In the case of LaRochelle v. Commissioner, TC Summary Opinion 2022-12[1] the taxpayers argued they should not be liable for an accuracy related penalty under IRC §6662 related to their failure to report an IRA distribution when the Form 1099-R had been sent to their former, rather than current, address. The Tax Court found, in these circumstances, that there was not reasonable cause for their failure to report the distribution despite the Form 1099-R being sent to the wrong address.

Accuracy Related Penalty for Substantial Understatement and Reasonable Cause Relief

IRC §6662(a) outlines a 20% accuracy related penalty:

(a) Imposition of penalty. If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies.

IRC §6662(b) has a list of nine circumstances in which this penalty will apply. Of concern for this case is the circumstance outlined in IRC §6662(b)(2):

(b) Portion of underpayment to which section applies. This section shall apply to the portion of any underpayment which is attributable to 1 or more of the following:

…

(2) Any substantial understatement of income tax.

A substantial understatement is defined at IRC §6662(d). The general definition is found at IRC §6662(d)(1)(A) which provides:

(d) Substantial understatement of income tax.

(1) Substantial understatement.

(A) In general. For purposes of this section, there is a substantial understatement of income tax for any taxable year if the amount of the understatement for the taxable year exceeds the greater of--

(i) 10 percent of the tax required to be shown on the return for the taxable year, or

(ii) $5,000.

And understatement itself is defined at IRC §6662(2)(A):

(2) Understatement.

(A) In general. For purposes of paragraph (1), the term "understatement" means the excess of--

(i) the amount of the tax required to be shown on the return for the taxable year, over

(ii) the amount of the tax imposed which is shown on the return, reduced by any rebate (within the meaning of section 6211(b)(2)).

The excess under the preceding sentence shall be determined without regard to items to which section 6662A applies.

This penalty does not apply if the taxpayer can meet the reasonable cause exception found at IRC §6664(c)(1):

(c) Reasonable cause exception for underpayments.

(1) In general. No penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.

Reg. §1.6664-4(b)(1) provides much more detail on what constitutes reasonable cause in such circumstances, beginning with:

(1) In general. The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances.

The regulation goes on to describe key factors that will be used to determine if a taxpayer qualifies for this relief (and which the taxpayer must demonstrate to obtain this relief) with the key one being the following:

Generally, the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.

The regulation notes that honest misunderstandings of fact or law may qualify, along with isolated errors

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. An isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith.

The regulation cautions that reliance on the advice of a professional or an information return does not necessarily demonstrate reasonable cause and good faith:

Reliance on an information return or on the advice of a professional tax advisor or an appraiser does not necessarily demonstrate reasonable cause and good faith. Similarly, reasonable cause and good faith is not necessarily indicated by reliance on facts that, unknown to the taxpayer, are incorrect. Reliance on an information return, professional advice, or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.

The regulation then discusses when such reliance on erroneous information can demonstrate reasonable cause and good faith:

For example, reliance on erroneous information (such as an error relating to the cost or adjusted basis of property, the date property was placed in service, or the amount of opening or closing inventory) inadvertently included in data compiled by the various divisions of a multidivisional corporation or in financial books and records prepared by those divisions generally indicates reasonable cause and good faith, provided the corporation employed internal controls and procedures, reasonable under the circumstances, that were designed to identify such factual errors.

Later in the same portion of the regulation the IRS addresses reliance on an information return, the item at issue today:

A taxpayer’s reliance on erroneous information reported on a Form W-2, Form 1099, or other information return indicates reasonable cause and good faith, provided the taxpayer did not know or have reason to know that the information was incorrect. Generally, a taxpayer knows, or has reason to know, that the information on an information return is incorrect if such information is inconsistent with other information reported or otherwise furnished to the taxpayer, or with the taxpayer’s knowledge of the transaction.

Fundamentally, a taxpayer cannot rely on advice or information returns to escape the penalty if the taxpayer knows or should have known the advice or information return was in error.

