On March 30, 2021, the Tax Court issued a Memorandum Opinion in the case of Walton v. Commissioner (T.C. Memo. 2021-40). The primary issue presented in Walton was whether the petitioner qualified for the reasonable cause exception to the imposition of an accuracy-related penalty.

Background to Walton v. Commissioner

The petitioner was a New Yorker,[1] who failed to report $170,000 in nonemployee compensation in 2015.

Strike one and two.

The petitioner was terminated from her employment, and negotiated a settlement with the employer that included severance and a bonus payment for 2015.  She launched a sole proprietorship the same year.

The petitioner engaged a CPA with 30 years of experience to prepare her 2015 return. The petitioner “reported” her income to the CPA in an email, stating “I am sure I need to pay taxes. If I did the math right, I earned about $525k in 1099 pay.” The petitioner based this estimate on the amounts deposited into her Citibank business account, which she had used to generate an Excel spreadsheet. The CPA relied on the $525,000 amount when determining that the petitioner was required to make an estimated tax payment for the fourth quarter of 2015.

In February 2016, the petitioner sent an email to her CPA attaching six tax reporting forms for 2015. Specifically, she attached Form W-2 (Wage and Tax Statement) from her former employer, as well as Forms 1099-MISC (Miscellaneous Income) from the five entities—not including one from her former employer.

Three days before Tax Day, the CPA’s office sent the petitioner an email asking “Did you send us all the 1099s? The 1099s for income that we have add up to 351,026, and the 1099s for subs adds up to 130,480. Should we use these numbers or the 525 and 140 per your email?”  The petitioner responded on April 14^th by emailing an itemized list of her mortgage interest, tuition and tax payments, charitable contributions, business expenses, utilities, insurance, and medical expenses. However, the petitioner’s email did not respond to the CPA’s inquiries about the “1099s for income.”

The CPA obtained an extension for the petitioner’s return and in late September specifically asked for the Form 1099-DIV (Dividends and Distributions) from the petitioner’s former employer. The petitioner, in typical New York fashion, replied “[Hey dumbass, I] attached the 1099s to the last email. [Fuhgeddaboudit.]”

Strike Three.

The CPA’s Standard Operating Procedure

In the case of a discrepancy between an estimate provided by a client and source documentation later supplied, the CPA’s firm typically would rely on “documentation” when preparing a tax return. However, since the petitioner was being a giant heifer and failed to address the discrepancy regarding “1099s for income,” a staff member at the CPA’s firm calculated her business income relying solely on the Forms 1099-MISC the CPA received in February 2016.

After preparation of the return the CPA mailed the return and an efiling authorization form, together with a self-addressed envelope, to the petitioner. The CPA’s firm requested oral authorization for efiling from certain longstanding clients, with the understanding that the client would send the written authorization later. The CPA obtained such oral authorization from the heifer for the filing of her return, and his firm thereafter efiled it. Not so unsurprisingly, the heifer did not review her draft return before authorizing the CPA to file it. She did deign to “skim” over a copy of her return after filing and “thought” that the totals were correct. Nevertheless, the heifer “trusted in the CPA’s expertise and experience and believed that he would be able to identify any issues related to the return.”

The AUR Strikes Back

The IRS’s Automated Underreporter System (AUR) matches third-party-reported payment information against a taxpayer’s already-filed tax return. Essner v. Commissioner, T.C. Memo. 2020-23, at *11. When there is a discrepancy, the AUR program calculates a proposed deficiency based on the statutory scheme and prepares a letter to the taxpayer requesting an explanation for the discrepancy. Serv. Ctr. Adv. 200211040 (Mar. 15, 2002). If the taxpayer does not respond, the program will issue a notice of deficiency. Id. If the taxpayer does not respond to the notice of deficiency, the deficiency will be assessed. Id.

The AUR detected a mismatch between the income on the tax return and the amounts that her clients reported to the IRS on their Forms 1099-MISC. As a result, the IRS issued the heifer a computer-generated letter CP 2501 informing her that she had failed to report nonemployee compensation. After that, the IRS issued a CP 2000 proposing additional tax, an accuracy-related penalty, and corresponding statutory interest.  Again, not unsurprisingly, the heifer did not respond, and the IRS issued a notice of deficiciency.

The Burden for Penalties

IRC § 7491(c) provides generally that the IRS has the burden of production in any court proceeding with respect to the liability of any individual for any penalty. This burden requires the IRS to come forward with sufficient evidence showing that the imposition of the penalty is appropriate. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the burden of production is met, the burden of proof shifts to the taxpayer to come forward with evidence sufficient to persuade a Court that the IRS’s penalty determination is incorrect. Id. at 447.

IRC § 6751(b)(1) Not Applicable to Automatically Calculated Penalties

IRC § 6751(b)(2)(B) carves out an exception to the prior written supervisory approval requirement for any penalty “automatically calculated through electronic means.” The Tax Court recently explored the contours of this exception, explaining that it encompasses a penalty “determined mathematically by a computer software program without the involvement of a human IRS examiner.” Walquist v. Commissioner, 152 T.C. 61, 70 (2019). The penalty at issue here, automatically generated by the AUR computer program, fits under IRC § 6751(b)(2)(B).

