Better Living Through Accuracy
The essential core of successfully defending your tax returns is meticulous and correct recordkeeping. As Kevin Costner said in his biopic Wyatt Earp, “fast is fine, but accuracy is final.”[1] This statement applies to both gunfights and tax returns. Furthermore, taxpayers must pay a 20% penalty for any understatements on reportable transactions under 26 USCA §6662(a), §6662(h), and §6662A. When the IRS finds you are deficient on your tax returns, typically, the burden is on you to prove them wrong. Additionally, the IRS will disallow your tax deductions; if the IRS asserts that the deductions were improper, and you cannot justify what you claim on your tax return. To defend yourself from the IRS, you must prove that your tax returns are reasonable, correct, and supported by competent evidence.
In Rogers v. Commr. of Internal Revenue, the tax court held Mr. and Mrs. Rogers liable for accuracy-related penalties under Internal Revenue Code §6662(a), (h) and 6662A.[2] Mr. and Mrs. Rogers, who are both attorneys understated their income for tax years 2005-2007 and 2009. Mr. Rogers concocted an elaborate tax shelter which he used to dramatically overstate his cost of goods sold and cost-basis in real estate properties. The couple also deducted personal expenses, such as entertainment and meals, as business expenses. The lawfully wedded attorneys even went as far as to claim negative taxable income in 2006, despite enjoying a good salary from Mr. Roger’s successful law practice. The beautiful days in Mr. and Mrs. Rogers’ neighborhood came to a screeching halt when the IRS audited their joint tax returns and the tax returns of their three S corporations.
In terms of negligence and accuracy-related penalties:
Section 6662(a) provides for a 20% accuracy-related penalty on an underpayment of tax attributable to (1) negligence or disregard of rules and regulations, (2) a substantial understatement of income tax, or (3) a substantial valuation misstatement. Sec. 6662(a) and (b)(1), (2), and (3). Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Code, including any failure to maintain adequate books and records or to substantiate items properly…[3]
Understatements of individual income tax are substantial when they exceed the greater of 10% of their required tax, or $5,000. Under §6662(h), the accuracy-related penalties increase from 20% to 40% if a valuation misstatement is 200% or more of the correct amount of the value or adjusted basis claimed on a tax return. For tax years 2005 and 2006, the IRS assessed a 40% §6662 penalty on Mr. Rogers’ real estate transactions, because he claimed deductions of approximately 5,000% of his basis in numerous real estate properties.
Your best defense against negligence penalties relies upon you proving that you prepared your tax returns reasonably and in good faith. Under §6664(c)(1), you can defend yourself from §6662(a) and (h) penalties concerning any underpayment of tax if you prove that you acted in good faith and had reasonable cause. Since this is a subjective test, your experience, knowledge, and education are relevant to demonstrate reasonable cause and good faith. Mr. Rogers was an attorney and a licensed CPA with over 30 years of experience. During the tax years at issue, Mr. Rogers ran numerous businesses, orchestrated elaborate tax-shelter transactions, and consistently functioned at a high cognitive level. Therefore, the tax court determined that Mr. Rogers was sophisticated enough to know that he grossly misreported his income on his tax returns. As a trained attorney with years of experience, Mrs. Rogers was intelligent and experienced enough to know that her and her husband’s jointly filed tax returns were egregiously incorrect. Because of their business experience and education, Mr. and Mrs. Rogers should have also known that they were negligent for keeping disorganized books and records that did not reconcile the business deductions they claimed with the expenses recorded. Lastly, Mr. and Mrs. Rogers should have known that they could not defend their returns with inadequately prepared books and records.
While you must correctly prepare your taxes, the IRS does not hold you responsible for making good business decisions. You have the right to make risky investments and run your business as you wish. However, if you want to successfully defend yourself against negligence penalties and deduct the costs of your activities as legitimate expenses, then you must accurately document your expenses and maintain meticulous records.
[1] Wyatt Earp, Motion Picture (Warner Brothers 1994).
[2] Rogers v. Commr. of Internal Revenue, 117 T.C.M. (CCH) 1306 (Tax 2019).
[3] Rogers v. Commr. of Internal Revenue, 117 T.C.M. (CCH) 1306, 17-18 (Tax 2019).
