The penalty for a substantial understatement of tax found at IRC §6662(b)(2) is triggered whenever a taxpayer faces a sufficiently large underpayment at the end of an examination. A substantial understatement exists for an individual if the understatement is greater than the greater of:

$5,000 or
10% of the tax required to be shown on the return for the taxable year.

Once the IRS establishes an underpayment that exceeds the thresholder, to escape the penalty, the taxpayer must meet one of the following criteria:

If the underpayment did not arise from a tax shelter (as defined at IRC §6662(d)(2)(C)) either:
- There was or is substantial authority for the treatment of the item or
- There was adequate disclosure (generally on a Form 8275 or Form 8275-R) and there exists or existed a reasonable basis for the position that gave rise to the underpayment (IRC §6662(d)(2)) or
There existed reasonable cause for the underpaymentm, the taxpayer acted in good faith (IRC §6664(c)) and the underpayment did not arise from a tax shelter (again as defined at IRC §6662(d)(2)(C)).

In the real world, the IRS is rarely going to agree that a position that lead to a tax underpayment had “substantial authority” and, in fact, the Courts, while not as sure that such a position does not exist, will generally conclude it won’t exist in the vast majority of cases. As well, in the real world it’s rare for the IRS to assert a penalty if there is disclosure on the return, if only because their burden to sustain the penalty becomes very difficult—they have to prove there was not a reasonable basis for the position.

For that reason the “reasonable cause” exception found at IRC §6662(d)(2)(C) is the one most often litigated in court cases—and that was true in the case of Whitsett v. Commissioner, TC Memo 2017-100.

There certainly existed a major understatement of tax in this case, along with a series of mistakes regarding the proper year in which the taxable event took place. The taxpayer had failed to report a gain of $1,076,038 in her 2012 income tax return, although she had paid what she thought was the tax due with a request for extension filed for her 2011 return—though, as she later discovered, that 2011 return was never actually filed.

The taxpayer had engaged her long-time tax preparer to prepare her 2011 and 2012 income tax returns. The preparer had been preparing Dr. Whitsett’s taxes for many years. She knew he had been providing tax preparation services for more than 25 years, and before starting his own firm in 1995 he had worked for several small firms. He prepared, on average, 100-125 returns per year, primarily for doctors and dentists. Dr. Whitsett had never had any serious problems with the IRS that arose from returns that she filed that had been prepared by this individual in the past.

Dr. Whitsett had acquired shares in a company that was being acquired by another entity. She had paid $11,000 for those shares and now was offered over $1,000,000 for her shares. She accepted the offer and informed her preparer of this fact. She received a document from the buyer’s agent, Computershare Trust Co., along with the check for her shares labeled “Corporate Action Advice.”

The document stated that the “payment date” was August 19, 2011 and the tax year was 2012. They also included a letter dated January 9, 2012 indicating her sale was “processed” as of January 4, 2012. She provided these documents to her preparer to be used in preparing her tax return for 2011.

The preparer advised her:

The sale should be reported on her 2011 income tax return (a conclusion that was incorrect—the sale actually took place in 2012 when payment was made);
Her basis was $639,437, which was the total of the $11,000 she had originally paid and $628,437 of dividends the advisers erroneously concluded, by looking at prior year’s tax returns, had been reinvested;
He needed extra time to prepare her return (this was true), and so she needed to pay $154,776 with the extension, which she did and
When he finally completed the return in February 2013, he advised her that he was going to electronically file the return for her (but it turns out it never actually got filed) and gave her a Form 1040-V to send in with a check for $5,393 which she paid.

The taxpayer again engaged the preparer to handle her 2012 returns. Sometime in early 2012 she received a Form 1099-B from Computershare showing the sales proceeds being reportable on her 2012 return. She sent this to her preparer along with a filled in organizer, along with a letter noting that she believed she had sold the stock in 2011. Again she filed for an extension of time to file the tax return.

The preparer determined that no gain should be reported in 2012, presumably holding to his prior conclusion that this was a 2011 tax event. Thus, no sale was reported on her 2012 income tax return which was again filed late in November 2013.

In December of 2013 Dr. Whitsett received her first (but not to be her last) notice from the IRS, a Form CP80 indicating that the IRS had a credit of $165,562 on her account for 2011 but that no 2011 return had been filed. She wrote the IRS indicating her belief that the return had been electronically filed by her prepare and send along a copy of the 2011 return she believed had been filed.

