Litigating IRS tax penalties is a central part of practicing tax law and representing taxpayers. The Taxpayer Advocate, in her last Annual Report to Congress, provided a studied summary of reported cases during the 2015 fiscal year litigating the failure-to-file penalty under § 6651(a)(1), the failure-to-pay penalty under § 6651(a)(2), and the failure to pay estimated tax penalty under § 6654. Not surprisingly, the study indicated that the majority of such cases are litigated in the Tax Court forum, rather than district court or the Court of Federal Claims. Also perhaps not surprising, the study indicates that taxpayers who are represented by counsel stand a better chance of defeating IRS penalties than those that represent themselves (i.e., pro se).
The report provides a handy summary of the penalties studied, which I will set forth in excerpt below:
Under IRC § 6651(a)(1), a taxpayer who fails to file a return on or before the due date (including extensions) will be subject to a failure to file penalty of five percent of the tax due (minus any credit the taxpayer is entitled to receive and payments made by the due date) for each month or partial month the return is late. This penalty will accrue up to a maximum of 25 percent, unless the failure is due to reasonable cause and not willful neglect. To establish reasonable cause, the taxpayer must show he or she exercised ordinary business care and prudence but was still unable to file by the due date. The failure to file penalty applies to income, estate, gift, employment, self-employment, and certain excise tax returns.
The failure to pay penalty, IRC § 6651(a)(2), applies to a taxpayer who fails to pay an amount shown as tax on the return. The penalty accrues at a rate of 0.5 percent per month on the unpaid balance for as long as it remains unpaid, up to a maximum of 25 percent of the amount due. When IRS imposes both the failure to file and failure to pay penalties for the same month, it reduces the failure to file penalty by the amount of the failure to pay penalty (0.5 percent for each month).
The failure to pay penalty applies to income, estate, gift, employment, self-employment, and certain excise tax returns. The taxpayer will not be held liable if he or she can establish reasonable cause, i.e., the taxpayer must show he or she has exercised ordinary business care and prudence but was still unable to pay by the due date, or that payment on that date would have caused undue hardship. Courts will consider “all the facts and circumstances of the taxpayer’s financial situation” to determine whether the taxpayer exercised ordinary business care and prudence. In addition, “consideration will be given to the nature of the tax which the taxpayer has failed to pay.”
IRC § 6654 imposes a penalty on any underpayment of estimated tax by an individual or by certain estates or trusts. The law requires four installments per taxable year, each generally 25 percent of the required annual payment. The required annual payment is generally the lesser of 90 percent of the tax shown on the return for the current taxable year or 100 percent of the tax for the previous taxable year. The IRS will determine the amount of the penalty by applying the underpayment rate, according to IRC § 6621, to the amount of the underpayment for the applicable period.
To avoid the penalty, the taxpayer has the burden of proving that one of the following exceptions applies:
- The tax due (after taking into account any federal income tax withheld) is less than $1,000;
- The preceding taxable year was a full 12 months, the taxpayer had no liability for the preceding taxable year, and the taxpayer was a U.S. citizen or resident throughout the preceding taxable year;
- The IRS determines that because of casualty, disaster, or other unusual circumstances, the imposition of the penalty would be against equity and good conscience; or
- The taxpayer retired after reaching age 62 or became disabled in the taxable year for which estimated payments were required, or in the taxable year preceding that year, and the underpayment was due to reasonable cause and not willful neglect.
(TAS 2015 Annual Report.)
The foregoing summary is a useful refresher on some of the more common run-of-the-mill penalties under the Internal Revenue Code. There are, of course others—for instance, the civil fraud penalty, the substantial understatement penalty. The Code provides for criminal penalties as well. The TAS summary excerpt above alludes to one of the most common defenses to IRS penalties—reasonable cause. Where a taxpayer successfully demonstrates reasonable cause for a failure that would otherwise trigger penalties, the taxpayer can avoid liability for those penalties. Notably, and not surprisingly, the report found that taxpayers who are represented by counsel stand a greater chance of success in avoiding penalties.
One of the common arguments put forward by taxpayers to establish reasonable cause is reliance on an agent who failed to perform a duty that caused the taxpayer to incur a penalty. (There are, of course, numerous other grounds that are often argued to establish reasonable cause.) The TAS report provides a pretty good summary of a few recent cases that demonstrate the background law on this defense and some of the nuances of the reliance-on-an-agent argument. Here is an excerpted portion of that section the report:
The U.S. Supreme Court, in United States v. Boyle, held that taxpayers have a non-delegable duty to file a return on time. [Boyle is the seminal case on this issue; it is not a recent case.] The Court noted that “[i]t requires no special training or effort to ascertain a deadline and make sure that it is met.” Therefore, a taxpayer’s reliance on an agent to file a return does not excuse any failure to comply with a known ling requirement.
