When giving advice, experience is key.

IRC section 6662 imposes a penalty on taxpayers who underpay their tax as a result of negligence. Before 1989 section 6653 imposed a similar penalty. Taxpayers can usually avoid negligence penalties by showing they relied on professional advice. A recent decision in a case that began nearly 20 years ago, however, illustrates an instance in which such reliance did not eliminate the section 6653 penalty. If a similar situation arose today, would a penalty be imposed under current law?

Addington, Cohn and Sann were attorneys employed by Sann and Howe, which also employed Guy Maxfield as senior tax partner on an "of counsel" basis. In 1981 Maxfield introduced the three attorneys to an investment partnership engaged in plastics recycling, which he had spent 50 to 75 hours investigating. Rather than independently investigating the partnership, the three attorneys invested solely on Maxfield's advice.

More than 200 tax cases have resulted from plastics recycling partnerships. The courts uniformly have concluded such transactions are shams and denied the claimed tax benefits. Consequently, the IRS denied the three taxpayers the 1981 and 1982 deductions they claimed and assessed negligence penalties. The Tax Court upheld the penalties. The taxpayers appealed the decision based on the argument that they relied on professional advice.

Result. For the IRS. It has long been established that taxpayers may rely on professional advice in preparing their tax returns without fear of a negligence penalty for failure to investigate the tax rules themselves. However, this presupposes that the adviser has the requisite knowledge and experience. The Tax Court held that the adviser in this case had no expertise in the relevant area (plastics recycling) and, therefore, it was unreasonable to rely on his advice. The appeals court concurred.

The case appears to say that an adviser must have experience in the specific industry before taxpayers can rely on his or her advice. This conclusion is offset somewhat by the statement in the appellate decision that the lengthy cautionary language in the offering memoranda and the taxpayers' own sophistication should have put them on notice that they needed to personally investigate the partnership to avoid a negligence penalty. To complicate matters the district court, in Klein, refused to grant summary judgment for the IRS in another plastics recycling negligence case on the grounds that an adviser does not always need specific industry experience. Depending on the final outcome of these cases, a taxpayer may have to investigate an adviser's background, knowledge and experience before trusting the advice he or she gives--at least for tax penalty purposes.

* Lawrence M. Addington v. Comm., 85 AFTR2d, 2000-496.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.