Facts of the Case

The Tax Court provided the following summary of the taxpayers’ move from Washington, DC to Florida, as well as the mail forwarding in place during the period in question:

During 2016 petitioners moved from Washington, D.C., to Florida. During 2017 petitioners lived in Florida, but they also owned a house in Washington, D.C. Petitioners signed up for and used mail forwarding through the U.S. Postal Service to forward mail from their Washington, D.C., house to their new residence in Florida. After starting mail forwarding, petitioners received mail at their Florida residence that had been mailed to their Washington, D.C., house, including monthly bills.[2]

The opinion continues noting the mailing of two Forms 1099-R:

Petitioners received a Form 1099–R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, from Fidelity with respect to a distribution of $60,000 during 2016 from an Individual Retirement Account (IRA). That Form 1099–R listed petitioners' address in Florida. Petitioners reported that distribution on their 2016 tax return. National Financial Services, LLC, issued a Form 1099–R to Mr. LaRochelle with respect to a distribution of $238,000 from an IRA during 2017. That Form 1099–R listed petitioners' Washington, D.C., address.[3]

The $238,000 distribution was not reported by the taxpayers on their tax return. Not surprisingly, the IRS’s computer systems noted this failure to report and issued a notice to the taxpayers:

The IRS Automated Underreporter (AUR) program detected a mismatch between the income reported on petitioners' 2017 tax return and the amount that petitioners' IRA custodian, National Financial Services, LLC, reported to the IRS. As a result the IRS issued petitioners a computer-generated CP2000 notice and proposed a deficiency stemming from the missing $238,000 IRA distribution.[4]

The taxpayers eventually conceded that the notice was correct (though after ignoring the initial notice), but asked that the penalty be waived:

Petitioners did not respond to the CP2000 notice. The IRS subsequently issued petitioners the notice of deficiency. Petitioners gave the notice of deficiency to Mr. Lander and asked him to investigate and verify the proposed deficiency. After Mr. Lander verified that the proposed deficiency was correct, petitioners paid it in full on January 27, 2020. On February 5, 2020, petitioners requested that the IRS abate the accuracy-related penalty.[5]

The IRS denied the request to abate the penalty, stating that the taxpayers had failed to establish reasonable cause for the failure to report this item.

Why the Taxpayers Failed to Show Reasonable Cause and Good Faith

The Tax Court notes that the taxpayers asked for reasonable cause relief based on the simple fact that they did not remember receiving the Form 1099-R:

Petitioners assert that they should not be liable for the penalty because they did not remember receiving the Form 1099–R for the unreported retirement distribution.[6]

However, the taxpayers did not dispute the fact that they had received the $238,000 distribution during the year, just stating that they did not recall receiving the Form 1099-R:

However, petitioners did not dispute that they received the $238,000 distribution sometime in 2017. Nonreceipt of tax information forms, such as a Form W–2, Wage and Tax Statement, or a Form 1099, does not excuse a taxpayer from his or her duty to report the income. See Du Poux v. Commissioner, T.C. Memo. 1994-448 (“[F]ailure to receive tax documents [such as Form 1099–MISC] does not excuse taxpayers from the duty to report income.”). Further, nonreceipt of a Form 1099–R does not constitute reasonable cause to prevent the application of a section 6662(a) accuracy-related penalty. See Ashmore v. Commissioner, T.C. Memo. 2016-36 (holding that any error by the company responsible for issuing the taxpayer a Form W–2 did not provide reasonable cause because the taxpayer should have known of his missing second Form W–2); Jones v. Commissioner, T.C. Memo. 2010-112 (failure to receive a Schedule K did not constitute reasonable cause where the taxpayer acknowledged she received a distribution from the entity); Brunsman v. Commissioner, T.C. Memo. 2003-291 (rejecting the reasonable cause defense where the taxpayer received only one Form 1099–MISC but knew he had held two jobs).[7]

Note that the taxpayers did not assert they were unaware that $238,000 of funds had been distributed from their retirement account in the year, just that didn’t recall receiving a Form 1099-R.

An unsophisticated taxpayer who had failed to receive a Form 1099 for income the taxpayer might not have otherwise been aware should be reported would have a better chance of prevailing on these facts, but that would be because the taxpayer was reasonably unaware that he/she had entered into a taxable transaction during the year. But the taxpayers here did not assert such facts nor does it appear likely, given both the amount of the distribution and the taxpayer’s business background, that such an argument would have been found plausible.

The taxpayers then fall back on reliance on their tax professional as showing reasonable cause for this failure. Interestingly, that same professional was representing the taxpayers before the Tax Court which may have played a role in limiting the effectiveness of this defense, though I suspect it likely had little impact.

The Court described the taxpayer’s position as follows:

Mr. LaRochelle asserted that petitioners relied on their tax professional, Mr. Lander, to handle their tax return.[8]

And then the decision goes on to outline how to evaluate that claimed reliance to see if it works to get penalty relief under the reasonable cause exception.

