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Reasonable Reliance on a Competent Advisor

Explaining Reasonable Reliance on a Competent Advisor to Uncle Bill.

Reasonable Reliance on a Competent AdvisorReasonable cause, specifically, reasonable reliance on a competent advisor will prove rather important to Uncle Bill, and so when he calls you to discuss this great scheme plan he’s been introduced to, you know that this is the time to breach the subject with Bill.

You see, Uncle Bill bought his first house from an infomercial he saw after the Ed Sullivan show in the mid-1960s.  That Bill might have been as high as the Golden Gate Bridge is long, and that he might have thought that Topo Gigio was explaining the general theory of relativity to him in terms he could understand, may also have played into the decision to buy the Airstream, but be that as it may, Bill has always been somewhat susceptible to influence when making major financial decisions—especially, it seems, at the behest of an foam rodent with a cheap Italian accent and doughy eyes.

In Bill’s defense, although Giancarlo “Lil’ Frankie” Bandolino was most certainly an Italian rat, who was manipulated by no less than three people, and voiced by another, he was not made of foam…full of hot air and fresh pasta, maybe, but not made of foam.  This was the best thing you could say about Lil’ Frankie.  What Biddeford, Maine lacked in worldliness, it made up for with gas station lobster rolls (don’t knock ‘em until you’ve tried ‘em – your dad always said) and Rapid Ray’s, where you could get a burger and a chocolate milk for less than two dollars until a Flock of Seagulls was more than an inconvenient accompaniment to said burger and choc.  Nevertheless, Lil’ Frankie was Biddeford’s Little Italy, a loan shark, and a dime store accountant, all rolled into one and served on a week-old bun (not unlike the gas station lobster rolls, it turns out).

Though you convinced Uncle Bill early on not to continue using Lil’ Frankie to prepare his taxes or his gnocchi, both of which were overcooked and lacking in substance, when Lil’ Frankie approached Bill with the chance to buy an island off the coast of Maine and deduct the entire thing by calling it a “conservation easement,” Bill was intrigued.

Lil’ Frankie explained that all Bill had to do was put up a couple of grand to buy in, and he would take care of the rest.  The fund would buy the island, reserve the right to build a couple of sensible homes on the eastern side, and “Down East Conservatories” a non-profit that Lil’ Frankie had put together to “save the whales and some shit,” would be given a perpetual easement over the other three-quarters of the island.

Reasonable Reliance on a Competent AdvisorMore specifically, Lil’ Frankie bought the island a year ago for $1 million from “some old codger who wouldn’t know a diamond from a duck turd.”  According to “conservative estimates,” the island is worth about $10 million, and the pair of rare, black-necked barnacle geese (Branta Leucopsis) that nest there, if captured, could bring a lot of money to the right buyer in Greenland.  For just $100,000 today, Lil’ Frankie could guarantee a $500,000 tax write-off in two years.

You ask Bill for a brief moment, put your headset on mute, curse your mother for ever reconciling with his Maine family, Lil’ Frankie, the barnacle geese, and “the whales and shit,” and then you calmly begin to explain that a syndicated conservation easement is pretty much the bane of the IRS’s existence at this point in time.

Not only will Bill not be able to claim a charitable deduction of any sort, but he will also likely be subject to substantial penalties, leaving him with a ten percent interest in the eastern quarter of an island seventeen miles off the coast of Biddeford, the only use of which is for lobstermen to use as a landmark when their navigation systems are on the fritz (meaning that they’re a bit drunker than usual).

Bill, a bit sobered by your advice and your opinion of Lil’ Frankie, asks if he could have one last minute of your time.  You begrudgingly oblige, and Bill asks about the letter he just received regarding his 2016 tax returns that Lil’ Frankie prepared.  (This was before your father made nice with Aunt Ethel, and before you ever spoke with Uncle Bill about his taxes or his cockamamie schemes, and so you take solace in this.)

Apparently, the IRS has asserted a “substantial understatement” penalty against Bill, and he wants to know how he can go about getting the IRS to see its way to giving him a pass, just this once.  Apparently, Lil’ Frankie told Bill that the income from the sale of the airstream was capital in nature, and Bill assented to reporting it as such.

Having made him promise to not buy into the syndicated conservation easement, you tell Bill that you will look into whether or not he’ll be able to establish reasonable cause based upon the reliance on a tax advisor.  You can just hear Uncle Bill’s eyes glazing over on the other end of the telephone, so you tell him not to worry and that you’ll hold his hand as you walk him through the accuracy-related penalty, the reasonable cause exception, and why his reasonable reliance on Lil’ Frankie’s advice might be able to get him out of the penalty.

