Lesson From The Tax Court: When 'My CPA Did It' Is No Defense To Penalties

Life is complex.  Tax shadows life.  So it is no wonder that Tax law is complex.  And the more complex a taxpayer’s financial life becomes, the more likely they will goof up.  While Congress imposes penalties for errors, it also recognizes the complexity of tax law by allowing taxpayers to avoid most penalties if they can show they had reasonable cause for their errors.  A common defense against penalties is that the taxpayer reasonably relied on the advice of a competent professional.

Sometimes, however, taxpayers think that relying on a professional to prepare the return absolves them of responsibility for any subsequent errors.  Today’s lesson puts the lie to that thought.  Relying on a CPA’s return preparation services is not the same as relying on a CPA’s advice and provides no protection from the various penalties in §6662.

In John R. Johnson, et al. v. Commissioner, T.C. Memo. 2023-116 (Sept. 13, 2023) (Judge Nega), the taxpayer was hit with §6662(b) penalties for substantially understating his income tax liabilities for four years in a row.  That’s a lot of error.  He argued that he had reasonable cause for the errors because he had used a CPA to prepare his returns and he had provided that CPA all the relevant information.  He even put his CPA on the stand.

The failure of that argument provides the lesson.  We learn that to avoid penalties taxpayer must do more than show they relied on a CPA to properly prepare the return, especially when the taxpayer is sophisticated.  Details below the fold. 

The Hierarchy Of Defenses To Penalties
Section 6662(a) imposes a penalty when a taxpayer understates their tax liability for any one of a bunch of reasons (currently 10) listed in §6662(b).  The penalty is 20% of the understatement.  There are several ways to avoid this penalty.

First, to state the obvious, if there is no understatement, then there is no penalty!  Thus a taxpayer (or representative) will naturally first try and defend the return by convincing the relevant IRS decision-maker that there was no error.  The relevant decision-maker might be a low level Tax Examiner (who start at GS-4) all the way up to a high level Revenue Agent (who top out at GS-13).  It depends on the complexity of the return and what triggers involvement of an actual IRS employee.  Those details are beyond today’s lesson.

Second, if the first defense does not work, the taxpayer can avoid penalties by showing they had either a reasonable basis or substantial authority for the position that resulted in the now-conceded error.  §6662(d)(2)(B).  Again, those details are beyond the scope of this lesson.  But they both go to the idea that if the taxpayer took a reasonable stab at dealing with some complexity in applying tax law to the facts, they should not be penalized when guidance is either missing or opaque.

Third, if that second defense does not work, the taxpayer must fall back onto a reasonable cause defense.  This basically concedes that the law was clear enough so that the taxpayer had no basis in law or fact for the error.  Nonetheless, if the taxpayer had a decent excuse for goofing up, no penalty will attach.  The legal term for decent excuse is “reasonable cause.” Specifically, §6664(c)(1) says that no §6662 penalty shall be imposed for any portion of an understatement when the taxpayer shows “there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”

Today’s lesson involves this third line of defense. Let’s take a quick look at two common, and related, ways of raising this third line of defense.

1. Substantial Compliance

Often Congress conditions a tax benefit (deduction, exclusion, credit) on the taxpayer substantiating their eligibility, but kicks to the IRS the duty to set out the rules for substantiation.  In those situations Courts sometimes permit taxpayers who do not comply 100% with the regulations to still be eligible for the tax benefit if they can show substantial compliance with the statute’s purpose.

For example, as relevant to today’s lesson, substantial compliance can be a reasonable cause defense for taxpayers who donate property to a charity and claim a resulting deduction of more than $5,000 under §170.  The statute says that such taxpayers must obtain a “qualified appraisal of such property” and attach it to the return. §170(f)(11)(C).  But then the statute kicks to the IRS the duty to create requirements for a qualified appraisal.  Id., §170(f)(11)(E).  The IRS has done so in Treas. Reg. 1.170A-13(c)(3)(ii), which sets out 11 items that an appraisal must include to be a "qualified appraisal."

If an appraisal does not strictly comply with the regulation, however, the Tax Court will still allow a taxpayer the deduction if the taxpayer substantially complied with the purpose of the statute.  See e.g. Emanouil v. Commissioner, T.C. Memo. 2020-120, where Judge Gustafson walks through the legal history of the concept of substantial compliance to explain why "the fact that a Code provision conditions the entitlement of a tax benefit upon compliance with respondent's regulation does not mean that literal as opposed to substantial compliance is mandated."  In that case, the Court found that the taxpayer had furnished sufficient information about valuation on their return even though not meeting all 11 requirements in the regulation.

Finally, even if taxpayers do not substantially comply—such as by simply failing to obtain or attach an appraisal—§170(f)(11)(A)(ii)(II) still allows them to claim the deduction (assuming they properly substantiate the valuation) if they had a good excuse for goofing up—i.e. they had a reasonable cause such as a reliance on a tax professional’s advice.

Which takes us to....

2. Reasonable Reliance

Taxpayers can establish a reasonable cause for avoiding the §6662 penalties if they can show they reasonably relied on the advice of a professional.  That is, they must show that the error was caused by their tax professional on whose advice or actions they reasonably relied.  Let’s look at that.

Treas. Reg. 1.6664-4(c) gives guidance on how the IRS and courts will evaluate a claimed reliance on a professional’s actions or advice.  For example, one very important factor listed in the regulation is the taxpayer's education, sophistication and business experience.

