The Tax Court has determined that a taxpayer failed to show that under Code Sec. 6664(c)(1) his reliance on persons he thought to be tax professionals established a reasonable cause and good faith defense to the Code Sec. 6662(a) accuracy-related penalties.

One expert lacked the necessary expertise and wasn't provided full and accurate information, while the other was a promoter who benefited financially from the transaction.

Background. Under Code Sec. 6664(c)(1), there is an exception to the Code Sec. 6662(a) accuracy-related penalty for any portion of an underpayment if the taxpayer shows that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.

Reliance upon the advice of a tax professional may establish reasonable cause and good faith. The taxpayer claiming reliance on a tax professional must prove that: (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. (Neonatology Associates, (2000) 115 TC 43, affd (CA 3 2002) 90 AFTR 2d 2002-5442)

Facts -  A medical doctor, who practiced medicine through his wholly owned S corporation, was looking for a way to increase his tax deductible retirement contributions. William Alexander, a promoter, advised him that he could do so and reduce his tax liabilities by using a Code Sec. 419 welfare benefit plan (419 plan) and a defined benefit plan (collectively, plans).

Alexander said that under his method his clients could basically control the amount of taxes they paid by using pension plans and corporations. He described his tax planning technique as “aggressive”—something conservative lawyers and accountants wouldn't recommend. He admitted that taxpayers really weren't supposed to borrow from a 419 plan, but since he was aggressive, he permitted it. When the Doctor received negative comments from other pension plan promoters on the use of 419 plans, Alexander chalked it up to their attempt to sell their own products. He advised the Doctor to keep their actions “as confidential as possible.”

At the Doctor’s request, the enrolled agent who normally prepared his return, Katherine Fallon, met with Alexander, who explained the deductions in general but provided no details on the plans. Fallon informed the Doctor that she was not familiar with the tax ramifications related to 419 plans or defined benefit plans. She advised the Doctor to continue to look into the plans. Dr. Hristov proceeded to hire Alexander to create and administer the plans, paying him a $2,500 setup fee for the plan idea, design and documents. In addition, Alexander charged an annual fee of 8% of the total contributions the Doctor made to the plans.

The overall strategy was for the Doctor to contribute money each year to a 419 plan and a defined benefit plan. For the 419 plan contributions, he would write a check to Lyons Pensions, Inc. Alexander would then deposit $10,000 of the contribution as an annuity, take his 8% fee, and return the remaining money to the Doctor as a “loan” from Lyons Pensions. Alexander told the Doctor that the loan would never have to be repaid because the plan would eventually close. Thus, the Doctor was free to invest the returned money however he chose. The loans would not be reported by the Doctor as taxable income and he was free to invest the returned money however he chose. Alexander also told the Doctor that he could receive a refund from IRS by amending his and his S corporation's 2002 returns and recharacterizing large purchases he had made (e.g., a rental triplex for $290,000 purchased in 2003) as contributions to a pension plan for the 2002 tax year.

IRS Audit - On audit of the plans and his and his S corporation returns for 2004, 2005, and 2006, the Doctor agreed to a complete disallowance of all deductions for the 419 plan contributions and defined benefit plan contributions. He agreed to increases in tax and to return the refund he had received as a result of amending his 2002 tax return. During the course of the audit, the Doctor learned that Alexander (who had professed to be an enrolled agent, but wasn't) had never filed the required Forms 5500, Annual Return/Report of Employee Benefit Plan. Additionally, at some point during the audit, the Doctor learned that Alexander, who had been representing him, was not responding to IRS's requests for documents.

IRS contended that the Doctor was liable for the accuracy-related penalty under Code Sec. 6662(a) for all three years at issue because either: (1) the tax underpayments were attributable to negligence or disregard of rules or regs under Code Sec. 6662(b)(1); or (2) there were substantial understatements of income tax under Code Sec. 6662(b)(2). The Doctor sought relief in the Tax Court where he argued that the reasonable cause exception under Code Sec. 6664(c)(1) provided a defense to the penalties.

Court's conclusion - The Tax Court found that the Doctor failed to show that because he relied on the advice of individuals he thought to be tax professionals there was reasonable cause and good faith for purposes of avoiding the accuracy-related penalties. The Court also concluded that the Doctor’s reliance on Alexander was unreasonable. He was a promoter and had a conflict of interest that the Doctor knew or should have known about. The advice from Alexander wasn't independent because he benefited financially from the Doctor using his plans.

Robert J. Coscia’s interpretation of the Doctor’s decisions and the ensuing court case is that a taxpayer (the Doctor), agreed to engage in aggressive questionable financial transactions at the suggestion of William Alexander. A tax court will always consider whether the actions of a taxpayer pursuant to advice from a “professional” are prudent and reasonable. A reasonable taxpayer is expected to conduct more due diligence when a tax scenario seems too good to be true. In the above case, the Doctor went as far as to ignore some information that, if he had researched and considered, may have prevented him from taking William Alexander’s advice.

References: For accuracy-related penalties, see FTC 2d/FIN ¶ V-2000 et seq.; United States Tax Reporter ¶ 66,624 ; TaxDesk ¶ 863,005 ; TG ¶ 71626