Because the penalty was determined mathematically by a computer software program without the involvement of an IRS examiner, the Tax Court concluded that the penalty was “automatically calculated through electronic means.” See IRC § 6751(b)(2)(B). The IRS, therefore, was not obligated to comply with the supervisory approval requirement. See Walquist, 152 T.C. at 70-74.

Reasonable Cause

IRC § 6664(c)(1) provides that the penalty under IRC § 6662(a) will not apply to any portion of an underpayment if it is shown that there was reasonable cause for the taxpayer’s position and that the taxpayer acted in good faith with respect to that portion. See Higbee, 116 T.C. at 448. The taxpayer bears the burden of proving reasonable cause and good faith. See id. at 446-447.

Reasonable cause requires that the taxpayer have exercised ordinary business care and prudence as to the disputed item. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). 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 all pertinent facts and circumstances. See Treas. Reg. § 1.6664-4(b)(1). Generally, the most important factor in determining the existence of “reasonable cause” is the taxpayer’s efforts to ascertain her proper tax liability. See id.

Good-faith reliance on the advice of an independent, competent professional as to the tax treatment of an item may meet this requirement. See Neonatology Assocs, 115 T.C. at 98 (citing United States v. Boyle, 469 U.S. 241 (1985)); Treas. Reg. § 1.6664-4(b). Under the Neonatology Assocs. tests, for the reliance to be reasonable, a taxpayer must prove:

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

Unconditional reliance on a tax return preparer or C.P.A. does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise diligence and prudence. Stough v. Commissioner, 144 T.C. 306, 323 (2015); see also Woodsum v. Commissioner, 136 T.C. 585, 595-596 (2011). Even if all data is furnished to the preparer, the taxpayer still has a duty to read the return and make sure all income items are included. Magill v. Commissioner, 70 T.C. 465, 479-80 (1978), aff’d, 651 F.2d 1233 (6th Cir. 1981); see also Metra Chem Corp. v. Commissioner, 88 T.C. 654, 662 (1987). Reliance on a preparer with complete information regarding a taxpayer’s business activities does not constitute reasonable cause if the taxpayer’s cursory review of the return would have revealed errors. Stough, 144 T.C. at 323; see also Woodsum, 136 T.C. at 595-96; Metra Chem Corp., 88 T.C. at 662.

The petitioner (ever so arrogantly and ever so erroneously) contends that she satisfied IRC § 6664(c)(1) by relying on her experienced and long-time C.P.A. to prepare an accurate return. Even assuming arguendo that the petitioner provided the missing Forms 1099-MISC to the CPA (she didn’t) or that she told the CPA to use the income amounts from her Citibank records rather than the income amounts from the documents she sent (she didn’t), the heifer admittedly did not review her tax return before authorizing the CPA to file it.

Trust but Verify

Although the Tax Court “understood” that the petitioner had developed “a high level of trust” in the CPA, a taxpayer still has a duty to read the return and make sure all income items are included. Magill, 70 T.C. at 479-80; see also Stough, 144 T.C. at 323. The heifer “was well aware” that she had earned approximately $525,000 from her consulting work, and even a cursory review of her return would have revealed the omission of $169,426–over 32% of her total nonemployee compensation for that year.

Although a taxpayer is not required to duplicate the work of his return preparer, Woodsum, 136 T.C. at 595, nor is an omission of an income item in a return prepared by a third party necessarily fatal to a finding of reasonable cause and good faith on the taxpayer’s part, Id. at 595-96, the Tax Court will assume that the reasonable cause defense may be available to a taxpayer; however, it is only available if said taxpayer actually reviews the third-party-prepared return with the intent of ensuring that all income items are included exerts effort that is reasonable under the circumstances but nonetheless fails to discover an omission of an income item. Id. at 596.

Here, the heifer (and I am actually quoting from the opinion here) “failed to do the bare minimum” or “expend reasonable effort” under the circumstances. See id.; see also Stough v. Commissioner, 144 T.C. at 323 (holding that claiming reliance on a tax return preparer and choosing to not adequately review the contents of a tax return is not reasonable reliance in good faith”).

Accordingly (and justly), the Tax Court held that the heifer-petitioner did not satisfy the IRC § 6664(c)(1) exception. She thus is liable for an accuracy-related penalty with respect to the underpayment of tax attributable to her abject failure.

Footnote re: Distrust (and Dislike) of New Yorkers

[1] And, as a consequence, we (Briefly Taxing) will make every inference in favor of the IRS in this summary.  The Tax Court was not too pleased with the petitioner, also, but not likely because Judge Urda doesn’t trust New Yorkers as far as he can throw them.

(T.C. Memo. 2021-40) Walton v. Commissioner

Add to favorites