10th Circuit reverses Tax Court on IRS failure to waive penalty.

In Fisher, 45 F3d 396 (1995), rev'g TC Memo 1992-740, the Tenth Circuit ruled that the IRS abused its discretion in refusing to waive the Sec. 6661 substantial understatement penalty. The Court of Appeals based its decision on the Service's failure to respond to the taxpayers' request for a waiver and failure to give reasons for denying the waiver.

Sec. 6661, which applies to tax returns due prior to Jan. 1, 1990, imposes a 25% penalty for any underpayment due to a substantial understatement of income tax. For individuals, an understatement is substantial if it exceeds 10% of the correct tax liability or $5,000, whichever is greater. For any item not involving a tax shelter, an understatement shall be reduced under Sec. 6661(b)(2)(B) when the taxpayer's treatment of the item was either based on substantial authority or the taxpayer adequately disclosed the relevant facts affecting the item's tax treatment on the return or in an attached statement.

Sec. 6661(c) allows the IRS to waive the penalty if the taxpayer shows both that there was reasonable cause for the understatement and that he acted in good faith. In Mailman, 91 TC 1079 (1988), the Tax Court ruled that the denial of a waiver by the Service is reviewable by the court on an "abuse of discretion" basis. Under this standard, it is not enough for the taxpayer to convince the court that the court would have waived the penalty. Instead, the court will defer to the IRS's judgment unless the taxpayer convinces the court that the Service denied the waiver "arbitrarily, capriciously, or without sound basis in fact."

For returns due after Dec. 31, 1989, Congress repealed Sec. 6661 and replaced it with Secs. 6662 and 6664. Sec. 6662, the accuracy-related penalty, imposes a 20% penalty for any underpayment of tax due to one or more of the following: negligence, substantial understatement of income tax, substantial valuation overstatement, substantial overstatement of pension liabilities, or substantial estate or gift tax valuation understatement. Sec. 6662 prevents the stacking of these penalties. The substantial authority and the adequate disclosure exceptions to the substantial understatement penalty continue to apply, with the additional requirement that, for adequate disclosure, there must be a reasonable basis for the treatment of the item.

Sec. 6664(c) specifies that no penalties shall be imposed under Sec. 6662 or 6663 (relating to fraud) if the taxpayer had reasonable cause for the understatement and acted in good faith. (There are additional requirements for certain substantial valuation overstatements.) A significant difference between the wording of the repealed Sec. 6661(c) and the current Sec. 6664(c) is that Sec. 6664(c) does not contain the words "the Secretary may waive." This difference gives the court greater scope for judicial review under Sec. 6664(c).

In Fisher, a cardiovascular surgeon with an extensive background in investing invested in a reinsurance program (which was not a tax shelter). Fisher made this investment on the advice of his attorney and financial adviser, who was also general counsel to this program. Fisher acted as an insurance company by receiving premiums and paying commissions. A CPA firm had issued an opinion letter stating that the commissions paid by Fisher were fully deductible in the year paid. This firm prepared Fisher's tax returns, which were reviewed by his attorney.

The IRS disallowed commissions deducted by the Fishers on their 1983 and 1984 tax returns, maintaining that they had to be amortized over five years. Before trial, the Fishers agreed to this and other adjustments. However, the Service had also assessed a substantial understatement penalty, most of which was due to this reinsurance investment. The Fishers requested a penalty waiver from the IRS, but the Service made no specific response to this request. Prior to the Tax Court trial, the IRS's only response was to issue an additional deficiency notice (with no reason given for this action).

In a lengthy opinion, the Tax Court thoroughly discussed whether the Fishers had substantial authority or had adequately disclosed the relevant facts affecting the deductibility of the commissions before considering the waiver. The court ruled that there was not substantial authority for the Fishers' commissions deduction; only corporations whose primary business was insurance could deduct the commissions when paid. Since the Fishers were not a corporation and Dr. Fisher's primary business was medicine, this exception did not apply. Also, the court ruled that the Fishers did not adequately disclose the commissions issue on their Schedule C by simply claiming unexplained deductions under "commissions." The Fishers did not attach a separate statement to their returns explaining their insurance investment.

On the waiver issue, the Tax Court agreed with the Service that the Fishers did not have reasonable cause and did not act in good faith with respect to the commissions deduction. The court cited Regs. Sec. 1.6661-6(b), which specifies that the most important factor in determining reasonable cause and good faith is "... the extent of the taxpayer's effort to assess the taxpayer's proper tax liability under the law." The following may indicate reasonable cause and good faith: (1) reliance on a proposed regulation; (2) an honest mistake of fact or law reasonable in light of the taxpayer's experience, knowledge and education; or (3) a computational or transcriptional error. Reliance on an attorney or accountant for tax advice does not necessarily constitute reasonable cause and good faith. The taxpayer must show that "... such reliance was reasonable and that the taxpayer acted in good faith" (Regs. Sec. 1.6661-6(b)). The Tax Court ruled that the Fishers' reliance on their attorney and CPA was neither reasonable nor in good faith; Fisher was an intelligent, experienced investor and both advisers' lack of independence was quite obvious.

The Court of Appeals reversed the Tax Court's opinion because the IRS did not "respond specifically" to the Fishers' waiver request until the case was before the Tax Court and did not offer reasons for the denial. The Tenth Circuit ruled that the Service must provide a written response to the waiver request in sufficient detail "... to reflect a considered response to the evidence and contentions of the losing party [the taxpayer] and to allow for a thoughtful judicial review if one is sought." A taxpayer cannot be forced to sue in Tax Court to obtain the IRS's reasons for its denial of the penalty waiver. Also, the Court of Appeals emphasized that it is not the Tax Court's role to determine what the Service's reasons might have been under the abuse of discretion standard.

For tax returns due prior to Jan. 1, 1990 that are either still being audited or are in litigation, Fisher allows the practitioner to obtain a detailed response from the IRS for a waiver denial under Sec. 6661(c). This response will facilitate the determination of whether to seek Tax Court review of the denial and the preparation of arguments for the waiver if such review is sought. For returns due after Dec. 31, 1989, the Tax Court will review the Sec. 6664(c) waiver denial under the same general standard that it uses in reviewing whether additional taxes are owed. This standard allows the court to decide the correct application of the law, with the burden of proof on the taxpayer; deference to the Service's judgment is not required. Therefore, if the IRS does not give its reasons for the waiver denial prior to trial, the Tax Court will determine if the taxpayer has proven reasonable cause and good faith.

Sec. 6664(c) is very important for practitioners because it applies to all of the accuracy-related penalties under Sec. 6662 and the Tax Court's review of the waiver denial is the more lenient general standard that the court uses on other tax issues. For example, if the Service assesses the negligence penalty (20% under Sec. 6662), arguing that the penalty should be waived under Sec. 6664(c) will often be the best alternative available. The regulations under Sec. 6664(c) are very similar to the Sec. 6661 regulations. Therefore, the extent of the taxpayer's effort to assess his proper tax liability under the law is still crucial in determining reasonable cause and good faith. The sophistication of the taxpayer, as well as the complexity of the issue in question, are significant in evaluating the taxpayer's effort. If the taxpayer used a paid tax preparer, the taxpayer must have disclosed all relevant facts to the preparer and must have reasonably believed that the preparer was competent.