No Reasonable Cause Defense for Preparer's Omission

The Tax Court upheld an accuracy-related penalty, rejecting the husband-and-wife taxpayers’ argument that they had reasonable cause for a tax understatement caused by their return preparer’s apparently accidental omission of an item of income.


The error involved omission of nearly $3.4 million in gain, which was slightly more than 10% of the nearly $33 million in income that taxpayers Stephen G. Woodsum and wife Anne R. Lovett acknowledged was the correct total, the rest of which they reported on their 2006 return. Evidence indicated the firm that prepared the return had overlooked a single Form 1099-MISC reporting the $3.4 million. Woodsum had supplied the firm with the form along with more than 160 information returns from third-party payers, the rest of which the firm included on the couple’s 115-page return.


The omitted amount represented a final distribution to Woodsum from a 10-year partnership-linked swap transaction he terminated during 2006. In previous years, the couple had reported income and deductions relating to the transaction on their income tax returns. Woodsum, the founding managing director of a private equity investment firm, was personally involved in monitoring and terminating the transaction.


A CPA with more than 20 years of tax compliance experience—including with major accounting firms—prepared the return, working for a firm specializing in tax work for private equity and hedge funds and their general partners. Among the other information returns it included was a Form 1099-INT reporting $60,292 interest income from the same partnership swap transaction. The couple met with their attorney, with whom they reviewed the return, and signed it the same day. The taxpayers and their attorney apparently did not notice the omission, the Tax Court said. The IRS did, determining a tax deficiency of $521,473, plus the accuracy-related penalty.


The penalty under IRC § 6662(a) is 20% of a substantial understatement of tax. An understatement is substantial if it is more than the greater of $5,000 or 10% of the correct amount of tax. The taxpayers agreed their correct amount of tax was $4,240,927, of which the deficiency therefore was more than 10%. However, they claimed the defense of section 6664(c)(1)—that they had reasonable cause for the error and acted in good faith. Reliance on professional advice is among grounds for the defense (Treas. Reg. § 1.6664-4(b)(1)).


But this was not a case of reliance on aberrant advice, the court noted. And even though the defense has occasionally been granted for an isolated computational or transcriptional error, those cases have involved complex issues of tax treatment, the court said. While Woodsum’s swap transaction may have been complex, the tax treatment of its resulting gain was not. (The court also said that although the evidence clearly implied that the preparer’s omission was inadvertent, the plaintiffs had presented no direct evidence to that effect.)


Moreover, the taxpayers did not show they had reasonably fulfilled their duty to review the return for accuracy. The taxpayers were unable to say how long they spent reviewing Schedule D (on which they acknowledged the item should have appeared) or the entire return, or whether they compared the schedule with information returns. Given Woodsum’s “watchful eye” over the transaction’s financial performance, the court said, his scrutiny of the tax return and its liability was “so casual that a half-million-dollar understatement of that liability could slip between the cracks,” and upheld the penalty.


  Stephen G. Woodsum and Anne R. Lovett v. Commissioner , 136 TC no. 29


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