The decision as to whether a taxpayer acted with reasonable cause and in good faith takes 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. Thomas v. Commissioner, T.C. Memo. 2013-60, at *7; Treas. Reg. § 1.6664-4(b)(1).[9]

But the opinion found that the taxpayer failed to explain the nature of this reliance on the tax professional:

Mr. LaRochelle did not explain what was meant by petitioners’ relying upon Mr. Lander to handle their tax return.[10]

Mr. LaRochelle’s background was consulted to note that, without needing to get professional advice, he was aware of the importance of financial records and the need to keep such records, including, presumably, the need to track things like distributions he took from retirement plans that would be subject to income taxes.

Mr. LaRochelle is a sophisticated businessperson who during 2017 was the general manager of a real estate partnership, was involved in more than ten other partnerships, and was responsible for recordkeeping for those partnerships. Therefore, Mr. LaRochelle was aware of the need to keep records concerning financial receipts.[11]

A key item not provided to the tax professional was any information beyond the one $60,000 Form 1099-R related to distributions from retirement plans, thus reliance on the tax preparer to somehow realize there was this reportable item was not reasonable:

The record shows that petitioners did not provide Mr. Lander with all of the information that was necessary to prepare an accurate income tax return, namely information about the $238,000 IRA distribution that petitioners acknowledged they received, or even any information that they had an IRA account. Reliance on the professional advice of a tax return preparer does not constitute reasonable cause where the taxpayer did not provide the representative with all the information necessary to prepare an accurate income tax return. Enoch v. Commissioner, 57 T.C. 781, 802 (1972).[12]

Rather, the Court found that the taxpayers paid little attention to the preparation of their tax returns and, as well, presented no evidence they had reviewed their tax returns prior to filing:

Other than handing over most of their documents to Mr. Lander, petitioners did not appear to actively participate in the return preparation process. Further, the record does not show that petitioners reviewed the completed return before it was filed.[13]

As was noted earlier, the same person represented the taxpayers before the Tax Court as prepared the return. In a footnote the Court noted that the taxpayers had been made aware that using their preparer to represent them in the Tax Court proceeding meant the preparer could not present testimony:

Arthur Lander represents petitioners in this case. At trial the Court apprised the parties of Rule 24(g)(2)(A), which provides that “[c]ounsel may not represent a party at trial if the counsel is likely to be a necessary witness within the meaning of the ABA Model Rules of Professional Conduct,” with several narrow exceptions. Petitioners stated that Mr. Lander was not likely to be a necessary witness, and Mr. Lander did not testify.[14]

Note the key factors involved with a successful use of the defense of reliance on a tax professional to obtain reasonable cause relief is that the taxpayer both engaged the professional to provide advice on the issue at hand and provided that professional with all necessary information. The tax professional obviously testify regarding exactly what information was provided to him/her and the nature of the engagement.

Not being able to have that person testify about those items makes the reliance defense tougher to successfully argue. An adviser testifying that he/she was provided all necessary information to see if any taxable event took place for the retirement account and that he/she had advised the taxpayer only the $60,000 distribution had to be reported would have greatly helped in this case.

But that brings us to why the loss of this testimony may not have hurt the taxpayer—given the Court’s comments that Mr. LaRochelle wasn’t involved in the return process aside from turning over documents, it is very possible that the only document Mr. LaRochelle gave his preparer was the single Form 1099-R showing a $60,000 distribution. If that was the case, the professional’s testimony would not have done the taxpayer much good.

Tax Preparers and Client Expectations

The mere hiring of a tax preparer does not provide a taxpayer with an automatic reasonable cause defense against penalties. And, in this case, the Court opinion seems to suggest that all the taxpayer could show was that they paid someone who prepared their return from the information they handed over.

But tax professionals need to be aware of this belief on the part of their clients that merely hiring the professional and dropping off the documents they decided were relevant means the return they get back will contain no errors. It is important to remind clients that it is their responsibility to provide all relevant information for their return and to make use of tools the professional may provide (like questionnaires, checklists and organizers) to help insure they are aware of the information they should be providing.

It is not reasonable to assume a client knows all of the various types of information that may be relevant to assuring their tax returns properly report all income and deductions for the year in question. While it is understandable that some clients will balk at filling in questionnaires and organizers, the adviser still must find some mechanism to educate the client regarding items that could impact their tax situation that need to be provided to the professional.

[1] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/couple-liable-for-penalty-for-failure-to-report-ira-distribution/7dmyj (retrieved July 16, 2022)

[2] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[3] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[4] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[5] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[6] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[7] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[8] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[9] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[10] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[11] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[12] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[13] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022

[14] LaRochelle v. Commissioner, TC Summary Opinion 2022-12, July 12, 2022