Reasonable Cause

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Chapter 7: Reasonable Cause and Good Faith – IRC § 6664

Reasonable Cause & Good Faith Exception - In General
Section 6664(c) provides an exception, applicable to all types of taxpayers, to the imposition of any accuracy-related penalty if the taxpayer shows that there was reasonable cause and the taxpayer acted in good faith. Special rules, described below, apply to items of a corporation attributable to a tax shelter resulting in a substantial understatement.

The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all relevant facts and circumstances.  See Treas. Reg. § 1.6664-4(b)(1).  The most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.  Other factors to consider are the taxpayer’s experience, knowledge, sophistication and education and the taxpayer’s reliance on the advice of a tax advisor.

All relevant facts, including the nature of the tax investment, the complexity of the tax issues, issues of independence of a tax advisor, the competence of a tax advisor, the sophistication of the taxpayer, and the quality of an opinion, must be developed to determine whether the taxpayer was reasonable and acted in good faith. 

Examples of types of conduct that may, or may not, constitute reasonable cause in this context are described in Exhibit 7

On December 30, 2003, Treasury and the Service amended the IRC § 6664 regulations to provide that the failure to disclose a reportable transaction, on Form 8886, “Reportable Transaction Disclosure Statement,” is a strong indication that the taxpayer did not act in good faith with respect to the portion of an underpayment attributable to a reportable transaction, as defined under IRC § 6011.  See below for a discussion of reliance on advice, in general, and reportable transactions, in particular.  In addition, Treas. Reg. § 1.6664-4(c)(iii) provides that a taxpayer may not rely on an opinion or advice that a regulation is invalid to establish that the taxpayer acted with reasonable cause and good faith unless the taxpayer adequately disclosed, in accordance with Treas. Reg. § 1.6662-3(c)(2), the position that the regulation in question is invalid.

Taxpayer’s effort to assess the proper tax liability
Generally, the most important factor in determining whether the taxpayer has reasonable cause and acted in good faith is the extent of the taxpayer’s effort to assess the proper tax liability.  See Treas. Reg. § 1.6664-4(b)(1); see also Larson v. Commissioner, T.C. Memo 2002-295.  For example, reliance on erroneous information reported on an information return indicates reasonable cause and good faith, provided that the taxpayer did not know or have reason to know that the information was incorrect.  Similarly, an isolated computational or transcription error may indicate reasonable cause and good faith. 

Generally, there is reasonable cause and good faith if the taxpayer relies on erroneous information inadvertently included in data compiled by various divisions of a multidivisional corporation or in financial books and records prepared by those divisions.  The corporation, however, must have employed internal controls and procedures, reasonable under the circumstances, which were designed to identify factual errors.  See, e.g., Vandeyacht v. Commissioner, T.C. Memo. 1994-148 (taxpayers not required to duplicate work done by bookkeepers and accountants; ordinary business care and prudence require taxpayers to take precautions to prevent inaccuracies in income tax returns and books and records used to prepare them). 

Experience, Knowledge, Sophistication and Education of Taxpayer
Circumstances that may suggest reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the facts, including the experience, knowledge, sophistication and education of the taxpayer.  The taxpayer’s mental and physical condition, as well as sophistication with respect to the tax laws at the time the return was filed, are relevant in deciding whether the taxpayer acted with reasonable cause.  See Kees v. Commissioner, T.C. Memo. 1999-41. 

If the taxpayer is misguided, unsophisticated in tax law, and acts in good faith, a penalty is not warranted.  See Collins v. Commissioner, 857 F.2d 1383 (9th Cir. 1988); cf. Spears v. Commissioner, T.C. Memo. 1996-341 (court was unconvinced by the claim of highly sophisticated, able, and successful taxpayers that they acted reasonably in failing to inquire about their investment and simply relying on offering circulars and accountant, despite warnings in offering materials and explanations by accountant about limitations of accountant’s investigation). 

Reliance on Advice
Reliance upon a tax opinion provided by a tax advisor may serve as a basis for the reasonable cause and good faith exception to the accuracy-related penalty.  The reliance, however, must be objectively reasonable.  For example, the taxpayer must supply the advisor with all the necessary information to assess the tax matter.  Similarly, if the advisor suffers from a conflict of interest or lack of expertise that the taxpayer knew or should have known, the taxpayer might not have acted reasonably in relying on that advisor.  See Treas. Reg. § 1.6664-4(c); Neonatology Associates, P.A. v. Commissioner, 299 F.3d 221 (3rd Cir. 2002).  The advice also must be based on all pertinent facts and circumstances and the law as it relates to those facts and circumstances. 

The advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.  For example, the advice must not be based on a representation or assumption which the taxpayer knows, or has reason to know, is unlikely to be true, such as an inaccurate representation or assumption as to the taxpayer’s purposes for entering into a transaction or for structuring a transaction in a particular manner.  See Treas. Reg. § 1.6662-4(g)(4)(ii).  Similarly, the advice must not be based on an assumption that the transaction has a business purpose other than tax avoidance.

Whether a taxpayer reasonably relied on an opinion or advice cannot be determined without reviewing the opinion(s).  At times, a taxpayer may refuse to turn over an opinion the taxpayer claims to have relied on or the taxpayer may assert a privilege claim.  If the taxpayer does so, seek the assistance of subject matter technical advisors or local Chief Counsel attorneys.

Reportable Transactions
The failure of a taxpayer to disclose a reportable transaction is a strong indication that the taxpayer did not act in good faith with respect to the portion of an underpayment attributable to a reportable transaction, as defined under IRC § 6011.  A taxpayer may argue that the failure to disclose was based on the advice of a tax advisor concluding that the transaction was not reportable. 