Accuracy-related Penalty under IRC § 6662

Reasonable Reliance on a Competent Advisor
Indeed it is…except in horseshoes and hand grenades.

You begin by observing that, under IRC § 6662, taxpayer may be liable for a penalty of 20% on the portion of an underpayment of tax due to: (1) negligence or disregard of Code or Treasury Regulations, or (2) a substantial understatement of income tax.[1] “Disregard” includes any careless, reckless, or intentional disregard of the Code or Treasury Regulations.[2] “Negligence” is defined as any failure to make a reasonable attempt to comply with the provisions of the Code, including by failing to keep adequate books and records or substantiate items properly.[3]

Bill tells you that he has all of the receipts from the purchase of the airstream down to its sale, and while this is all well and good—you tell him—that’s not what you’re most worried about here.  This is so, because negligence has also been defined as the failure to exercise due care or the failure to do what a reasonable person would do under the circumstances.[4]

The substantial understatement of income, as in Bill’s case, is treated by the IRS as negligent.  Before he can interrupt, you explain that in this context, “understatement” means the excess of the amount of the tax required to be shown on the return over the amount of the tax imposed which is shown on the return, reduced by any rebate,[5] and a “substantial” understatement of income tax is defined as an understatement of tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000.[6]

Reasonable Cause

The accuracy-related penalty of IRC § 6662(a) does not apply with respect to any portion of the underpayment for which the taxpayer shows that there was reasonable cause and that he acted in good faith.[7] Reasonable cause and good faith are determined on a case-by-case basis, considering all of the pertinent facts and circumstances.[8]  And no, you explain to Bill, a good faith in the Lord God Almighty, is not what the IRS means here.

Reasonable Reliance on a Competent AdvisorSuch circumstances include an honest and reasonable misunderstanding of fact or law, where reasonableness is measured against the experience, knowledge, and education of the taxpayer.[9]  Here, the fact that Bill is a borderline illiterate moron with the effective IQ of a lead paint chip when it comes to tax matters is quite helpful.

Reliance on a competent professional demonstrates reasonable cause when a taxpayer (1) selects a competent adviser, (2) supplies the adviser with all relevant information, and (3) relies in good faith on the adviser’s professional judgment.[10]

Reasonable Reliance

Reasonable Reliance on a Competent AdvisorReliance on the advice of a professional, such as a tax attorney or certified public accountant, may constitute good faith and reasonable cause, but only in the event that the taxpayer can prove by a preponderance of the evidence that the taxpayer reasonably believed the professional advisor was a competent tax professional with sufficient expertise to justify reliance; that the taxpayer provided all necessary and accurate information to the tax professional; and that the taxpayer actually relied in good faith on the professional’s advice.[11]  Stated more succinctly, a taxpayer who reasonably relies on the advice of a tax professional after being provided with all necessary information has reasonable cause to avoid the accuracy-related penalty.[12]

Specific Cases where Reliance was Reasonable

Numerous courts have held that a taxpayer may reasonably rely on the professional advice of a tax return preparer as to questions of law, including reporting income.  With respect to the taxability of certain income, the Tax Court refused to sustain a penalty against a landowner, who reasonably relied upon an accountant’s advice that income from the sale of dirt should be nontaxable because, in the accountant’s view, the income should be applied toward the basis of the land from which it was extracted.[13] The Tax Court has ruled that no penalty was justified where the taxpayers received erroneous advice that certain income should be treated as nontaxable loans or loan repayments.[14]

In some cases, a taxpayer may file as an incorrect entity based upon the advice of its tax professional.  In these cases, a taxpayer may be able to establish reasonable cause based upon such reliance.  For instance, in a memorandum opinion the Tax Court ruled that an accuracy-related penalty was not appropriate when a corporation followed a professional’s tax advice and erroneously filed its returns as an S corporation.[15]

The difference between hobby losses and business-related deductions is often a fine one.  When the IRS determines that an activity is a hobby rather than a business, the IRS may propose significant accuracy-related penalties.  Fear not, as the Tax Court has ruled that an accuracy-related penalty was not appropriate in a situation where taxpayers claimed hobby losses while relying upon their accountant who treated their horse-related activity as a business.[16]

Whether an item of income is ordinary in nature or is capital gain is often a rather technical question—so technical in fact that the Tax Court sometimes gets it wrong.  In the Henry case, the Tax Court ruled against the taxpayer on the issue of whether he reasonably relied upon his accountant when characterizing the proceeds from certain stock options as capital gain.[17]

