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:: Accuracy - Reasonable Cause and Good Faith
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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