Escaping Tax Penalties – “Reasonable Cause” & Reliance on Professional Advice

Today’ lesson – Choose your US tax advisor very carefully.  If he or she lacks the US international/foreign tax experience you may need, reliance on the tax advice may not be considered “reasonable,” leading to plenty of penalties.  Let’s explore!

Various civil tax penalties can be assessed when a taxpayer fails to pay the correct amount of tax that is due or fails to timely submit tax or tax information returns. Today’s blog post will focus on the so-called “accuracy-related” penalties involved with foreign tax issues and penalties for failure to file tax information returns for certain foreign assets.  These are issues that I often see in my international US tax practice. Since the tax rules are far more complicated when foreign issues are involved in the case, this is not surprising.  Due to one reason or another, income is omitted or tax incorrectly determined (for example, the taxpayer claims a foreign tax is eligible for the foreign tax credit when it is not, or he claims the foreign earned income exclusion but is not entitled to it or has not properly apportioned it in the year he returns to the US after ending the foreign assignment).  Very commonly, the taxpayer may have failed to file one or more tax information returns pertaining to foreign assets or international transactions (among these are IRS forms related to ownership in, or transactions with, non-US entities or foreign trusts, e.g., IRS Forms 5471, 926, 8621, 8865, 8938, 3520, 3520-A).

Penalty Box

Broadly, the accuracy-related penalty can arise when there is an underpayment of tax that is due to “negligence” or “disregard of rules and regulations”. The penalty may be imposed pursuant to Internal Revenue Code Section 6662(a) in an amount equal to 20% of the tax underpayment. The penalty is increased to 40% when the understatement of tax relates to an undisclosed foreign financial asset (Internal Revenue Code Section 6662(j)).

Penalties for failing to file a foreign-related information return vary, but it is common to see a $10,000 penalty or a penalty based on a percentage. The penalties can be steep. For example, failure to timely file a Form 5471 (pertaining to ownership in a foreign corporation) or Form 8865 (pertaining to ownership in a foreign partnership) is generally subject to a $10,000 penalty per information return. This increases to an additional $10,000 for each month if the failure continues after the IRS notifies the taxpayer of the failure, up to a maximum of $60,000 per return.  Penalties can also be based on a percentage. For example, failure to file Form 3520 to report certain gifts or bequests received from a foreign individual or estate can result in a penalty of 25% of the fair market value of the gift/bequest.

“Reasonable Cause”

One possible defense to the accuracy-related penalty or penalty for failure to file one of the foreign information returns above, is the so-called “reasonable cause” defense. If the taxpayer’s error or omission was due to reasonable cause and not willful neglect and he acted in good faith, the penalty may possibly be abated.  “Reasonable cause” may be a defense based on the tax law statute itself (e.g., IRC Section 6664(c)) or based on a particular IRS procedure (e.g., the Delinquent International Information Return Procedure).

“Reasonable cause” generally means that the taxpayer has exercised ordinary business care and prudence. Whether reasonable cause exists is a very “fact sensitive” inquiry; it depends on the facts and circumstances of the particular case.  The IRS Treasury Regulation Section 1.6664-4 make this clear and examines some of the relevant factors.  The Internal Revenue Manual (IRM) is another useful source of information on “reasonable cause”.

Some of the “reasonable cause” factors listed in the IRM at Section 20.1.1.3.2 include whether the taxpayer’s noncompliance was caused by (1) a death, serious illness, or unavoidable absence; (2) a fire, casualty, or natural disaster; (3) an inability to obtain necessary records despite the exercise of ordinary business care and prudence. An honest misunderstanding of the law may help establish reasonable cause.  Again this depends on the particular facts.  The taxpayer’s experience, knowledge, and education may negate an ignorance of the law excuse.

One factor listed in both the Treasury Regulations and the IRM deserves special mention and discussion – reliance on incorrect professional advice as establishing “reasonable cause”.

Professional Advice

It is often the case that the taxpayer will claim that the error or omission was caused by their tax professional on whose advice the taxpayer will claim to have reasonably relied.  Treasury Regulation 1.6664-4(c) provides substantial guidance on how the IRS and courts will evaluate such a claim when made by a taxpayer. A very important factor listed is the taxpayer’s education, sophistication and business experience. The Regulations state, for example, that “reliance may not be reasonable or in good faith if the taxpayer knew, or reasonably should have known, that the advisor lacked knowledge in the relevant aspects of Federal tax law.”

In the case Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), aff’d 299 F.3d 221 (3rd Cir. 2002) the Tax Court examined the reasonable reliance defense and formulated a useful test by asking 3 questions: (1) was the adviser a competent professional having sufficient expertise so as to justify the taxpayer’s claimed reliance? (2) did the taxpayer provide the advisor with all accurate and relevant information? and (3) did the taxpayer actually rely in good faith on the professional’s advice or judgment?  This last test involves examining the taxpayer’s education, background and business experience.

In the area of US international taxation, the tax laws are particularly complicated and require special expertise of a tax professional who is very familiar with them. Many US-based tax professionals lack the requisite experience since their client base is often domestic and their cases may not involve foreign tax issues. It behooves the taxpayer to find out if the professional on whom he plans to rely has the required tax knowledge.  Otherwise, the taxpayer may lose out on his claim that the tax underpayment or failure to file a relevant information return was due to reasonable reliance on the tax professional.

Be Proactive – Avoid Tax Penalties in the First Place

Want to avoid penalties? Get the right tax advice. “Fast tax advice” is like “fast fashion”, a waste!

I am here to assist.  With my tax colleagues who are attorneys, CPAs and EAs we can get your situation under control before the IRS comes calling. Even if the IRS has contacted you and assessed penalties, it is possible we can help get them abated.

Posted September 16, 2021

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