When will reliance on a tax adviser avoid an accuracy-related penalty?

One potential defense to a Sec. 6662 accuracy-related penalty is the taxpayer's reasonable cause, good faith reliance on a tax adviser under Sec. 6664(c)(1). Through the use of examples based on actual cases, this article explains when use of that defense may (or may not) be successful.

The IRS may penalize taxpayers for failing to meet specific standards prescribed by the Code and/or regulations. One potential defense to imposition of a Sec. 6662 accuracy-related penalty, blaming the inaccuracy on the taxpayer's adviser, is experiencing rapidly growing use among taxpayers. This article analyzes this defense and provides examples and needed guidance.

As summarized in the table on page 774, Sec. 6662(a) and (b) impose penalties for tax underpayments due to negligence or disregard of rules or regulations, substantial understatements of income tax, substantial valuation mis-statements or substantial overstatements of pension liabilities. Taxpayers may avoid these penalties by meeting standards prescribed in Secs. 6662 and 6664 and the regulations thereunder (e.g., under Regs. Sec. 1.6662-3(b)(1), the negligence penalty can be avoided if the return position has a reasonable basis or by disclosure if the position meets the realistic possibility standard).

However, as indicated in the last column of the table, when a taxpayer does not meet the Sec. 6662 standards or no standards are prescribed (e.g., for corporate understatements due to tax shelters and for valuation-related penalties), Sec. 6664(c)(1) and the regulations thereunder provide for a "reasonable cause/good faith" (RCGF) defense.(1) While RCGF may be based on any number of reasons, the most prevalent RCGF defense is that the taxpayer followed the advice of a tax adviser. Taxpayers have often raised the RCGF defense since its inception.(2)

Defining RCGF

Sec. 6664(c)(1) provides that no penalty will be imposed with respect to any portion of an underpayment if the taxpayer shows RCGF for such portion. Regs. Sec. 1.6664-4(b) states generally that RCGF depends on the facts and circumstances of each case; the most important factor is the extent of the taxpayer's effort in determining his proper tax liability. In determining whether a taxpayer's efforts have been sufficient to raise the RCGF defense, the taxpayer is deemed to know not only what he actually knows, but what he should have known after reasonable diligence.

Example 1:(3) Based on a recommendation from friends, A hires B, a CPA and professional tax adviser, to provide advice concerning the deductibility of payments A made to his state and local governments. After A provides B with full details about the payments, B states that A's payments are deductible state and local taxes. Everything else being equal, if A acts in good faith and deducts the payments based on B's recommendations, A has an RCGE defense if the deduction is later determined to be erroneous.

Example 2:(4) C procrastinates until the evening of April 15, 1998 to prepare his 1997 return. He hurriedly attempts to prepare the return and at 11:00 p.m. has questions about many deductions. C calls D, an acquaintance who is a CPA. In answer to C's questions, D replies that the items might be deductible, but that he would have to obtain more information and research the issue in the following week before being able to provide a definitive answer. Based on that conversation, C claims the items as deductions. C cannot use the RCGF defense if the deductions are later determined to be erroneous.

In considering the level of the taxpayer's efforts, Regs. Sec. 1.6664-4(b)(1) states that reliance on professional advice constitutes RCGF if, under all the circumstances, it was reasonable and the taxpayer acted in good faith. Similarly, Internal Revenue Manual (IRM) (20)331(2) states generally that each RC request must be evaluated on its own merit, which should be determined based on the events or parties involved and on whether or not the taxpayer exercised ordinary business care and prudence.

Because the regulations and the IRM refer to reasonable conduct under the circumstances and to ordinary business care and prudence respectively, the RCGF defense basically depends on the presence or absence of negligence. Further, 0every item subject to the RCGF defense is treated separately (e.g., a taxpayer may have RCGF for some items, but not for others).(5) Lastly, as indicated below, a review of the administrative and judicial interpretations shows that reliance on a tax adviser has two aspects--the taxpayer's responsibilities and the advise responsibilities.

