Will Reasonable Reliance on Tax Professionals Save You in an Audit?

Businesswoman working finance with calculator in office.

When taxpayers hire accountants to help prepare their tax returns, they expect it to be done right, and to save them from audits. But sometimes the quality of that product is limited by the information the taxpayers themselves provide. A recent United States Tax Court decision shows the limits of reasonable reliance on tax professionals’ advice, and serves as a cautionary tale for business owners trying to do their own tax law defense.

Small Business Owners Represent Themselves Against the IRS

Ernesto and Marilyn Patacsil are small business owners in California. They own and operate group homes for adults with developmental disabilities. This is unfortunately not an especially profitable business. The state only pays $1,365 per month for each client receiving nonmedical out-of-home care. From that amount, the Patacsils had to pay for testing, licensing, background checks, continuing education, transportation, client activities and entertainment, and holiday gifts. They were also required to keep a registered nurse and behavioral analyst on staff.

That all added up to a loss. In 2014, the couple owned seven group homes, each with up to 6 employees. They went to great lengths to fund their businesses, refinancing their mortgages to make payments. Mr. Patacsil even turned to gambling, which unfortunately did not improve the family’s financial situation. In 2016, they lost one of their properties to foreclosure. A second followed a year later.

Tracking Business Expenses Affects Family’s Ability to Respond to an Audit

While the family was struggling, they were still trying to file their income taxes and claim business deductions for their expenses. They used accountants to prepare their taxes each year, but beyond that, they had a very “old-school accounting system,” according to the Tax Court. Mrs. Patacsil put business-expense receipts in envelopes labeled with the type of purchase and the amount spent. At the end of the year, she boxed up those envelopes and sent them to the tax professionals to prepare the returns.

That system had gotten them into trouble in the past. In 2013, the IRS had issued a deficiency in income tax and penalties for a failure to substantiate their business expense deductions. But Ms. Patacsil kept using her envelopes, and the family kept working with the same tax professional, until at least 2015. For tax years 2016 and 2017, they hired a licensed CPA who had worked as an IRS revenue agent in the past. But even then, the Tax Court wasn’t convinced that the way the Patacsils used their tax professional’s advice was always enough to excuse all the errors revealed in their tax audit.

How Discharged Debts Affect Income

When business owners and taxpayers struggle financially, they can face unique challenges in correctly reporting their income and expenses. For example, when a creditor releases a taxpayer from debt, the taxpayer receives income for tax purposes equal to the face value of the debt minus the amount paid to satisfy it. They must report that income in the year the debt is canceled. However, if the taxpayer is insolvent when their debts are forgiven, their income is limited by the amount their total liabilities exceed the fair market value of their assets.

The trouble comes in proving those amounts. The Patacsils had looked up the values of their properties on Zillow, but could not say at court exactly when that happened in relation to the debt being forgiven. Similarly, the business was involved in a wage-and-hour lawsuit with some employees, but at trial Mrs. Patacsil could not estimate the liability from that, simply that she was confident she would win. They provided no other evidence of their liabilities or the value of their business. Those are details a tax professional or tax attorney would need to help defend their insolvency claim and limit the income resulting from the discharge of their debts.

Tax Court Considers When Tax Professionals’ Advice Counts as Reasonable Cause for Errors in Business Expense Deductions

The U.S. Tax Code also allows business owners to deduct their ordinary and necessary expenses from their gross income. However, it is up to the taxpayer and their tax professional to provide records of those expenses, or at least some evidence to help the court estimate them. Errors in calculating those amounts can sometimes be excused for reasonable cause. One such reasonable cause is the reasonable reliance on a tax professional’s advice.

However, the reasonable cause defense requires more than just hiring a tax preparer to fill in the boxes on a tax return. There are 3 factors in determining whether reasonable reliance on a tax professional’s advice counts toward a reasonable cause defense:

  1. Was the advisor a competent tax professional with the appropriate expertise?
  2. Did the taxpayer provide necessary and accurate information to the tax professional?
  3. Did the taxpayer actually rely on the tax professional’s judgment?

The Tax Court said, “Reasonable cause requires that a taxpayer exercise ordinary business care and prudence” in making business deductions. The Patacsils’ record keeping method wasn’t up to that standard, at least, not after they were audited in 2013. The Court said they should have known the system was vulnerable to errors and updated their methods after the first deficiency was entered. The information they provided to their tax professionals in 2016, at least, had errors and omissions that defeated their reasonable cause defense.

Similarly, they did not reasonable rely on their tax professionals’ advice in claiming those deductions. Instead, they simply provided them to the accountant’s office, which helped them complete their tax returns. There were no judgment calls and no advice about whether those amounts were deductible as business expenses.

The exception was in claiming depreciation on the company’s net operating losses in 2017. The Court found that calculating the amounts carried forward and backward “are not intuitive” and a small business owner could not be expected to understand those calculations. They were excused for those errors because they were made in reliance on their tax professional’s advice.

Tax Court Decision Shows Why Parties Should Rely on Tax Professionals’ and Tax Attorneys’ Advice

Likely the biggest thing working against the Patacsils in their tax court case was that they were trying to do their tax law defense themselves. Self-represented taxpayers aren’t uncommon in tax court, which is unfortunate and expensive for people trying to defend themselves. Tax law is complicated, so complicated that even tax attorneys need an additional degree to handle many cases. Business owners are well-advised to work with experienced tax professionals to prepare their tax returns, document income and properly claim deductions. If you find yourself facing a tax deficiency notice you should contact a tax attorney right away to develop a strong defense.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding reasonable reliance defenses to tax deficiencies, contact Joe Viola to schedule a consultation.