The Tax Court, however, was overturned by the Ninth Circuit, which found that the taxpayers were not negligent (so as to support the accuracy-related penalty) when the taxpayers’ CPA “made the ultimate decision to classify [income in a certain manner], and [the taxpayers] had no reason to doubt his professional judgment.”[18]

Thus, if the tax advisor has an outstanding professional reputation, the taxpayer has used the advisor for a number of years, and the taxpayers were pleased with the advisor’s representation during those years, accordingly, the taxpayers will have “every reason to rely on [the advisor’s] professional acumen.”[19]

The Supreme Court has weighed in strongly on this issue:

When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the [accountant], to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.[20]

Reliance on Promoters not Reasonable

If the taxpayer relies on the advice of a competent, independent advisor (meaning that the advisor has no conflict of interest and does not rely on the advice of “promoters of the investment,” this reliance may be reasonable.[21]  Nonetheless, a taxpayer’s reliance on the advice from interested persons or promoters is categorically unreasonable.[22]

As such, Bill would not be able to avail himself of the “reasonable reliance” defense with respect to the syndicated conservation easement.  However, unless Lil’ Frankie was promoting the sales of vintage airstreams for tax avoidance purposes, the promoter limitation probably does not come into play with respect to Bill’s 2016 taxes.

Burden of Production

Reasonable Reliance on a Competent AdvisorThe IRS bears the burden of production with respect to the taxpayer’s liability for penalties, including the IRC § 6662(a) penalty.[23] Therefore, the IRS and must produce sufficient evidence indicating that it is appropriate to impose the penalty.[24] Once the IRS meets its burden of production, the taxpayer must come forward with persuasive evidence that the IRS’s determination is poppycock or that the taxpayer had reasonable cause or substantial authority for the position.[25]

Reasonable Reliance on a Competent AdvisorYou allow Bill to finish audibly giggling at the word “poppycock” and tell him to send you the letter and the 2016 return.  You will see what you can do.  He thanks you and says that he’ll fax the documents to you after lunch.  The mail room and copy store in Biddeford, which has the only publicly available fax machine this side of Saco, it turns out, also serves lobster rolls.


Footnotes:

[1] See IRC §§ 6662(a), (b)(1), and (b)(2).

[2] IRC § 6662(c).

[3] IRC § 6662(c); Treas. Reg. § 1.6662-3(b)(1).

[4] See Allen v. Commissioner, 92 T.C. 1, 12 (1989), aff’d, 925 F.2d 348 (9th Cir. 1991); Neely v. Commissioner, 85 T.C. 934, 947 (1985).

[5] IRC § 6662(d)(2)(A).

[6] IRC § 6662(d)(1)(A).

[7] See IRC § 6664(c)(1).

[8] Treas. Reg. § 1.6664-4(b)(1).

[9] Id.

[10] See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

[11] See United States v. Boyle, 469 U.S. 241 (1985); see also Neonatology Assocs., 115 T.C.at 99.

[12] IRC § 6664(c); Treas. Reg. § 1.6664-4(c); IRM 20.1.1.3.3.4.3; IRM 20.1.5.7.4; Boyle, 469 U.S. at 250; and Canal Corp. v. Commissioner, 135 T.C. 199, 218 (2010).

[13] Hunt v. Commissioner, T.C. Memo. 1978-150.

[14] Jaques v. Commissioner, T.C. Memo. 1989-673, aff’d, 935 F.2d 104 (6th Cir. 1991); see also Mayworm v. Commissioner, T.C. Memo. 1987-536 (same).

[15] Columbia Steak House II, Inc. v. Commissioner, T.C. Memo. 1981-142.

[16] Pitts v. Commissioner, 1999-72.

[17] Henry v. Commissioner, T.C. Memo. 1997-29.

[18] Henry v. Commissioner, 170 F.3d 1217 (1999).

[19] Id. at 1220, n.6.

[20] Boyle, 469 U.S. at 251.

[21] 106 Ltd. v. Commissioner, 136 T.C. 67, 79 (2011); Mortensen v. Commissioner, 440 F.3d 375, 387 (6th Cir. 2006), aff’g T.C. Memo. 2004-279), aff’d, 684 F.3d 84 (D.C. Cir. 2012); see also Mazzei v. Commissioner, 150 T.C. 138, 181 (2018) (citing Neonatology Assocs., 115 T.C. at 98).

[22] Campbell v. Commissioner, T.C. Memo. 2020-41.

[23] IRC § 7491.

[24] See IRC § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446-47 (2001).

[25] Id.

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