Reliance on accountant's advice regarding treatment of stock options is sufficient to negate negligence penalty.

The complexity of the tax laws challenges the ability of most taxpayers. This certainly includes corporate executives, many of whom must deal with the myriad hidden consequences underlying the exercise of stock options (an increasingly common form of compensation). As a result, such taxpayers often turn to their CPAs or tax attorneys to provide tax advice and to prepare their tax returns. A recent Ninth Circuit case reaffirms the long-standing principle that taxpayers who consult their tax advisers are generally presumed to have exercised a fair degree of care and prudence, and are, therefore, entitled to rely on the advice they receive from such presumed experts.

The Henry Case

Albert Henry was the vice president-finance, chief financial officer, and director of IMED Corp. (IMED). Henry, along with other IMED officers, was granted stock options in 1979. They all filed Sec. 83(b) statements reporting the stock's fair market value as zero. Subsequently, Warner-Lambert acquired IMED and also purchased its outstanding stock options. Warner-Lambert issued a 1982 W-2 to Henry reporting only wage income. Henry received no other Form W-2 or 1099 reporting his stock option proceeds as income.

In preparing his 1982 return, Henry provided the W-2 to his accountant and indicated that he believed the stock options were structured to achieve long-term capital gain treatment. Henry also advised his accountant to contact IMED's stock option program managers if he had further questions about the options. Although aware of the fact that the options contained restrictions--and, therefore, based on Regs. Sec. 1.83-7(b)(2), might be challenged by the IRS with respect to Henry's classification as long-term capital gains--the accountant never told Henry of the risk or about the regulation, and never requested copies of the option certificates. The accountant advised Henry that both he and his practice partner believed that IMED had structured the stock options to achieve long-term capital gain treatment.

On audit, however, the Service determined that the proceeds from the options were ordinary income and imposed penalties for negligence and substantial understatement. Henry, along with three other officers who were audited for their treatment of the stock options, petitioned the Tax Court. In pursuing his case separately, Henry stipulated that he would be bound by the court's decision as to the other three IMED officers (see Cramer, 101 TC 225 (1993), aff'd, 64 F3d 1406 (9th Cir. 1995)), but only as to the determination of the proper tax treatment of the options (which the Cramer court ultimately concluded should be taxed as ordinary income).

Unlike his fellow officers--who were found liable in Cramer for intentional disregard under former Sec. 6653(a) because the Tax Court determined that they knew or should have known that their long-term capital gain treatment was contrary to Regs. Sec. 1.83-7(b)(2), but chose to ignore the regulation based on their mistaken belief that that the regulation was invalid--Henry asserted that he (1) acted in good faith and reasonably relied on the advice of his accountant in reporting the option proceeds as long-term capital gains and (2) did not know nor should have known of Regs. Sec. 1.83-7(b)(2) and, thus, did not intentionally ignore its requirements. The Tax Court sustained the penalties after concluding that Henry's reliance on his accountant was unreasonable because he failed to provide him with copies of the 1979 or 1981 IMED options when his return was prepared, and that his claim of ignorance of the regulations was undermined by his involvement at the top level of management within IMED and in the sale negotiations with Warner-Lambert. Henry appealed.

In Henry (3/23/99), the Ninth Circuit reversed the Tax Court, finding that Henry's reliance on his accountant's treatment of the options on the return was reasonable. As a preliminary matter, the court determined that, "it was reasonable that a taxpayer would not know the relevant information his or her accountant needed to proceed with preparation of the tax returns unless the accountant requests such information." The court observed that, contrary to the Tax Court's determination that Henry offered no explanation as to why he did not provide the options to his accountant, the record showed that Henry did not even possess the options when his return was prepared in 1983, because all options had been delivered to Warner-Lambert when the IMED sale closed in 1982.

Addressing the Tax Court's finding that Henry "failed to ask pertinent questions or even make a cursory investigation beyond the information provided to [him] concerning the IMED stock options" the Ninth Circuit explained that Henry satisfied his obligation by consulting his long-time accountant. Noting the Supreme Court's observation in Boyle, 469 US 241 (1985), that most taxpayers are unable to discern error in the substantive advice of an accountant or an attorney and to require a second opinion would nullify the purpose of seeking the advice of the presumed expert in the first instance, the court concluded that Henry's reliance was reasonable.

Addressing the Tax Court's conclusion that Henry was aware of Regs. Sec. 1.83-7(b)(2), the Ninth Circuit rejected the Tax Court's conclusions as being based on "pure speculation and conjecture" not supported by the record. The Tax Court determined that, because the IMED officers had advised Henry that the stock option proceeds would be structured as capital gains, Henry was put on notice that their tax treatment was questionable and, therefore, warranted further investigation. The Ninth Circuit concluded, however, that such information could only strengthen (not weaken) Henry's belief that capital gain treatment was proper. Similarly, the Ninth Circuit rejected the Service's assertion that Tax Court testimony by IMED's general counsel that he told IMED officers that capital gain treatment was "not bullet-proof" and that there was a risk of IRS challenge was sufficient in itself to sustain the Tax Court's opinion. Such evidence did not establish that Henry knew of Regs. Sec. 1.83-7(b)(2), and knowing there is a risk in filing a tax return that may result in an audit does not prove that "the taxpayer knew or should have known of the tax regulation and unreasonably disregarded it." Lastly, addressing the Tax Court's conclusion that Henry's involvement at the top levels of IMED undermined his claims of good faith and ignorance, the Ninth Circuit concluded that such findings were based entirely on "speculation and guilt by association," and an erroneous attempt by the Tax Court to impute other IMED officers' knowledge of the regulations to Henry.

Observations

The Ninth Circuit's opinion appears to counter what may have been a rush to judgment by the Tax Court in the taxpayer's case, given its findings against the other IMED officers with regard to their level of knowledge of the tax treatment of the options. The opinion may also be a signal by the Ninth Circuit to other courts and the Service that parties to a common transaction do not always possess the same level of knowledge and understanding of the transaction and, therefore, are entitled to be examined based on the individual's facts and circumstances. The opinion also demonstrates the importance of building a detailed factual record in the trial court, especially when the case involves inherently factual issues.

Editor's note: Mr. Ely chairs the AICPA Tax Division's Tax Practice & Procedures Committee. Messrs. Stein and Olson are members of the committee.

KENNETH S. SAVELL, J.D., LL.M., KPMG, LLP, WASHINGTON, DC