1.6694-1(e) - most important part of final regs

I have identified the following quoted language of the regulations as the most important part of the regulations because if you are not careful, it is a trap. Read the language slowly and digest the highlighted portion. How can a return preparer rely on information supplied by a client whan at the same time the return preparer has to make sure that the data complies with the substantive requirements of the IRS Code, IRS regulations, published positions and the rest of the tax law? All items in the schedules filed with any income tax return are based on the technical requirements of the IRS Code, IRS regulatins, etc.

It is my opinion that the reliance on the client information without verification is misleading. Yes, you do not have to verify that your client paid $600 to a charity, but you still have to make sure that charitable deduction meets IRS substantiation requirements which were recently modified. The point is guys & gals, you can no longer just put numbers into software and expect that you will nlot be hit with a $5,000 "reckess" payment for negligently not checking the technical requirements for substantiation.

The language in 1.6694-1(e)and (f) is essentially a trap for the unwary tax return preparer if they think there will be no penalty if they do not check the technical substantiation standards.

There is one important thing you must know. The standard of conduct, even for disclosed positions, is higher than not being negligent. This means that if the return preparer is "negligent" the reckless penalty is predictable.

(e) Verification of information furnished by taxpayer or other party --(1) In general . For purposes of sections 6694(a) and (b) (including demonstrating that a position complied with relevant standards under section 6694(a) and demonstrating reasonable cause and good faith under §1.6694-2(e)) , the tax return preparer generally may rely in good faith without verification upon information furnished by the taxpayer. A tax return preparer also may rely in good faith and without verification upon information and advice furnished by another advisor, another tax return preparer or other party (including another advisor or tax return preparer at the tax return preparer's firm). The tax return preparer is not required to audit, examine or review books and records, business operations, documents, or other evidence to verify independently information provided by the taxpayer, advisor, other tax return preparer, or other party. The tax return preparer, however, may not ignore the implications of information furnished to the tax return preparer or actually known by the tax return preparer. The tax return preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. Additionally, some provisions of the Code or regulations require that specific facts and circumstances exist (for example, that the taxpayer maintain specific documents) before a deduction or credit may be claimed. The tax return preparer must make appropriate inquiries to determine the existence of facts and circumstances required by a Code section or regulation as a condition of the claiming of a deduction or credit.


(2) Verification of information on previously filed returns . For purposes of section 6694(a) and (b) (including meeting the reasonable to believe that the position would more likely than not be sustained on its merits and reasonable basis standards in §§1.6694-2(b) and (d)(2), and demonstrating reasonable cause and good faith under §1.6694-2(e)) , a tax return preparer may rely in good faith without verification upon a tax return that has been previously prepared by a taxpayer or another tax return preparer and filed with the IRS. For example, a tax return preparer who prepares an amended return (including a claim for refund) need not verify the positions on the original return. The tax return preparer, however, may not ignore the implications of information furnished to the tax return preparer or actually known by the tax return preparer. The tax return preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. The tax return preparer must confirm that the position being relied upon has not been adjusted by examination or otherwise.


With this last blog of the year, let me wish you all a very Happy New Year without and 6694 penalties.

This web page picks up about 50 new IP addresses each day of the week. We have received lots of positive feedback. The comment comes in through ab@irstaxattorney.com. However you can make comment to these blogs. I would like nothing better than to have blogs like the one above debated or apended. I could write an article on just the analysis of 1.6694-1(e) and (f). You are welcome to make negative comment and disagree on any point made. Or if you wish, comment or related technical issues.

I deal with the IRS examiners regularly. They are aggressive. They will be motivated to go after the penalties. If there is a substantiation problem in the soon to be filed tax returns, expect to be changed with the penalty. I have been pounding the table saying that any compliance matters will be viewed as your fault and per se negligence. "Negligence" is sufficient to trigger the 6694 penalty even under pre-1979 law. If the penalty would be triggered under pre-1979 law, is it not obvious that it would trigger the "reckless" 6694(b) $5,000 penalty even for disclosed positions that the IRS has determined to be negligent for missing substantiation requirements? I believe that is an obvious conclusion. If I have dwelled on this, it is because I consider the above language to be a "trap."

Thank you all for all of the kind message you have sent to my office.

Alvin S. Brown, Esq.

Passive losses and 6694

The Lowe case, decided yesterday, is instructive on passive loss issues. The Tax Court also commented on due care and what a reasonably prudent person would do. Obviously, this is threshold all return preparer need to meet and more. With the 6694 penalty in mind, return preparers would have to treat as a “red flag” any situation where your client is generating losses. One of the points I have made repeatedly is the necessity for return preparers to make sure that they have acess to a tax research service and make sure the client meeets all technical standards. As noted by the Tax Court... Negligence has been defined as lack of due care or failure to do what a reasonably prudent person would do under like circumstances. See, e.g., Hofstetter v. Commissioner, 98 T.C. 695, 704 (1992). It also "includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return." Sec. 1.6662-3(b)(1), Income Tax Regs. If you jurt rely on client data, without checking for technical substantiation, you will be destroyed by the oppressive $5,000 penalties for being "reckless."


William C. and Cristina Lowe v. Commissioner.Dkt. No. 15592-06 , TC Memo. 2008-298, December 29, 2008. T.C. Memo. 2008-298

1. Held: The 1994 and 1996-2002 losses constitute suspended passive activity losses, and the excess of those losses over the unreported 1995 gain may be carried forward as a partial offset to Ps' unreported 2003 long-term capital gain from DA.

2. Held, further, Ps have not produced credible evidence that there are any suspended passive activity losses from 1985-90 or 1992 available for carryover to 2003, and, therefore, no carryover from those years is permitted.

3. Held, further, R's penalty against Ps is sustained, in part, under sec. 6662, I.R.C.

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: By notice of deficiency dated May 9, 2006, respondent determined a deficiency in petitioners' 2003 Federal income tax of $69,351 and an accuracy-related penalty of $13,870.20. Petitioners assign error to both of those determinations. The issues for decision are (1) the extent, if any, to which there exist unused or suspended passive activity losses arising in taxable years before 2003 and attributable to petitioner William C. Lowe's (Mr. Lowe's) interest in a real estate limited partnership that, pursuant to section 469(b) and (g), 1 are available to petitioners as offsets to the unreported 2003 long-term capital gain Mr. Lowe realized upon the termination of his investment in the partnership, and (2) whether petitioners are liable for the accuracy-related penalty under section 6662(a).

The notice contains certain other adjustments that are purely computational. Their resolution depends upon our resolution of the first issue in dispute.
FINDINGS OF FACT 2

Some facts are stipulated and are so found. The stipulation of facts, with accompanying exhibits, is incorporated herein by this reference.

At the time the petition was filed, petitioners resided in Lake Forest, Illinois.
Mr. Lowe's Background and Job History
Mr. Lowe earned a B.S. in physics from Lafayette College in 1962. He then was employed by IBM as an engineer and, by 1985, had become a corporate vice president and president of IBM's entry systems division. Although his formal training was in physics, he had some responsibilities for business decisions in his area. In general, however, Mr. Lowe depended upon the chief financial officer to support the financial decisions relating to the products with which he was concerned.

During 1985, Mr. Lowe resided in Chappaqua, New York. He became an executive for Xerox Corp. in 1988 and remained at Xerox until 1991. During that period, he continued to reside in Chappaqua. He then embarked upon a series of job changes and relocations: In 1991, he became the chief executive officer (CEO) of Gulfstream Aerospace in Savannah, Georgia, and he moved to Hilton Head, South Carolina; in 1993, he became the CEO of New England Business Services in Groton, Massachusetts, and he moved to Concord, Massachusetts; and, in 1996, he became executive vice president, North America, for Moore Corp., headquartered in Lake Forest, Illinois, which became his new place of residence. Then, in late 1998 or early 1999, petitioner Cristina Lowe's (Mrs. Lowe's) mother passed away, and petitioners moved to Tucson, Arizona, to be with Mrs. Lowe's father. In 2004, petitioners moved back to Lake Forest, Illinois.
Mr. Lowe's Investment in Douglas Associates
In 1985, while Mr. Lowe was at IBM, a financial adviser from Chase Bank, used by Mr. Lowe and a number of other IBM executives, advised Mr. Lowe to get involved in some limited partnerships. He specifically recommended that Mr. Lowe invest in Douglas Associates, a limited partnership engaged in renting real estate. Thereupon, Mr. Lowe invested $200,000 in Douglas Associates in exchange for a limited partnership interest.