Advice From Tax Advisers

Regs. Sec. 1.6664-4(c)(2) broadly defines "advice" as any communication (including the opinion of a professional tax adviser) setting forth the analysis or conclusion of a person (other than the taxpayer) provided to (or for the benefit of) the taxpayer and on which the taxpayer directly or indirectly relies. The use of "including" implies that others may be considered tax advisers; further, the advice at issue may be oral or written, from a paid or unpaid adviser in taxation or other field.

Example 3:(6) E and F filed for divorce; at their dissolution hearing, the judge ruled that one of the parties should bear all the tax consequences of the monthly separation payments. Based on the judge's order, E and F take appropriate positions in married filing separate returns. For Sec.6664(c)(1) purposes, the judge is a tax adviser.

Taxpayer's Responsibilities

IRM (20)331(1) provides that taxpayers have the burden of proving RC. Under Regs. Sec. 1.6664-4(c)(1) and IRM (20)333.7(1), RC does not exist when tax advice is tainted because the taxpayer intentionally failed to provide all the relevant information or negligently failed to confirm the adviser's qualifications.

Intentional actions may involve conspiracies between the taxpayer and the adviser or the use of an innocent tax adviser as a shield. Taxpayer negligence includes the failure to make reasonable inquiries about a tax adviser's competence before relying on his advice.

Conspiracies

When a conspiracy exists between the taxpayer and the tax adviser, the taint is obvious, because the taxpayer and the adviser jointly conspired to report transactions that did not occur. For instance, post-transaction planning to create written records is not appropriate and can subject the taxpayer to the accuracy-related and fraud penalties.

Example 4:(7) After considering the previous year's transactions of G's two corporations, H, a tax adviser, advises G that the companies should file a consolidated return. While the corporations were created independently and years apart, H believes that G always intended for one corporation to be the owner of the other. Because there is no written evidence of such intent, H backdates a legal document and journal entries. Even if G really always had such intent, reliance on the backdated document and journal entries is not a valid RCGF defense.

Using a Tax Adviser as a Shield

Fortunately, taxpayer/adviser conspiracies are not that common. More common is a taxpayer's intentional conduct to deceive the tax adviser and the IRS by leading the adviser to take a misinformed position or opinion; on audit, the taxpayer then tries to use the misinformed opinion as a shield to avoid the accuracy-related penalty. However, to maintain a successful RCGF defense based on reliance on a tax adviser, the taxpayer must have timely revealed to him all relevant facts.(8)

Example 5: The facts are the same as in Example 1. A can claim RCGF if the IRS attempts to impose an accuracy-related penalty, because A timely sought the advice of a competent tax adviser and disclosed to him all relevant facts. However, A did not act in good faith if for example, he did not disclose that someone else paid his state and local taxes for him.(9)

Example 6:(10) Based on the advice of P, his accountant, J, the executor of a large estate, directed some legatees to renounce their legacies, which increased the estate remainder. The remainder was then distributed to the decedent's surviving spouse, resulting in a larger marital deduction. However, without P's knowledge, J also made simultaneous gifts to the disclaimants in consideration for their renunciations. Because J did not disclose to P the simultaneous gifts, J cannot claim RCGF reliance on P's advice.

Example 7:(11) K, the executor of a large estate, failed to disclose to Q, the estate's accountant, information concerning the existence of safe deposit boxes containing untitled assets (e.g., cash,jewelry and bearer bonds). In defense to the accuracy-related penalty, K claims that he relied on Q to prepare an accurate return. The RCGF defense is not valid, because K did not disclose all relevant assets to Q.

Failing to Inquire About Adviser's Expertise

IRM (20)333.7(1) states that there may be RC if the taxpayer contacted a tax adviser who is competent on the specific tax matter. On the other hand, Regs. Sec. 1.6664-4(c)(1) states that reliance on a tax adviser is not reasonable or lacks good faith if the taxpayer knew or should have known that the adviser lacked knowledge in the relevant aspect of Federal tax law. For a valid RCGF defense, the taxpayer has to show that (1) the adviser 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.(12) The taxpayer's willingness to take a position"too good to be true" may indicate negligence.

