Tax Court Sends Another Sobering Reminder to Taxpayers: Carefully Review Your Tax Return Before Filing
The Tax Court made itself loud and clear again in its recent decision Yapp v. Commissioner: carefully review your return before filing even if a professional is used to prepare the return. A failure to do so can have drastic consequences down the road. A copy of the Yapp case is available here. In Yapp v. Commissioner, T.C. Memo 2018-47, the taxpayers, who relied on a CPA to prepare their tax returns, were hit with a $95,027 accuracy-related penalty as they were unable to argue they acted with reasonable cause. The court found the taxpayer’s reliance on their CPA unreasonable because had the taxpayers reviewed their tax returns before filing they would have discovered the numerous mistakes the CPA had made. Without further review of the case, this holding appears to place an onerous burden on taxpayers who are not well versed in tax return preparation to check the work of their CPA. However, looking deeper into the court’s analysis reveals at least one red flag taxpayers with businesses should be aware of as they file their tax returns.
The husband and wife taxpayers in Yapp each owned and operated a separate business during the 2009 and 2010 tax years that were treated as disregarded entities on Schedule C of their Form 1040. The husband, J. Yapp, owned and operated a musical artist promotional company in conjunction with MTV with Taylor Swift as its principal musical artist. The company attempted to deduct wages paid to MTV employees associated with the company, but the IRS disallowed the deduction as the company was unable to substantiate the deduction by providing such support as employment contracts, Forms W-2, or Forms 1099-Misc. The wife, T. Yapp, owned and operated a health food business. The business attempted to deduct expenses related to the startup of her business as trade or business expenses, but the IRS disallowed the deduction finding the business’ activities did not rise to the level of trade or business until 2011. As a result of the disallowed deductions, the taxpayers’ income in 2010 was substantially understated triggering a 20% underpayment penalty ($95,027) under IRC sections 6662(a) and (b)(2).
As is often the case when the IRS attempts to assess penalties, the taxpayers argued the underpayment of tax was due to reasonable cause as they acted in good faith and in reliance on their CPA to report their federal income tax liabilities. The court noted that a taxpayer’s reliance upon professional advice can be reasonable cause when (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.
However, here, the court found the taxpayers’ reliance upon the CPA unreasonable because the identified mistakes undermined any assumption that the preparer was a competent professional. Specifically, the court pointed to the taxpayers’ testimony at trial that they approved the filing of the returns without fully reviewing them. Had they reviewed the returns, the court noted, the taxpayers would have seen, among other things, personal expenses being deducted as business deductions, the wrong accounting method being used to report one business’ income, and a failure to continue to claim depreciation deductions from 2009 in 2010.
The decision in Yapp reiterates a burden on taxpayers to review their tax return carefully before filing — even when a professional prepared the return. That being said, one issue that frequently appears in IRS audits of small and/or closely-held businesses is the deduction of personal expenses as business deductions. If a taxpayer reviews its return and notices large amounts of personal expenses are being deducted as business deductions, it should send a red flag that the returns may not have been prepared correctly. If you any have questions regarding IRS penalties in general and/or arguing reasonable cause to abate the penalties, please contact Daniel Boysen at (214) 749-2413 or firstname.lastname@example.org.