In Clark v. Commissioner, T.C. Memo. 2025-13, the Tax Court addressed whether the taxpayer was liable for self-employment tax and an accuracy-related penalty. The Court resolved both issues in favor of the Commissioner.

Facts of the Case

The taxpayer, James Clark, was a high school graduate who had worked as a "W-2 wage earner" selling food service to restaurants and hotels. He then owned and operated a mobile disc jockey business until 1995. After 1995, he worked as a freelance movie reviewer. In 2019, Clark received $8,250 from his freelance writing work. Additionally, he bought and sold movie memorabilia through eBay, receiving $41,972 in 2019 via PayPal. PayPal issued a Form 1099-K to the IRS and Clark reporting the gross amount of payment card/third party transactions.

Clark prepared his 2019 tax return with the assistance of H&R Block. He reported the combined income from his freelance writing and memorabilia sales ($50,222) as "[o]ther income" on line 7a of his return rather than on Schedule C, and he did not subject it to self-employment tax. He claimed the standard deduction and reported a tax liability of $4,369. The IRS then sent a notice proposing changes to his return because the information received from third parties did not match what he reported. After Clark failed to respond, the IRS issued a Notice of Deficiency, determining the income was subject to self-employment tax and a substantial understatement of income tax penalty under section 6662(a) and (b)(2).

Clark then petitioned the Tax Court. The Social Security Administration (SSA) subsequently sent Clark a letter stating that his self-employment income was being reduced to $0 based on information from the IRS. The IRS also reversed the premature assessment and issued Clark a refund.

The Premature Assessment

The IRS's premature assessment of the deficiency, penalties, and interest in Clark v. Commissioner, T.C. Memo. 2025-13, was a result of a procedural issue related to the timing of the litigation hold on the taxpayer's account. Here's a detailed explanation:

Initial IRS Actions and Notice of Deficiency

James Clark filed his 2019 tax return, reporting income from freelance movie review writing and sales of movie memorabilia as "[o]ther income," which is not subject to self-employment tax. The IRS received a Form 1099-K from PayPal showing that Clark had received $41,972 from his memorabilia sales. The IRS's Automated Underreporter (AUR) Program detected a mismatch between the information reported on Clark's return and the information it received from third parties, including the Form 1099-K. Consequently, the IRS sent Clark a Notice CP2000 proposing changes to his 2019 return. When Clark failed to respond to this notice, the IRS issued a Notice of Deficiency, determining that the income Clark had reported as "[o]ther income" was subject to self-employment tax, and that he was liable for a substantial understatement of income tax penalty under section 6662(a) and (b)(2).

Tax Court Petition and Delayed Litigation Hold

Clark then filed a petition with the Tax Court in response to the Notice of Deficiency. Although Clark's petition was postmarked February 5, 2022, the Court did not receive and file it until July 19, 2022. The court served the petition on the IRS on August 3, 2022. Critically, the IRS was not aware of Clark's petition until sometime in August 2022, meaning there was a delay between the filing of the petition and the IRS's awareness. As a result, the IRS did not place a litigation hold on Clark's account at the time the petition was filed.

Premature Assessment

Because a litigation hold was not in place, the IRS processed the assessment of the deficiency and penalty amounts reflected in the November 15, 2021, Notice of Deficiency, along with interest, on March 28, 2022. This action occurred about four months before the IRS even received notice of Clark’s petition. The premature assessment occurred because the IRS's systems were not informed that Clark was disputing the deficiency in Tax Court. The litigation hold is a critical procedure to prevent the IRS from taking collection actions while a case is in litigation.

IRS Reversal and Refund

Upon realizing the error, the IRS reversed the premature assessment. The IRS then issued a refund to Clark of $2,886 on April 3 and May 5, 2023, which consisted of various amounts, including the amount Clark had paid for failure to pay estimated tax, federal income tax withheld, and other credits and interest. The refund was issued to bring Clark's IRS account into the proper status given the litigation and to reflect the effects of the delayed litigation hold.

Taxpayer’s Arguments

Clark argued that he should not be liable for self-employment tax, contending the IRS had conceded the issue. He based this on the letter from the SSA reducing his self-employment income to $0 and the IRS refund he received.