Example 8:(13) L asks his friend M, who is not a tax professional, for advice on reducing L's tax liability. M suggests that L make a relatively small investment in ABC corporation that will yield relatively large tax credits. M claims that he and others have made such investments and have taken large tax credits in their returns. Without obtaining professional verification of M's claims, L makes the investment and eventually claims tax credits. L cannot argue RCGF, because he made no good faith attempt to ascertain the correctness of M's advice.

A finding of negligence requires a comparison of the taxpayer's conduct with the conduct of a reasonable taxpayer under similar circumstances, taking into account the taxpayer's expertise and/or education.

Example 9:(14) The facts are the same as in Example 8, except that L is an attorney and M is a financial planner. L's RCGF defense is invalid because she is educated and M has no specific training in tax matters.

In addition, the courts also consider the taxpayer's motive in selecting the tax adviser.

Example 10: The facts are the same as in Example 8, except that M is a CPA with a good general reputation, but not specifically as a tax adviser. A major factor in assessing the validity of L's RCGF defense will be the fact that L selected M based on his general reputation, not on his tax expertise.

On the other hand, when a taxpayer has made a good faith effort to select a professional tax adviser, reliance on that professional's advice is reasonable even if the advice is wrong.

Example 11:(15) N retained CPA D because he believed that he could not prepare his own return properly. N provides all relevant tax information to D, including all Form 1099s. D erroneously failed to include some Form 1099 information in N's return. N has a valid RCGF defense.

However, in all cases, regardless of the adviser's level of expertise, the taxpayer is expected to use ordinary business care and prudence. For instance, lack of education or tax sophistication is not an excuse when the tax adviser fails to file a required return and the taxpayer knew or should have known that such filing was required.(16)

Taxpayer's Level of Education and Experience

The regulations and the IRM appear to differ as to the weight to be given to the taxpayer's level of education and experience. Regs. Sec. 1.6664-4(b)(1) takes a narrow view, stating that "circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge and education of the taxpayer...." IRM (20)333.7(1) takes a broader view, that in determining whether "the taxpayer exercised ordinary business care and prudence...", the taxpayer's own information and knowledge should be considered.

The cases seem to follow the IRM and have considered the taxpayer's degrees, experience and available professional resources as evidence against an RCGF defense.(17) Therefore, the higher the level of the taxpayer's education, the less likely the courts are willing to accept a claim that he acted in good faith in following his adviser's questionable advice.

Example 12: O holds an undergraduate degree in economics and is a graduate of a nationally prominent law school. In addition, O has business experience and various tax, accounting and law advisers readily available to him. Based on O's education, experience and/or his access to qualified advisers, a higher standard will be applied to O in assessing the validity of his RCGF defense.

On the other hand, a taxpayer's lack of education and/or sophistication is also relevant in determining the validity of an RCGF defense.

Example 13:(18) P developed a very lucrative business in the U.S. despite having had only seven years of education in his native land and only limited knowledge of English and of American business customs. To help his son, S, start his own business, P guaranteed S's bank loan. After S failed to pay the bank, P paid off the loan as a guarantor. P consulted both his CPA and his attorney on the deductibility of the guarantee payment as a bad debt expense. If P is erroneously advised to deduct the payment, P is likely to have a valid RCGF defense.

However, as mentioned earlier, even if the taxpayer is unsophisticated about tax laws, he is not excused from having to have exercised ordinary business care and prudence.(19)

Example 14: (21) Q was a majority shareholder in a family-owned corporation. The family's holdings were subject to a restrictive shareholders' agreement. In light of the restrictions, Q's advisers suggested that, for gift tax purposes, Q discount the value of the shares by 50%. Although the IRS or a court may disagree with the amount of the discount, Q's lack of sophistication on valuation and tax issues is relevant when considering imposition of the accuracy-related penalties.