Douglas Associates issued Schedules K-1, Partner's Share of Income Credits, Deductions, etc. (the Schedules K-1), to Mr. Lowe for each year of its existence (1985-2003), and Mr. Lowe retained his limited partnership interest in Douglas Associates for that entire period. The Schedules K-1 reported Mr. Lowe's annual share of Douglas Associates' gains and losses as follows:
Year Gain (Loss) 1985 ($7,961) 1986 (31,817) 1987 (61,526) 1988 (71,581) 1989 (63,587) 1990 (58,029) 1991 (49,152) 1992 (49,336) 1993 (46,596) 1994 (43,615) 1995 107,580 1996 (15,102) 1997 (15,469) 1998 (16,667) 1999 (14,257) 2000 (20,645) 2001 (6,638) 2002 ($7,835) 2003 1292,853 1 The 2003 Schedule K-1 (which covered Douglas Associates' final taxable year, ending July 15, 2003) also reported that Mr. Lowe's share of unrecaptured depreciation gain from "flow through entity" was $109,913. Respondent does not argue that that amount reduces the amount of suspended passive activity losses that may be available to offset the $292,853 long-term capital gain Mr. Lowe realized upon the termination of his investment in Douglas Associates. Therefore, we will ignore that amount in determining the amount of suspended passive activity losses, if any, available for that purpose.

The 1985 and 1986 Schedules K-1 reported Mr. Lowe's losses for those years on line 1, "Ordinary income (loss)". The Schedules K-1 for all subsequent years (1987-2003) reported his gains or losses on the line entitled "Reconciliation [or 'Analysis'] of partner's capital account", and/or that entitled "Income [or 'Net income'] (loss) from rental real estate activities".

Mr. Lowe received the 1985-93 Schedules K-1 and turned them over to his tax return preparer. Having failed to notify Douglas Associates of his various changes of address between 1994 and 2003, Mr. Lowe did not receive any of the Schedules K-1 issued for those years. 3
Tax Reporting of the Gains and Losses Reflected on the Schedules K-1
Mr. Lowe reported the losses attributed to him on the 1991 and 1993 Schedules K-1 (jointly with his former spouse for 1991 and jointly with Mrs. Lowe for 1993) as currently deductible on the returns filed for those years. On the joint returns petitioners filed for 1994 through 2003, they reported neither the gains, for 1995 and 2003, nor the losses, for the other years, reflected on the Schedules K-1 for those years. Mr. Lowe was unable to obtain copies of his 1985-90 and 1992 returns, and those returns are not in evidence. 4

Mr. Lowe's 1985-92 returns were prepared by Joseph Cannistra & Co., in Mount Kisco, New York. His 1993-2003 returns were prepared by at least six different tax preparers, generally located near his residence, which, as noted supra, changed several times during those years.
OPINION
I. Petitioners' Entitlement to a Passive Activity Loss Carryover
A. Applicable Law

Section 469, dealing with passive activity losses and credits, was added to the Internal Revenue Code by section 501 of the Tax Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 501, 100 Stat. 2233. Theretofore, there had been no generally applicable limitation on a taxpayer's ability to use losses from a particular trade or business activity to offset income from other such activities. That circumstance gave rise to the proliferation of tax shelters permitting taxpayers to reduce or avoid taxes on salary or other positive income through the use of losses (often in excess of real economic costs) incurred in advance of any income from the shelters. See H. Conf. Rept. 99-841 (Vol. II) at II-137 (1986), 1986-3 C.B. (Vol. 4) 1, 137; S. Rept. 99-313, at 713 (1986), 1986-3 C.B. (Vol. 3) 1, 713.

In pertinent part, section 469(a)(1) provides that an individual's "passive activity loss" for any taxable year shall not be allowed. Section 469(c)(1) defines a "passive activity" as one which involves the conduct of any trade or business in which the taxpayer does not materially participate. 5 Section 469(d)(1) defines a passive activity loss as the amount, for the taxable year, by which aggregate losses from all passive activities exceed aggregate income from those activities. Thus, losses arising from a passive activity are deductible only against income from that activity or another passive activity. See S. Rept. 99-313, supra at 722, 1986-3 C.B. (Vol. 3) at 722. Section 469(b) provides that any passive activity loss disallowed under subsection (a) shall be treated as a deduction allocable to that same passive activity in the next taxable year. If the carried-over passive activity loss becomes a nonallowable passive activity loss for the carryover year, it is carried over to the succeeding year. Disallowed or suspended losses may be carried over indefinitely until they are used. 6 See S. Rept. 99-313, supra at 722, 1986-3 C.B. (Vol. 3) at 722; Bittker & Lokken, Federal Taxation of Income, Estates and Gifts, par. 28.9, at 28-91 (3d ed. 1999). Pursuant to section 469(g)(1)(A) and (B), if a taxpayer disposes of his entire interest in a passive activity to an unrelated person in a transaction in which all gain or loss is recognized, suspended passive activity losses (remaining after the application of section 469(b)) are deductible without limitation (i.e., they are treated as losses "not from a passive activity") in the year of disposition. 7

Section 469 generally applies to taxable years beginning after December 31, 1986, and does not apply to losses from pre-1987 taxable years carried forward to post-1986 taxable years. TRA sec. 501(c)(1) and (2). Section 469(m) provides a 5-year phase-in for passive activity losses from interests held before the new law's date of enactment, October 22, 1986, pursuant to which an increasing percentage of such losses becomes subject to the new rules, with 100 percent of such losses becoming subject thereto for taxable years beginning in or after 1991.

B. Arguments of the Parties

Petitioners argue that the losses set forth on the Schedules K-1 issued to Mr. Lowe by Douglas Associates for 1985-90, 1992, 1994, and 1996-2002, totaling $484,065, and from which they "have received no tax benefit", 8 are passive activity losses, which "more than offset any gains from Douglas Associates"; i.e., the 1995 and 2003 gains totaling $400,433. 9

Respondent argues: "Because petitioners have failed to substantiate the transactions surrounding the alleged passive activity losses * * *, petitioners cannot satisfy the statutory requirements for carrying forward suspended * * * [passive activity losses]". He concludes that those alleged losses "cannot be properly carried forward because they are not suspended * * * [passive activity losses] pursuant to * * * [section] 469." Alternatively, respondent argues that, even if we decide that the losses set forth on the 1994 and 1996-2002 Schedules K-1, totaling $140,228, constitute suspended passive activity losses available as a carryover, 10 they must be offset by the unreported 1995 gain of $107,580, leaving only $32,648 in suspended passive activity losses as an offset to the unreported 2003 gain of $292,853, resulting in net unreported gain of $260,205.

C. Burden of Proof

In pertinent part, Rule 142(a)(1) provides, as a general rule: "The burden of proof shall be upon the petitioner". In certain circumstances, however, if the taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the proper tax liability, section 7491 places the burden of proof on the Commissioner. Sec. 7491(a)(1); Rule 142(a)(2). Credible evidence is evidence that, after critical analysis, a court would find constituted a sufficient basis for a decision on the issue in favor of the taxpayer if no contrary evidence were submitted. Baker v. Commissioner, 122 T.C. 143, 168 (2004); Bernardo v. Commissioner, T.C. Memo. 2004-199 n.6. Section 7491(a)(1) applies only if the taxpayer complies with substantiation requirements, maintains all required records, and cooperates with the Commissioner's requests for witnesses, information, documents, meetings, and interviews. Sec. 7491(a)(2).

