Expert's advice eliminates negligence penalty.

A recent case held that a taxpayer's reasonable reliance on a tax professional was sufficient to avoid the negligence penalty under Sec. 6653(a) (Chamberlain, 5th Cir., 1995). The Chamberlains had invested in a partnership and deducted their 1% share of the partnership's loss. They sought a tax expert's advice, who told them that there was "a good faith, supportable position " that would justify the deduction. The transaction generating that loss was subsequently held (in other tax litigation) to be a sham. In disallowing the loss, the IRS assessed enhanced interest against the Chamberlains; the finding that the transaction was a sham made it a tax motivated transaction under then Sec. 6653(a). That section (which is now Sec. 6662(c)) provided for a 5% penalty on an underpayment if any part of the underpayment was due to negligence. The Tax Court affirmed both the enhanced interest and negligence penalty assessments.

The Fifth Circuit reversed the negligence penalty. It began its analysis by stating that once the Service assesses the negligence penalty, the taxpayer has the burden of disproving negligence. Under prior cases, negligence includes a "failure to reasonably attempt to comply with the tax code, including the lack of due care or the failure to do what a reasonable or ordinarily prudent person would do under the circumstances."

The court noted prior decisions supporting a taxpayer's reasonable reliance on professional advice as a defense to the negligence penalty. For this defense to apply, the adviser had to be independent and could not have any economic interest in the transaction that was the subject matter of the advice. Under the circumstances, the court held that the taxpayers met their burden of disproving negligence. The court, apparently being somewhat lenient in helping the Chamberlains with their burden of proof, said that there was no basis for finding that it was not reasonable for them to rely on their expert. The Tax Court had ruled that the Chamberlains did not prove that their expert was qualified to give advice with respect to the type of partnership they invested in. According to the Tax Court, the Chamberlains should have taken steps to satisfy themselves that their expert (who was both a CPA and an attorney) had made an independent investigation of the investment. However, the Court of Appeals said that such a standard was too stringent, holding that good faith reliance on an expert did not require the Chamberlains to monitor the expert on the provisions of the Code.

Thus, although the Chamberlains had no profit motive, thereby justifying the enhanced interest assessment, their reliance on an expert allowed them to avoid the negligence penalty.