What Level Of Diligence Must A Taxpayer Prove To Overcome a Penalty? Part II

By George W. Connelly

In the last article, we focused on overcoming an accuracy penalty when the taxpayer uses and relies on tax preparation software.  Let’s see what the “rules of the road” are if he instead relies on professionals.

The case of Curcio v. Commissioner, T.C. Memo 2010-115, decided May 2010, provided a challenging situation.  It involved four taxpayers whose companies had participated in a “Section 419 Plan” where they claimed deductions as business expenses for significant life insurance premiums, and the Court rejected the deductions under the Plan.  The 419 Plan at issue was created by Daniel Carpenter, a lawyer with experience in tax and employee benefits law.  He designed the plan, drafted and approved all amendments, and secured a legal opinion by a separate lawyer.  These Taxpayers, however, did not just buy the Plan from him and rely upon his representations.

All of the taxpayers were experienced business people.  Mr. Curcio had an accounting degree, and his partner, Mr. Gelling, owned and operated a car dealership.  Before they enrolled in the Plan, they consulted an accountant for their dealerships.  He reviewed the opinion letters, and affirmatively advised his clients that the companies could claim deductions for the contributions.  However, the Court’s opinion stressed that that accountant was not “an expert” in welfare benefit plans.  Mr. Curcio also relied upon his insurance agent to review the Plan.

The next taxpayer, Samuel Smith, owned a construction business.  He and his financial adviser selected a particular variation of the plan.  The fourth Taxpayer, Stephen Mogelefsky, had a degree in real estate and finance and was the President of a company called Discount Funding Associates, Inc.  Before having his company invest in the plan, Mr. Mogelefsky consulted his accountant, who was also an accountant for the Company, but who conducted no research about the Plan and, according to the Court, had no particular expertise in welfare benefit plans, but relied upon the legal opinion provided when the Plan was presented to his client.

The taxpayers claimed that they had both reasonable cause and, with respect to the substantial understatement facet of the penalty, substantial authority, but Judge Cohen found they had neither.  Before upholding the penalties against all of these individuals, Judge Mary Ann Cohen of the U.S. Tax Court observed that contributions to plans similar to this one were held not to be deductible in at least two other cases.  One was decided and reported before these individuals had invested, which is not a good fact, and the other decided after afterwards.    Substantial authority requires a demonstration that the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment, but is not as strict as “more likely than not.”  The Court found that the Taxpayers provided no such authority, and in particular noted that their reliance upon anyone’s professional opinion is not in itself substantial authority.

With respect to the professionals upon whom they relied, Judge Cohen noted that there was no evidence that their accountants had any particular expertise in employee benefit plans, or that they thought their accountants had such expertise.  There was no evidence that the accountants conducted anything more than cursory independent research on their deductibility, and one testified he relied only upon the opinion letter provided with the investment.  The Court further found that there was no evidence that the Taxpayers relied on tax advice from their insurance agents, and if they had, there is no evidence that their agents were educated in tax or held themselves out to be tax advisors, or that the Taxpayers even believed they were educated in tax law.  Finally, the Court stresses that these were all experienced business people presented with a program that was “too good to be true.”

So what does all this tell you?  The Curcio case presents a standard that reflects the law but which will shock most taxpayers.  It is doubtful that most people go beyond skimming a legal opinion which appears to be thorough, or the advice of a trusted tax return preparer, one that was not the “salesman” for the promotion or tax deduction.  Curcio stands for the proposition that a significant level of due diligence is necessary beyond that with respect to anything but the most common, ordinary tax deductions that are claimed.  Perhaps the most essential part of any defense will be securing the review of the underlying transaction from a competent, knowledgeable, independent professional.

The case probably also stands for the proposition that professionals should be wary in these situations, because their clients in all likelihood expect them to have a greater level of knowledge than they do, so that they should point out their own limitations and perhaps point the client in the direction of someone with greater expertise for fear that they will later be “blamed” for a deduction gone wrong.

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