For the reasons discussed infra section E.3.a., we find that petitioners have failed to introduce credible evidence that any of the losses reflected on the Schedules K-1 for 1985-90 and 1992 (the pre-'93 losses) constitute suspended passive activity losses. It follows that petitioners retain the burden of proving that those losses are available to offset their 2003 gain on the disposition of Mr. Lowe's interest in Douglas Associates, a burden that, because of the absence of credible evidence on that issue, petitioners cannot sustain. See Bernardo v. Commissioner, supra n.7; see also Rendall v. Commissioner, 535 F.3d 1221, 1225 (10th Cir. 2008) (citing Bernardo v. Commissioner, supra), affg. T.C. Memo. 2006-174. Therefore, our discussion of that issue may be viewed as setting forth the basis for our determination that petitioners have failed to (1) introduce credible evidence and (2) carry their burden of proof. See Bernardo v. Commissioner, supra; see also Rendall v. Commissioner, supra at 1225.

The parties also disagree as to the status of the losses reflected on the Schedules K-1 for 1994 and 1996-2002 (the post-'93 losses) as suspended passive activity losses. We need not decide whether section 7491(a) applies to that issue because we resolve it upon a preponderance of the evidence. Therefore, resolution of the issue does not depend upon which party bears the burden of proof. See, e.g., Bergquist v. Commissioner, 131 T.C. ___, ___ (2008) (slip op. at 30).

D. Respondent's Motion for Leave To File Amendment to Answer To Conform to the Evidence

On January 31, 2008, respondent moved, pursuant to Rule 41(b), for leave to file an amendment to the answer to conform to the evidence (the motion). In the motion, respondent raises the duty of consistency as an affirmative defense to what he considers petitioners' attempt to characterize the 1985-93 losses, alleged by respondent to have been reported as active losses on the 1985-93 returns, 11 as suspended passive activity losses available to offset their unreported 2003 passive activity gain. 12 Petitioners oppose the motion.

We need not rule upon the motion because, as noted supra, we find that petitioners have failed to introduce credible evidence that the pre-'93 losses constitute suspended passive activity losses. That finding, together with the parties' stipulation that petitioners reported the 1991 and 1993 losses as active losses (so that petitioners concede they may not be carried forward as suspended passive activity losses) renders moot respondent's motion, which, in substance, seeks the same result.

E. Discussion

1. Introduction

The parties' joint exhibits include copies of petitioners' 1994 and 1996-2002 returns. Those returns show that petitioners did not report or deduct the post-'93 losses. Petitioners' tax treatment of the pre-'93 losses is not evidenced by copies of returns filed for those years. The only support for petitioners' argument that those losses were never deducted and, therefore, remain available for carryover to 2003 is Mr. Lowe's testimony to that effect. Because of that evidentiary difference, we separately consider those two groups of alleged passive activity losses.

2. The Post-'93 Losses

a. Analysis

Respondent states that petitioners have failed to provide a "valid explanation as to why * * * [Mr. Lowe] invested in Douglas Associates" and that Mr. Lowe "failed to explain why he had very limited records relating to his roughly 20-year participation in" that partnership and why he never inquired further relating to his $200,000 investment therein. Respondent concludes: "Because petitioners have failed to substantiate the transactions surrounding the alleged passive activity losses * * * [they] cannot satisfy the statutory requirements for carrying forward suspended * * * [passive activity losses]." Respondent also cites a taxpayer's right, under section 469(g)(1), to carry forward suspended passive activity losses to the year in which the taxpayer disposes of his entire interest in the passive activity to an unrelated party, provided all gain or loss on the disposition is recognized. He then states: "[Mr. Lowe] has not substantiated that this [i.e., that there is a suspended loss] is true for any of the * * * [passive activity losses], and thus, [he] cannot carry any of * * * [them] forward." (Emphasis supplied.) We disagree as regards the post-'93 losses.

Mr. Lowe testified that he invested in Douglas Associates upon the advice of a financial adviser who provided investment advice to IBM executives like him. The adviser suggested that he become involved in limited partnerships and, specifically, that he invest in Douglas Associates. The parties have stipulated that from 1985 through 2003 Douglas Associates was a limited partnership engaged in the activity of renting real estate, and that Mr. Lowe held a limited partnership interest therein. According to the Schedules K-1 issued by Douglas Associates, which are unchallenged, Mr. Lowe's investment in Douglas Associates did give rise to the alleged losses (both pre-and post-'93), and the 1994 and 1996-2002 returns provide unchallenged verification that the post-'93 losses were not claimed on those returns and did not give rise to any tax benefit to petitioners before 2003. Moreover, pursuant to section 469(c)(1) and (h)(2) and section 1.469-5T(e), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988), which, together, establish that Mr. Lowe's limited partnership interest in Douglas Associates constituted a passive activity, it is clear that the post-'93 losses constituted passive activity losses. Lastly, there is no dispute that all of the other requirements of section 469(g)(1) for carrying forward the post-'93 losses to offset the 2003 capital gain on termination of Mr. Lowe's interest in Douglas Associates have been met. Respondent does not dispute that, as reflected on the 2003 Schedule K-1, the partnership was terminated in a fully taxable transaction, and respondent does not allege that that termination constituted a "disposition [of the limited partnership interests] involving [a] related party" within the meaning of section 469(g)(1)(B).

b. Conclusion

The post-'93 losses constitute suspended passive activity losses that may be carried forward to 2003 pursuant to section 469(b) and (g)(1)(A).

3. The Pre-'93 Losses

a. Analysis

Because the 1985-90 and 1992 returns are not in evidence, petitioners' position that the pre-'93 losses constitute suspended passive activity losses available for carryover to 2003 is based solely upon Mr. Lowe's testimony. That testimony is not persuasive.

Mr. Lowe testified that, beginning with his receipt of the 1985 Schedule K-1, his "process was to turn * * * [the Schedules K-1] over to my tax preparer, who I depended upon to deal with them properly and put my returns in proper form." 13 He further testified that the C.P.A. firm that prepared his 1985 return (as well as all subsequent returns through 1992) told him that the 1985 loss was a "passive loss", that he could not "do anything with" the loss, and that his "expectation from that point forward was that's the way they would be treated". Mr. Lowe expressed his "belief" that the 1985-90 losses reflected on the Schedules K-1 for those years "were never claimed", and that the same was true for 1992. He had no explanation as to why the 1991 and 1993 losses were reported as "active losses" on the returns for those years, and he testified that "it was a surprise to me to discover that those losses had been claimed."

Mr. Lowe's testimony that the pre-'93 losses were not claimed is implausible in several respects. To begin with, before the enactment of section 469 in 1986, the concept of active versus passive losses did not exist for deductibility purposes, and, with the exception of the section 1211(b) limitations on the deductibility of capital losses, losses incurred by an individual in connection with a trade or business or in a transaction entered into for profit were fully deductible under section 165(c)(1) and (2). Moreover, as noted supra section I.A., section 469 did not become effective until 1987; and, until 1991, it only affected a portion of the losses from preenactment investments such as Mr. Lowe's interest in Douglas Associates. Lastly, the Schedules K-1 for 1985 and 1986 listed the losses for those 2 years on a line entitled "Ordinary income (loss)". 14 Under those circumstances, we find incredible Mr. Lowe's testimony that his professional tax-advisor (1) did not deduct the losses reflected on the Schedules K-1 for 1985 and 1986 and (2) told him, in connection with the preparation of his 1985 return, that the 1985 loss was a "passive loss" and that he "couldn't do anything with it."

