Yes, There Are Defenses To Tax Penalties
The Internal Revenue Code (the “Code”) contains numerous penalties. These penalties breakdown into “Non-willful” and “Willful”. This article focuses on “Non-willful” penalties.
The most common “Non-willful” penalty is the “accuracy related penalty” also known as the “negligence ” penalty , sec 6662(a). This section imposes a 20% penalty on the portion of the underpayment of tax attributable to any substantial understatement of income tax or negligence or disregard of rules or regulations. Sec. 6662(a) and (b)(1) and (2). Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Code; and disregard includes any careless, reckless, or intentional disregard. Sec. 6662(c). The accuracy related penalty is subject to defenses. This article discusses those defenses.
The IRS has the initial burden of production to show that the understatement of income tax was substantial. Sec.7491(c). This is a math question: An understatement of income tax is substantial if it exceeds the greater of $5,000 or “10 percent of the tax required to be shown on the return.” Sec. 6662(d)(1)(A). Once the math question is answered the burden shifts to the taxpayer . The taxpayer has to show that there was “substantial authority” or that they acted with reasonable cause and in good faith. See secs. 6662(d)(2)(B)(i), 6664(c)(1); sec. 1.6664-4(a), Income Tax Regulations. Good faith includes Reliance on Professional advice.
Reliance on an adviser is reasonable if:
• the adviser was a competent professional who had sufficient expertise to justify reliance;
• the taxpayer provided necessary and accurate information to the adviser; and
• the taxpayer actually relied in good faith on the adviser’s judgment.
The adviser must be independent, meaning, a taxpayer cannot reasonably rely on a “Promoter” or adviser to a “Promoter” as these persons are not truly independent. A promoter is “an adviser who participated in structuring the transaction or is otherwise related to, has an interest in, or profits from the transaction.” This is a point where a lot of taxpayers fall short. It is often the case that a taxpayer is “pitched” an investment product that includes tax benefits that are often very attractive. (Examples include, Private Placement Life Insurance offered by off-shore agents; numbered and unreported foreign financial accounts, including in some cases cryptocurrency accounts, and captive insurance).
I have found in the course of my practice, that most taxpayers do not contact professionals with the requisite experience and training to competently evaluate these complex products in advance of making the investment decision. Instead, they rely on the promotional material, which may include a legal opinion addressed to the Promoter. These opinions are often based upon “assumed facts” and may or may not cover all the important issues to the taxpayer. Further, there is no attorney-client relationship between the taxpayer and the issuing firm. So what is a taxpayer to do? When in doubt DISCLOSE!
Taxpayers can disclose their investment using Disclosure Statement, Form 8275. A Disclosure Statement should be drafted by an attorney retained by the taxpayer and be based on a complete review of the facts and circumstances. The investment in a skilled lawyer who drafts a competent disclosure statement can be worth its weight in penalties NOT asserted and therefore not paid. The alternative is to run the risk of not disclosing and litigating the penalty. It should be obvious, that the odds of succeeding are not in favor of the taxpayers who choose this approach. We are here to help.