Accuracy-related penalties: When a promise is not enough
S corp. shareholders lacked good faith or reasonable cause, despite a “promise” to amend returns.
December 12, 2013
A promise to report income on a tax return is not the same as actually reporting it. For purposes of the substantial understatement penalty of Sec. 6662, this distinction can result in a significant addition to a tax liability, as one California couple’s recent Tax Court case illustrates.
The decision in Sampson, T.C. Memo. 2013-212, focused only on the accuracy-related penalty for substantial understatement because the actual tax deficiencies were not disputed but were instead paid in full with interest upon assessment. The taxpayers disagreed with the IRS’s application of the Sec. 6662 penalty and challenged it in Tax Court.
The defenses they raised, along with the court’s analysis, shed light on the concept of substantial understatement and the Sec. 6662(d)(2)(B) exceptions from the penalty. This article describes the case, the law, and the implications for taxpayers and practitioners.
Reginald Sampson was the sole shareholder of two S corporations, Montebello Medical Center Inc. and Reginald Sampson M.D. PC. When the due dates of the companies’ 2008 and 2009 tax returns arrived, the Sampsons’ longtime CPA refused to prepare the S corporation returns because neither company provided him with source documents to support the companies’ QuickBooks financial statements. The Sampsons claimed to have difficulty locating the documents because the medical offices had been renovated and the records had been moved to storage. They also claimed that Sampson’s primary focus was to pay attention to his medical practice.
Because the CPA had not prepared the S corporation tax returns and the related Schedules K-1, he did not report any of the Sampsons’ passthrough activity on their 2008 and 2009 Forms 1040, U.S. Individual Income Tax Return. Instead, he attached the following statement to each return:
In addition to omitting the S corporations’ income, the Sampsons could not determine their charitable contributions for those years and used estimated amounts. After the IRS corrected the contribution amounts and reported the S corporation income, the Sampsons owed $41,449 for 2008 and $91,882 for 2009, including interest. The Sampsons agreed with these amounts and paid the liabilities. But when the IRS also billed them for the 20% accuracy-related penalty, the Sampsons objected, ultimately ending up in Tax Court. Significantly, the Sampsons did not file amended returns reporting the omitted S corporation income until after the IRS notified them that their returns would be examined.
The taxpayers conceded that a substantial understatement existed for both 2008 and 2009. The S corporations’ unreported net income was $95,863 and $240,625 for 2008 and 2009, respectively, and the charitable contributions were overstated by $6,815 and $13,900, respectively. The Sampsons claimed the understatements should be reduced, however, because they had substantial authority for their treatment of their corporations’ income. In addition, they claimed that they adequately disclosed this treatment and that they had a reasonable basis for doing so.
To uphold the integrity of the income tax system, lawmakers created various penalty provisions to ensure compliance with filing requirements and to be sure that filed returns are complete and accurate in the information they are reporting. To accomplish these objectives, penalties for taxpayers who intentionally disregard their tax reporting responsibilities tend to be onerous, but the law provides relief for those who act in good faith or with a reasonable basis.
The penalty that the Sampsons contested, which is imposed under Sec. 6662(b)(2), is a 20% addition to a tax underpayment that constitutes a “substantial underpayment”: an understatement that exceeds the greater of (1) 10% of the tax required to be shown for the year, or (2) $5,000. In the Sampsons’ case, 10% of the tax that was required to be shown was $6,941 and $12,156 for 2008 and 2009, respectively, resulting in a combined penalty of $25,097 under Sec. 6662.
However, the law permits a reduction in the amount subject to this penalty if certain conditions are met. The Sampsons claimed that the underpayments of tax for the S corporations’ income, which was the majority of their underpayment, qualified under Sec. 6662(d)(2)(B) because there was substantial authority or because it was disclosed. Under the first requirement, the amount of the understatement subject to the 20% penalty is reduced by the amount attributable to the treatment of an item for which there is or was substantial authority. (Regs. Sec. 1.6662-4(d)(3) provides guidance for determining the existence of substantial authority.)
The Sampsons argued that substantial authority existed for their treatment of the passthrough income, which they omitted from their originally filed returns but promised to report on later amended returns. The taxpayers referred to Regs. Sec. 1.6664-2(c)(2), which allows the amount of tax shown on a return to include amounts from a qualified amended return. Because the Sampsons’ amended returns showed the entire tax liability, the substantial understatement could be reduced to zero for purposes of applying the 20% penalty.
To support their treatment of attaching disclosure statements promising to file amended returns, the Sampsons noted several Tax Court cases where the court stated that a Sec. 6651(a)(1) late-filing penalty could have been avoided by filing a timely return even if sufficient information was not available, and subsequently correcting any errors on an amended return. The Sampsons’ argument here seemed to be that despite the unavailable K-1 information, they still made a good-faith effort to file the return and disclosed the fact that information was missing.
