Taxpayers, Preparers, and the Negligence Penalty
Barton, Peter, The CPA Journal
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 be accurate return solely by hiring a preparer. However, under limited circumstances, the Tax Court allows an exception to the general rule if the taxpayer be 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. …