IRS Tax Penalties And The Tax Professional Reliance Defense

• Published date: 24 May 2022
• Subject Matter: Tax, Income Tax, Tax Authorities
• Law Firm: Freeman Law
• Author: Mr Matthew Roberts

No one wants to pay federal taxes. And this truism applies more so with respect to federal tax penalties. Accordingly, clients often call upon their tax professionals to request waiver or abatement of any asserted penalties.

Chief among the waiver or abatement defenses is so-called "reasonable cause."¹ To show reasonable cause, a taxpayer must show that he or she exercised ordinary business care and prudence in determining a tax obligation but nevertheless was unable to comply with the tax obligation.² Because taxpayers routinely rely upon their tax advisers, federal courts have for some time now recognized a reasonable cause defense for reliance on a tax professional.

Contrary to popular belief, the usage of a tax professional to prepare a tax return is not a get-out-of-jail free card. Rather, taxpayers have the burden of proof to show that reliance on the tax adviser was reasonable under the circumstances. In many cases, this requires a taxpayer to meet all three requirements under the United States Tax Court's decision in Neonatology. This article discusses the Neonatology requirements and the professional reliance defense.

Federal Tax Penalties.

Federal tax penalties have been in our federal tax system since the Civil War.³ Today, the Internal Revenue Code of 1986, as amended (the "Code"), contains over 100 different types of federal tax penalties. According to the IRS, all of these tax penalties have a common thread: they were enacted by Congress to promote voluntary compliance with our federal tax system. Therefore, taxpayers are generally not surprised to learn that certain types of conduct are subject to penalties, such as late filing and late payment of tax.

These tax penalties are here to stay. Aside from promoting voluntary compliance, federal tax penalties provide a significant source of revenue for the United States government. For example, in fiscal year 2020, the IRS assessed over $31 billion of civil penalties against taxpayers, as shown in the below graph:

Because these numbers were during the height of the COVID-19 pandemic, taxpayers can expect a steady trend upwards in the IRS's imposition of tax penalties in the foreseeable future.

The Neonatology Factors.

On July 31, 2000, the Tax Court issued its division opinion in Neonatology Associates, P.A. v. Commissioner.⁴ In that test case, the IRS asserted deficiencies against several taxpayers for their participation in certain employee welfare benefit plans. The IRS also proposed...