Reasonable reliance on your CPA could eliminate penalties

Good news for taxpayers! The Tax Court has concluded that a taxpayer’s failure to include unreported income on his return was reasonable because he relied in good faith on his tax adviser. Consequently,  no accuracy-related penalty was imposed.

There is a provision in the law that states that the accuracy-related penalty shall not apply for any portion of an underpayment if the taxpayer shows that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.

Reliance on the advice of a tax professional may establish reasonable cause and good faith. The taxpayer claiming reliance on a tax professional must prove that: (1) the adviser was a competent professional who 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.

Here are the facts of the most recent case:

Michael Thomas formed two businesses: (1) TIC Capital, LLC (TIC), an investment company that purchased real estate; and (2) TICC Property Management, LLC (TICC), a property management company supporting TIC. After purchasing real estate, TIC would resell interests in the property to investors at a profit and TICC would then manage the property. The purchase and resale of the real estate usually occurred simultaneously.

Thomas hired Don Steeves as an independent contractor to act as TIC’s chief financial officer and TICC’s managing partner. Steeves also managed the investor and broker-dealer side of TIC. Thomas had previously met Steeves when they were both working in the real estate investment business. Steeves was a certified public accountant (CPA) with a master’s degree in accounting and seven years of specialized experience working in the real estate investment business.

In addition to these duties, Steeves prepared Thomas’ returns for 2005, 2006, and 2007 (although he only signed the 2005 return). He oversaw and maintained all the books, records, bank accounts, and other financial information from which the income and expenses were derived and reported on Thomas’ returns. Steeves digitally maintained these records on his computer, and Thomas wasn’t able to readily access them. Thomas didn’t see or review the books, and he completely relied on Steeves to maintain his records and prepare his returns. In preparing Thomas’ returns, Steeves also requested and received from Thomas statements of mortgage interest, his wife’s Forms W-2 (Wage and Tax Statement), and interest income information.

In September of 2007, Steeves resigned from Thomas’s companies but continued to perform the bookkeeping until March of 2008. He also continued to act as Thomas’ accountant/representative until he was replaced in 2009.

Late in 2008, IRS selected Thomas’ 2006 and 2007 returns for audit and uncovered discrepancies and inadequacies in his business records. Once he had discovered the problems with Steeves’ accounting practices, Thomas brought his concerns to Steeves’ attention in a letter dated Dec. 12, 2008, requesting that Steeves produce the companies’ records.

In 2009, Thomas replaced Steeves as his representative in the audit examination with another CPA, who worked with IRS to reconstruct accounts and balance sheets to determine the actual amounts of income for the tax years at issue. Thomas made a number of criminal allegations against Steeves (theft, fraud, and misappropriation of funds) and eventually filed a civil lawsuit against him.

Court’s conclusion. The Tax Court found that Thomas had reasonably relied on the advice of a tax professional, and so he wasn’t liable for the accuracy-related penalty on any underpayment for 2006 or 2007. The Court determined that Thomas met the three-prong test laid out in Neonatology Associates:

  • Competent professional. The Tax Court concluded that it was reasonable for Thomas to perceive Steeves as a competent professional and to rely on him. Thomas, having worked with Steeves and been aware of his professional background and experience, exclusively relied upon him to maintain his records, handle his business financial matters, and prepare his returns. Steeves was a CPA and accountant and had seven years of experience in the same type of business as Thomas.
  • Necessary and accurate information. The Tax Court found that Thomas’ efforts were sufficient to ensure that his return preparer had adequate and accurate information. Thomas was reasonable in his reliance on Steeves to correctly and accurately prepare his books. Thomas understood that those books were used in the preparation of his 2006 and 2007 returns. In addition, he provided Steeves with all other information Steeves requested that was necessary to complete his returns, including the amounts of mortgage interest and interest income and Forms W-2
  • Good faith reliance. The Tax Court held that Thomas relied in good faith on Steeves’ judgment. Although there came a time when Thomas had doubts about the accuracy and quality of Steeves’ recordkeeping—ultimately believing him guilty of theft, fraud, and misappropriation of funds—his doubts about Steeves’ ability or honesty did not arise until sometime after the 2006 and 2007 returns were filed and IRS began an audit of those returns. At the outset of the IRS examination (even after Steeves had resigned from Thomas’ companies), Thomas continued to believe in and rely upon Steeves, to whom he gave a power of attorney to represent him before IRS.

This goes to show that hiring qualified professionals protects you when dealing with the IRS.  If you have any questions about this case or reasonable cause, please do not hesitate to contact us.

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