Reliance on the Tax Adviser – There Are Limits
March 02, 2020
We’re well into the income tax return “preparation-n-filing” season. It’s the time of year during which many businesses and their owners recognize the importance of working with a competent tax professional, one on whom they may rely not only for their tax reporting services but, more importantly, for the practical tax guidance they provide throughout the year.
Unfortunately, many business owners tend to equate “reliance” upon a tax adviser to assist them in fulfilling their tax-related obligations[i] with “abdication” of their responsibilities with respect to many of these obligations to such an adviser. These taxpayers may be unpleasantly surprised to learn that they remain subject to various penalties notwithstanding their having worked with a tax adviser. The case described below provides an illustration of one taxpayer’s recent experience.[ii]
Taxpayer’s Tax Team
Taxpayer was an S corporation. As such, it was required to file an annual return reporting its tax items on IRS Form 1120S, and to issue Schedule K-1s to its shareholders.[iii] Taxpayer failed to timely file its returns for five consecutive taxable years, though it did issue K-1s to its shareholders, who used the information reported thereon to prepare their own returns and determine their tax liability,[iv] which they satisfied.
According to Taxpayer, throughout the relevant time period, Individual was “treated as and effectively exercised the authority and control of CEO and Chairman of the Board over all of the family of companies,” including Taxpayer. In that capacity, Individual controlled and exercised final decision-making authority over all financial and tax-related matters for Taxpayer.
CPA was hired by Taxpayer and “functioned as, possessed and exercised the responsibilities of Chief Financial Officer” for Taxpayer and all its related companies, though CPA was never an employee, officer, or director on the books and records of Taxpayer or of any related company.
Nonetheless, it was undisputed that CPA was solely responsible for preparing and filing the federal and state income tax returns for Taxpayer, as well as preparing and issuing the Schedule K-1s to its shareholders. All IRS notices and correspondence issued to Taxpayer were given directly to CPA.
CPA reported directly to, and was supervised by, Individual.
Failure to File
At some point before the years at issue, Individual became very ill. Eventually, this illness prevented Individual from fulfilling their responsibilities to the Taxpayer.
Shortly afterward, CPA became very ill. Despite this illness, CPA continued to act as Taxpayer’s de facto CFO. Indeed, CPA did not outwardly exhibit any behavior or symptoms that would have led anyone to question their ability. Unbeknownst to Taxpayer, however, CPA failed to file the income tax returns for Taxpayer for several years, though they did in fact prepare Taxpayer’s returns, and issued the Schedule K-1s, but failed to file the Forms 1120S and other returns for the years in question.
After CPA’s death, unopened IRS notices addressed to Taxpayer were found in their desk. Taxpayer hired an outside accounting firm to review Taxpayer’s income tax filing compliance. This firm found that CPA had prepared Taxpayer’s returns but failed to file them. The outside firm filed the delinquent returns for Taxpayer, several years after their due date.
The Code provides that “if any S corporation required to file a return . . . for any taxable year fails to file such return at the time prescribed therefor . . . such S corporation shall be liable for a penalty . . . unless it is shown that such failure is due to reasonable cause.”[v]
Taxpayer paid the penalty, then filed a refund claim for the amount of the penalty. After failing to convince the IRS that its failure to file timely was due to reasonable cause, Taxpayer petitioned a Federal District Court for relief.[vi]
The Court began by stating that a taxpayer “bears a heavy burden to prove that the failure to timely file was” due to reasonable cause. It noted that, although “reasonable cause” is not defined under the applicable provision, guidance could be found under an analogous provision[vii] which imposes a penalty for failure to file other types of returns “unless it is shown that such failure is due to reasonable cause and not due to willful neglect.”
Under that standard, the Court explained, a taxpayer demonstrates reasonable cause if it can show that it “exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time period.[viii]
The Court then summarized the position of the U.S. Supreme Court regarding reasonable cause in the case, like the present one, of a taxpayer who hires a tax professional to prepare and file their return. The Court explained that Congress placed the burden of prompt filing on the taxpayer, not on an agent or employee of the taxpayer. Because of this “bright line rule,” reliance could not “function as a substitute for compliance.” Thus, “[t]he failure to make a timely filing of a tax return is not excused by the taxpayer’s reliance on an agent, and such reliance is not ‘reasonable cause’ for late filing under [the Code].”
In the instant case, the government argued that Taxpayer’s failure to timely file was due solely to its reliance on its agent, CPA, who was supposed to file its returns but failed to do so. Such reliance did not constitute reasonable cause excusing a late filer from penalties.
In response, Taxpayer tried to distinguish the question of a taxpayer’s misplaced reliance on an agent to perform a known statutory duty, from the question of the taxpayer’s “inability to perform such duty.” Specifically, Taxpayer argued that it was incapable of filing because of the incapacity of Individual and of CPA, the persons who effectively controlled Taxpayer.
The Court observed that the principle underlying the IRS regulations – that a taxpayer should not be penalized for circumstances beyond their control – might cover a filing default by a taxpayer who relied on an attorney or accountant because the taxpayer was, for some reason, incapable by objective standards of meeting the criteria of “ordinary business care and prudence.”
While the Court conceded that an individual taxpayer’s illness and health problems can constitute reasonable cause for a late filing, it also noted that whether a corporation can be incapable of timely filing based on the incapacity of a corporate officer was another matter.