The problem with both of these arguments is that in each case the substantial authorities the Sampsons pointed to did not apply to their circumstances. Under Regs. Sec. 1.6664-2(c)(3), a qualified amended return must be filed before the date the taxpayer is first contacted by the IRS concerning any examination of the return. Until the Sampsons were notified of the IRS examinations, they had only promised to file amended returns. Simply making a promise, but not actually filing the amended return until after they were notified of the exam, does not constitute a qualified amended return for purposes of reducing the amount of substantial understatement.
The Sampsons other argument was that the Tax Court cases they cited provided substantial authority for filing an incomplete return with a promise to correct it in a later amended return. But, as the court noted, those earlier cases concerned avoidance of the late-filing penalty under Sec. 6651(a)(1), not the 6662(b)(2) accuracy-related penalty, and therefore were not relevant.
The second circumstance allowing a reduction of the understatement is for a disclosed item. A qualified disclosed item for this purpose is one in which the relevant facts affecting the item’s tax treatment are adequately disclosed in the return (or an attached statement) and the taxpayer has a reasonable basis for the tax treatment of that item. The Sampsons claimed that their omission of the S corporations’ income met these criteria, presumably because of the statements they attached to the tax returns and the substantial authority referred to earlier.
The Tax Court found that the Sampsons’ promise on a statement attached to their income tax return to file an amended return once the passthrough information was available did not suffice. For disclosure in the Sampsons’ case to be considered adequate, it needed to be made on the proper form (Forms 8275 or 8275-R) with the S corporations’ returns, which were not filed until after the Sampsons had filed amended Forms 1040. Alternatively, a taxpayer may make an adequate disclosure with respect to income from an S corporation by filing two properly completed Forms 8275 or 8275-R, one with the taxpayers’ return and one with the IRS service center with which the entity’s return is required to be filed.
Despite the lack of substantial authority or adequate disclosure, the Sampsons still had the potential for relief from the 20% penalty. Sec. 6664(c)(1) provides that “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.” The Sampsons had to show ordinary business care for the omitted S corporation income, along with proving that they intended to perform all lawful obligations.
The Sampsons claimed that they had reasonable cause and acted in good faith by relying on their CPA’s advice. However, regardless of their CPA’s advice, the Sampsons could not reasonably believe that failing to estimate their S corporation income and report an amount was a show of good faith. They signed their tax returns under penalties of perjury declaring that the returns “were true, correct, and complete.” In general, the most important factor in determining whether taxpayers acted with reasonable cause and in good faith is the extent of the taxpayers’ effort to assess their proper tax liability. Reporting no income from the medical practices for which they had maintained the books and records does not constitute an attempt to file a complete return or assess their proper liability. Promising to correct the returns, but failing to act on this promise until they were under examination, was not a show of good faith.
Practitioners must be aware of the accuracy-related penalties and ensure that their clients are advised of their responsibility to file complete returns to the best of their ability. The CPA in this case may have felt the statement attached to the Sampsons’ personal returns was an appropriate, good-faith disclosure. He was persistent in following up with the taxpayers to obtain the documents needed to complete the S corporation returns and correct the personal returns. But he also had access to the companies’ financial statements. He had done the taxpayers’ compliance work for years and was familiar with their business. The court said it was not reasonable for the taxpayers to omit any sort of passthrough income on the Forms 1040. The practitioner could have refused to prepare a clearly incomplete return.
At a minimum, the taxpayers could have reported the amounts shown in the unverified QuickBooks financial statements with the intention of amending the returns once the financial statements were finalized. Alternatively, they could have filed the Forms 1040 late once the S corporations could provide the necessary documents. The late-filing penalties under Sec. 6651(a)(1) that would have been imposed probably could have been waived if reasonable cause was demonstrated. The fact that the Sampsons had been doing substantial renovations and moving files to storage, coupled with a history of timely filing and efforts to promptly remedy the problem, might have constituted reasonable cause.
Practitioners may sometimes encounter difficulty getting complete tax information from their clients to prepare a timely return. But when income is known to exist, omitting it from the tax return until the exact amount can be determined is not the appropriate treatment. In fact, the resulting understatement could give rise to Sec. 6694 preparer penalties if the preparer did not have a reasonable basis for the reporting position or ignored the implications of information actually known at the time of filing.
One can speculate whether the Sampsons would have filed amended returns if the IRS had not examined their returns, but that misses the point. Taxpayers have a responsibility to make a good-faith effort to correctly report their income tax liability. The government has established harsh penalties to encourage adherence to this responsibility, and reporting nothing, with a promise to fix it later, does not suffice.
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Daniel Rowe, CPA, is the tax manager in the Savannah, Ga., office of Deemer Dana & Froehle LLP.