For 1989 and later tax returns, the Revenue Reconciliation Act of 1989 (RRA) raised the rate of the negligence penalty from 5% to 20%. This 300% rate increase means taxpayers will be more likely to appeal assessments of the penalty. Cases on these returns are not yet before the Tax Court; however the IRS has already audited 1989 returns.

One approach taxpayers can use to avoid the negligence penalty is to prove good faith reliance on their tax preparer. Knowing the standards the Tax Court has applied in allowing this defense to the penalty, taxpayers and their advisors will be able to contest IRS assessments of the 20% negligence penalty and to take steps to minimize exposure to such penalty.

The History of Negligence

Penalties

The Tax Court has defined negligence using a reasonable person standard. Negligence is the failure to do what a reasonable and ordinarily prudent person would do under the circumstances. For 1988 and earlier returns, reliance on a tax preparer is a defense recognized by the Tax Court that allows the taxpayer to avoid the negligence penalty. As a general rule, the taxpayer cannot avoid the statutory duty to file a complete and accurate return solely by hiring a preparer. However, under limited circumstances, the Tax Court allows an exception to the general rule if the taxpayer proves good faith reliance on his or her competent preparer. The taxpayer satisfies the reasonable person standard by meeting the requirements of this reliance exception.

For 1989 and later returns, the RRA added IRC Sec. 6664(c)(1), which provides an exception to several penalties, including negligence, when the taxpayer proves reasonable cause and good faith. The taxpayer's good faith reliance on his or her preparer comes under this section. The conference committee report to the RRA pointed out that "reasonable cause" and "good faith" should be interpreted as they have been under prior law. Also, the recently issued final regulations on Sec. 6664 concurred with the committee report by following the test the Tax Court has used in interpreting "reasonable cause" and "good faith." Finally, the IRS, in its recently released Penalty Handbook for employees, emphasized the same points contained in the Tax Court's analysis. Therefore, current Tax Court cases on the good faith reliance exception to the negligence penalty will continue to provide authoritative guidance for practitioners.

It should be noted that for 1989 and later returns, the 20% penalty applies only to the items on the return that are in error due to negligence. For earlier returns, if any error is due to negligence, the 5% penalty is applied to the total underpayment resulting from all errors.

The Tax Court's Approach

In all Tax Court cases involving the negligence penalty, the IRS assesses the penalty and the court must decide whether it will be sustained. The taxpayer bears the burden of proof on the penalty. He or she must prove it is more likely than not that the IRS erred in making the assessment.

The Tax Court has consistently applied a "facts and circumstances" test to determine whether taxpayers can avoid the negligence penalty by proving good faith reliance on their tax preparers. This means that instead of a specific rule, the court has considered a variety of factors in deciding these cases. The factors are - * Complete and accurate information from the taxpayer; * The competence of the preparer; * The sophistication of the taxpayer; * The taxpayer's review of the return, and; * The number of errors on the return.

With the exception of the first factor, the importance of the individual factor varies with the facts of each taxpayer's situation. No single court case contains all of the factors.

Complete and Accurate

Information

In sustaining the penalty, the Tax Court has consistently cited the failure of the taxpayer to provide complete and accurate information to the preparer. Also, after providing the preparer with such information, the taxpayer is then required to follow the preparer's advice to prove good faith reliance on the preparer.

In each of the following cases, the penalty was sustained by the court because the taxpayers did not provide the preparer with complete and accurate information. In Noah, the taxpayer told the preparer that several expenses were business expenses when they were personal or fictitious expenses. The taxpayer in Novack gave the preparer incorrect casualty loss figures. In Hull the taxpayer deducted large losses on a yacht chartering activity without telling the preparer the yacht was also her residence. Such deductions violate Sec. 280A. The Tax Court ruled in Langer that a general discussion of the home office deduction with the preparer did not satisfy the requirement for complete and accurate information. In Jamar, a taxpayer deducted his C corporation's losses on his individual return, claiming reliance on his preparer. However, the preparer testified he did not know the business was a C corporation until long after the incorporation. The preparer had recommended an S corporation.

The penalty was not sustained by the Tax Court in the following cases in which the taxpayer was held to have provided compete and accurate information to the preparer. The taxpayer in Barton, a pipefitter, told his preparer that he had received large per diem allowances ($10-18,000 per year). They were not reported on the taxpayer's return due to the preparer's contention the related travel expenses were deductible. However, the Tax Court ruled they were not deductible because four years at the new job location was not "temporary." In Pinson, the taxpayer, an attorney on the cash basis, told his preparer his law partner had embezzled $130,000 from the taxpayer's firm shortly before the firm liquidated. The preparer incorrectly advised a $130,000 ordinary loss deduction, but the correct deduction was a $100,000 capital loss due to the liquidation. The embezzlement loss was not deductible since it was never reported in income. In Evatt the taxpayer's personal service corporation (PSC) reported income from real estate sales which should have been reported on his individual return. This case is interesting because the court ruled that since the preparer was involved in the creation of the PSC, he had complete and accurate information.

