While the Fifth Circuit Court of Appeals upheld the Tax Court’s decision regarding the amount of tax owed by the taxpayer in the case of Ray v. Commissioner, Docket No. 20-60004, CA5,[1] the panel overruled the Tax Court on the issue of penalties and found that the taxpayer had a reasonable basis for a portion of his substantial understatement of tax on the return in question.

A penalty under IRC §6662, such as the substantial understatement penalty for income taxes, is waived if the taxpayer can demonstrate:

• Reasonable cause for the underpayment and

• The taxpayer acted with good faith with regard to the underpayment.[2]

In this case, the Fifth Circuit Court of Appeals agreed with the Tax Court that the taxpayer’s legal expenses related to litigation that traced back to trading activities conducted with his ex-spouse in the 1990s did not arise from a trade or business.  Thus, they were deductible only under IRC §212 as an expense related to the production of income rather than under IRC §162 as an expense related to a trade or business.

Not surprisingly, the taxpayer faced a greater tax liability when the expenses were deducted under IRC §212 than when they were deducted under IRC §162.  In 2014 the lower benefits arose because:

• IRC §212 expenses are only deductible as a miscellaneous itemized deduction, requiring the taxpayer to itemize deductions and then also having to reduce the total deduction for miscellaneous itemized deductions by 2% of adjusted gross income for the year and

• Such expenses were not deductible at all in computing the alternative minimum tax.

Today the result is even worse, since IRC §67(g) added by the Tax Cuts and Jobs Act in 2017 completely denies individual taxpayers the benefit of any miscellaneous itemized deductions.

But even though the panel found that the Tax Court arrived at the correct decision regarding these expenses being deductible under IRC §212, the panel found that the taxpayer had reasonable cause to claim the deduction as a trade or business expense based on a settlement with the IRS of an issue related to this trading activity in 1997.

The Court describes the 1997 IRS exam and settlement as follows:

Ames deducted his trading agreement losses as a Schedule C business loss on his 1993 tax return. The Internal Revenue Service (IRS) disallowed the deduction and sent Ames a notice of deficiency. Ames disputed the IRS's deficiency determination in the U.S. Tax Court, and he and the IRS eventually reached a settlement, which was entered by the Tax Court on December 16, 1997 as a stipulated decision “[p]ursuant to the agreement of the parties.” Under the stipulated decision, Ames was charged a deficiency of $88,926.42 for the 1993 tax year and was still allowed to deduct $374,102.00 as a Schedule C business loss labeled “Futures Trader.”[3]

The taxpayer argued that, based on that agreement, he believed the IRS had agreed that the activity was a trade or business.

But the IRS argued that this agreement was simply a way to settle the issue as a compromise, thus:

…the 1997 stipulated Tax Court decision was entered pursuant to the agreement of the parties, and thus the issue of whether the trading agreement loss was a deductible business loss was not actually litigated. In response to Ray’s alternative argument on the merits of § 162(a) deductibility, the Commissioner avers that Ray did not carry on the trading venture as a trade or business and was nothing more than an investor.[4]

The Tax Court agreed with the IRS that the taxpayer could not reasonably rely on that settlement to take the position the activity was a trade or business, finding “Ray’s reliance on the 1997 stipulated Tax Court decision was unreasonable, as the stipulated decision “does not state or give rise to an inference that petitioner was involved in a computer programming business as he claims here[.]”[5]

The appellate panel described the reasonable cause exception as follows:

An accuracy-related penalty does not apply to any portion of a taxpayer’s underpayment for which the taxpayer had “reasonable cause” and acted in good faith. I.R.C. § 6664(c)(1). The taxpayer bears the burden of proving entitlement to the reasonable cause and good faith defense. Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 548 (5th Cir. 2009); accord Brinkley, 808 F.3d at 668. The assessment of whether the taxpayer has met this burden is “made on a case-by-case basis, taking into account all pertinent facts and circumstances.” Treas. Reg. § 1.6664-4(b)(1); Brinkley, 808 F.3d at 669. “Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” Treas. Reg. § 1.6664-4(b)(1). “The most important factor[,]” however, “is the extent of the taxpayer’s effort to assess his proper liability in light of all the circumstances.” Klamath, 568 F.3d at 548.[6]

The panel concludes the Tax Court erred when concluding this did not represent reasonable cause for Mr. Ray:

The Commissioner is correct that the stipulated Tax Court decision related solely to Ray’s trading agreement losses and not to Christina Ray’s indebtedness. As discussed, Ray has failed to show that the claims underlying his first cause of action in Ray I are related to the trading agreement venture. However, the 1997 stipulated Tax Court decision is related to the characterization of the trading agreement losses, which implicates the portion of the accuracy-related penalty that was imposed on the difference in the amounts Ray would be allowed to deduct for the relevant legal expenses if they were deductible under § 162(a) rather than § 212. Given the IRS’s prior position regarding Ray’s trading agreement venture, and considering the particular facts and circumstances of this case, it was reasonable for Ray to have relied upon the stipulated decision in assessing whether his legal expenses could be deducted under § 162(a) as a Schedule C business loss. We conclude that Ray is entitled to a reasonable cause and good faith defense for his understatement attributable to deducting his trading agreement legal fees under § 162(a) rather than § 212.[7]

Note that this holding is based on Mr. Ray’s particular situation. An individual tax professional who had decades of experience in tax controversy matters might find that the Court would find his knowledge of the status of such a stipulated decision could make that person’s reliance on the same stipulated decisions not undertaken in good faith, and thus not make the reasonable cause exception available.  But Mr. Ray had no such expertise.

[1] Ray v. Commissioner, Docket No. 20-60004, CA5, September 14, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/fifth-circuit-affirms-tax-court-on-deficiency-but-not-penalty/784j0 (retrieved September 15, 2021)

[2] IRC §6664(c)(1)

[3] Ray v. Commissioner, Docket No. 20-60004, CA5, September 14, 2021

[4] Ray v. Commissioner, Docket No. 20-60004, CA5, September 14, 2021

[5] Ray v. Commissioner, Docket No. 20-60004, CA5, September 14, 2021

[6] Ray v. Commissioner, Docket No. 20-60004, CA5, September 14, 2021

[7] Ray v. Commissioner, Docket No. 20-60004, CA5, September 14, 2021