After United States v. Boyle, we know that relying on an adviser to meet a filing deadline does not excuse a penalty. But Boyle also said that relying on an adviser's substantive tax advice can be reasonable cause. The obvious next question is: what counts? Neonatology Associates, P.A. v. Commissioner is the Tax Court's answer, and it is the test courts still use.
The Facts
The case grew out of arrangements that insurance salesmen set up as voluntary employees' beneficiary associations, known as VEBAs. Medical practices, including a neonatology practice and a radiology practice, contributed to plans under these arrangements to buy life insurance for their physician-owners and others. The plans were marketed as providing current-year term life insurance. In reality, the premiums were substantially greater than the cost of term coverage, because they also funded credits that could later be applied to conversion universal life policies for the individual insureds.
The practices deducted the contributions. The IRS disallowed the deductions above the cost of term life insurance, treated the excess as constructive dividends to the owners, and asserted accuracy-related penalties under IRC § 6662(a) for negligence or intentional disregard of rules or regulations. The cases were tried together in the Tax Court as test cases.
On the penalties, the taxpayers argued they reasonably relied on professionals. The "professional" they pointed to was their insurance agent. They also claimed they relied on tax opinion letters and on the fact that certified public accountants prepared their returns.
The Issue
When can a taxpayer avoid an accuracy-related penalty by relying on someone else's advice?
The Holding
Judge Laro's opinion set out the rule: "for a taxpayer to rely reasonably upon advice so as possibly to negate a section 6662(a) accuracy-related penalty determined by the Commissioner, the taxpayer must prove by a preponderance of the evidence that the taxpayer meets each requirement of the following three-prong test: (1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment." None of the taxpayers met any of the three, and the penalties were sustained. The Third Circuit affirmed in 2002.
The Reasoning
Reasonable cause and good faith
The accuracy-related penalty does not apply to a portion of an underpayment if the taxpayer shows reasonable cause and good faith. Treas. Reg. § 1.6664-4 governs that defense. The Court explained that reasonable cause requires ordinary business care and prudence as to the disputed item, citing Boyle, and that good faith reliance on the advice of an independent, competent professional as to the tax treatment of an item may meet that standard.
When reliance is not reasonable
The Court identified situations where reliance fails. Reliance may be unreasonable when it is placed on insiders, promoters or their offering materials, or on a person with an inherent conflict of interest the taxpayer knew or should have known about. Reliance is also unreasonable when the taxpayer knew or should have known the adviser lacked the expertise to opine on the tax treatment of the item.
The insurance agent failed the first prong
The taxpayers' main adviser was their insurance agent. He was not a tax professional and never held himself out as one. Most of the taxpayers knew he stood to gain financially from selling the arrangements. Given the size of the investments and the tax benefits promised, the Court said any prudent taxpayer, "especially one who is as educated as the physicians at bar, would have asked a tax professional to opine on the tax consequences." It added a line every taxpayer should remember: "The represented tax benefits of the C-group product were simply too good to be true." The physicians who testified admitted they knew term insurance cost significantly less than what they were paying.
No opinion letter in the record
The taxpayers said they relied on tax opinion letters by attorneys and accountants. The record contained neither a credible statement that any of them saw and relied on such a letter nor the letter itself. Statements in a brief are not evidence.
A CPA-prepared return is not an opinion
The taxpayers also argued their returns were prepared by CPAs. The Court rejected that too: "The mere fact that a certified public accountant has prepared a tax return does not mean that he or she has opined on any or all of the items reported therein."
"First impression" and "test case" arguments failed
The taxpayers argued the issues were novel. The Court said the underlying principle, shareholders trying to withdraw money from closely held corporations without tax, was well settled. And being a test case did not make a negligent position less negligent.
A late return, too
One of the practices, Lakewood, filed its 1992 return on May 28, 1993. It was due March 15, 1993, and Lakewood neither requested nor received an extension. It did not show reasonable cause, so the Court sustained a 15 percent addition to tax under § 6651(a), 5 percent for each month the failure continued. That is Boyle in miniature: a filing deadline missed without an extension is the taxpayer's problem.
The IRS overreached on sanctions
The IRS also asked the Court to impose a penalty of up to $25,000 on each taxpayer under § 6673 for frivolous positions. The Court refused. It found the litigation conduct the IRS complained about was mostly attributable to counsel, and it would not impute that to the taxpayers, who had reasonably relied on their trial counsel's advice that their positions had merit.
What It Means for Taxpayers Today
Use the three prongs as a checklist
If you may need to rely on advice later, build the record now. Is the adviser a qualified tax professional with relevant expertise and no stake in selling you the transaction? Did you give the adviser all the facts, in writing? Did you actually rely on the advice, and can you prove you received it before you filed? The current regulation, Treas. Reg. § 1.6664-4(c)(1), adds that the advice must be based on all pertinent facts and must not rest on unreasonable assumptions, and that reliance is not reasonable if you knew or should have known the adviser lacked knowledge in the relevant area of tax law.
Salespeople are not advisers
The single most common way taxpayers fail the test is by relying on the person who sold them the deal. An insurance agent, a promoter, or anyone paid when you say yes has a conflict. If a transaction is pitched with tax benefits, get an independent opinion from someone who gets paid the same either way.
Your return preparer is not automatically your adviser
A preparer who enters numbers on a return has not necessarily blessed every item on it. If you want to rely on your CPA's judgment about a specific position, ask the specific question, give the facts and get the answer, ideally in writing.
Too good to be true is a legal standard, not just a saying
Courts look at a taxpayer's education and sophistication. Highly educated people who invest large sums in arrangements promising outsized tax benefits will be expected to ask hard questions. Our article on penalty abatement strategies covers other routes to relief, and Graev v. Commissioner covers a procedural defense the IRS must clear before penalties stick.
The Bottom Line
Neonatology turned a vague defense into a three-part test, and the test is demanding. Competent adviser, complete facts, actual good faith reliance. Miss any one and the penalty stays. The good news is that all three are within your control, if you think about them before you file instead of after the IRS asks.