A taxpayer’s reliance on an opinion that a transaction is not reportable must be reasonable and made in good faith.  An opinion providing that a transaction is not reportable, and, therefore, need not be disclosed is subject to the same scrutiny as the underlying tax opinion or advice.  The taxpayer must demonstrate reasonable cause and good faith as discussed in this ATG.

Nontax Matters
Where a tax benefit depends on nontax factors, the taxpayer has a duty to investigate the underlying factors rather than simply relying on statements of another person, such as a promoter.  See Novinger v. Commissioner, T.C. Memo. 1991-289.  Further, if the tax advisor is not versed in these nontax matters, mere reliance on the tax advisor does not suffice.  See Addington v. United States, 205 F.3d 54 (2d Cir. 2000); Collins v. Commissioner, 857 F.2d 1383 (9th Cir. 1988).

Advisor Independence
Although a tax advisor’s lack of independence is not alone a basis for rejecting a taxpayer's claim of reasonable cause and good faith, the fact that a taxpayer knew or should have known of the advisor's lack of independence is strong evidence that the taxpayer may not have relied in good faith upon the advisor's opinion.  Goldman v. Commissioner, 39 F.3d 402 (2nd Cir. 1994); Pasternak v. Commissioner, 990 F.2d 893, 903 (6th Cir. 1993)(finding reliance on promoters or their agents unreasonable, as “advice of such persons can hardly be described as that of ‘independent professionals’”); Roberson v. Commissioner, 98-1 U.S.T.C. 50,269 (6th Cir. 1998) (court dismissed taxpayer’s purported reliance on advice of tax professional because professional’s status as “promoter with a financial interest” in the investment); Rybak v. Commissioner, 91 T.C. 524, 565 (1988) (negligence penalty sustained where taxpayers relied only upon advice of persons who were not independent of promoters); Illes v. Commissioner, 982 F.2d 163 (6th Cir. 1992) (taxpayer found negligent reliance upon professional with personal stake in venture not reasonable); Gilmore & Wilson Construction Co. v. Commissioner, 99-1 U.S.T.C. 50,186 (10th Cir. 1999) (taxpayer liable for negligence since reliance on representations of the promoters and offering materials unreasonable); Neonatology Associates, P.A. v. Commissioner, 299 F.3d 221 (3rd Cir. 2002)(reliance may be unreasonable when placed upon insiders, promoters, or their offering materials, or when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about). 

Similarly, the fact that a taxpayer consulted an independent tax advisor is not, standing alone, conclusive evidence of reasonable cause and good faith if additional facts suggest that the advice is not dependable.  Edwards v. Commissioner, T.C. Memo. 2002-169; Spears v. Commissioner, T.C. Memo. 1996-341, aff’d 98-1 USTC  50,108 (2d Cir. 1997).  For example, a taxpayer may not rely on an independent tax advisor if the taxpayer knew or should have known that the tax advisor lacked sufficient expertise, the taxpayer did not provide the advisor with all necessary information, the information the advisor was provided was not accurate, or the taxpayer knew or had reason to know that the transaction was “too good to be true.”  Baldwin v. Commissioner, T.C. Memo. 2002-162; Spears v. Commissioner, T.C. Memo. 1996-341, aff’d 98-1 USTC  50,108 (2d Cir. 1997). 

Special Rules for Tax Shelter items of a Corporation
If a corporate taxpayer has a substantial understatement that is attributable to a tax shelter item, the accuracy-related penalty applies to that portion of the understatement unless the reasonable cause and good faith exception applies.  See Treas. Reg. § 1.6664-4(f) at Exhibit 8.  The determination of whether a corporation acted with reasonable cause and good faith is based on all pertinent facts and circumstances.  Treas. Reg. § 1.6664-4(f)(1). 

A corporation's legal justification may be taken into account in establishing that the corporation acted with reasonable cause and in good faith in its treatment of a tax shelter item, but only if there is substantial authority within the meaning of Treas. Reg. § 1.6662-4(d) for the treatment of the item and the corporation reasonably believed, when the return was filed, that the treatment was more likely than not the proper treatment.  Treas. Reg. § 1.6664-4(f)(2)(i)(B).

The reasonable belief standard is met if:

  • the corporation analyzed pertinent facts and relevant authorities to conclude in good faith that there would be a greater than 50 percent likelihood (“more likely than not”) that the tax treatment of the item would be upheld if challenged by the IRS; or
  • the corporation reasonably relied in good faith on the opinion of a professional tax advisor who analyzed all the pertinent facts and authorities, and who unambiguously states that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld if challenged by IRS.  (See Treas. Reg. § 1.6664-4(c) for requirements with respect to the opinion of a professional tax advisor).

Satisfaction of the minimum requirements for legal justification is an important factor in determining whether a corporation acted with reasonable cause and in good faith, but not necessarily dispositive.  See Treas. Reg. § 1.6664-4(f)(3).  For example, the taxpayer’s participation in a tax shelter lacking a significant business purpose or the taxpayer is claiming benefits that are unreasonable in comparison to the taxpayer’s investment should be considered.  Failure to satisfy the minimum standards will, however, preclude a finding of reasonable cause and good faith based (in whole or in part) on a corporation’s legal justification.  See Treas. Reg. § 1.6664-4(f)(2)(i).

If a corporation does not claim legal justification, then other facts and circumstances also may be taken into account regardless of whether the minimum requirements for legal justification are met.  See Treas. Reg. § 1.6664-4(f)(4).

 

 

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