She asked her preparer in January 2014 if she should the IRS another copy of the 2011 return for processing, and was assured that this was not necessary, as her return had been electronically filed. In October of 2014 the IRS sent Dr. Whitliff another CP80 form again showing a large credit balance and stating (correctly) that no 2011 return had been filed. On October 18, 2014 she responded to this notice, again stating that her 2011 return had been electronically.

Nine days later the IRS issued a CP2000 notice on Dr. Whitliff’s 2012 income tax return, noting the missing sales proceeds of $1,717,038 on this return and advising the doctor she had a balance due of $680,086. This letter worried the taxpayer, so she sent the preparer both notices and asked him what was going on. He responded by asking her to execute a power of attorney, which she apparently did.

Over the next few months, the preparer assured Dr. Whitliff by email that he was talking with the IRS about her 2011 and 2012 returns. Finally, in an email dated February 2, 2015, the preparer indicated that he had now concluded the sales proceeds really should have been reported in 2012 and that he would prepare amended income tax returns for her to file on paper with the IRS. However, he never actually provided her with these promised returns.

In April of 2015 the IRS, having not heard from anyone on the CP2000 issue, issued a notice of deficiency for 2012, looking for $541,522 of tax and an accuracy related penalty of $107,995. At this point Dr. Whitliff decided something has gone very wrong, and she sought the advice of an attorney who prepared a 2011 Form 1040 that did not report the sale which was filed with the IRS and showed a refund due which was requested to be applied to the 2012 tax. The attorney also prepared a petition before the Tax Court for 2012 to redetermine the deficiency and penalty.

Prior to trial the IRS and the taxpayer agreed on the tax due for 2012, so the only item left for the Tax Court to deal with was the penalty. Clearly the underpayment was well over the trigger level for a substantial understatement and the taxpayer did not argue that there existed substantial authority for her position. Rather she argued that the penalty should not apply based on the reasonable cause exception found at IRC, specifically arguing that she had reasonably relied upon the advice of her preparer as discussed at Reg. §1.6664-4(c).

The Court first looked the basic issue of whether the taxpayer acted in good faith—since without good faith, reliance on a professional will not be an effective defense. The IRS contended the taxpayer should have known from the documents she received from Computershare that the gain should have been reported on the 2012 return. But the Tax Court disagreed—while the taxpayer was a highly educated individual, she did not have special expertise in taxation and the documents were, at best, confusing.

So, she acted reasonably by referring the question of the proper year of inclusion to her tax adviser. And, as the Court pointed out, she sought this advice even though it would have been to her advantage (based on the time value of money) to delay reporting the gain until 2012. So her request for advice was a genuine attempt to comply with the law, not an attempt to get a “better than she should obtain” result.

The Tax Court outlined, in the case of Neonatology Associates, PA v. Commissioner, 115 TC 43, 99, three criteria the taxpayer must show to justify relief based on reliance on the advice of a tax professional:

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 IRS first tried to argue that the large number of errors made by the professional meant that the taxpayer could not meet the first test. But the Court notes that if there weren’t errors made by a professional in giving advice, the question of reasonable reliance would likely never come up. Rather, the question was whether Dr. Whitliff, given her education and background, reasonably (even if erroneously ultimately) believed her long-time preparer was competent and had sufficient expertise to handle this matter. The Court found, based on years of interactions with the adviser, knowledge of his background and no prior significant issues with returns he had prepared, that her reliance was justified.

The taxpayer also clearly provided the adviser with all information she received, forwarding documents to the preparer as she received them as she believed they were relevant to obtaining proper advice. She had approached him shortly after she received the check specifically to obtain information on reporting. At no time did the adviser lack the information necessary to provide proper advice.

Finally, the Court found her reliance on his advice was reasonable. The Court noted that the advice she received was not “too good to be true” advice that she should have realized was likely in error.

Quite the contrary: As noted previously, Mr. Whittemore’s advice (to report the gain in 2011 rather than 2012) was contrary to petitioner’s economic interest, but she nevertheless accepted it. In our view, this constitutes proof positive of her good faith.

But, the IRS protested, what about that $600,000+ overstatement of her basis—shouldn’t that have tipped her off about relying on this advisers’s advice? The Tax Court disagreed, nothing in a footnote:

The original 4,000 shares had been purchased in 1982; she had acquired them from her ex-husband in 1998; and they had mushroomed to 63,594 shares because of stock splits and (Mr. Whittemore erroneously told her) reinvested dividends. Petitioner did not have records going back 30 years, and she had no knowledge of how “basis” in corporate stock should be computed under these circumstances. She reasonably left this determination to her tax adviser and reasonably relied on his advice.