In the case of Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion)[1] the taxpayers argued that they should not be subjected to penalties for understating their tax due to the fact they failed to notice their tax software only worked with full dollar amounts. Because of this, they overstated their mortgage interest deduction by factor of 100.

This taxpayer was preparing the couple’s return using consumer tax return preparation software:

Candice Busch prepared the return using a popular version of return preparation software. According to petitioners, the program allows only for the entry of items of income and deduction in whole dollar amounts, that is, it does not allow for the entry of cents, or numbers to the right of the decimal point.[2]

The mortgage interest entry error she made was entering the cents portion of the interest listed on the Form 1098 she received:

Petitioners paid $21,201.25 of mortgage interest during 2017, and they are entitled to a mortgage interest deduction in that amount for that year. That being so, when Mrs. Busch entered $21,201.25, on the line for the deduction for mortgage interest, the deduction was shown as $2,120,125 instead. The overstated deduction is taken into account in the computation of petitioners’ taxable income and Federal income tax, both shown as zero on the return, which in turn resulted in the refund of all of the Federal income tax withheld from both of their wage incomes over the course of 2017.[3]

Apparently neither taxpayer questioned why they were getting a refund of the entire amount of taxes paid in during 2017, and simply filed the return asking for all of their wage withholdings back.

The IRS, not surprisingly, noticed this error when matching up the Form 1098 with what was reported on the taxpayers’ return and issued a notice of deficiency which included the 20% accuracy related penalty:

The correct amount of their mortgage interest deduction is taken into account in the computation of the deficiency shown in the notice. Petitioners now concede that deficiency.[4]

The taxpayers, while fine with the tax shown as due, complained they should not have to pay the accuracy related penalty equal to 20% of the deficiency, while the IRS believed that the penalty was appropriate in the circumstances:

We are called upon to decide whether they should be held liable for the accuracy-related penalty imposed in the notice. According to petitioners, the overstatement was due to an "honest" mistake, and they should not be penalized for that mistake. According to respondent, imposition of the penalty is appropriate under the circumstances.[5]

The penalty in question here is the substantial understatement penalty:

As relevant here, section 6662(a) imposes a penalty of 20% of the portion of an underpayment of tax attributable to the taxpayer's substantial understatement of income tax. Sec. 6662(a) and (b)(2). In this case the underpayment of tax, as defined in section 6664(a), is equal to and computed in the same manner as the deficiency, see sec. 6211, and that underpayment of tax is a substantial understatement of income tax because it exceeds the greater of $5,000 or 10% of the amount of tax required to have been shown on petitioners' 2017 return, see sec. 6662(d)(1)(A).[6]

As the tax due was in excess of the level necessary to trigger this penalty, the burden now shifted to the taxpayers to demonstrate there was reasonable cause for the understatement per IRC §6664(c)(1). The question was whether the taxpayers had reasonable cause given the error arose from the data entry issue the taxpayer had with the software program.

According to petitioners, they should not be liable for the penalty because the overstatement of their home mortgage interest deduction was due to a return preparation software feature or limitation that resulted in an unnoticed error made by Mrs. Busch after the amount of mortgage interest was entered in the program. According to petitioners, the penalty should not apply to any portion of the underpayment of tax. As they see, they had reasonable cause and acted in good faith with respect to the entire amount of the underpayment of tax that resulted from the mistaken entry.[7]

The Court begins by recognizing that there are situations of reasonable cause for an understatement due to an entry error or software issue.

They ask the Court to recognize, as they point out that honest mistakes are sometimes made. As a general proposition of life, we agree with petitioners on the point, and we further agree with petitioners’ suggestion that not every mistake made on a Federal income tax return should result in the imposition of an accuracy-related penalty. A person preparing a return might understandably get distracted while doing so and enter the wrong amount for an item, or if not distracted, when transferring numbers from one document to another, transpositions often occur. If a computer-based software program is being used in the process, the limitations and requirements of a software program might not be fully appreciated by the user. Any number of situations could cause an “honest” mistake to be made when amounts are incorrectly reported on a Federal income tax return.[8]

But that mistake, by itself, would not constitute reasonable cause if the error is one that should have been noticed by the taxpayer when reviewing the return before signing:

But petitioners’ focus on the erroneous entry as the “mistake”, and their explanation describing how the mistake occurred, misses the point. The mistaken entry is not the real problem. Their mistake was failing to review the return carefully enough to have recognized the erroneous entry before the return was filed. After all, it should go without saying, that a taxpayer’s obligation to prepare and file a Federal income tax return includes the duty to review that return to ensure that the information reported or shown on the return is accurate before the return is filed.[9]

And here is where the Court found that the return produced by the software clearly showed an amount of interest deduction that the taxpayer should have immediately realized was wildly overstated had they looked at Schedule A.

The deduction for mortgage interest shown on the return occupies at least two additional columns to the left of any other number shown on the page of the return where the deduction is claimed. Looking up and down the columns showing other items reported on the return, the mortgage interest deduction sticks out, as the saying goes, “like a sore thumb”. A careful review of the return after it was prepared would most certainly have caught the error; actually, even as little as a quick glance at the return probably would have done so.[10]

As the taxpayers had tacitly admitted in the case, they had not reviewed the return before it was submitted—and that failure is not one that a party taking reasonable care to assure they had accurately computed the proper amount of tax due would have allowed to happen.

At trial petitioners more or less acknowledge that they failed to carefully review the return before it was forwarded to the Internal Revenue Service. It was a mistake for petitioners not to review the return carefully, or as recollected by one of them, not to review it at all after it was prepared. Their failure to review the return carefully was a careless mistake that completely undermines their claim that they acted with reasonable cause and in good faith with respect to the underpayment of tax that, as it turned out, resulted from that failure.[11]

Note that the same requirement applies to taxpayers who have their return prepared by a tax professional, something that the Tax Court had pointed out in the past. But at least in that case the taxpayers likely have some recourse against the professional who would have allowed the return to be released to the client with this sort of obvious error on the return.

So even though this is just a bench opinion (and thus not precedential), it does point out a key responsibility all taxpayers have.

[1] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/failure-to-review-return-undermines-couple%e2%80%99s-penalty-defense/7d76f (retrieved February 27, 2022)

[2] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[3] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[4] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[5] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[6] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[7] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[8] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[9] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[10] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022

[11] Busch v. Commissioner, Tax Court Docket No. 14085-20S (Bench Opinion), February 25, 2022