Petitioners' argument that the pre-'93 losses subject to section 469, in whole or in part (1987-92), were not deducted is not based upon the returns for those years (which are not in evidence) or even upon Mr. Lowe's recollection based upon his prior review of those returns but, instead, upon his "belief" that those losses "were never claimed". That belief, based upon an alleged conversation that took place some 22 years earlier, is belied by the 1991 return, which shows that the firm responsible for preparing the 1985-92 returns treated the loss reflected on the 1991 Schedule K-1 as a deductible, ordinary loss. The 1991 return, at the very least, implies that neither the return preparer nor the reviewer(s) (if any) were aware of the section 469 limitations on the deductibility of passive activity losses, and that they, therefore, continued to deduct in full, after 1986, the losses reflected on the Schedules K-1. 15 On the other hand, if we assume that Mr. Lowe's return preparers applied section 469 to Mr. Lowe's passive activity losses reflected on the Schedules K-1 for 1987-90 and 1992, including the phase-in rules of section 469(m) applicable to 1987-90, there is no evidence of the extent to which those passive activity losses may have been used as offsets to passive activity income or gain from interests other than Mr. Lowe's interest in Douglas Associates, thereby making them unavailable for carry forward to 2003. 16

b. Conclusion

Mr. Lowe has not provided credible evidence of the existence of pre-'93 passive activity losses available for carry forward to 2003 pursuant to section 469(b) and (g)(1)(A).

F. Conclusion

Petitioners may carry forward to 2003 post-'93 losses of $32,648.
II. Section 6662(a) Penalty
A. Applicable Law

Section 6662(a) provides for a penalty equal to 20 percent of the portion of any underpayment of tax attributable to, among other things, negligence or intentional disregard of rules or regulations (without distinction, negligence), any substantial understatement of income tax, or any substantial valuation misstatement. See sec. 6662(b)(1)-(3). Although the notice states that respondent bases his imposition of the penalty of $13,870.20 on "one or more" of the three above-referenced grounds, on brief he relies upon only the first two of those grounds: negligence and substantial understatement of income tax.

Negligence has been defined as lack of due care or failure to do what a reasonably prudent person would do under like circumstances. See, e.g., Hofstetter v. Commissioner, 98 T.C. 695, 704 (1992). It also "includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return." Sec. 1.6662-3(b)(1), Income Tax Regs.

For individuals, a substantial understatement of income tax exists "if the amount of the understatement for the taxable year exceeds the greater of --(i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $5,000." Sec. 6662(d)(1)(A).

Section 6664(c)(1) provides that the accuracy-related penalty shall not be imposed with respect to any portion of an underpayment if it is shown that there was reasonable cause for that portion and the taxpayer acted in good faith with respect to that portion. Further:

The 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. * * * Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of * * * law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer. * * * [ Sec. 1.6664-4(b)(1), Income Tax Regs.]

B. Analysis

Even with a $32,648 offset to petitioners' unreported capital gain for 2003, it is clear that there was a substantial understatement of petitioners' 2003 income tax within the meaning of section 6662(d)(1)(A). 17 Alternatively, we find that that understatement was attributable to negligence, within the meaning of section 6662(c), on Mr. Lowe's part. He did not exercise due care or do what a reasonably prudent person would do; rather, he adopted an attitude of total indifference to his investment in Douglas Associates. That indifference caused him not to notify Douglas Associates of his various changes of address after 1993, and that inaction resulted in his not receiving the 2003 Schedule K-1 or including, on his 2003 return, the long-term capital gain of $292,853 reflected on that Schedule K-1. Mr. Lowe's stated assumption that Douglas Associates would perpetually generate nondeductible losses (so that there was no reason for him to make certain that he would receive the Schedules K-1 after he changed his address in 1993) was not a reasonable or prudent assumption, even if it was based upon advice from a professional tax return preparer. The reasonableness of Mr. Lowe's predicating such an assumption upon that advice is undercut by his testimony that the advice related only to the initial year of the investment, 1985, a year which preceded the effective date of the passive loss provisions, and that it was his own "expectation from that point forward" that the losses would continue to be nondeductible. Moreover, it was not reasonable for an individual of Mr. Lowe's background and experience to make a $200,000 investment with the sole expectation that it would do no more than generate perpetual losses of no economic benefit to him. He knew, or should have known, that Douglas Associates owned real estate of some potential value, which might be sold at some time, and that such a sale, in part because of the property's depreciated tax basis, might produce a taxable gain to the investors. For that reason alone Mr. Lowe was negligent in turning his back on the Schedules K-1.

The same reasons that form the basis for our finding that petitioners' underpayment of the 2003 tax liability was attributable to Mr. Lowe's negligence also form the basis for our finding that there was no reasonable cause for that underpayment, and that Mr. Lowe failed to act in good faith with respect thereto. See sec. 6664(c)(1).

C. Conclusion

Petitioners are liable for the section 6662(a) penalty as applied to the underpayment of tax determined herein.

To reflect the foregoing,

Decision will be entered under Rule 155.
1 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the year at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.2 Pursuant to Rule 151(e)(3), each party, in the answering brief, is required to "set forth any objections, together with the reasons therefor, to any proposed findings of any other party". Petitioners have filed an answering brief, but they have failed to set forth objections to respondent's proposed findings of fact. Accordingly, we must conclude that petitioners have conceded that respondent's proposed findings of fact are correct except to the extent that those findings are clearly inconsistent with either evidence in the record or petitioners' proposed findings of fact. See, e.g., Jonson v. Commissioner, 118 T.C. 106, 108 n.4 (2002), affd. 353 F.3d 1181 (10th Cir. 2003).3 The 1998-2002 Schedules K-1 were addressed to Mr. Lowe at his address in Lake Forest, Illinois, which indicates that someone had advised Douglas Associates that Mr. Lowe resided at that address. Presumably, Mr. Lowe's failure to receive them is attributable to petitioners' late 1998 or early 1999 move from Lake Forest to Tucson, Arizona. The 2003 Schedule K-1 was mistakenly addressed to Mr. Lowe at a different address in Lake Forest, Illinois, at a time when petitioners were still residing in Tucson.4 The 1995 return is also not in evidence, but the parties stipulate that petitioners did not report on that return the $107,580 gain reported on the Douglas Associates 1995 Schedule K-1.5 With exceptions not here relevant, an individual is not treated as materially participating in any activity of a limited partnership of which he is a limited partner (e.g., Mr. Lowe is not treated as materially participating in Douglas Associates' activities). See sec. 469(h)(2); sec. 1.469-5T(e), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988).6 Because disallowed or suspended losses from a passive activity are allowable in full upon a fully taxable disposition of that activity (see discussion infra), it is necessary to determine the portion of each year's passive activity loss carryover that is allocable to each of the taxpayer's passive activities, assuming the taxpayer owns interests in more than one. See S. Rept. 99-313, at 722 (1986), 1986-3 C.B. (Vol. 3) 1, 722; sec. 1.469-1(f)(4)(i), Income Tax Regs.; sec. 1.469-1T(f)(2), Temporary Income Tax Regs., 53 Fed. Reg. 5706 (Feb. 25, 1988).7 In this case, the nonpassive activity loss characterization would apply only to the extent Mr. Lowe's suspended loss carryover exceeded his unreported capital gain on the disposition of his interest in Douglas Associates.8 The parties stipulate (and the 1991 and 1993 returns verify) that the losses reported on the 1991 and 1993 Schedules K-1 were deducted as nonpassive or "active" losses, and petitioners concede that the alleged passive activity loss carryover is "net of claimed active losses".9 Petitioners do not dispute the status of the unreported 1995 gain as an offset to their alleged suspended passive activity loss carryover to 2003. What they seek is to "apply all passive * * * [losses] ( net of claimed active losses and unreported gains) to offset any tax liability for 2003." (Emphasis supplied.)10 As explained infra sec. I.D., respondent believes that petitioners' duty to be consistent forecloses their claim that the 1985-93 losses are available to offset their unreported 2003 passive activity gain.11 As noted supra note 8, the parties stipulate that the losses reported on the 1991 and 1993 Schedules K-1 were deducted as active losses for those years.12 The "Amendment To Answer" filed with the motion erroneously refers to "passive gains in 2004".13 Mr. Lowe's practice of turning over the Schedules K-1 to his accountants of course ceased after 1993 when he no longer received any from Douglas Associates.14 For subsequent years, the Schedules K-1 listed Mr. Lowe's pass-through gain or loss on a line entitled "Income [or 'Net income'] (loss) from rental real estate activities" and/or on a line entitled "Reconciliation of partner's capital account".15 The ordinary loss treatment in 1993 by a new return preparer of the loss reflected on the 1993 Schedule K-1 is, perhaps, explainable if we assume that that preparer followed the questionable practice of treating the Schedule K-1 loss for 1993 just as the Schedule K-1 losses had been treated by the prior return preparer for prior years. Of course, that practice, if it existed, necessarily stopped, beginning in 1994, when Mr. Lowe stopped receiving Schedules K-1 from Douglas Associates and, therefore, was unable to furnish them to his return preparers.16 The 1991 and 1993 returns, both of which reflect investments in partnerships other than Douglas Associates, indicate that Mr. Lowe may very well have maintained such investments during the entire 1987-92 period.17 Mr. Lowe Petitioners' taxable unreported long-term capital gain for 2003 as determined herein is $260,205 ($292,853 - $32,648). Applying the 15-percent maximum capital gain rate under sec. 1(h)(1)(C) applicable to net capital gain realized in taxable years ending on or after May 6, 2003, petitioners' understatement of tax attributable to that gain is $39,031 (15 percent of $260,205). That understatement exceeds $5,000 and 10 percent of the tax required to be shown on petitioners' 2003 return, which, as computed by respondent is $71,820, an amount that, presumably, will be reduced by our allowance of a portion of the passive activity loss carryover claimed by petitioners.

