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Reliance on the Return Preparer, Too Good to Be True?

Posted on Sep. 3, 2021

We welcome back guest blogger James Creech. Today James discusses a recent opinion by Judge Goeke examining a taxpayer’s reasonable cause defense. Reasonable cause is a frequent topic on PT, but this case involves a provision we rarely discuss: the ASED extension for failure to notify the government of certain foreign transfers. Christine

On June 28 the Tax Court released a 71 page decision in Kelly v Commissioner T.C Memo 2021-76. In Kelly, the IRS sought 6 years of income tax deficiencies and Section 6663 fraud penalties, with accuracy-related penalties in the alternative. For three of the years, the IRS needed an expanded statute of limitations to make its assessments. As an alternative argument as to why the expanded statute of limitations was appropriate for 2008 and 2009, even if there was not fraud, on the eve of trial the IRS raised the issue that the Taxpayer had not timely filed Forms 5471 for KY&C, a corporation he owned that was in part owned by another controlled entity based in the Cayman Islands.

How does the failure to file Form 5471 extend the ASED for Mr. Kelly’s personal income taxes? Section 6501(c)(8)(A) provides:

In the case of any information which is required to be reported to the Secretary pursuant to an election under section 1295(b) or under section 1298(f), 6038, 6038A, 6038B, 6038D, 6046, 6046A, or 6048, the time for assessment of any tax imposed by this title with respect to any tax return, event, or period to which such information relates shall not expire before the date which is 3 years after the date on which the Secretary is furnished the information required to be reported under such section.

Luckily for Mr. Kelly, the extension is much narrower if 6501(c)(8)(B) applies:

If the failure to furnish the information referred to in subparagraph (A) is due to reasonable cause and not willful neglect, subparagraph (A) shall apply only to the item or items related to such failure.

As Judge Goeke explains, “ if reasonable cause for the failure to file Forms 5471 exists, then under section 6501(c)(8)(B) only the adjustments related to KY&C would remain open under the statute of limitations.”

While the facts are complicated, and involve a company named after Dr. Evil’s company from the Austin Powers movies, the Tax Court held that the fraud assertions were not sustained. The Court then evaluated if the failure to file the 5471’s held the statute open or if, as the Taxpayer claimed, there existed reasonable cause for the failure to file because he had reasonably relied upon his CPA.  

The three-prong test to see if Taxpayer had a reliance defense is

  1. the adviser was a competent professional with sufficient expertise
  2. the taxpayer provided necessary and accurate information to the adviser, and
  3. the taxpayer relied in good faith on the adviser’s judgment.

Applying this test, the Court found that Mr. Kelly had reasonable cause based upon reliance on his tax return preparer. In a rather detailed analysis, the Court referenced the return preparer’s impartiality and lack of disciplinary record, contemporaneous emails where the Taxpayer disclosed the existence of the Caymen ownership to his preparer, and most interestingly the level of imputed knowledge the Taxpayer should have had about the return:

Respondent contends that it was not enough for Mr. Kelly to inform [his tax preparers] S&C that KY&C was a foreign entity, and he implies that Mr. Kelly should have advised Mr. Scott [of S&C] that Form 5471 was required.

The Court rejected this position.

The failure to file the Forms 5471 does not present an obvious tax obligation which was negligently omitted from information that a taxpayer provided to the return preparer. Mr. Kelly, through his staff, provided the necessary information to S&C, identified KY&C as a foreign corporation, and stated that he was unsure of the reporting requirements. Having done this, Mr. Kelly reasonably relied on S&C to prepare his returns properly. While it could be argued that S&C should have done more to ascertain Mr. Kelly’s filing obligations, it was reasonable for Mr. Kelly to rely on S&C do so. A taxpayer need not question the advice provided, obtain a second opinion, or monitor the advice received from the professional. Boyle, 469 U.S. at 251.

The Court’s citation of United States v. Boyle here, in a taxpayer victory, is an ironic twist. As Les discussed in a recent post,

Boyle essentially stands for the position that taxpayers have a nondelegable duty to be aware of tax deadlines. An agent’s incompetence or willful misconduct will not excuse the taxpayer from delinquency penalties.

Here, the Court seemed to impose a catchy “too good to be true” standard when it came to the Taxpayer’s knowledge:

At trial, Mr. Scott credibly described the reasons that his firm failed to prepare Form 5471 for KY&C. No facts suggest that the failure was the result of a conflict of interest or a “too good to be true” situation for either year. … We hold that Mr. Scott’s lack of prior experience with Form 5471 was not fatal to a finding of Mr. Kelly’s reasonable reliance on him or S&C.

The Court also recognized that when it came to filing Mr. Kelly’s tax return, informational returns do not impact the economics of the return. After all, most taxpayers only know how much money they made during the year, whether that be $35,000 or $3,500,000. If the only thing missing is an informational Form or a Statement, taxpayers, especially taxpayers who do not have a tax background, do not have the requisite knowledge to recognize such an error and insist the return preparer correct the return.

Time will tell if the “too good to be true” standard catches on as the knowledge requirement for a taxpayer’s review a return for correctness. As even simple returns grow more complex it would be useful to have a more definable standard that taxpayers can use to frame their standard of care when it comes reviewing returns and reliance on return preparers.

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