IRS Pushes Bad Position in Penalty Case and Loses on Reasonable Cause Grounds

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August 17, 2016

The U.S. Tax Court recently held that an individual taxpayer was not liable for failure-to-file and failure-to-pay penalties under Code Sections 6651(a)(1) and 6651(a)(2), respectively, due to reasonable cause.  In Rogers v. Commissioner, a 2007 fire nearly destroyed Rogers’ home, resulting in losses exceeding $150,000 and essentially leaving her homeless.  Rogers did not deduct the losses on her 2007 or 2008 return, believing that she could claim the deduction only in the year the insurance company resolved her claim.  In 2009, the insurance company paid her $43,964, and she did not file an income tax return or pay the related taxes because she believed that her casualty losses (to the extent not compensated by insurance) fully offset her 2009 income.

The IRS disagreed with the timing of this deduction because a casualty loss is generally deductible in the year of the casualty.  Only if and to the extent a taxpayer has a reasonable prospect of insurance recovery, the deduction is deferred until it can be ascertained whether such reimbursement will be received.  Thus, Rogers should have deducted the casualty losses in 2007 or 2008, not in 2009.  Rogers and the IRS settled the deduction issue and litigated the penalties under Sections 6651(a)(1) and 6651(a)(2).

The Tax Court ruled that the taxpayer’s error was due to reasonable cause and not willful neglect for three key reasons.  First, Rogers had a significant compliance history hallmarked by timely filing and paying her federal income taxes, and “significant efforts to correctly prepare her income tax returns” by consulting tax books and articles and even the IRS.  Second, following the casualty, Rogers suffered personal hardships.  From 2007 through 2009, she suffered bouts of depression, experienced living conditions she found dehumanizing, and in 2009, fractured her skull after falling from a subway platform.  Third, Rogers’ error—deducting a loss in a year later than the correct year—was an error made in good faith and not a blatant tax avoidance technique.  Although the court did not explicitly mention the difficulty of applying the law as a factor, the court did highlight the murkiness of the issue: determining the year in which there was “no prospect of recovery from insurance.”

The reasonable cause exception exists because Congress recognized that even the most compliant taxpayers are not perfect.  Notwithstanding case law on penalties that is often viewed as unfavorable, taxpayers often prevail in penalty cases before IRS Appeals.  Although the taxpayer in Rogers was an individual, the case sheds light on why the IRS concedes penalty cases when businesses demonstrate a history of compliance and identify rational and understandable reasons for the errors at issue.  Reasonable cause exists when a taxpayer exercises “ordinary business care and prudence.”  Ordinary business care and prudence is determined based upon all the relevant facts and circumstances, and the burden of proof rests on the taxpayer.

Consistent with Rogers, taxpayers can elevate their chances for abatement by establishing a history of tax compliance.  Further, when things go awry, taxpayers should promptly take responsibility and correct the mistake, and then take steps to identify the cause of the failure and establish procedures to prevent a recurrence of the failure.  By taking swift action, the taxpayer increases the odds of overcoming its burden to show reasonable cause.