6694 - alimony- reliance

Section 71(b) of the Code provides a statutory definition of "alimony or separate maintenance payments." If return preparers merely accept a number from a client as “alimony or separate maintenance” without checking the documentation for that number or the legal definition directly in the Code, that would be clearly “reckless” and I do not have the slightest doubt that the return preparer and the firm who employs the return preparer will each be liable for $5,000 in penalties.

There is zero doubt in my mind that the failure to not follow Code and Regulation definitions is per se “reckless” within the meaning of section 6694(b).

This issues comes up with some frequency. I have received lots of calls from taxpayers when audited on this issues and, for that reason.

Where there are CPA firms and other tax preparation organizations, you need to make sure that you have procedures in place to make sure employees do not miss the substantiation requirements in statutes and regulations, as well as IRS published positions.

Although the final 6694 regulations indicate that you can rely on data from clients, those regulations also have due diligence requirements. All exclusion from income issues should be documented and substantiated. That should be in every procedures book for every return preparer and return preparation firm.

I do not know how return preparers without technical research services will be able to survive as tax return preparers because of the large size of the return preparer penalties. For those with research capabilities, you need to staff up for the extra time that will be needed to prepare tax returns.

For any questions on this topic, contact ab@irstaxattorney.com.




W.O. MelvinDecember 29, 2008WALTER OLIVER MELVIN, Petitioner-Appellant v. COMMISSIONER OF IRS, Respondent-Appellee.

IN THE UNITED STATES COURT OF APPEALS FOR THE ELEVENTH CIRCUIT. No. 08-13329. Non-Argument Calendar. Agency No. 21192-06. Petition for Review of a Decision of the United States Tax Court. (December 17, 2008).

Before DUBINA, BARKETT and PRYOR, Circuit Judges.PER CURIAM: Appellant Walter Oliver Melvin, proceeding pro se , appeals the U.S. Tax Court's final decision in favor of the Commissioner of the Internal Revenue Service ("Commissioner" or the "IRS") on his petition for redetermination of deficiency.

On appeal, Melvin first argues that he was entitled to deduct $6,000 from his 2003 income tax returns because his 1985 divorce decree ordered that he pay alimony, through the seizure of property to be credited at the rate of $500 per month, to his ex-spouse. He asserts that, because he was required to pay all of the alimony in advance, he should thus be allowed to claim a deduction on his 2003 tax return. Second, Melvin argues that he was denied due process of law because his trial before the Tax Court was cut short before he was allowed to hear the position of, and cross-examine, the IRS.

I. Tax Deficiency

We review a Tax Court's conclusions of law de novo and its factual findings for clear error. Creel v. Comm'r , 419 F.3d 1135, 1139 (11th Cir. 2005). "The Commissioner's determination of a deficiency is presumed correct, and the taxpayer has the burden of proving it is incorrect." Webb v. Comm'r , 872 F.2d 380, 381 (11th Cir. 1989).Section 215 of the Internal Revenue Code ("I.R.C.") states, "[i]n the case of an individual, there shall be allowed as a deduction an amount equal to the alimony or separate maintenance payments paid during such individual's taxable year." I.R.C. § 215(a) , 26 U.S.C. § 215(a) . It further states that alimony means any alimony payment as defined in I.R.C. § 71(b) "which is includible in the gross income of the recipient under section 71 ." I.R.C. § 215(b) , 26 U.S.C. § 215(b) .Section 71(b) of the I.R.C. states:

(1) In general. --The term "alimony or separate maintenance payment" means any payment in cash if --

(A) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument,

(B) the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under this section and not allowable as a deduction under section 215 ,

(C) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made, and

(D) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.
I.R.C. § 71(b) , 26 U.S.C. § 71(b) ."If [a] statute's meaning is plain and unambiguous, there is no need for further inquiry. The plain language is presumed to express congressional intent and will control a court's interpretation." United States v. Fisher , 289 F.3d 1329, 1338 (11th Cir. 2002).Because in 2003 Melvin admittedly made no alimony payments, as defined in the I.R.C., we conclude that he was not allowed to claim an alimony deduction on his 2003 income tax returns. Melvin was thus unable to meet his burden to show that the Commissioner erred in Melvin's deficiency determination, and the Tax Court properly entered a decision in the Commissioner's favor.

II. Due Process

The Due Process Clause of the Fifth Amendment provides that "[n]o person shall ... be deprived of life, liberty, or property, without due process of law." U.S. Const. amend. V. Rudimentary due process includes reasonable notice and an opportunity to rebut the charges and be heard. American Druggists Ins. Co., Inc. v. Bogart , 707 F.2d 1229, 1237 (11th Cir. 1983).The IRS made its arguments known to Melvin in both its answer to his petition, and its pretrial memorandum. At Melvin's trial before the Tax Court, Melvin and the Commissioner had the opportunity to challenge each other's arguments. Furthermore, Melvin and the Commissioner prepared memoranda addressing their arguments raised during trial. We thus conclude from the record that Melvin was afforded the opportunity to be heard, both at his trial and in a memorandum of law. See id. Accordingly, his due process argument fails.For the above-stated reasons, we affirm the Tax Court's judgment.AFFIRMED.

