In Johnson v. Commissioner,[1] the taxpayer conceded multiple errors on the returns in question but opted for litigation solely to contest the 20% accuracy-related penalty under IRC §6662(a). The taxpayer argued that the penalty was unwarranted due to their reasonable reliance on the advice of the CPA who prepared the returns, which led to the erroneous positions taken.

Unfortunately for the taxpayer, his extensive experience in the real estate industry, spanning over half a century, counted against him in court. The Court concluded that, had he reviewed the returns before filing, he should have identified most of these errors. Furthermore, he failed to demonstrate that the CPA had actually advised him on any of the disputed positions.

The Errors Conceded to Exist on the Returns

As previously mentioned, the taxpayers did not dispute the presence of significant errors on their returns, leading to a tax deficiency of just under $1,000,000 for the years 2015-2018, before accounting for any interest or penalties.

Using a 7 Year Life on Commercial Real Estate for Depreciation Purposes

The most substantial portion of the adjustment stemmed from the taxpayers’ use of a seven-year life to depreciate a building they had acquired in 2006. As the Court observed:

The Johnsons improperly claimed depreciation deductions from 2006 to 2013 amounting to 100% of the value of the commercial buildings (Lawton Best Western and Lawton Extended Stay) on the Lawton hotel property. They accomplished this by applying a seven-year depreciation period to the commercial buildings, which should have been subject to a 39-year depreciation period. This amounted to a total depreciation deduction of $2,120,250 between 2006 and 2013, while the correct method would have yielded a total deduction over that period of only $595,811. The correct 39-year depreciation period would have produced a deduction of $54,364 for each full year. The method the Johnsons actually used produced a deduction of $519,249 for 2007 alone with deductions for other years varying between $94,563 and $370,832 according to the MACRS seven-year method. They sold the Lawton Hotel property in 2016 for $5 million.[2]

Some readers might question the significance of this error, especially since the excess depreciation was claimed in years no longer subject to assessment under the statute of limitations, and the building was fully depreciated by 2015—the first year covered by this case. However, the use of an incorrect depreciation life is considered an improper accounting method. Consequently, IRC §481 mandates an adjustment under §481(a) to recapture depreciation that should not have been claimed prior to the year in which the accounting method change is made, which in this case was 2015.

As the opinion notes:

Because of the Johnsons’ improper depreciation deductions claimed between 2006 and 2013, respondent made a section 481 method of accounting adjustment for 2015 of $1,969,976. Since the depreciation adjustment affected their basis in the Lawton Hotel property at the time of sale in 2016, respondent adjusted the amount of gain that they realized on the 2016 disposition of the Lawton Hotel.[3]

Charitable Contribution Deduction Claimed Without Proper Documentation

The second most significant adjustment involved two non-cash charitable contributions claimed by the taxpayers on their 2015 income tax return. The first was a building valued at $150,000, and the second was fencing valued at $2,500. IRC §170 sets forth a variety of documentation requirements that must be strictly adhered to when claiming a charitable contribution.

For any donation of $250 or more, IRC §170(f)(8) stipulates that the taxpayer must obtain a contemporaneous written acknowledgment from the charity, containing specific information. This acknowledgment must be received prior to the earlier of the return’s due date or the date the taxpayer actually files their return.

For property donations valued at over $5,000, IRC §170(f)(11)© mandates that the taxpayer secure a qualified appraisal, unless one of a very limited number of specific exceptions applies. In this case, none of these exceptions were applicable.

If either requirement is not met, the taxpayer will not be allowed to claim a charitable contribution deduction. The opinion highlighted that the taxpayers failed to comply with either of these rules.

Furthermore, for 2015 the Johnsons claimed a charitable contributions deduction of $152,500. They attached an incomplete Form 8283, Noncash Charitable Contributions, specifying that $2,500 of this deduction was attributable to a donation of fencing to Ka Hale Pomaikai, a rehabilitation center in Hawaii, and $150,000 to the donation of a building to the Elgin Opera House in Oregon. They did not obtain a qualified appraisal for the donation of the building. The recipient of the building did not sign the Form 8283. They did not submit a contemporaneous written acknowledgment or receipt from either recipient as part of the 2015 return or at trial. The portions of Form 8283 that call for the signature of an appraiser and the signature of a representative of the Elgin Opera House were left blank. The submitted form describes the donated property as “Building” without any further identifying information and describes the condition of the property as “Good used.”[4]

Claiming the Same Interest Deduction Twice on the Return

The taxpayers also erroneously duplicated a deduction for interest paid, claiming it as home mortgage interest on Schedule A and again on Schedule E.

