Andersen v Comm’r, a summary opinion from last week, caught my eye. The case is not precedential, and involves a relatively modest accuracy-related penalty. The case stands out to me because it is a rare case where taxpayers leave off a significant amount of W-2 income (about $28,000) from the return, but the court still found that they should not be subject to civil penalties. Most taxpayers leaving off a big slug of income are going to face a bill of back taxes, interest, and a 20% civil penalty. Yet, Andersen suggests that an isolated mistake combined with a history of past compliance can insulate a taxpayer from penalties.
I will briefly describe and give some context.
Mr. and Mrs. Andersen had been married 47 years; the opinion tells us that they had a history of timely filing their returns, and their returns had always been accepted as filed. Mr. Andersen worked for a window furnishing company, receiving a salary with the potential for bonuses. Mrs. Anderson was a part-time nurse with somewhat irregular shifts. The taxpayers also had some S Corporations that held and leased farmland. In 2010, Mrs. Anderson’s income was about $28,000. Mr. Andersen’s wages were about $87,000, and there was about $70,000 of other income, presumably investment or rental income. To prepare their returns, the Andersens had for many years used a CPA.
The opinion describes how the Andersens had kept track of their tax documents in a dedicated tax folder, and in February or March they would meet with the CPA/return preparer, and then again meet with the CPA to review the return before filing.
In 2010, the Andersens used the same system—they had collected their tax documents throughout the year, and met in February with their CPA, Curtis Trader, who had prepared their returns since 2005. Trader was a CPA with 20 plus years experience. He had a masters in accountancy. In 2010, Mrs. Anderson’s employer’s payroll agent discontinued issuing paper W-2s, though neither her employer nor the payroll agent told her about the switch. So, when they met with Trader, they did not give any information about Mrs. Andersen’s wages. Trader, as he testified, was under the impression that Mrs. Andersen had retired, based on past talks he had with the couple and the presence of a 1099-R.
An Unexpected Letter from the IRS –Penalty and Applicable Law
After filing their return that reflected a modest overpayment, IRS through I suspect its correspondence exam process issued a notice of deficiency, proposing a deficiency of $7,907 due to the wife’s unreported wages. The IRS also determined an accuracy-related penalty of 20% of the $7,907 understatement on the basis that the understatement was substantial (discussed below). After getting the notice, the taxpayers immediately faxed the notice to Trader in an effort to determine why the IRS contacted them, realized their mistake, paid the tax and interest within a week of the notice, and filed a petition challenging the penalty.
What was the penalty about? For individuals, an understatement is substantial and will trigger a 20% civil penalty if it is more than the larger of 10 percent of the correct tax or $5,000 (a different trigger applies for corporate taxpayers). Taxpayers can avoid the penalty if they adequately disclose the position and there is at least reasonable basis for the treatment, or if there is substantial authority for the treatment. Absent disclosure or substantial authority, (each of which has nuances that I will not describe here, though readers can look at revised Saltzman and Book Chapter 7B for a thorough discussion of both) the taxpayer can avoid the 20% penalty if she can show that she had reasonable cause for the mistake and acted in good faith, under Section 6664(c).
This case turned on the reasonable cause and good faith exception. The taxpayers have the burden of showing that they are not liable for the penalty, once the IRS establishes that the understatement was substantial, i.e., the numerical threshold is hit and there was no disclosure or substantial authority. In most cases, if a taxpayer leaves off wage income of $28,000, it means that they will not be able to show that the taxpayer had reasonable cause and acted in good faith—both of which are necessary to avoid the penalty.
So, how did the Andersens prevail in this case?
The case lays out the 6664(c) standard, looking to the regs and caselaw:
The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account the pertinent facts and circumstances, including the taxpayer’s knowledge, education, and experience, as well as the taxpayer’s reliance on professional advice. Thomas v. Commissioner, T.C. Memo. 2013-60; sec. 1.6664-4(b)(1), Income Tax Regs. Generally, the most important factor is the extent of the taxpayer’s effort to assess his or her proper tax liability. Humphrey, Farrington & McClain, P.C. v. Commissioner, T.C. Memo. 2013-23; sec. 1.6664- 4(b)(1), Income Tax Regs.
One interesting part of the case is the candor that the opinion takes in addressing applying the standard to the facts of the case. The opinion states that this is “an exceptionally close case” though in light of the evidence it found that the penalty should not be imposed:
Clearly, petitioners made a mistake. But we think it was an honest mistake and not of a type that should justify the imposition of the accuracy-related penalty. In short, we think that petitioners’ diligent efforts to keep track of their tax information, hiring a C.P.A. to prepare their tax return, reviewing their return with the C.P.A. when it was completed, and prompt payment of the deficiency upon receipt of the notice of deficiency, together with the other facts and circumstances discussed above, represent a good-faith attempt to assess their proper tax liability. Accordingly, we hold that petitioners have carried their burden with respect to the reasonable cause and good faith exception under section 6664(c)(1) and that petitioners are therefore not liable for the accuracy-related penalty under section 6662(a).
Some of the “other facts and circumstances discussed above” included the following:
- That the Andersens had a close to 50 year or so record of filing returns, and there were no prior problems.
- They testified credibly about how the mistake arose, and the opinion notes that the taxpayers were direct and accepting of their responsibility, and were not defensive.
- The accountant testified, indicating he thought Mrs. Anderson had retired, based on prior conversations with the husband and an information return showing a distribution from a retirement account.
- The accountant was credible and a “highly credentialed tax professional.”
- The prior year return’s income was only $1,000 higher than 2010, the year where Mrs. Anderson’s W-2 income was omitted.
Some Parting Thoughts
Whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, and it is hard to draw general conclusions, especially from a nonprecedential S case.
Steve’s recent posts on penalties have shown that reliance on an advisor may not be enough to get penalty relief. Here, the Andersens did not avoid the penalty based on reliance on professional advice (after all they failed to provide the information to the CPA, a necessary element for a reliance defense). Yet, the presence of a competent professional was a crucial element in the Andersons’ victory.
In addition, way back in the early days of the blog, Steve discussed how in the IRM “under the reasonable cause penalty abatement provisions for the failure to file and failure to pay penalties, is an underutilized provisions for penalty abatement called the first time abate program.” Even though the taxpayers were not able to use that program here—the penalties in the first time abate are for delinquency and not accuracy-related penalties, the case suggests that past tax compliance history can be relevant in assessing whether a taxpayer made a sufficient effort to determine the tax liability in the year in question.
Sometimes when I read penalty cases involving individuals I am struck by how the penalties are inappropriate. Here, I understand why IRS counsel stuck to its guns and tried the case, but I also agree with the court’s conclusion on these facts. I suspect that very few taxpayers leaving off this amount of income would get relief from the penalties, though wonder if the IRM should extend the first time abatement relief to penalties other than failure to file or failure to pay, so that perhaps Counsel or Appeals will feel more comfortable in exercising discretion if there are facts suggestive of an isolated and understandable mistake.