Other cases that deal with this issues are noted below

Monthly payments that were awarded to a taxpayer in a legal separation and were reaffirmed in the final divorce decree were includible in her gross income. The payments were in the nature of support, rather than a property division, as indicated by the fact that they were in addition to the taxpayer's award of substantially all of the marital estate.C.S. McKay, 52 TCM 820, Dec. 43,443(M), TC Memo. 1986-514.Amounts paid by a taxpayer to his ex-wife were alimony payments rather than nontaxable distributions of community property. The payments were originally characterized as support, but a subsequent court order reduced the wife's share of the couple's community property by the amount of the support payments. That reduction alone did not convert the payments into a division of marital property as long as they continued to meet the statutory definition of alimony. The tax-benefit rule had no application since the reduction represented part of the determination by the court, and not a recovery of any portion of the payments.M.H. Soriano, 61 TCM 1622, Dec. 47,103(M), TC Memo. 1991-2.Lump-sum alimony payments made by a taxpayer to his former spouse were not deductible as alimony because they were made under a consent order that specifically identified them as an additional property settlement. However, the characterization of the payments as lump-sum alimony did not apply to alimony arrearages that had accrued prior to the settlement. Therefore, the arrearages constituted deductible alimony.P.M. Barrett, Jr., CA-5, 96-1 USTC ¶50,084, 74 F3d 661.An individual's periodic payments to his ex-spouse under their integrated property settlement were not alimony. Although the settlement described the payments as alimony, the evidence showed that they were part of the couple's property division. Also, the husband was obliged to continue the payments after the wife's death. E.S. Pettet, DC N.C., 97-2 USTC ¶50,948.A husband's payments under a marital settlement agreement were not deductible as alimony. The agreement's unequivocal terms provided that the parties waived all rights to support or maintenance and that all payments were for the division of community property. Further, the payments would not terminate at the death of the wife.A.T. Croteau, 75 TCM 1550, Dec. 52,511(M), TC Memo. 1998-9.A husband could deduct payments he made under a divorce decree because they satisfied the statutory requirements for alimony. It was irrelevant that an appellate court that later reviewed the decree held that the payments were in the nature of a property division.T.H. Nelson, 76 TCM 145, Dec. 52,804(M), TC Memo. 1998-268.One half of the amounts that a certified public accountant's ex-wife withdrew from a money market account while she and her ex-husband owned it jointly as tenants by the entirety constituted alimony that was includible in her gross income and deductible by her ex-husband. Although their divorce agreement did not provide a definitive characterization of the withdrawals, a subsequent court order confirmed that the funds were required for her support and maintenance. Further, language in the agreement that made the husband responsible for taxes on the withdrawals did not amount to a designation that the payments did not constitute alimony. The other half of her withdrawals represented a distribution of her own funds.I.C. Jaffe, 77 TCM 2167, Dec. 53,417(M), TC Memo. 1999-196.Amounts received by the taxpayer under a provisional order entered by a state (Indiana) divorce court were for her support and, thus, constituted taxable alimony. The payments were not in the nature of a property settlement because they would have terminated in the event of her death under state (Indiana) law. Moreover, a provisional order was merely for the purpose of maintenance and was distinct from a property settlement.M.K. Heckaman, 79 TCM 1643, Dec. 53,795(M), TC Memo. 2000-85.Military retirement payments received by the divorced wife of an Air Force officer under the couple's divorce judgment constituted alimony, despite the fact that the provision appeared under the "Property Settlement" title of the couple's divorce judgment. A common-sense reading of the divorce judgment did not establish a nonalimony designation regarding the income tax implications of the payments.M.J. Baker, 79 TCM 2050, Dec. 53,889(M), TC Memo. 2000-164.A payment that the taxpayer made to his former spouse under their divorce decree was not deductible as alimony. Both the decree and a subsequent modification designated the payment as a nontaxable division of marital property. The payment, which represented the ex-wife's share of a lump-sum separation payment the taxpayer received in lieu of his retirement benefits from the armed forces, was explicitly designated in the modified decree as a nontaxable event. Further, the original divorce decree precluded the payment of spousal support by either party.T. Clarence, 80 TCM 53, Dec. 53,952(M), TC Memo. 2000-214.The intent of formerly married individuals was frustrated when the IRS determined that the husband was liable for taxes on payments made under a divorce settlement agreement. The IRS had determined that the payments in question were taxable as a property settlement, even though the terms of the settlement provided that the payments were alimony taxable to the wife and deductible by the husband. Thus, the calculation of taxes that the wife was obligated to reimburse to the husband did not modify the settlement agreement, it only effectuated the intent of the parties in a manner that preserved the rights of the parties under the agreement. E.A. Eldridge, CA of Mich., 2003-1 USTC ¶50,485.A payment made by a divorced husband to his ex-wife under their divorce decree constituted a property settlement and did not give rise to an alimony deduction. The decree specifically stated that the payment "does not constitute, nor shall it be interpreted to be, any form of spousal support, alimony, or child support." R.S. Simpson, I, 86 TCM 470, Dec. 55,325(M), TC Memo. 2003-294.A taxpayer's contributions and loan repayments to his retirement plan were not deductible alimony. Although his divorce settlement awarded his ex-wife an interest in the plan, it also designated the plan as marital property; thus, payments related to the plan were part of the couple's marital property settlement.W.E. Johnson, 91 TCM 1239, Dec. 56,534(M), TC Memo. 2006-116.The portion of a husband's disability benefits that he paid over to his ex-wife was alimony, and not a division of martial property. There was no indication that the couple had considered his professional disability insurance policy to be marital property. Rather, their divorce agreement merely required him to pay alimony from his earned income or from his disability benefits. J.A. Perkins, 95 TCM 1165, Dec. 57,345(M) , TC Memo. 2008-41.Payments made under a divorce decree were part of the couple's property settlement, rather than alimony. The decree characterized the payments as personalty rather than as alimony, it provided that they were not taxable to the recipient, the amount of the payments was much larger than the amount of the payments that were characterized as alimony, and it did not appear that the payment obligation would terminate upon the recipient's death.R.W. Fields, 96 TCM 130, Dec. 57,528(M), TC Memo. 2008-207.

6694 "unreaslonable positions" are not unreasonable

An “unreasonable position” is defined as a position that a tax return preparer cannot support with “substantial authority” if the position is not disclosed to the IRS. If the “unreasonable position” is disclosed to the IRS, then the tax return preparer need only have a “reasonable basis” to support the position taken. Either way, with or without disclosure of a position in your tax return to the IRS, the position is only “unreasonable” if a return preparer does not have the requisite technical authority or technical skill to support the position taken in your tax return. The term “unreasonable position” in section 6694 is a misnomer or erroneous classification of positions that can be supported with “substantial authority.”
.
To make this point clearer, why is any position in a tax return deemed to be "unreasonable" if it can be supported with substantial technical authority? If the tax return decided to disclose the position to the IRS, he is disclosing a position he "thinks" might be unreasonable. There may be obvious substantial athority at the time the position is taken in the tax return. But the return preparer may want to disclose the position just to play it safe for the availability of the lower "reasonable basis" standard. If all return preparers, even those confident about their technical positions, "disclose" those positions to the IRS, the IRS will be bombarded with disclosed positions. Not a bad strategy. The IRS is not staffed to handle a millions of disclosed positions.

A more important point is the fact that return preparers who have little or no technical skills will get blased with 6694 penalties even if there is "substantial authority" for the positon. How can a return preparer supply any technical authority, even for the reasonable basis standard, if they lack the technical skill or technical resources to defend the position? IRS examiners are not your friends. They are aggressive. They like to make examples of return preparers. They will be motivated to go after the very large penalties. I predict the IRS examiners will treat return preparer negligence as "reckless" and go after the $5,000 penalties.

In my tax practice, I have lots of battles with the IRS over technical issues. Without the requisite technical research, analysis, interpretative skill, advocacy skill, the IRS would prevail over a raft of issues that they should not win. That is the point. Tax return preparers without the necessary technical skills, including the ability to draft a technical memorandum for managers, reviewers and appeal personnel, the IRS would win on those issues. Return preparers will inevitably get "nailed" for large 6694 penalties merely because they do not know how to find that support or analyze the nuances of that technical support.

I am left with the conclusion that positions that can be supported with strong technical support will be deemed to be "unreasonable positions" when handled by inept tax return preparers in many cases. Simple example: every side business with losses is nearly always treated as a hobby. But that is not necessarily the correct conclusion.

My personal belief is that all problematical positions should be disclosed to the IRS even those positions I believe that have strong technical support. The disclosure will cover for a missed detail in a regulation, a missed fact, or some kind of other error. Why take the chance? If the position appears factually or legally complex - disclose it. If your gut tells you that you are uncertain about the position - disclose it.

Continue to send questions to ab@irstaxattorney.com.

The final 6694 regulations have been uploaded

Just a reminder that you can download the final 6694 regulations from the home page and also from one of the blogs below.

There were more than 10,000 downloads of the proposed regulations and less than half as much on the more important and final 6694 regulations, although the population of those who have found this web page and blog have grown substantially.

