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April 15, 2016

U.S. Tax Court Holds Law Firm Liable for Accuracy-Related Penalties

Nardone Limited’s experienced tax attorneys, in Columbus, Ohio, routinely assist individuals and businesses that become subject to an Internal Revenue Service (“IRS”) audit or examination. An IRS audit or examination occurs when the IRS selects a tax return and reviews the taxpayer’s records from which the reported information on the tax return is derived. If a taxpayer is negligent or disregards the rules or regulations, causing an underpayment in tax, the IRS is authorized to impose a penalty. One of the penalties the IRS may impose is an accuracy-related penalty.

Accuracy-Related Penalties

Internal Revenue Code §6662 allows the IRS to impose a penalty against a taxpayer if the taxpayer’s negligence or disregard for the rules and regulations causes an underpayment of tax, or if the underpayment exceeds a computational threshold called a substantial understatement. Generally, an “understatement” is the difference between the correct amount of tax and the tax reported on the return, reduced by any rebate. Understatements are reduced by the portion attributable to an item for which the taxpayer had substantial authority, or any item for which the taxpayer, in the return or an attached statement, adequately disclosed the relevant facts affecting that item’s tax treatment and the taxpayer had a reasonable basis for the treatment.

The amount of an accuracy-related penalty equals 20 percent of the portion of the underpayment attributable to the taxpayer’s negligence or disregard of the rules or regulations by the taxpayer. “Negligence” includes any failure to make a reasonable attempt to comply with the tax law, and “disregard” includes any careless, reckless, or intentional disregard. Negligence can arise by failing to keep adequate records or to substantiate items that give rise to the underpayment. However, taxpayers are generally not subject to the accuracy-related penalty if they establish that they had a reasonable cause for the underpayment and acted in good faith. A recent U.S. Tax Court decision, which upheld accuracy-related penalties against a law firm, exemplifies the IRS’ ability to assess penalties against negligent taxpayers.

Brinks Gilson & Lione A Professional Corp. v. Commissioner

In Brinks Gilson & Lione A Professional Corporation, the U.S. Tax Court upheld the accuracy-related understatement penalties against a law firm (“taxpayer”) for mischaracterizing, as compensation for services, dividends paid to shareholder-attorneys, that the firm later agreed were nondeductible dividends. The taxpayer argued that it had substantial authority for deducting in full the yearend bonuses it paid to its shareholder-attorneys. Additionally, it argued that, because it relied on the services of a reputable accounting firm to prepare its returns, it had reasonable cause to deduct those amounts and acted in good faith in doing so. The IRS, however, argued that amounts paid to shareholder-employees of a corporation do not qualify as deductible compensation to the extent that the payments are funded by earnings attributable to the services of nonshareholder employees or to the use of the corporation’s intangible assets or other capital.

Previous courts that have assessed compensation paid to shareholder-employees by its effect on the returns available to shareholders’ capital refer to the independent investor test. The test recognizes that shareholder-employees may be economically indifferent to whether payments they receive from their corporation are labeled as compensation or dividends. While compensation is deductible to the corporation, dividends are not.

In applying this test, courts consider whether ostensible salary payments to shareholder-employees meet the standards for deductibility by taking the perspective of a hypothetical “independent investor” who is not also an employee. Ostensible compensation payments made to shareholder-employees by a corporation with significant capital that zero out the corporation’s income and leave no return on the shareholders’ investments fail the independent investor test. Therefore, the taxpayer’s practice of paying out yearend bonuses to its shareholder attorneys that eliminated its book income fails the independent investor test.

Additionally, the court rejected the taxpayer’s argument that it had reasonable cause and acted in good faith in claiming the deductions because it relied on the accounting firm. The court rejected this argument for two reasons. First, the record provided no evidence that the accounting firm advised the taxpayer regarding the deductibility of the yearend bonuses. Second, in characterizing as compensation for services amounts that have been determined to be dividends, the taxpayer failed to provide the accounting firm with accurate information. For additional information on this case, please click here.

Vince Nardone Comment: This case emphasizes the importance of taxpayers working with experienced tax controversy attorneys to properly document the underlying facts and circumstances to support a reasonable cause defense, as it relates to the abatement of penalties, including negligence. Too many taxpayers, and too many tax professionals, attempt to handle this matters without the necessary experience.

Contact Nardone Limited

Nardone Limited represents individuals and businesses in a multitude of federal tax matters, including taxpayers who are subjected to an IRS audit or examination. If you are facing an IRS tax audit or examination, or if you wish to learn more about how to avoid possible penalties for underpayment of tax, contact one of our experienced tax attorneys today. Nardone Limited’s tax lawyers and professionals have vast experience representing clients undergoing IRS audits and examinations. We will thoroughly review your case to determine what options and alternatives are available.

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April 15, 2016

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