Tax Court’s Analysis

Self-Employment Tax

The Court noted that section 1401 imposes a tax on an individual’s self-employment income, and section 1402(a) defines "net earnings from self-employment" as gross income from any trade or business, less deductions attributable to that trade or business. The Court determined Clark was self-employed as a freelance writer and seller of movie memorabilia. The Court stated that the IRS’s determinations in a Notice of Deficiency are presumed correct, and the taxpayer bears the burden of proving the Commissioner’s determinations are erroneous, citing Welch v. Helvering, 290 U.S. 111, 115 (1933).

The Court rejected Clark’s argument that the IRS had conceded he did not have self-employment income. It cited Ashford v. Commissioner, T.C. Memo. 2022-101, aff’d, Nos. 22-2307, et al., 2023 U.S. App. LEXIS 19297 (4th Cir. July 27, 2023) where a similar argument was rejected, that a letter from the SSA reducing self-employment income to $0 was not a concession by the IRS. The Court in Ashford found that the IRS had not made a concession where the taxpayer had stipulated the amount of income he had received, as well as the characterization of that income. The court reasoned that Clark’s argument was “contrary to the evidence” given he did not dispute the income amounts he received. The Court explained that the SSA letter merely reflected a moment in time regarding Clark’s earnings record for Social Security purposes, not his income tax record, and the refund was to correct Clark’s account due to the delayed litigation hold. The Court also noted that section 6103(l)(1)(A) allows the IRS to share tax information with the Social Security Administration.

Accuracy-Related Penalty

The Court then addressed the accuracy-related penalty under section 6662(a) and (b)(2) for a substantial understatement of income tax. The Court observed that section 6662(a) imposes a 20% penalty on an underpayment of tax due to a substantial understatement of income tax. The Court cited section 6662(d)(2)(A), noting that an understatement is generally the excess of the tax required to be shown on the return over the amount actually shown. The Court stated that for an individual, an understatement is substantial if it exceeds the greater of 10% of the tax required to be shown or $5,000, referencing section 6662(d)(1)(A).

The Court noted the IRS bears the burden of production regarding the penalty, citing section 7491(c) and Higbee v. Commissioner, 116 T.C. 438, 446 (2001). This burden includes providing evidence that the procedural requirements of section 6751(b) have been met, specifically that the penalty was personally approved in writing by the immediate supervisor of the individual making the determination, except when the penalty is automatically calculated through electronic means, referencing section 6751(b)(1) and (b)(2) and Walquist v. Commissioner, 152 T.C. 61, 68–69 (2017). Once this burden is met, the taxpayer bears the burden of proving the penalty determination is incorrect, also citing Higbee, 116 T.C. at 446–47 and Welch v. Helvering, 290 U.S. at 115.

The Court found that the IRS had met its initial burden, as Clark’s understatement was substantial. The penalty was automatically calculated through the IRS’s AUR program, thus it was excepted from the written supervisory approval requirement of section 6751(b)(1), referencing section 6751(b)(2)(B) and Walquist, 152 T.C. at 73.

The Court then noted that the penalty can be avoided if the taxpayer shows reasonable cause and good faith, referencing section 6664(c)(1) and Higbee, 116 T.C. at 446–47. The determination of reasonable cause depends on the facts and circumstances of the case, with consideration of the taxpayer’s experience, education, and sophistication, referencing Treas. Reg. § 1.6664-4(b)(1) and Higbee, 116 T.C. at 448. The Court stated that reliance on professional advice may indicate reasonable cause and good faith if, under the circumstances, the reliance was reasonable, also citing Higbee, 116 T.C. at 448–49.

Despite Clark’s apparent sincerity, the Court found that Clark’s understanding of tax matters was limited. While Clark had been in business for himself for over 30 years, the Court noted that he admitted to always paying the penalty for failure to pay estimated tax. Although Clark stated that H&R Block prepared his return, this did not prove reliance on professional tax advice, and the Court determined that Clark did not show reasonable cause for the error.

Findings

The Tax Court ruled in favor of the Commissioner. The court found that Clark was liable for self-employment tax on his freelance writing and movie memorabilia income. It also found that Clark was liable for the accuracy-related penalty due to the substantial understatement of tax because he did not demonstrate reasonable cause or good faith in claiming his income was not subject to self employment tax.

Prepared with assistance from NotebookLM.