For 2015 the Johnsons properly claimed a home mortgage interest deduction of $44,806 on Schedule A, Itemized Deductions. They also claimed the same $44,806 on Schedule E, Supplemental Income and Loss, as mortgage interest related to a commercial property in Valdez, Alaska.[5]

Needless to say, the taxpayers cannot claim a deduction for the same interest twice; they must instead be content with claiming the benefit of this deduction solely on Schedule A.

Misreporting Their Social Security Income

The least significant obvious error detailed by the court is an error in reporting their Social Security benefits for 2015.

Also in 2015 they misreported their Social Security income as $30,813 instead of $35,492 as shown on their SSA-1099, Social Security Benefit Statement.[6]

Penalties and the Reasonable Cause Defense

As the taxpayers had conceded that the above adjustments were properly made by the IRS, the only remaining question was if the taxpayers owned penalties under IRC §6662. IRC §6662 imposes a 20% accuracy related penalty on certain understatements.

The IRS argued that all of the understatements should incur a penalty under the provisions of IRC §6662(b)(1) for negligence or disregard of rules or regulations. The Tax Court concurred, stating that the IRS had demonstrated such negligence or disregard of the rules or regulations:

Respondent has established negligence and disregard of the rules and regulations with respect to the entire underpayment for each year at issue for reasons including, but not limited to, using an improper depreciation method, inaccurately reporting Social Security income, claiming duplicate mortgage interest deductions, and lacking proper substantiation and qualified appraisals for the charitable contributions.[7]

IRC §6662(b)(2) offers a second basis for applying the accuracy-related penalty under IRC §6662 when taxpayers have understated their tax by more than 10% of the amount required to be shown on the return. The Court observed that the conceded tax liabilities exceeded this threshold, thereby making this second justification applicable as well.

In addition, assuming Rule 155 computations confirm substantial understatements of income tax for the years at issue, respondent has met his burden of producing evidence that the petitioners substantially understated their income tax within the meaning of section 6662(b)(2).[8]

In both of these scenarios, taxpayers have the potential to avoid the penalty by demonstrating that they had reasonable cause and acted in good faith with regard to the disputed positions, as per IRC §6664(c)(1).

However, the IRS contended that the taxpayer's charitable contribution had violated IRC §6662(e) by being grossly or substantially overvalued—a condition met if the claimed value exceeds 150% or 200% of its accurate value. If this provision applies, IRC §6664(c)(3) precludes the use of the reasonable cause/good faith exception for the tax attributable to the valuation overstatement. The Court determined that, since neither party had produced evidence regarding the property's value, the IRS had not fulfilled the requirements to impose the penalty on the charitable contributions under this provision.

Section 6664(c)(3) disallows the reasonable cause defense for a charitable contribution deduction as long as the contributed property is substantially or grossly overvalued — defined as valuing the property in excess of 150% or 200% of its accurate value. §6662(e), (h). Since no evidence has been introduced about the correct valuation of the contributed property, we are unable to conclude that the property was substantially or grossly overvalued. Accordingly, section 6664(c)(3) does not apply, and the reasonable cause and good faith defense in section 6664(c)(1) is available to petitioners with respect to the penalties arising from the denied charitable contribution deductions for 2015.[9]

The Court then shifted its focus to assess whether some or all of the penalty could be waived due to the taxpayers having reasonable cause and acting in good faith. Specifically, the Court examined whether the taxpayers had justifiably relied on their CPA who prepared the return.

The opinion starts by outlining the criteria that taxpayers must meet to demonstrate that they reasonably and in good faith relied upon the advice of their CPA.

Reasonable cause requires that the taxpayer exercise ordinary business care and prudence as to the disputed item. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); see also United States v. Boyle, 469 U.S. 241, 251 (1985). The determination of reasonable cause must be “made on a case-by-case basis, taking into account all pertinent facts and circumstances.” Treas. Reg. § 1.6664-4(b)(1). The most important factor in this determination is the “extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.” Id. Reasonable reliance on the advice of an independent, competent professional as to the tax treatment of an item may meet the requirement of ordinary business care and prudence. See id. para. (c). The taxpayer’s education and business experience are relevant to the determination of whether the taxpayer’s reliance on professional advice was reasonable and in good faith. Id. subpara. (1). [10]

Specifically, to qualify for reasonable cause relief based on reliance on the advice of a tax professional, the following criteria must be met:

In order for a taxpayer to reasonably rely on advice of a professional, the taxpayer must prove (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided all necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Assocs., P.A., 115 T.C. at 99.[11]

The Court determined that the taxpayers satisfied the first two criteria.