There are two additional points that are important to note in the above cases. The first is that the burden was on the taxpayer to provide the preparer with complete and accurate information about the issue. This means the taxpayer cannot avoid the penalty by claiming he or she did not know the information was important. The second is that if there are no other factors that would cause the Tax Court to sustain the penalty, the court will believe the taxpayer if he or she truthfully testifies complete and accurate disclosure was made to the preparer even if the preparer does not testify. For example, in one case the court pointed out the taxpayer convincingly stated he provided all the information to his preparer and there was no reason to think the taxpayer was not telling the truth.

Competence of the Preparer

One of the other factors is the competence of the preparer. The Tax Court will accept as competent a tax attorney, a CPA who has a tax practice, or an enrolled agent. In Barton the court noted as a reason for not sustaining the penalty that the taxpayer always hired CPAs to prepare his return.

On the other hand, if the penalty is sustained in a case where the credentials of the preparer have not been established, the court will usually point out the preparer has not been shown to be competent. For example, in Kamholz, a hobby loss case, the taxpayer relied on a tax advisor who was not an accountant or tax expert. The court ruled that this reliance was unreasonable. In Allen, a sham charitable contributions case, the taxpayer, a small business owner, did not reveal to the court any information about the expertise or qualifications of the preparer. The Court of Appeals noted this in sustaining the penalty.

Sophistication of the Taxpayer

Another factor is the sophistication of the taxpayer. The Tax Court is more likely to sustain the negligence penalty if the taxpayer has a college education, a professional job, or other relevant experience. Of course, sophistication is linked to the complexity of the issue in the case. The more complex the issue, the less the taxpayer can be expected to understand it. In fact, if the issue is too complex, given the taxpayer's sophistication, the taxpayer may be negligent for not hiring a preparer, as the court ruled in Anderson.

In each of the following cases, the court sustained the penalty because either the taxpayer was sophisticated or the issue required no sophistication. The court in Langer emphasized the taxpayer was an IRS revenue agent and should have known the requirements for a home-office deduction. Also, the court ruled the taxpayer's exaggeration of the size of his home office is an issue that requires no tax expertise. The court ruled in Easter, a hobby loss case, that any taxpayer should know losses are not deductible in transactions not having a profit objective. In Allen, the court ruled the taxpayer should have been suspicious of the overly attractive aspects of his charitable contribution deduction. In McMurray, which involved the valuation of a real estate contribution, the court noted the taxpayer was knowledgeable about real estate.

Taxpayer Must Review the

Return

A taxpayer has an obligation to review the return before signing it, and the Tax Court sustained the penalty in the following cases where the taxpayers did not satisfy this requirement. In Brown, the taxpayer did not review the return and claimed the preparer entered the disallowed $195,000 deduction after the taxpayer signed it. The court ruled reliance on the preparer does not excuse the taxpayer from the duty of reviewing the return. Similarly in Levie, the taxpayer blamed his preparer for the failure to report dividend and interest income, which the taxpayer said he did not detect when he "scanned" the return. The court held he should have read the return, not "scanned" it. The court extended this point in Abernathy where the taxpayer incorrectly reported certain credit sales. The court linked the lack of taxpayer review to its rejection of the lack of sophistication argument. If the taxpayer had reviewed the return, he would have questioned the treatment of the credit sales.

Number of Errors on the Return

Finally, the number of errors on the return is a factor. If there are errors involving more than one issue, the likelihood increases that the court will sustain the penalty. In Langer and Noah the court noted the numerous errors on the return in sustaining the penalty.

Is the Preparer Liable for the

Errors?

If the.taxpayer is not liable because he or she relied on the preparer, is the preparer liable? No penalties were assessed against the preparers in the above cases. In Weis the court stated that finding an exception to the negligence penalty for the taxpayer, based on the reliance on the preparer, meant the errors were the result of the preparer's mistakes. In the case of preparer error, the IRS could assess a $250 penalty under Sec. 6694(a), which prohibits the preparer from taking a position on a return that does not have a realistic possibility of being correct. "Realistic possibility" is a new standard enacted in the RRA. Since it applies to 1989 and later returns, it has not yet been interpreted by the courts. It is generally believed to be a more rigorous standard than negligence, which is the preparer standard under Sec. 6694(a) for 1988 and earlier returns. For those years, the penalty is $100. Also, for all years, there are larger penalties under Sec. 6694(b) if the error on die return is due to the preparer's wflm or reckless conduct.

Planning Points

In situations involving competent preparers, errors on returns should be such, that they do not result in a negligence penalty against the taxpayer or a Sec. 6694 penalty against the preparer. The key to avoiding errors is adequate communication between the taxpayer and the preparer. Such communication will require the taxpayer to allow sufficient time in working with the preparer. In most of the above cases, a competent preparer with knowledge of all the facts would have known the correct tax treatment or been able to research the appropriate answer.