Numerous cases, the Court stated, have struggled with the application of disability in the corporate context. These cases have generally involved a key financial management employee who failed to carry out the tax obligations assigned to them and then hid that fact from the corporation. Most of the courts recognized that there were “at least some instances in which the conduct of an officer might render a company disabled from timely [filing], and that such situations are quite rare.”
The Court found that Taxpayer’s case was not one of those rare situations.
Taxpayer relied on CPA; regardless of whether CPA was its agent or its employee, Taxpayer could not simply rely on CPA’s illness to demonstrate Taxpayer’s inability to file. The corporation had a president and board members independent from CPA and Individual, all of whom had a responsibility to ensure that the corporation carried out its statutory duties, including the timely filing of tax returns.
What’s more, Taxpayer failed to present any evidence of any ordinary business controls to ensure that it met its responsibility. Indeed, it admitted that it ceded all responsibility to CPA without any oversight. This did not demonstrate ordinary and prudent business practice.
Consequently, the Court upheld the government’s denial of Taxpayer’s requests that the late filing penalty be abated and the amount paid refunded.
The Court’s decision in Taxpayer’s case was correct. Taxpayer had abdicated its responsibility to CPA. It never followed up to ensure that the assigned function had, in fact, been properly performed on a timely basis. It had no mechanisms or processes in place by which to confirm that its tax obligations were being satisfied. The worst part: these safeguards could have been implemented very easily.
Although the focus of the foregoing discussion has been on the importance of a taxpayer’s “follow-through,” the more important consideration for the closely held business remains the selection of a tax adviser and the latter’s role in protecting the taxpayer from the imposition of tax-related penalties.[ix]
In many cases, a taxpayer may be able to avoid the imposition of certain penalties if the taxpayer can demonstrate that they exercised ordinary business care and prudence in determining their tax obligations, and that they acted reasonably and in good faith.
The determination of whether a taxpayer acted with good faith must be made on a case-by-case basis, and all pertinent facts and circumstances must be considered. Among the relevant circumstances are the experience, knowledge, and education of the taxpayer, and whether the taxpayer reasonably relied on the advice of a professional tax adviser.[x] For example, a taxpayer’s inexperience in tax matters and the complexity of this area of law, in conjunction with a track record of compliance, may demonstrate that the taxpayer acted reasonably in relying upon its tax advisers.
In determining whether the taxpayer reasonably relied upon a tax adviser, one must consider whether “(1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.”[xi]
All well and good, but how does a taxpayer who is in the market for a tax adviser assess a candidate’s experience, knowledge and competence?
The courts have taken a practical approach toward this issue. The Tax Court, for example, has rejected the IRS’s argument that a taxpayer cannot in good faith rely on an accountant where the taxpayer did not conduct an investigation into the accountant’s background and experience prior to retaining him. In rejecting this argument, the Tax Court has stated that: “Given what little [the taxpayer] knew about the U.S. system of taxation, we cannot imagine [the taxpayer] would have known how to conduct such an investigation, let alone what value such uninformed inquiries would have added. [The taxpayer] acted reasonably, given its admitted inexperience.”[xii]
The Supreme Court has reflected a similar approach toward the guidance provided by an adviser to a taxpayer after they have been retained. According to the Court:[xiii]
When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place. […] “Ordinary business care and prudence” do not demand such actions.
That being said, the taxpayer should not ignore their “spidey sense”[xiv] – that intuitive feeling that something is risky or plainly wrong. I am not referring to the more easily applied “too good to be true” test, or the equally tried and true “smell test” – these should rarely be overridden by a “well-reasoned” legal analysis. I am talking about that degree a doubt that a reasonably intelligent business owner experiences just before they ask “Are you sure?” followed by “If you say so.” At that point, it may behoove the business owner to push their adviser to defend or clarify their analysis until the owner is comfortable.
[i] Which is generally understandable, given the complexity of the tax laws.
[ii] Hunter Maintenance & Leasing Corp., Inc., Plaintiff, v. the U.S. (D.C. N.D. Ill.), Case No. 18 C 6585 (February 25, 2020).
[iii] IRC Sec. 6037. An S corporation must file Form 1120S by the 15th day of the 3rd month after the end of its tax year. For calendar year S corporations (the majority of such corporations), the due date is March 15 of the immediately succeeding tax year. Schedule K-1 must be provided to each shareholder on or before the day on which the corporation’s Form 1120S is required to be filed.
[iv] IRC Sec. 1366.
[v] IRC Sec. 6699. The penalty is equal to $195 per shareholder for every month the return was late, not to exceed 12 months.
[vi] IRC Sec. 7422.
[vii] IRC Sec. 6651.
[viii] Reg. Sec. 301.6651-1(c)(1).
[ix] Of which there are many, including, for example, penalties for (i) the late filing of a tax return, (ii) the late payment of tax (whether or not shown on a return), (iii) underpayments attributable to a taxpayer’s negligence or disregard of the tax rules, (iv) underpayments attributable to the misstatement of the value of property, (v) the failure to disclose certain investments, certain transactions, certain tax positions (including those for which there is no substantial authority), and (vi) underpayments due to fraud. See, for example, IRC Sections, 6651, 6662 and 6663, and Reg. Sec. 1.6662-4(d).
[x] Reg. Sec. 1.6664-4.
[xi] Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43 (2000), aff’d 299 F.3d 221 (3d Cir. 2002).
[xii] Grecian Magnesite, 149 T.C. No. 3 (July 2017).
[xiii] United States v. Boyle, 469 U.S. 241 (1985).
[xiv] Admit it, you followed Spiderman as a kid, didn’t you? At least enough to get the reference, right?