Tuesday, December 9, 2014

Don't Ignore Your CPA's Advice!

Amit Chandel, a CPA in Orange County, California, made this post in the CPA Sole Practitioners and CPA Small Firms group on LinkedIn. In it, he provides an excellent example that supports  the imperative that is the subject of both his post and mine.

A California couple, Madhu and Tara Singhal, recently learned that lesson the hard way. In late October, the Tax Court upheld the IRS's imposition of an accuracy-related penalty under section 6662(a). The decision was a summary opinion by Judge Carolyn Chiechi.

Madhu Singhal an electrical engineer and also a member of the California bar, a fact noted by Chiechi,. In 2009 the Singhals formed a limited liability company (MMIT) as a vehicle to sell one of Singhal's inventions. In 2010 MMIT sold the invention for a long-term capital gain of $553,750.

Madhu Singhal engaged a CPA, Paul Gray, to prepare the 2010 Form 1065, "U.S. Return of Partnership Income," for MMIT. On September 15, 2011, Gray sent the completed return for MMIT, including Schedules K-1, to the Singhals. The Schedules K-1 showed their distributive shares, which included the long-term capital gain of $553,750. Gray also sent a separate letter to the Singhals advising that their distributive shares were the amounts to be reported on their 2010 individual tax return and that those shares may not correspond to their actual distributions. It was this latter advice that was the focus of the Tax Court opinion.

The Singhals filed their return on November 6, 2011. Singhal prepared the Form 1040; Gray did not. Their tax return did not reflect the long-term capital gain of $553,750 from MMIT. Instead, they reported a much lower amount.

The IRS issued a deficiency notice to the Singhals regarding their return. The Service determined that the long-term capital gain from MMIT was $553,750, the amount reported on MMIT's Form 1065. The deficiency notice determined an underpayment of $60,687 under section 6651(a)(1) and an accuracy-related penalty under section 6662(a) of 20 percent of the underpayment, or $12,137.

Before trial, the Singhals conceded the underpayment determination by the IRS but contested the accuracy-related penalty. There are two alternative prongs to the section 6662(a) penalty. Under section 6662(b)(1), the penalty is applicable if attributable to the taxpayer's negligence. Under section 6662(b)(2), the penalty is applicable if it amounts to a substantial understatement. As an objective metric, the substantial underpayment prong obviously provides an easier path for the IRS.

A taxpayer can defend against the accuracy-related penalty under section 6662(a) if he can demonstrate reasonable cause and that he acted in good faith under section 6662(c). The IRS carried its burden of proof of a substantial underpayment under section 6662(b)(2) simply by referencing the numbers reported on the Singhals' Form 1040. The taxpayers therefore had the burden of proving reasonable cause.

Their principal argument was that they believed the proper amount to be reported was the amount of distributions received from MMIT. It was that belief, the taxpayers argued, that demonstrated they acted in good faith when underreporting the long-term capital gain.

Chiechi quickly rejected the reasonable cause argument. She noted that the reasonable cause defense is a facts and circumstances determination, which includes an analysis of the taxpayers' "efforts to assess (their) proper tax liability" and their "reliance on the advice of a professional, such as an accountant."

In making her determination, Chiechi focused on the CPA's letter, which specifically advised the taxpayers that the proper amount reportable on their Form 1040 may not correspond to the amount of the distributions from MMIT. At some point during the trial, Chiechi took over the trial's proceedings to ask Singhal a critical question. What, she asked, was his understanding of the letter? Singhal's response must have made his fellow attorneys wince. He said he never read the letter. That answer was clearly the clincher for Chiechi. She said a reasonable person would not have ignored his CPA's advice in preparing the Form 1040. "A reasonable person would have read" the letter, she wrote.

Mr. Chandel's original post is here (LinkedIn membership required). The Tax Court ruling is here (PDF format).

All the code section numbers aside, the taxpayers erroneously did not include almost $554,000 capital gain on their own tax return. Besides additional tax $61,000, the taxpayers owed an accuracy related penalty (of called the negligence penalty) of more than $12,000. One fact that often helps some taxpayers to avoid this penalty is to assert they were following the advice of a tax professional. Unfortunately for the taxpayers in this case, their CPA advised them to do the exact opposite of what they actually did.

As the subject line urges, DON'T IGNORE YOUR CPA'S ADVICE!