I do not prepare tax returns. But I feel for the long-suffering preparers who try their best to get the information from clients to prepare an accurate tax return. For people with a variety of sources of income, like self-employed consultants with multiple clients, the process is burdensome—at least when compared to employees who more or less automatically get W-2s with withholding that tends to approximate liability. I also feel for taxpayers who have income from a myriad of sources because collecting and insuring that the income from each source that gets reported can prove difficult. Neither taxpayers nor preparers have a computer system akin to the IRS underreporter program that matches all of their third party returns against the amounts reported on the returns. If such a program existed presubmission to the IRS, returns would be much more accurate.
The recent case of Walton v Commissioner involved a psychologist whose 2015 tax return failed to include almost $170,000 in compensation. Prior to 2015, Walton had been employed with a consulting firm. In 2015 she went out on her own and had multiple clients. When it came time to file her 2015 return, she attempted to give all her information to her preparer but, as we will see below, she may not have given all of her 1099’s and the preparer failed to include a sizable chunk of her income. The issue in the case involved substantial understatement penalties-namely whether the IRS satisfied the supervisory approval requirement under 6751(b) or whether her omission should be excused by good faith reliance on her longtime experienced CPA return preparer.
In this post I will discuss the latter issue though I note the opinion discusses that the 6751(b) approval was not necessary because of the exception to the supervisory approval requirement for a “penalty automatically calculated through electronic means.” The opinion discusses how Walton’s omission was flagged by the IRS’s Automatic Underreporting Program (AUR) and thus was “determined mathematically by a computer software program without the involvement of an IRS examiner” leading it to conclude that the penalty was “automatically calculated through electronic means.” (citing Walquist v Comm’r, which Keith discussed in Automatically Generated Penalties Do not Require Managerial Approval and which Bob Kamman also addressed in Some Facts About the Walquist Case, Along with Some Nuance).
After rejecting the 6751(b) defense the court turned to whether Walton had reasonable cause for the omission and whether she acted in good faith. In setting up the issue the opinion notes that reliance of a qualified and competent preparer is not enough; there must be evidence that the taxpayer acted with diligence and prudence.
In evaluating whether she acted with both prudence and diligence, the opinion discusses the back and forth between Walton and her preparer. As a starting point the atmosphere here is bad: the return left off almost 1/3 of her total compensation. Yet the exchange showed she gave her preparer a starting point on income that was well in excess of the 1099’s she had sent over. In January of 2016 she sent an email to her preparer stating that “I am sure I need to pay taxes. If I did the math right, I earned about $525k in 1099 pay.” A month later Walton sent over a W-2 showing some income from her former employer as well as five 1099 MISC’s totaling over $350,000. Fast forward to April 12: another CPA at the firm sent Walton an email asking a bunch of questions on unrelated issues as well as if she was sure that she had sent all the 1099’s as the total was well below the 525,000 estimate in her January email.
Two days later Walton responded to the questions but did not answer the 1099 MISC question. After that exchange the CPA firm obtained an extension to October 15th. On September 29 her preparer (who had done her taxes for twenty years and prepares over 1,000 returns a year) emailed Walton a list of things he needed to complete the return. That did not include a specific ask for 1099 MISC’s but instead focused on 1099- DIV, business and travel expenses and other issues. Walton responded and said that she “attached the 1099s to the last emails”, and the preparer replied that “I have all the 1099s and the kids accounts, … the taxes and interest on the house …[and] the charities as well.”
The opinion notes that it is the preparer’s practice when there is a discrepancy between a client estimate and documentation to rely on the numbers in the document. Unfortunately for Walton, she testified that she did not review the return before the preparer e-filed it as she trusted his expertise. That admission was fatal to the defense—even though there was some uncertainty as to whether she gave all 1099 MISC’s to her preparer, the failure on Walton’s part to review the return led to a finding that she failed to act with the prudence and diligence necessary to avoid the penalty.
In reading this opinion I was reminded of one of my early blog posts back in 2013, Omitted Income, Accuracy-Related Penalties and Reasonable Cause. That post discussed Andersen v Comm’r, a summary opinion where a taxpayer also used a longtime preparer and left off a significant amount of W-2 income (about $28,000) from the return, but the court still found that they should not be subject to civil penalties. The opinion found that the taxpayer acted with reasonable cause and good faith, looking to an almost 50 year record of taxpayer compliance, only a slight difference in income from the year in question and the prior year’s return and circumstances that showed how the preparer mistakenly believed that he had all the information returns from the taxpayers.
All of these cases are fact specific. Walton does reveal how burdensome our filing system is. The amount of time necessary to fish for all information returns is wasteful and prone to error. Taxpayers can set up online accounts with the IRS so that they (and their preparers) can see what information returns IRS has received, but that system is not easily accessible. While I understand the court’s conclusion in Walton, we would all be better off if taxpayers and their preparers could easily see all information returns on file. Our system does not make it easy. I am glad I do not prepare tax returns for a living.