Small Business Taxes & Management^TM--Copyright 2013, A/N Group, Inc.

The accuracy-related penalty applies if there's a substantial understatement of income tax on your return. The understatement is substantial if it's more than the greater of 10 percent of the tax required to be shown on the return for the year or $5,000. The penalty can also be imposed for negligence defined as any careless, reckless or intentional disregard of the rules or regulations or any failure to make a reasonable attempt to comply with the tax law. (The penalty can be imposed for some other, less frequently encountered reasons.)

The IRS routinely imposes the penalty if it applies. It's rare for a taxpayer to escape the penalty if he or she prepares their own return. You've got a better chance of avoiding the penalty if you can show you relied on a competent professional. But even here you'd have to meet several requirements and avoiding the penalty isn't guaranteed. Among other factors, you'll have to show you relied on the professional and you wouldn't have been expected to spot the error when you reviewed your return. For example, on your Schedule C the preparer deducted an expense that should have been capitalized. It was highly unlikely a nonprofessional would have noticed the error.

In the case of Gary W. Andersen and Linda C. Andersen (T.C. Summ. Op. 2013-100) the wife worked as a registered nurse on a part-time basis. For the year she earned $28,446. This was the amount omitted from the taxpayers' income. Her husband received a fixed salary with a potential for bonuses creating the possibility his income would fluctuate from year to year. They had been married for 47 years and filed joint returns during that time. The Court noted that overall they had a 50-year history of filing timely returns they were all accepted as filed by the IRS.

The taxpayers saw their tax situation as fairly complex. They received income from multiple sources including two S corporations. The taxpayers kept good records and had a system of keeping track of documents needed for their return. They gave their records to a CPA who was an accountant for 20 years and a CPA for most of that period.

Mrs. Andersen was used to receiving a paper W-2. In 2010, the year at issue, the payroll agent discontinued that method, making the W-2 available only electronically over the internet. She received no notice of the change and no paper copy of the W-2. When the taxpayers presented the information to the tax preparer, they didn't realize they were missing the W-2.

The CPA didn't question the missing W-2 because the taxpayers had discussed Mrs. Andersen's plans to retire when the return for the prior year was being prepared. In addition, there was a Form 1099-R reporting a small distribution from a nonemployer payor. The return, without the missing W-2, showed wages of $87,631 and total income (and AGI) of $153,225. When the taxpayers reviewed the completed return for major deviations in income or apparent discrepancies compared to the prior year. Since the AGI on each return was within $1,000 and there were no anomalies, the absence of the W-2 went unnoticed.

On receiving the notice of deficiency from the IRS, the taxpayers were perplexed and telephoned their CPA the same day. The CPA confirmed the IRS was correct. Within one week of receiving the notice of deficiency the taxpayers paid the deficiency and associated interest and filed a petition challenging the accuracy-related penalty.

The Court noted that Sec. 7491(c) places the burden of production on the IRS requiring it to come forward with sufficient evidence indicating it is appropriate to impose the penalty. The taxpayer must then come forward with persuasive evidence that the IRS's determination is incorrect. The law provides an exception to the penalty if the taxpayer establishes that there was a reasonable cause and he acted in good faith. Whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account the pertinent facts and circumstances, including the taxpayer's knowledge, education, and experience, as well as the taxpayer's reliance on professional advice. Generally the most important factor is the extent of the taxpayer's effort to assess his or her proper tax liability.

The Court noted he testimony of both of the taxpayers was straightforward and fully credible. They admitted they made a mistake. When cross-examined by the IRS's counsel, they were not defensive or argumentative, but rather direct and forthright, striking the Court as trustworthy individuals who play by the rules and take their tax responsibilities very seriously. Their 50-year history of filing accepted returns reinforced that impression.

That the taxpayers acted with reasonable cause and in good faith was also demonstrated by the fact they hired a CPA to prepare their returns and actively participated in the return preparation process by maintaining a system to keep track of their records. The oversight of the missing W-2 was at least partially understandable by the Court, given the lack of notice and the change after so many years. The Court also noted that the CPA was a highly credentialed tax professional and, had he not proceeded on the mistaken impression about Mrs. Andersen's retirement, the income would never have gone missing from the return. Finally, the Court found the taxpayers' quick attention to the notice and the payment of the deficiency a sign of good faith.

The Court admitted this was as an exceptionally close case. However, after weighing the evidence it felt the balance shifted in the taxpayers' favor. The Court held the taxpayers were not liable for the accuracy related penalty.

The case is interesting in that despite what would appear to be a good position for the taxpayers, the Court found the decision a close one. A good track record definitely helps, but few taxpayers are likely to be able to show a 50-year history of filing on time with all returns accepted as filed. The use of a competent tax professional, credible testimony, and the demonstration of a recordkeeping system certainly helped.

Is it worth going to court to fight the penalty? Consider your facts against this case. Talk to your tax professional. The taxpayers represented themselves in court. This was a Tax Court Summary Opinion and cannot be cited as precedent.

--Last Update 12/24/13