In general, in connection with appraised values, many courts believe that valuation is not an exact science and have held that RCGF exists for reliance on a tax adviser's appraisal advice, even if the adviser is not a valuation expert.(21) Similarly, the courts have upheld the RCGF defense when the taxpayer has relied on his adviser in difficult technical areas.(22)

Finally, both the regulations and the IRM mention that the taxpayer's defense depends on his knowledge and information, a defense that depends in part on the taxpayer's testimony and credibility. IRM (20)331(4) directs tax auditors to review the prior two years and any other open years for payment patterns and penalty history. While a first-time delinquency does not establish RC, a history of penalties will undermine the taxpayer's credibility.

Adviser's Responsibilities

A tax adviser must consider a taxpayer's motives and the advice must have a reasonable foundation. Regs. Sec. 1.6664-4(c)(1)(i) explains that the advice must take into account the taxpayer's motives for entering into and structuring a transaction in a particular way. Further, even when all facts are known to the adviser, Regs. Sec. 1.6664-4(c)(1)(ii) states that the advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings or agreements of the taxpayer or any other person.(23)

Additionally, a court will scrutinize the relationship between the adviser and the taxpayer to decide whether a true "advisory" relationship existed.

Example 15:(24) R is S's tax adviser. However, if S tells or orders R what to say or advise, then R is really S's scrivener, not S's adviser. S cannot use the RCGF defense for following R's alleged advice.

Protecting the Adviser

As was mentioned earlier, the tax adviser should recognize that some taxpayers may not be forthcoming with all relevant data. In some unusual cases, taxpayers may even attempt to use the tax adviser's prepared return or advice as a shield against the accuracy-related penalties. This may cause serious problems for the tax adviser with the client and with the IRS, for which there is no clear solution.

First, the tax adviser's duty is limited by Statements on Responsibilities in Tax Practice (SRTP) No. 3, Certain Procedural Aspects of Preparing Returns,(25) which states that in preparing or signing a return, the CPA may in good faith rely without verification on information furnished by the client. However, the CPA should make reasonable inquiries if the information furnished appears to be incorrect, incomplete or inconsistent either on its face or on the basis of other facts known to the CPA.(26) Therefore, if there are doubts, the facts should be confirmed to the extent possible.

Testifying for a Client

The taxpayer has the burden of proving the existence of the advice and that an error resulted from following it. Thus, the success of a RCGF defense may depend on the adviser's credibility and willingness to testify.

As the trier of fact, a trial court is strongly persuaded by testimony from the professional adviser and/or introduction of his written recommendations.

Example 16:(27) At T's trial, T's CPA testified and a letter from T's attorney was introduced to support the claim that T relied on his advisers reasonably and in good faith. The court found that T relied in good faith on his advisers concerning the Sec. 6664(c)(1) defense, but did not accept or rely on T's self-serving testimony concerning the substantive nonpenalty-related issues.

Even when a professional adviser is judged to be completely wrong, so that the taxpayer's reliance thereon was misplaced, the adviser's testimony as to his reasons for taking the return position can be helpful to the taxpayer's RCGF defense. As indicated earlier, while a court may find the taxpayer's reliance on his CPA "misplaced and unfortunate,"(28) it may nevertheless hold that such reliance was RCGF.

However, a taxpayer is not likely to satisfy his burden of proof (and the court is likely to summarily dismiss the taxpayer's defense) if the adviser fails to testify and/or the taxpayer fails to present any other evidence to support the RCGF defense.(29)

Asserting RCGF

Finally, the RCGF reliance defense should be claimed with specificity; the taxpayer should explicitly claim that, pursuant to Sec. 6664(c)(1), the accuracy-related penalties should be excused because the taxpayer acted with RCGF in relying on his tax adviser's advice. At least one court denied the taxpayer's RCGF defense when he simply claimed reliance on professional tax advice and failed to mention Sec. 6664(c)(1).(30)

