Citation: Woodsum v. Commissoner, 136 T.C. 29 (6.14.2011)
The taxpayer (“Woodsum”) was a financially sophisticated man; the founding managing director of a private equity investment firm. He entered into a transaction that yielded $3,400,000 of long-term capital gain in 2006. Woodsum received a 1099-MISC reflecting the gain, and handed that 1099 — along with approximately 150 other 1099s, K-1s, and the like, – to his tax advisors for inclusion in his 2006 tax return.
His tax preparers were no novices; they had spent over 20 years working with complex tax returns for reputable firms.
In preparing Woodsum’s 2006 tax return, however, the preparers fell asleep at the wheel and accidentally omitted the $3,400,000 of long-term capital gain. Though Woodsum met with the preparers to review the return prior to signing, neither party noticed the absence of an item that would have been the third largest line item of long-term capital gain on the tax return.
The IRS, having received a copy of the Form 1099-MISC from the payor, assessed Woodsum an additional tax of $521,000 and an accuracy related penalty of $104,295. Woodsum agreed to pay the assessed tax, but argued that he had reasonable cause for the underpayment, as he had relied on his advisors to include the amount in his taxable income, and thus should not be required to pay the penalty.
Section 6662(a) and (b)(2) imposes an accuracy related penalty of 20% of the portion of an underpayment of tax attributable to a “substantial understatement of income,” defined as an underpayment that exceeds the greater of 1) $5,000 or 2) 10% percent of the required total tax.
A taxpayer, however, can avoid the penalty if they prove that they had “reasonable cause” with respect to the underpayment as provided for in Section 6664.
Regulations further provide that reliance on professional advice constitutes reasonable cause if such reliance was reasonable given the taxpayer’s knowledge and experience, and the extent to which he relied on the advice of a tax professional.
I placed the word “advice” in bold because the regulations define advice as “any communication setting forth the analysis and conclusion of a person other than the taxpayer provided to the taxpayer.”
The Tax Court
The Tax Court denied Woodsum’s request for abatement of the underpayment penalty, holding that he did not have reasonable cause under the “reliance on professional advice” exception for the following reasons:
1. Woodsum did not rely on “advice” from his preparers to omit the income, as the omission was not the result of the preparer’s analysis or conclusions, but rather a mere oversight. As a result, Woodsum did not rely on his preparer’s judgment in omitting the income.
2. Professional advice should be contrasted with things that require no special training. No special training was required for Woodsum to know that the $3,400,000 should be included in income.
3. The court conceded that a taxpayer can prove reasonable cause when their preparer commits an isolated computational or transcriptional error. However, Woodsum failed to provide the nature of or the reason for the omission of the income. While the logical explanation was that the preparers simply lost sight of the 1099 among 150 other informational forms, since no evidence was submitted to support this contention, Woodsum failed to carry his burden of proof.
4. Citing earlier law, the court noted, “Even if all data is furnished to the preparer, the taxpayer still has a duty to read the return and make sure all income items are included.”
5. Woodsum failed to prove the effort he expended in attempting to assess his proper tax liability, as he could not recall details regarding the nature of his review prior to signing.
At first blush, the decision in Woodsum appears unduly harsh. The taxpayer handed a 1099-MISC to his qualified and experienced advisors, and had the expectation that they would include the item in his income tax return. That their failure to do so should cost the taxpayer $104,000 seems a touch unfair.
But the law is the law, and the Tax Court has established with this ruling that a taxpayer can not simply shift the burden of proper reporting to their advisor by turning over the forms necessary for preparation; ultimately, the taxpayer retains responsibility for completing a thorough and complete review of the finished return.
In its discussion, the court was gracious enough to provide the following vague, unquantifiable advice for taxpayers to follow in order to establish reliance on a professional advisor and reasonable cause in the future:
The reasonable cause defense may be available to a taxpayer who conducts a review of his third-party prepared return with the intent of ensuring that all income items are included, and who exerts effort that is reasonable under the circumstances, but who nonetheless fails to discover an omission of an income item.
Clearly, the precedent set in Woodsom is an ominous one for taxpayers; the reasonable cause exception just became that much more difficult to come by.