The Tax Court has structured its evaluation of a reasonable reliance defense into three very useful elements: (1) was the adviser a competent professional who had sufficient expertise to justify reliance, (2) did the taxpayer give the advisor accurate relevant information, and (3) did the taxpayer actually rely in good faith on the adviser's judgment?  Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), aff’d 299 F.3d 221 (3rd Cir. 2002).

As we see today, it’s this 3^rd element where the Tax Court takes into account the taxpayer’s education, sophistication, and business experience.

Facts
Technically, the case involves the joint returns of Mr. Johnson and his wife, but since he was the main player I’ll just refer to him.

The IRS audited Mr. Johnson’s 2015-2018 tax returns and found substantial errors, amounting to a total understatement of tax of about $982,000.  Additionally, the IRS proposed §6662(a) penalties for each year, totaling just under $200,000.

Three errors are relevant to today’s lesson.

First, in 2006 he bought some hotel property for $4.1 million with just over $2.1 million allocated to the two hotel buildings on it.  He sold the property in 2016 for $5 million.  However, he “improperly claimed depreciation deductions from 2006 to 2013 amounting to 100% of the value of the commercial buildings...by applying a seven-year depreciation period to the commercial buildings.”  Op. at 2-3.  He should have used the 39 year depreciation recovery period.  To fix the error, the IRS “made a section 481 method of accounting adjustment for 2015 of $1,969,976.”  Op. at 3.

Second, he double-counted his home mortgage interest deduction of $44,806 on his 2015 return, once on Schedule A and then again on Schedule E.

Third, on his 2016 return he claimed a §170 charitable donation deduction for $152,500, $2,500 for the donation of some fencing to a rehab facility and $150,000 for the contribution of a building to the Elgin Opera House in Elgin, Oregon.  The goofs here were multiple: (a) there was no contemporaneous written acknowledgment from either donee (see Lesson From The Tax Court: The Sharp Corners Of The §170 Substantiation Requirements, TaxProf Blog (May 21, 2022); (b) there was no qualified appraisal for the building donation (instead he apparently used the County Tax Assessor valuation); and (c) the Form 8283 attached to the return did not have the signatures of either an appraiser or a representative of the Elgin Opera House.

The IRS issued an NOD on July 27, 2020.  Mr. Johnson timely filed a petition in October, 2020.  Trial was had in Alaska on June 13, 2023. Mr. Johnson did not contest the errors.  He did, however, contest the §6662(a) penalties.

At the time of trial, in June 2023, Mr. Johnson had been in the business of buying, selling, and leasing real estate for some 50 years.

Lesson: Return Prep Is Not “Advice” To Avoid Penalties
The IRS argued that Mr. Johnson should not be permitted to even contest the §6662 penalties for goofing up his claimed charitable deductions.  That would be true if the goof had been to grossly overstate the value of the donated building.  §6664(c)(3).  However, as Judge Nega points out, “no evidence has been introduced about the correct valuation of the contributed property.”  Op. at 6.  Therefore, so long as the goof being penalized was the omission of required substantiation, Judge Nega allowed Mr. Johnson to argue that he had reasonable cause.

Fat lot of good it did Mr. Johnson.  He did not even try to argue substantial compliance for the §170 error.  Instead, his entire good cause argument was that he relied on his CPA return preparer for all those years.  This is basically the Turbo Tax defense as applied to a human.  “I did not commit the errors, my return preparer did!”

Using the three-part test from Neonatology that I outline above, Judge Nega finds that the CPA “was a competent professional and petitioners provided her with all the necessary and accurate information.”  Op. at 7.  Yeah, my eyebrows are twitching on that.  See Comment below.

The problem for Judge Nega was that Mr. Johnson was unable to show that the CPA did anything more than prepare the returns.  In order to win a reliance argument, taxpayers must first “establish that their CPA communicated something constituting advice.”  Op. at 7 (emphasis added)  Here, “petitioners have failed to meet their burden of establishing that they received any advice about the...the proper tax treatment of any of the understatements.”  Id. (emphasis added).  The mere fact that their CPA prepared the returns “does not mean that...she has opined on any or all of the items reported therein.” Id., quoting Neonatology).

Judge Nega gives us the lesson:

“Taxpayers have a nondelegable duty to review the return for accuracy before filing. We are unpersuaded that Mr. Johnson—a sophisticated participant in real estate transactions—would have missed the duplicate interest deductions, the grossly overstated depreciation, or the lack of a qualified appraisal if he had conducted even a cursory review of the returns.”  Op. at 8. (emphasis added).

Comment: Was This CPA Really Competent? 
I confess I do not understand why Judge Nega thought this CPA was a competent professional.  All three goofs seem really about basic stuff I teach to beginning tax students.  And if Mr. Johnson truly gave the CPA all the relevant information, then I really would question her competence.  For example, the CPA apparently testified at the trial that she never discussed with Mr. Johnson whether it was proper to use the County Tax Assessor valuation for the donated building rather than obtain a qualified appraisal.  Op. at 7.  She apparently just did it.  So that goof is all on her.  To my mind, it negated even the availability of a reasonable reliance defense.  Even if she and Mr. Johnson had discussed the matter, relying on advice from an incompetent professional is per se not reasonable.

I welcome any thoughts from readers on that.  And...should this CPA now be worried about a malpractice suit? 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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