in making his 2009 return.  Since he was wrong on the tax position taken on his return and the resulting tax mistake exceeded $5,000, the IRS met its burden of production with respect to the imposition of the penalty; however, he still had the opportunity to Stand and Fight and to show pursuant to section 6664(c)(1) that there was reasonable cause for the position he took and that he acted in good faith.

The Court noted that reliance on the advice of an acquaintance “would hardly support a finding that he had reasonable cause for, and acted in good faith with respect to, the exclusion of the taxable portion of his military retirement pay.”  Mr. Taylor did not apparently put into evidence information that his acquaintance was a tax professional of some type.  Had the acquaintance been a tax professional and had Mr. Taylor been able to show that he provided the individual with all of the relevant facts that might have formed the basis for reasonable cause.  See U.S. v. Boyle, 469 U.S. 241 (1985) and Estate of La Meres v. C.I.R., 98 T.C. 294 (1992).  One gets the impression that if any facts at all came out about the acquaintance, the facts supported the conclusion that the acquaintance was not someone upon whom to rely for an important determination on the taxability of the pension and doing so Let It All Fall Down.

Nonetheless, the Court kept going because “not once, not twice, but three times petitioner claimed refunds computed by excluding the taxable portions of his military retirement pay… and not once, not twice, but three times the refund claims were allowed.”  The Court found that because the allowance of the prior claims caused him to exclude the income in 2009 he qualified for the reasonable cause basis for relief from the imposition of the penalty.  It is not often that the IRS will provide this kind of excuse nor litigate to emphasize its failures.  Mr. Taylor’s case does provide hope for those who have reasonably relied on the IRS past actions or inactions as a basis for penalty relief, if not tax relief.  There are at least some “Sunny Skies” for Mr. Taylor.

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