Conclusion

The use of the RCGF reliance defense based on the advice of tax professionals is increasing. A review of the regulations, IRM and cases suggests that each case turns on a determination of whether the facts, circumstances and merits demonstrate that the taxpayer used ordinary business care and prudence in relying on the advice and whether the advice was "tainted." The advice is "tainted" when the tax adviser and/or the taxpayer conspire to avoid tax through fraudulent actions, the taxpayer attempts to use the adviser as a "shield," or the taxpayer is negligent in the selection of a tax adviser. In addition, tax advisers are expected to act within a certain standard of conduct. This includes ascertaining the taxpayers' motives and all relevant facts; using the appropriate defensive standards in Sec. 6662; acting as advisers and not as scriveners; claiming the RCGF reliance defense with specificity; and finally, standing behind their advice (and their clients) by testifying when needed.

(1) Sec. 6694(a) contains a similar RCGF defense for tax return preparers to avoid the understatement penalty. For a discussion of that penalty and the conflict of interest it may present between taxpayers and return preparers, see Gardner and Willey, "A Look at Chapter 11 of the Consolidated Penalty Handbook," 25 The Tax Adviser 67 (Feb. 1995). Sec. 6664(c)(1) states that "no penalty shall be imposed under this part"; thus, except for some limits on the valuation penalties related to (1) Sec. 482 transfer pricing adjustments and (2) charitable donations of property, the RCGF defense is available for all Secs. 6662 and 6663 penalties.

(2) Effective for returns due (without extensions) after 1989. For returns due before that date, if the taxpayer had a valid RCGF defense, under Sec. 6661 the Secretary could waive the substantial understatement penalty if the taxpayer proved that the IRS acted arbitrarily, unreasonably or capriciously.

(3) See Regs. Sec. 1.6664-4(b)(2), Example 1.

(4) See Regs. Sec. 1.6664-4(b)(2), Example 4.

(5) See, e.g., Thomas B. Drummond, TC Memo 1997-71.

(6) See, e.g., Edward J. Richardson, TC Memo 1995-554; see also Raymond N. Rosenthal, TC Memo 1995-603, in which the taxpayer's attorney and the attorney representing his ex-spouse were deemed the taxpayer's "advisers.

(7) See George Georgiou, TC Memo 1995-546.

(8) See Regs. Sec. 1.6664-4(c)(1); IRM (20)333.7; see, e.g., Edward Kelly, TC Memo 1996-529; Cordes Finance Corp., TC Memo 1997-162; Floyd L. Garrett, TC Memo 1997-231.

(9) See e.g., Bryan J. Baugh, TC Memo 1996-70; John T. Barrett, Jr., TC Memo 1996-199; and Eyefull Inc., TC Memo 1996-238.

(10) See Est. of Louise S. Monroe, 104 TC 352 (1995) (upholding fraud penalty).

(11) See Est. of Nathalie N. Fox, TC Memo 1995-30.

(12) See Deja Vu, Inc., TC Memo 1996-234.

(13) See Regs. Sec. 1.6664-4(b)(2), Example 2.

(14) See Dawn V. Martin, TC Memo 1995-448. Taxpayer who are tax professionals themselves are held to a higher standard of care; see, e.g., James W. Tippin, 104 TC 518 (1995). A court is less likely to sustain an RCGF defense based on reliance on anther tax adviser.

(15) See Dona E. Conway, TC Memo 1994-405.

(16) See Deja Vu, note 12.

(17) In Georgiou, note 7, the court noted that the taxpayer held degrees in economics and mathematics and had worked as a systems analyst. In Martin, note 14, the court noted that the taxpayer had graduated from Columbia University cum laude and from New York Law School. Similarly, in Est. of Fox, note 11, the court noted in a footnote that the executor had a Cornell engineering degree, had been advised by various CPAs and attorneys, and was well-versed in tax law. Finally, in Tippin, note 14, an attorney/CPA taxpayer was held to a higher standard of care.

(18) See John L. Viani, TC Memo 1994-471.

(19) See Deja Vu, note 12.