Also entered into one of the recent blogs is IRS Notice 2009-5 which addresses the standard of conduct for return preparers. Now that the "substantial authority" standard has replaced the "more than likely standard, you have to have some clarification of how to measure "substantial authority."

Although "substantial authority" is defined in the section 6662 negligence regulations, it is Notice 2009-5, not the final 6694 regulations, that clarify that the IRS will look to section 1.6662-4(d) for the definition of "substantial authority." Those regulations specify all of the tax law: the IRS Code, the regulations under the Code, the case law, legislative history, IRS published positions, and more. In addition, those regulations require the anlysis used to support "substantial authority" must be relevant.

There is a huge body of case law that defines "substantial authority."

WARNING! Do not assume that the standard of conduct for return preparer is "negligence" merely because the proposed regulations, either directly or indirectly through Notice 2009-5 reference the negligence regulations.

Negligence was the standard of conduct for return preparers prior to 1989. What you have to understand is that you can be not-negligent, and still be hit with the $1,000 and $5,000 penalties for each wrong position.

The test is a purely technical test on the quality of the authority you have to support any position in the tax return. A large part of the issues arise in a Form 1040 in Schedule A and Schedule C. That means that if you do not support any of those items with the specificity demanded by the regulations that deal with those issues, you will be hit with those penalties.

The above also applies to the "reasonable basis" standard for disclosed positions. Do not assume that you do not have to apply the specificity of the income tax regulations for disclosded positions. For example, there are high technical substantiation requirements under the travel and entertainment regjulations, as you all know. You are "red meat" for the $5,000 penalty for being "reckless" (within the meaning of 6694(b)) if you do not meet the substantiation requirements of the section 167 regulations.

What does thils really mean for most of the return preparers?

You need to have access to current tax law and regulations. How can you possibly meet the "substantial authority" or "reasonable basis" standards without having immediate access to all of the current tax law? I have always used CCH, a personal habit with me. There are other tax resource services.

The reason we have these new draconian penalties is that return preparers would take any number given to them by their client, put those numbers into software, collect their fees and be done with the return.

No more, now way, Jose! That is the past!

I have represented a fair number of tax return preparerers undergoing civil and criminal examinations. Whether you know it or not, the IRS software is able to identify a high error rate by tax return preparers. In those examinations, the 6694 penalty was never an issue because of the small size of the $250 penalty.

I am certain that the IRS will be motivated to go after the very large draconian penalties. Example, three negligent errors in any tax return is certain to be viewed as "reckless" and translate into $15,000 in penalties ($5,000 x 3). You can take a travel expense of $100 and if you cannot support that travel expense with the technical authority in the regulations, that $100 will cost you $5,000 in penalties because the failure of a tax return preparer to apply long standing IRS regulations is simply "reckless." If you claim $600 for a charitable deduction and do not apply the NEW substantiation requirements, you will be hit with another $5,000 for being reckless. If you make the same mistakes in a typical three year examination, your penalties could be $45,000 ($15,000 x 3).

Because of this new high risk for large penalties that most return preparers cannot afford, I am at a total loss to understand why the ABA, AICPA, NAEA, and NATA professional associationsare not alerting you to this new high financial risk of these new high technical standards for all return preparers.

I deal with IRS examiners on a regular basis. They are aggressive. Do not expect that they are your friends. They are now motivated to go after these large penalties. If you are "negligent" because you misapply any substantiation requilrement, you should expect to be able to expect these penalties.

For the rest of this blog, I will assume that you can access tax research services. If you do not, you will not be return preparers very long unless you restrict your services to tax returns using the standard deduction. But if you work any tax return with itemized deductions, you will not be able to afford to stay in the return preparation business without access to a tax research service which allows you to cite the tax statute, read and apply the relevant regulations and the rest of the tax law.

I will use just one example for those of you who can research the relevant tax law: the business loss-hobby loss issue. I see this issue a lot. Lots of people have small Schedule C businesses that lose money. The IRS examiners will always go after those issues, and they only way to deal with it is to cite the applicable statute, regulations, and find some case law that will support your position. I would disclose those positions to get into the "reasonable basis" standard. Given the fact that there is a lot of litigation in this area and lots of losses of this issue in the Tax Court, I would not bet that you can win this issue with "substnatial authority" on a high frequency basis.
But even if your client does not win the 162 issue, you may prevail on the 6694 issue, depending on the quality of your technical research. But this also means that you have to put a lot of time into the technical research and writing. This is an example of they type of issue you should disclose to the IRS to take advantage of the much lower "reasonable basis" standard. Your client might lose the issue and be hit with the 20% negligence penalty, but you should be able to avoid the 6694 penalty by citing some of the relevant case law and the IRS regulations that deal with this issue.

I have recently uploade some recent case law to illustrate the type of issues that are litigated, and I will continue to do that, particularly in negligence cases which indicate sloppy work by the taxpayer or his tax return preparer.

If you have any comment to make on any of the above, you can reply to this blog without disclosing your identify. Quite a few of you have, instead, contacted me directly at ab@irstaxattorney.com or you can leave a message at 703 425-1400 ex 106 or ex 111.

Good luck in the upcoming final season. You will need it with the risk of $1,000 or $5,000 penalties (or the higher of 50% of your fee).

Substantial authority case

Substantial authority was not offered under Sec. 6662(d)(2)(B) in Kenneth F. Reinert v. Commissioner, Filed December 23, 2008, T.C. Summary Opinion 2008-163. The taxpayer was liable for the substantial understatement component of the accuracy-related penalty. The individual had failed to provide substantial authority for excluding distributions from terminated life insurance and endowment policies from income.

This case is offered for your review because of the application of the "substantial authority" standard. Notice that Taxpayer's argument was not as strong as a case cited in the TC decision.
If this would have been a 2008 tax year case and prepared by a return preparer, the return preparer would be liable for the 6694 penalty.

The issue of whether it would be the $1,000 or $5,000 penalty situation is problematical. I can simply tell you, as a tax attorney dealing with IRS examination every day, they are aggressive and will take positions that are not justified. In this case, as an advocate, I would argue that the penalty in this case was not "reckless" and that the $5,000 should not be applied.

The larger point in this blog is to illustrate the fact that when a return preparer gets an issue like this with some technical complexity involving an interpretative analysis, that return preparer must have access to technical research services and have the technical ability to research the applicable tax law. If you cannot do that, then you have to bring in a tax expert to assist in the research and analysis and provide a written opinion that would support "substantial authority." You do not have to win the issue to provide substantial authority. And it is expensive to take cases to the Tax Court.

GERBER, Judge: This case was heard pursuant to the provisions of section 7463 1 of the Internal Revenue Code in effect when the petition was filed. Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.

Respondent determined a $5,368 income tax deficiency and a $1,074 accuracy-related penalty under section 6662(a) for petitioner's 2005 tax year. The issues for our consideration are whether petitioner received gross income of $21,248.18 because of the termination of his life insurance policy and whether he is liable for an accuracy-related penalty under section 6662(a).
Background 2

At the time his petition was filed, petitioner resided in Arizona. On July 17, 1958, petitioner purchased a life insurance policy with the Northwestern Mutual Life Insurance Co. (Northwestern). The face amount of the policy was $10,000, and the $52.40 premium was payable every 4 months until July 17, 2035, or until petitioner's 65th birthday, at which time the policy would be fully paid. The policy had a cash surrender value which continued to increase.

As the cash value increased, petitioner borrowed against that value. As of 2005 the cash value of the policy was $29,933.78. At the same time, petitioner's outstanding loan balance against the cash value was $28,492.40, and the premiums he paid totaled $8,685.60. Over the years petitioner was not paying interest on the loans outstanding against the cash value of the insurance policy, and Northwestern treated the interest on the loans, under the terms of the policy, as additional loans against the cash value of the policy.