For example, in Specht v. United States, Mrs. Specht (a co-fiduciary of the Escher estate), sought to recover penalties and interest in the amount of $1,198,261.38 imposed for failing to timely file the estate tax return and pay estate taxes. Mrs. Specht, a 73-year-old high school-educated homemaker and the cousin of the deceased, was asked to be executor of the estate and formally accepted this role in February 2009. She hired Ms. Escher’s former attorney, Mary Backsman, who had over 50 years of experience in estate planning, to represent the estate. Unknown to Mrs. Specht, Ms. Backsman was fighting brain cancer.
Ms. Backsman informed Mrs. Specht that the federal estate tax return was due by September 30, 2009, though she did not file it by that date. Additionally, Ms. Backsman failed to arrange for an agreed upon sale of stock to pay off the estate tax and lied to Mrs. Specht about it. She failed to file a first accounting of assets for the estate, missed probate deadlines, lied to Mrs. Specht about filing an extension, failed to file state estate tax returns, and failed to file the federal estate tax return. Ms. Backsman lied repeatedly about her handling of the situation. After discovering that Ms. Backsman had failed to request sale of the stock, Mrs. Specht red her and hired another attorney on November 1, 2010. The estate led a malpractice suit against Ms. Backsman that was settled.
Despite the above failures on the part of Ms. Backsman, the court determined that Mrs. Specht’s reliance on her was unjustified. First, Mrs. Specht could not confirm if she had timely completed her listed obligations as a fiduciary and showed no concern about that duty. She stated in testimony that she was unsurprised Ms. Backsman had missed the filing deadline. She took no steps to proceed with the sale of stock before the deadline and received numerous warnings that Ms. Backsman was missing filing dates. Mrs. Specht did not attend probate hearings prior to the filing deadline. She received four notices from the probate court before the deadline, warning that Ms. Backsman was not performing her duties and that she had missed deadlines. After the deadline for filing the federal estate tax return had passed, Mrs. Specht received two more notices and was contacted in July and September 2010 by another client of Ms. Backsman, who warned her that Ms. Backsman was incompetent. In August 2010, she received a letter from the Ohio Department of Taxation alerting her that Ms. Backsman had not responded to their inquiries, and it could impose penalties. Lastly, in September 2010, she contacted an attorney who told her she needed to replace Ms. Backsman.
The court noted the precedent of United States v. Boyle, which established a distinction between relying on an attorney for legal advice and relying on an attorney to file tax returns, a non-delegable duty which requires no particular expertise. “‘Ordinary care and prudence’ requires more than mere delegation.” The court also cited Valen Mfg. Co. v. United States, where a corporation’s reliance on a bookkeeper who actively concealed a failure to file, did not establish reasonable cause. This court clearly felt constrained by precedent, noting that while Ohio had refunded the estate tax penalties after the malpractice suit, it was “truly unfortunate that the United States did not follow the State of Ohio’s lead.”
A taxpayer may establish reasonable cause for a failure to file if he or she can prove reasonable reliance on a professional tax advisor’s substantive legal advice. To reasonably rely on the advice of a tax professional, the taxpayer must present evidence of the professional’s expertise and show he or she provided the professional with all necessary and accurate information.
In Cavallaro v. Commissioner, the IRS issued a notice of deficiency to Mr. and Mrs. Cavallaro, determining a liability for the addition to tax under IRC § 6651(a)(1) in the amount of $29.6 million for the failure to file gift tax returns. The court held that the IRS showed the additions to tax were applicable but sustained the Cavallaros’ defenses of “reasonable cause.”
Mr. and Mrs. Cavallaro had little to no advanced education, including no formal accounting, legal, or business education. They hired advisers who were competent professionals with sufficient expertise to justify reliance. They engaged professionals from a well-known accounting firm and a well-known law firm to structure the tax-free merger of their S corporation, Knight Tool Co., with their sons’ S corporation, Camelot Systems, Inc. The merger transaction was eventually structured according to the advice given by the Cavallaros’ attorney. Under this advice, it was determined that rights to technology developed by Knight Tool Co. (i.e., a computer-controlled liquid dispensing machine known as CAM/ALOT) were previously transferred to Camelot Systems, Inc. prior to the merger and therefore could not be gifted to Camelot Systems, Inc. at the time of the merger.
The court found that taxpayers had reasonably relied upon their advisors. They had no formal legal, accounting, or business education and had hired competent professionals. Those professionals had explicitly considered the relevant issue. Citing Boyle, the court noted that taxpayers are not required to challenge an attorney’s tax advice to satisfy ordinary business care and prudence. The court found the Cavallaros had provided accurate and necessary information to their advisors. They had relied sufficiently upon the advisors, and their tax positions were not attributable to themselves but to their advisors. The court concluded that the Cavallaros had reasonable cause for not filing a gift tax return and were not liable for the failure to file penalty.
(TAS 2015 Annual Report.)
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