(20) See Bernard Mandelbaum, TC Memo 1995-255.

(21) In Maschmeyer's Nursery, Inc., TC Memo 1996-78, in connection with a rental value issue, the court stated that the making of an appraisal is not an exact science and that the taxpayer had RCGF in following his CPA's advice, even though the adviser was not an expert in valuation. In PMT, Inc., TC Memo 1996-303, the court considered the accountant's testimony and advice regarding the reasonableness of the taxpayer's (an S corporation president's) compensation, even though the CPA was not a compensation expert; see also Est. of Dorothy Morganson Schauerhamer, TC Memo 1997-242.

(22) See, e.g., J. Brent Haymond, TC Memo 1997-28 (computation of adjusted basis); Tebarco Mechanical Corp., TC Memo 1997-311 (classification of items as inventory under state law); B. Albert Holowinski, TC Memo 1997-168 (determination of profit motive); James E. Zurcher, Jr., TC Memo 1997-203 (classification of losses), but see Edward Kelly, note 8. However, in unreasonable compensation cases, the courts have denied the RCGF defense to sophisticated and experienced shareholder-employees who controlled their own levels of compensation; see, e.g., The Escrow Connection, Inc., TC Memo 1997-17.

(23) For instance, in Georgiou, note 7, because the taxpayer and his advisers relied on their own false and/or backdated documents, the conclusions reached by the taxpayer's advisers were not reasonable.

(24) See Georgiou, note 7, in which the taxpayer's attorney testified that in his activities for his client, he was a scrivener, not a business adviser, who would produce documents to reflect agreements that had been reached by his client. He further stated that he would "absolutely not" describe himself as the taxpayer's or his corporations' tax adviser; see also Cordes Finance Corp., note 8.

(25) AICPA Federal Taxation Executive Committee, Statements on Responsibilities in Tax Practice (SRTP) (1991 rev.), No. 3, Certain Procedural Aspects of Preparing Returns.

(26) According to SRTP No. 3., id., "Explanation," this statement is based on the preparer's declaration on the income tax return that the information contained therein is true, correct and complete "to the best of the preparer's knowledge and belief `based on all information of which the preparer has any knowledge: The declaration does not require the CPA to examine or verify supporting data...In fulfilling his or her obligation to exercise due diligence in preparing a return, the CPA ordinarily may rely on information furnished by the client unless it appears to be incorrect, incomplete, or inconsistent. Although the CPA has certain responsibilities...the client has ultimate responsibility for the contents of the return...."

(27) See Viani, note 18.

(28) Conway, note 15; see also Allied Marine System, Inc., TC Memo 1997-101.

(29) See, e.g., Lawton K. Stroud, 906 F Supp 990 (DC S.C. 1995)(76 AFTR2d 95-7733, 96-1 USTC [paragraph] 50,012); Mohammed M. Saghafi, TC Memo 1994-238; John Epps, TC Memo 1995-297; Jimmy Song, TC Memo 1995-446; Bruce Selig, TC Memo 1995-519; Richardson, note 6; Eddie M. Chandler, TC Memo 1996-51; David E. Jackson, TC Memo 1996-54; Martin H. Droz, TC. Memo 1996-81; Arnold P. Mordkin, TC Memo 1996-187; and M. Bennett Marcus, TC Memo 1996-190.

(30) See Selig, id. (taxpayers failed to invoke Sec. 6664(c)(i) in their Tax Court-petition and opening brief court concluded that the taxpayers had not "particularized the portions of the 1989 and 1990 underpayments with respect to which they claim to have acted with reasonable cause and in good faith....").

RELATED ARTICLE: EXECUTIVE SUMMARY

* In determining the existence of RCGF, the taxpayer's education and experience will be considered.

* To prove RCGF, the taxpayer must show that (1) the adviser 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.

* In determining whether a taxpayer's efforts have been sufficient to raise the RCGF defense, he is deemed to know not only what he actually knows, but what he should have known after reasonable diligence.