Petitioners satisfy each of the first two prongs of the test laid out in Neonatology. Their CPA was a competent professional and petitioners provided her with all necessary and accurate information. Mr. Johnson testified about limited use of handwritten notes related to cash donations to charitable organizations but supplemented those notes with phone calls and appropriate documentation for all items other than the cash donations.[12]

However, the Court concluded that the taxpayers had not demonstrated that the CPA had actually provided any advice upon which they could reasonably rely, a requirement to comply with the third test.

Petitioners presented no evidence that their CPA told them that the seven-year depreciation schedule was applicable to commercial buildings or that the mortgage interest deduction could be claimed twice. Petitioners also failed to show that their CPA advised them that the county assessor’s valuation would suffice instead of a qualified appraisal for the building donated to the Elgin Opera House. When asked whether she advised Mr. Johnson that the charitable contribution deduction could be claimed using the county assessor’s valuation instead of a qualified appraisal, petitioners’ CPA testified that she “never had that discussion with [Mr. Johnson.]” Petitioners cannot claim to have reasonably relied on advice which was never given. In addition, Mr. Johnson was not credible when he definitively stated: “We thoroughly discussed the tests” related to the donation of the building to the Elgin Opera House. This was decidedly in contrast with his immediately following statement that details about the donation were “[t]oo far to remember.” Petitioners have failed to meet their burden of establishing that they received any advice about the propriety of claiming a charitable contribution deduction over $5,000 without a qualified appraisal or any advice concerning the proper tax treatment of any of the understatements. See Woodsum v. Commissioner, 136 T.C. 585, 593-94 (2011).[13]

One might argue that such advice is implicit when a CPA prepares a return and the first two criteria are met. However, the Court disagreed with this notion, stating:

Failing to show that they received any advice about the correct tax treatment of any of the items noted in the deficiency, petitioners' last remaining contention is that they are entitled to the reasonable cause and good faith exception merely because their CPA prepared the returns. “The mere fact that a certified public accountant has prepared a tax return does not mean that he or she has opined on any or all of the items reported therein.” Neonatology Assocs., P.A., 115 T.C. at 100. Taxpayers have a nondelegable duty to review the return for accuracy before filing. See Metra Chem Corp. v. Commissioner, 88 T.C. 654, 662 (1987).[14]

The opinion concluded that the taxpayers failed to conduct a proper review of the return.

We are unpersuaded that Mr. Johnson — a sophisticated participant in real estate transactions — would have missed the duplicate interest deductions, the grossly overstated depreciation, or the lack of a qualified appraisal if he had conducted even a cursory review of the returns.7 See, e.g., Schweizer v. Commissioner, T.C. Memo. 2022-102, at *11 (finding defective Form 8283 lacking qualified appraisal); Chiarelli v. Commissioner, T.C. Memo. 2021-27, at *22 (finding sophisticated taxpayer unable to escape accuracy-related penalties by blaming CPA); Langston v. Commissioner, T.C. Memo. 2019-19, at *16-18, aff’d, 827 F. App’x 900 (10th Cir. 2020). Mr. Johnson later claimed that depreciation schedules are incomprehensible numbers of which he has no understanding. We find that Mr. Johnson’s self-serving testimony as to this issue lacked credibility.[15]

As a result, the taxpayers were found liable for the penalties imposed in the notice of deficiency.

Does the Opinion Mean the Tax Preparer is Blameless?

Readers should note that the tax preparer was not the subject of this case; the focus was solely on the taxpayer’s potential liability for penalties. While the Court determined that the taxpayer had not appropriately relied on the advice of a tax professional in taking the positions deemed unreasonable, it made no comments on whether the CPA’s conduct could be subject to civil liability for negligence toward the client, or whether such conduct could prompt action by either the IRS or the appropriate State Board of Accountancy.

[1] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/couple%e2%80%99s-reasonable-cause-defense-to-penalties-is-rejected/7h938 (retrieved September 14, 2023)

[2] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[3] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[4] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[5] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[6] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[7] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[8] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[9] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[10] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[11] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[12] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[13] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[14] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023

[15] Johnson v. Commissioner, TC Memo 2023-116, September 13, 2023