Under the policy, "If indebtedness equals or exceeds the cash value at any time, his policy shall terminate thirty-one days after a notice of termination has been mailed to the last known address of the Owner". The policy terms also provided that "Upon receipt at the Home Office of this policy and of a full and valid surrender of all claims, the insurance shall terminate and the Company will pay, as directed, the cash value less any indebtedness." At the end of December 2004, Northwestern sent petitioner a notice that the loan amount would soon exceed the cash value and that the policy would "terminate". The notice also advised that termination would trigger a taxable event and would result in reportable ordinary income. At that point petitioner owed $1,356.78 interest on his loan against the cash value of the policy and chose not to pay the interest, resulting in the loan balance exceeding the cash value of the policy. Petitioner advised Northwestern that if the policy "terminated" it was not a taxable event, whereas if the policy was "surrendered" it was a taxable event. Petitioner chose not to pay the interest, the loan amount exceeded the policy cash value, and the policy was terminated. Petitioner did not physically surrender the policy.

On February 21, 2005, petitioner received a form entitled "Surrender of Policy for Cash Value" along with a $1,269.57 check from Northwestern representing the residual cash value after considering petitioner's outstanding loan balance. Petitioner signed the form and endorsed and cashed the $1,269.57 check.

Because of the termination, petitioner lost the $10,000 of life insurance coverage. In January 2006 petitioner received a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for his 2005 tax year from Northwestern reflecting a gross distribution of $29,933.78 and a taxable amount of $21,248.18. The difference between the gross distribution and the taxable amount was $8,685.60, the total amount petitioner had paid in premiums on the policy.

Petitioner believes that Northwestern used the termination as leverage to force policy holders to pay interest on their outstanding loans borrowed against the cash surrender value of their policies. In other words, petitioner had $10,000 of fully paid life insurance in force and had borrowed all of the increases in cash surrender value to a point where the annual increases in policy value paid the interest on petitioner's outstanding policy loans. In that way, the insurance company did not collect interest on the loans, and, because petitioner was 65 years old (making his policy paid up), he made no more premium payments.
Discussion

Petitioner allowed his policy to terminate by not paying the interest on outstanding loans so that the loan balance exceeded the threshold for termination. Petitioner contends that a "termination" of a policy in this manner is not a taxable event because the pertinent statutes and regulations expressly apply to a "surrender" of a policy.

Section 72(e)(1)(A)(i), (5)(A), and (C) generally provides that an amount received in connection with a life insurance contract, which is not received as an annuity, constitutes gross income to the extent that the amount received exceeds the investment (basis) in the insurance contract. Section 72(e)(6)(A) generally provides that the "investment" in the contract is the aggregate amount of premiums.

In particular, and as pertinent to this case, section 1.72-11(d)(1), Income Tax Regs., provides

Any amount received upon the surrender, redemption, or maturity of a contract to which section 72 applies, which is not received as an annuity under the rules of paragraph (b) of § 1.72-2, shall be included in the gross income of the recipient to the extent that it, when added to amounts previously received under the contract and which were excludable from the gross income of the recipient under the law applicable at the time of receipt, exceeds the aggregate of premiums or other consideration paid. * * *

Petitioner argues that his insurance policy contract was "terminated" and that he did not literally "surrender" the policy. He relies on dictionary definitions of those terms; i.e., a "termination" in the setting of his case is an involuntary event, whereas a "surrender" is a voluntary act that he did not perform. Because the statute and the regulations use the term "surrender" and the term "termination" is absent, petitioner argues that Congress intended that amounts received in excess of investment on account of termination are not includable in his gross income. Petitioner has not provided any reference to legislative history in support of his contention. Petitioner does not question the amounts in dispute, only the legal question of whether the excess over investment is taxable.

We addressed a substantially similar set of circumstances in Atwood v. Commissioner, T.C. Memo. 1999-61. In that case, as with petitioner, the insurance contracts provided for the termination or lapse of the policy when the total loan, including unpaid interest, exceeded the policy cash value or a similar threshold. Likewise in Atwood, the taxpayers failed to repay any portion of the loans or interest thereon. Their insurance policy contracts were terminated, and they were sent a small check reflecting the amount of the cash surrender value after considering the outstanding loans. In Atwood, as in petitioner's case, the termination resulted in the outstanding loan's being satisfied by the cash value of the policy. In Atwood the excess of the cash surrender value over the total premiums was held to be ordinary income.

The cash value of petitioner's insurance policy increased from its 1958 inception to the time of termination by $29,933.78. No amount of that increase in value was distributed to petitioner as a dividend or distribution and, as a result, petitioner paid no tax on the increase between 1958 and 2005. During that same period petitioner paid $8,685.60 in premiums on the life insurance policy and borrowed $28,664.21 (representing principal and interest). As of 2005 petitioner had attained the age of 65, no further premiums were due, and his life insurance policy was considered fully paid.

After petitioner was warned by Northwestern that his outstanding loans and interest were going to exceed the amount that would result in termination under the terms of the life insurance contract, he decided to allow the termination. In response, Northwestern sent petitioner a $1,269.57 check representing the difference between the $29,933.78 cash value of the policy and petitioner's $28,664.21 outstanding loan (including interest accretions) against the cash value. Northwestern sent petitioner a Form 1099-R reflecting the above information and advising petitioner that $21,248.18 was includable in his 2005 income. The $21,248.18 represents the $29,933.78 cash value less petitioner's investment/basis of $8,685.60 in premiums paid.

Although petitioner complains that he received only $1,269.57 and he did not "surrender" his policy, 3 when the policy terminated, petitioner was relieved of $28,664.21 in outstanding loans which he had taken out during the 47 years the policy was in force. So, in effect, he received $29,933.78, $1,269.57 in cash and $28,664.21 in payment or credit against his outstanding loan obligations. Petitioner could have further deferred reporting this income by paying interest on or reducing the principal of his loan to an amount that would not have caused termination. In addition, he could have maintained his paid-up life insurance coverage by maintaining the loan balance below the threshold amount.

Section 72(e) causes the increases in value of insurance contracts to be taxable when the policy ends prior to the payment of an annuity. This situation is one that permits the deferral of the reporting of income until a triggering event occurs. We see no distinction between the termination and surrender of an insurance policy for this purpose. The physical act of submitting the policy is of no import in this setting. The policy has been terminated and no contractual relationship continued between petitioner and Northwestern. In reality, petitioner was allowed to defer the increases in value of his policy for many years, a fact that he fails to focus upon. We accordingly hold that petitioner had $21,248.18 of income as determined by respondent.

Respondent also determined that petitioner was liable for an accuracy-related penalty under section 6662(a) on the underpayment of tax for his 2005 tax year. Section 6662(a) imposes a 20-percent penalty on the portion of an underpayment of tax attributable to, among other things, a substantial understatement of income tax, which is defined in section 6662(d)(1)(A) as an understatement that exceeds the greater of 10 percent of the tax required to be shown or $5,000. Petitioner reported $2,853 of tax and accordingly his tax was understated in the amount of $5,368, an amount that is more than 10 percent of the tax required and also more than $5,000.

Petitioner would therefore be subject to the penalty unless he can show that any part of the understatement is attributable to an item that was adequately disclosed and has a reasonable basis, or for which there was substantial authority for its tax treatment. Sec. 6662(d)(2)(B).

Petitioner, although issued a Form 1099-R by Northwestern indicating taxable distributions upon termination of his insurance policy, made no disclosure on his income tax return of the Form 1099-R from Northwestern or explanation as to why the amounts shown thereon were not reported on his 2005 return. See sec. 6662(d)(2)(B)(ii)(I). Petitioner has argued that a termination was not contemplated but has not shown any authority, substantial or otherwise, for excluding these amounts from income.

We accordingly hold that petitioner is liable for the accuracy-related penalty, as determined by respondent.

To reflect the foregoing,

Decision will be entered for respondent.
1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for 2005, the taxable year in issue.2 The parties' stipulation of facts and exhibits is incorporated by this reference.3 We note that although petitioner may not have physically surrendered his policy, he did sign a form entitled "Surrender of Policy for Cash Value" in order to negotiate the $1,269.57 check from Northwestern.

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