Accuracy Related Penalty Under Section 6662 Imposed on Joint Return Despite Claimed Reliance on Tax Return Preparer. Prudhomme et us v. Commissioner, Fifth Circuit, July 16, 2009



The Fifth Circuit Court of Appeals, in a per curiam decision, affirmed the findings and holding of the Tax Court and upheld the imposition of an accuracy related penalty on a husband and wife based on the record before the court. The testimony proferred by each side was conflicting, which is frequently if not generally true in tax litigation proceedings, but the Tax Court found that the taxpayer had not met its burden of production that it acted in good faith and reasonable cause in relying on their accountant who prepared their returns. See §6664(c)(1). Tax Court held that the Prudhommes did not meet this standard because they provided their accountants with insufficient information to prepare the tax return accurately and did not make a reasonable effort to assess their proper tax liability.

After operating a family business for a period of years, the taxpayers sold the business for approximately $11M with approximately one half or $5.5M received in cash, the acquiring company’s stock, valued at $2M and a promissory note for $3.5M. The sale took place in 2003 and the Prudhommes long-standing accounting firm prepared the return which was timely filed after extensions were applied for. The tax return omitted substantial amount of the sales proceeds resulting in additional taxes that were assessed by the Service in the amount of $576,728 which was paid in November, 2005. The accounting firm admitted during the audit  that the error was its error. The taxpayers challenged a 20 percent underpayment (accuracy related) penalty and small penalty for failure to pay the correct amount of estimate taxes. The IRS contended that the taxpayers failed to properly notify the accounting firm of the total amount of sales proceeds it received in the transaction, including a $3.2M dividend they received from the sale. A Tax Court petition subsequently followed on the issue of the penalties..

On appeal to the Fifth Circuit, the Prudhommes asserted that the lower court’s findings of a lack of reasonable cause or acting in good faith on the part of the taxpayers was clearly erroneous. The Fifth Circuit was faced, under its applicable standard of review under §7482(a)(1), as to whether the Tax Court’s fact findings were clearly erroneous.

The Treasury regulations provide that "[t]he determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances." Treas. Reg. § 1.6664-4(b). "Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Id. The regulations also state that a court must consider whether the taxpayer made "an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer." Id. That is, even if a taxpayer relies on an expert, the court still must take into account "[a]ll facts and circumstances" regarding whether that reliance was reasonable and in good faith, including the "taxpayer's education, sophistication and business experience."Treas. Reg. § 1.6664-4(c)(1). Case law reveals that the most important factor is "'the extent of the taxpayer's effort to assess [his] proper tax liability' is '[g]enerally[] the most important factor' in determining reasonable cause and good faith." Stanford v. Comm'r, 152 F.3d 450, 460-61 (5th Cir. 1998) (quoting Treas. Reg. § 1.6664-4(b)). In other words, reliance on a tax professional, however, must be reasonable, and simply relying on a professional is not dispositive. While a taxpayer in avoiding the penalty based on reliance on a tax professional does not require obtaining a second opinion, there is no good faith reliance wheref the taxpayer fails to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item." Treas. Reg. § 1.6664-4(c)(i); see Srivastava v. Comm'r, 220 F.3d 353, 367 (5th Cir. 2000) (rejecting argument that the taxpayers reasonably relied upon a professional because, inter alia, they never gave their accountant a copy of the settlement agreement subject to the tax)..

The record established at trial, in the view of the Fifth Circuit, supported the Tax Court’s holding on the imposition of the penalties. First, the taxpayers did not fully reveal the details of the sale to the accounting firm. This included bank records, a large dividend distribution and other documents of the sale. Second, the court concluded that the Prudhommes did not make a good faith effort to assess their correct tax liability. The court noted that Richard Prudhomme did not even read or sign the return, that Cathy Prudhomme did not verify that all income from the sale of the company was on the return, and that both Prudhommes were not unsophisticated taxpayers but were successful business people.

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