The accuracy-related penalty under §§ 6662(b)(1) and (2) of the Internal Revenue Code has been the most-litigated federal tax issue for years, according to the National Taxpayer Advocate’s Reports to Congress. It is unlikely to leave this number-one position for the foreseeable future in light of the 2017 Tax Cuts and Jobs Act’s (“TCJA’s”) recent changes to the Code. These changes have not only created new situations where taxpayers or their advisers risk making mistakes while learning the new rules, but they have also lowered one of the thresholds for imposing the penalty.
While the case law indicates that the Internal Revenue Service usually prevails in collecting the accuracy-related penalty, taxpayers who successfully use the "reasonable cause and good faith" defense can be excepted. A common way of asserting reasonable cause and good faith is to blame a third-party, such as a tax return preparer, accountant or attorney, for providing incorrect advice around the propriety of the amounts claimed. With this in mind, it is essential for taxpayers and all their advisers to know the factors that are relevant and significant to the reasonable cause and good faith defense, not only when a taxpayer is actually facing a penalty, but also in the tax planning and preparation stages in order to minimize overall risk.
A Review of the § 6662 Accuracy-Related Penalty, TCJA Changes and the Reasonable Cause and Good Faith Defense
§ 6662 imposes a penalty of 20% to 40% of any underpayment of tax attributable to certain enumerated causes, set out at § 6662(b). The cases indicate that the most common causes of underpayment attracting the accuracy-related penalty are “negligence or disregard of rules or regulations” (§ 6662(b)(1)) and “substantial understatement of income tax” (§ 6662(b)(2)), both of which attract the 20% rate for calculating the penalty. “Gross valuation misstatements” and “disallowance of claimed tax benefits by reason of a transaction lacking economic substance” attract the 40% rate. § 7491(c) provides that the government bears the burden of production with respect to the taxpayer’s prima facie liability for the penalty—but only if the taxpayer is an individual.
§ 6664(c) provides that, with certain exceptions (such as underpayments attributable to non-economic substance transaction, or gross valuation misstatements with respect to charitable deduction property), no accuracy-related penalty shall be imposed if it is shown that there was “reasonable cause” for the underpayment and the taxpayer acted in “good faith” with respect to it.
The TCJA introduced the “qualified business income deduction” (“QBID”) at § 199A which allows a deduction relating to “qualified business income,” calculated with respect to certain “qualified businesses,” earned by individuals, trusts and estates through entities such as sole proprietorships, partnerships and S corporations. At the same time, the TCJA made it easier for the government to prove an underpayment of tax by any taxpayer who takes advantage of the QBID, by amending the definition of “substantial understatement of income tax.” Subject to a certain minimum amount of underpayment, the TCJA’s addition of § 6662(d)(1)(C) lowers the threshold at which a “substantial understatement of income tax” occurs from 10% of the tax required to be shown on the tax return to 5% if the taxpayer has claimed any deduction allowed under § 199A. Interestingly, the trigger for the 5% lowered threshold is simply any deduction under § 199A—whether or not the § 199A deduction is actually the cause of the underpayment.
Factors Relevant to Reasonable Cause and Good Faith
Treasury Regulation 1.6664-4 states that “all pertinent facts and circumstances” need to be considered in determining whether a taxpayer acted with reasonable cause and good faith. As expounded in the regulation as well as the case law, such facts and circumstances include the education, experience and knowledge of the taxpayer, the clarity of the law or rule in question, the quality of the taxpayer’s records and recordkeeping, the taxpayer’s level of review of the tax return, and reliance on any advice. Whether reliance on third party advice is reasonable has its own legal test requiring that the adviser be a competent professional, possessed of all necessary information to give the advice and that the taxpayer actually relies in good faith on the adviser’s judgment.
According to Treas. Reg. 1.6664-4, however, the “most important factor” in the analysis is “the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.”
Keeping this in mind, how does one translate “all pertinent facts and circumstances” into a measure of “effort to assess proper tax liability”?
Consider, for example, a taxpayer who relies on the erroneous advice of a qualified tax professional. By itself, that might sound fine as the basis of an argument for reasonable cause and good faith. But what if the taxpayer happens to be a sophisticated business corporation? Given that context, did the taxpayer make a sufficient “effort” to assess the proper tax liability by taking the adviser at his word? It did in Syzygy Insurance Corporation v. Commissioner (T.C. 2019), where there was a lack of precedent in relevant law regarding captive insurance, and there was no question that the adviser had all necessary information from the corporation before he gave his opinion. On the other hand, the corporate taxpayer did not make the appropriate effort in Curtis Investment Co. v. Commissioner, 909 F.3d 1339 (11th Cir., 2018), where the law was clear and the adviser’s independence was compromised.
What about when the taxpayer is a relatively unsophisticated individual? Where an accountant’s errors were so obvious that the taxpayer would have noticed them upon a more than cursory review of the tax return, such as in Yapp v. Commissioner (T.C. 2019), no reasonable cause and good faith could be made out on the basis of reliance on a professional adviser. In contrast, in Triggs v. Commissioner (T.C. 2018), the taxpayer, who had no financial or accounting background, successfully made a reasonable cause and good faith defense based on reliance on his accountant’s advice regarding claiming expenses, even though the taxpayer could not substantiate most of the expenses claimed.
In an often complex, multi-factorial analysis, machine learning provides a way to connect the dots between facts and circumstances around an accuracy-related penalty and the conclusion to be drawn from them regarding the taxpayer’s good faith efforts. Blue J Legal’s machine learning algorithm is able to assess the same factors as those considered in the universe of past decisions and make a prediction based on the same. In doing so, it not only provides professionals with a means to predict the application of accuracy-related penalties, but also to plan defensively against them.
If you’re interested in learning more about the factors that drive the assessment of the reasonable cause and good faith defense to the accuracy-related penalty, and how machine learning can help practitioners advise their clients and reduce their own exposure, watch the webinar hosted by Blue J Legal CEO Benjamin Alarie.