Under Mortensen v. Commr., 440 F.3d 375, 385 (6th Cir. 2006), it was held that reasonable minds can differ over tax reporting, and under tax audits the IRS may disallow certain transactions.
The U.S. Congress was concerned that taxpayers would participate in the “audit lottery” and take questionable positions on their tax returns in the expectation of not being audited (See: H.R. Rep. No. 101-247, 1388 (1989). H.R. Rep. No. 101-247, as reprinted in 1989 U.S.C.C.A.N. 1906, 2858.
IRC Sec. 6662(b) imposes a civil penalty for substantial understatements of income, or liability overstatements (in addition, other civil penalties may be imposed for negligence and substantial valuation misstatements).
Under IRC Sec. 6064(c), no penalty will be imposed with “respect to any portion of an underpayment if it is shown that there was reasonable cause and the taxpayer acted in good faith.”
Under Treasury Regulation Section 1.6664-4(b)(1), “reasonable cause” and “good faith” require courts to review the following taxpayer issues:
5. Taxpayer reliance on a tax professional; and
6. Taxpayer’s effort to assess the taxpayer’s proper tax liability.
Under Treas. Reg. Sec. 1.6664-4(c), the IRS minimum requirements for determining whether a taxpayer reasonably relied in good faith on advice including a tax advisor’s professional opinion.
The minimum requirements include:
1. The advice must be based on all pertinent facts and circumstances and the law as it relates to those facts and circumstances;
2. The advice must not be based on unreasonable factual or legal assumptions;
3. The advice must not unreasonably rely on the representations, statements, findings or agreements of the taxpayer or any other person;
4. A taxpayer may not rely on an opinion or advice that a regulation is invalid to establish that the taxpayer acted with reasonable cause and good faith unless the taxpayer adequately disclosed that the regulation in question is invalid (Treas. Reg. Sec. 1.6662-3(c)(2).
Under Treasury Regulation Sec. 1-6664-4(b)(1), reasonable cause and good faith are not necessarily established by reliance on the advice of a professional tax advisor.
However, under Treas. Rg. Sec. 1.6664-4(b)(2), a taxpayer may satisfy the “reasonable cause” and “good faith” exception because the taxpayer believed that the tax professional had knowledge in the relevant aspects of federal tax law.
In United States v. Boyle, 469 U.S. 241, 251 (1985), the U.S. Supreme Court held:
1. Taxpayers may not be sophisticated in tax matters, and that it is unrealistic for taxpayers to recognize errors in the substantive advice of an accountant or attorney;
2. To require the taxpayer to challenge the attorney, to seek a second opinion, or to try to monitor counsel would nullify the purpose of seeking the advice of a presumed expert in the first place.
Under Sklar, Greenstein & Scheer, P.C. v. Commr., 113 T.C. 135, 144-145 (1999) citing Ellwest Stereo Theaters of Memphis, Inc. v. Commr., T.C.M. 1995-610, the Tax Court established a three-prong test to prove reasonable cause, where a taxpayer is asserting a defense against an IRC Sec. 6662 penalty:
1. The tax advisor was a competent professional who had sufficient expertise for justifying reliance;
2. The taxpayer provided necessary and accurate information to the advisor;
3. The taxpayer actually relied in good faith on the advisor’s judgment.
Under Treas. Reg. Sec.1-6664-4(b)(1), reliance on a tax advisor may be considered reasonable when the taxpayer knew that the tax advisor possessed specialized knowledge in the relevant aspects of federal tax law.
In the case Neonatology Assoc., P.A. v. Commr., 115 T.C. 43, 99 (2000), aff’d 299 F.3d 211 (3d Cir. 2002) the court held:
1. Taxpayer reliance on an insurance agent was found to be unreasonable because the insurance agent was not a tax professional;
2. The taxpayers were sophisticated and should have known that the tax benefits discussed were “too good to be true’;
3. The court rejected the evidence the taxpayers presented that they also relied on tax attorneys and accountants.
In Stanford v. Commr., 152 F3d 450 (5th Cir. 1998) the court held:
1. Taxpayer could rely on a CPA with extensive experience in international banking law for advice regarding the taxpayer’s controlled foreign corporation.
2. It was not reasonable to expect the couple to monitor their CPA to make sure he conducted sufficient research to give knowledgeable advice.
3. Intelligent investors have independent educated experts to advise them, particularly with respect to arcane matters of the law.
4. The Court vacated the penalty since the CPA was diligent in reviewing the taxpayer’s business and tax records, and studying the statute, legislative history and regulations.