Preparers should take the following steps to reduce the possibility the IRS will assess the 20% negligence penalty against your clients: * Inform your clients of the importance of providing complete and accurate information about the items on their returns. * Ask clients if they have reported all their income to you. Also, ask for more information about any unusual deductions, especially in cases of decluctions that appear to be primarily tax avoidance schemes. * Advise clients to review the return and ask any questions they might have about it before it is sent to the IRS.

If the IRS assesses the negligence penalty, use the factors discussed in prior court cases to attempt to successfully appeal the penalty.

SUMMARY OF

NEGLIGENCE PENALTY CASES

Abernathy,TCMeno1992-237Iftaxpayerreviewedthereturn,hewould

havedetectedunreportedsales.Penalty

sustained.

Allen,92TC1(1989),aff'dTaxpayershouldhavesuspectedcharitable

925F.2D348(9thCir.1991)contributionwasasham.Also,preparernot

proventobecompetent.Penaltysustained.

Anderson,TCMemo1992-130Foracomplexissue,taxpayermaybenegligent

fornothiringapreparer.Penaltysustained.

Barton,TCMemo1992-25Taxpayercompletelyandaccuratelyinformed

prepareroftravelreimbursements

thatwerenotreportedonthereturn.Ruled

tobetaxable.Penaltynotsustained.

Brown,TCMemo1992-15Relianceonpreparerdoesnotexcusethe

taxpayerfromreviewingthereturn.Penalty

sustained.

Easter,TCMemo1992-188Taxpayershouldknowthathobbylosses

arenotdeductibleinactivitywithoutprofit

motive.Penaltysustained.

English,TCMemo1993-111Taxpayermisclassifiedgainonthesaleof

22parcelsofimprovedrealestateascapital

gain.CPApreparedreturnandcourtfound

issuecomplex.Penaltynotsustained.

Estes,TCMemo1992-531Sophisticatedtaxpayerblamedpreparer,

whowasnotproventobecompetent,for

overstatementofcostofgoodssold.

Penaltysustained.

Evatt,TCMemo1992-368Sincepreparerwasinvolvedinthecreation

ofthetaxpayer'spersonalservicecorporation,

thepreparerhadcollipleteandaccurate

information.Penaltynotsustained.

Heasley,TCMemo1988-408Unsophisticatedtaxpayerinvestedintaxshelter

inrelianceonfinancialadvisorandCPA.

Lossesnotdeductible.Penaltynotsustained

by5thCircuit,reversingTaxCourt.

Hull,TCMemo1991-582Taxpayerdeductedlargelossesonyacht

charteringactivitywithouttellingpreparer

yachtwasherresidenceinviolationof

IRCSec.280A.Penaltysustained.

Jamar,TCMemo1991-602TaxpayerdeductedCcorporationlosseson

individualreturn,claimingrelianceonpreparer,

whotestifiedthathebelievedentity

wasanScorporation.Penaltysustained.

Johnson,TCMemo1992-151Negligenceisthefailuretodowhatareasonable

andordinarilyprudentpersonwoulddo

underthecircumstances.

Kamboltz,TCMemo1990-192Taxpayerreliedonataxadvisorwhowasnot

anaccountantortaxexpert.Penaltysustained.

Keough,TCMemo1992-151Sincetaxpayerprovedgoodfaithrelianceon

preparer,preparerwasnegligent.Penaltynot

sustained.

Klieger,TCMemo1992-734Taxpayer'spreparersweretaxshelterpromoters,

notcompetenttaxprofessionals.Penalty

sustained.

Langer,TCMemo1992-46Taxpayer'sgeneraldiscussionofhome-office

deductionwithpreparerdidnotgivepreparer

completeandaccurateinformation.Taxpayer

wassophisticatedandshouldhaveknown

therequirements.Partiallysustained.

Levie,TCMemo1992-230Taxpayerfailedtodetectomittedinterestand

dividendincomewhenhe"scanned"the

return.Penaltysustained.

McMurray,TCMemo1992-27Sophisticatedtaxpayerfoundknowledgeable

abouttheareatowhichthereturnrelated.

Penaltysustained.

Noah,TCMemo1992-18Taxpayertoldpreparerthatseveralexpenses

werebusinesswhentheywerepersonalor

fictitious.Penaltysustained.

Novack,TCMemo-1989-538Taxpayergavepreparerincorrectcasualty

lossfigures.Penaltysustained.

Pinson,TCMemo1990-234Capitallossof$100,000incorrectlydeducted

as$130,000ordinaryloss.Taxpayergave

preparercompleteandaccurateinformation.

Penaltynotsustained.

Reile,TCMemo1992-408Unsophisticatedtaxpayersinvestedintax

shelteronadviceofaccountant-preparer,

whomtheymetatchurch.Lossesnot

deductible.Penaltynotsustained.

Spears,TCMemo1992-78College-educatedtaxpayerswithprofessional

jobsshouldhaveinvestigatedtaxsheltersfurther

beforeinvesting.Lossesdisallowedand

penaltysustained.

Weis,94TC473(1990)Sincetaxpayerwasnotliableforthepenalty

becauseofgoodfaithrelianceonthepreparer,

theerrorswereduetothepreparer'smistakes.

Penaltynotsustained.