Accuracy-Related Penalties: The Burdens of Proof and Production

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Accuracy-Related Penalties: The Burdens of Proof and Production

Accuracy-related penalties under section 6662 are among the most common penalties in the Tax Code.  As a result, they are often at issue in tax litigation against the IRS.  That raises the question: What are the burdens of proof and production when it comes to accuracy-related penalties?

Accuracy Related Penalties under Section 6662 of the Code

The Internal Revenue Code (I.R.C.) section 6662 addresses rules applicable to accuracy-related penalties for the underpayment of tax. Generally, I.R.C. § 6662 allows the IRS to impose an accuracy-related penalty of 20% of a portion of underpaid tax. See I.R.C. § 6662(a). This rule applies where the underpayment is due to one or more of the following reasons:

(i) negligence or disregard for the tax rules or regulations,

(ii) a substantial understatement of income tax,

(iii) a substantial valuation misstatement under chapter 1 of the Code,

(iv) any substantial overstatement of pension liabilities,

(v) any substantial estate or gift tax valuation understatement,

(vi) any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o) of the Code) or failing to meet the requirements of any similar rule of law,

(vii) any undisclosed foreign financial asset understatement, (viii) any inconsistent estate basis, or

(ix) any overstatement of the deduction provided in section 170(p) of the Code. See I.R.C. § 6662(b).

However, section 6662 does not apply where a penalty is already imposed on the underpaid tax under section 6663 of the Code. See id. Moreover, except as provided in paragraph (1) or (2)(B) of section 6662A(e), § 6662 does not apply to the portion of any underpayment which is attributable to a reportable transaction understatement on which a penalty is imposed under section 6662A. Id.

 Burdens of Proof and Production

Generally, the taxpayer bears the burden of proving that the Commissioner’s determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under section 7491(a)(1) of the Code, “[i]f, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B, the Secretary shall have the burden of proof with respect to such issue.” See Higbee v. Commissioner, 116 T.C. 438, 442 (2001). If the taxpayer is claiming basis in any investment, then the taxpayer bears the burden of proving that basis. O’Neill v. Commissioner, 271 F.2d 44, 50 (9th Cir. 1959), aff’g T.C. Memo. 1957-193; see also Powers v. Commissioner, T.C. Memo. 2013-134, at *28-*30. However, taxpayers cannot rely solely on their own income tax returns to establish the losses they sustained. Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979) (citing Roberts v. Commissioner, 62 T.C. 834, 837, 839 (1974)).

The Commissioner bears the initial burden of production to show an individual taxpayer’s liability for a penalty and is required to present sufficient evidence showing that the penalty is appropriate. Sec. 7491(c); Higbee v. Commissioner, 116 T.C. at 446-447. To meet this burden, in certain cases, the Commissioner also must show that he complied with the procedural requirements of section 6751(b)(1) of the Code. See sec. 7491(c); Graev v. Commissioner, 149 T.C. 485, 492-493 (2017).

Once the Commissioner has satisfied his burden of production, the taxpayer bears the burden of proving that the Commissioner’s penalty determination is incorrect or that the taxpayer has an affirmative defense such as reasonable cause. See U.S. Tax Court Rule 142(a); see also Higbee v. Commissioner, 116 T.C. at 446-447. The taxpayer then has two non-exclusive avenues: (1) claim that the Commissioner did not comply with applicable rules and regulations, and (2) argue an affirmative defense such as good faith and reasonable cause for the underpayment of tax. See Est. of Morgan v. Comm’r of Internal Revenue, T.C.M. 2021-104 (T.C. 2021) (where the Petitioners claimed (i) that the Commissioner did not comply with section 6751(b)(1), which provides that no penalty is allowed unless the “initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination”, and (ii) that alternatively, the taxpayers had good faith and reasonable cause for the underpayment).

The first avenue requires the taxpayer to prove that a rule or regulation required the Commissioner to take a certain action, and that such action was not taken. Usually, this depends on the type of underpaid tax and the reason for underpayment under § 6662(b). If the Court finds that the Commissioner complied with all requirements imposed by tax rules and regulations, then the taxpayer bears the burden of proving reasonable cause and good faith for any portion of the underpayment. Higbee v. Commissioner, 116 T.C. at 448-449.

I.R.C. § 6664(c)(1) allows a taxpayer to avoid a section 6662 penalty by showing reasonable cause for any portion of the underpayment and the taxpayer acted in good faith. The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances, including the taxpayer’s efforts to assess the proper tax liability and the taxpayer’s knowledge, experience, and education. See Income Tax Regs. § 1.6664-4(b)(1).

Reasonable reliance on professional advice may constitute reasonable cause and good faith if the taxpayer proves, by a preponderance of the evidence, that

(1) the adviser was a competent professional with 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.

See Alt. Health Care Advocates v. Commissioner, 151 T.C. 225, 246 (2018).

Usually, courts consider the following factors in assessing whether a tax adviser is a competent professional:

(i) the degree the adviser holds,

(ii) whether the adviser regularly prepares tax returns or provides financial advice, and

(iii) whether the adviser has a long-term history of providing financial or tax-related advice to the taxpayer.

See, e.g., Pankratz v. Commissioner, T.C. Memo. 2021-26, at *24 (holding that a longtime employee who provided financial-related support to taxpayer and had a bachelor’s degree in accounting lacked sufficient expertise to prepare a large and complex tax return); see also Thousand Oaks Residential Care Home I, Inc. v. Commissioner, T.C. Memo. 2013-10, at *41 (holding that an accountant with an M.B.A. degree who was a full-time return preparer and enrolled agent was competent to advise on employment-plan contributions).

The second requirement of reasonable reliance is that the taxpayer provided necessary and accurate information to the adviser. The taxpayer must not “fail to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item.” Reg. § 1.6664-4(c)(1)(i). A taxpayer is not obligated to share details that a reasonably prudent taxpayer would not know, or that he would neither know nor reasonably should know are relevant. CNT Inv’rs, LLC v. Commissioner, 144 T.C. 161, 228 (2015).

Lastly, the good faith reliance requirement necessitates that the taxpayer actually relied on the advice in good faith. Advice is defined as “any communication, including the opinion of a professional tax advisor, 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 relies, directly or indirectly”. Income Tax Regs § 1.6664-4(c)(2). If the taxpayer satisfies all three requirements of reasonable reliance, then the taxpayer has established good faith and reasonable cause and is thus not liable for § 6662 accuracy related penalties. Est. of Morgan v. Comm’r of Internal Revenue, T.C.M. 2021-104 (T.C. 2021). There are other instances where good faith and reasonable cause are satisfied, and this determination is made on a case-by-case basis. See Reg. § 1.6664-4(b)(1).