There is more to this opinion than just the regular run-of-the-mill taxpayer penalty. I encourage you to read on.
In the early 80’s, Mr. Pack, at the advice of his CPA, invested $25k in a limited partnership called Platte Leasing Associates. A $25k investment in 1981 equates to about a $60k investment today (per the calculator on The Federal Reserve Bank of Minn.'s website). Prior to Mr. Pack’s investment, he was informed via several documents that Platte was taking significant tax risks, and would most likely be challenged by the IRS. Within those documents was a section that stated Platte’s general partners were involved in other partnerships that were currently under IRS audit. As a result of those audits, the partnerships deductions were disallowed.
In 1983, Platte passed-through ordinary losses and interest expense, which Mr. Pack reported on his 1983 tax return. Similarly, in 1985, Platted passed-through ordinary income and interest expense, which Mr. Pack reported on his 1985 tax return.
In the early 90’s, the IRS adjusted Platte’s 1983 & 1985 tax returns. In 2006, the Tax Court upheld those adjustments. Shortly thereafter, the IRS sent Mr. Pack a notice of deficiency relating to his 1983 and 1985 tax returns.
The issue for the Tax Court is whether penalties imposed by section 6653(a) and 6661(a) apply to Mr. Pack. Don’t go looking for section 6661(a); it is not part of the current tax code, it was repealed in 1989. Section 6653(a) – under the 1954 tax code - imposes a 5% penalty for underpayments “due to negligence or intentional disregard of rules or regulations.” Section 6653(a)(2) imposes an additional tax “equal to 50 percent of the interest payable under section 6601.” This means, that whatever interest penalty the Pack’s have to pay because of underpayment, increase it by 50%.
Here, the Tax Court has to determine if the Pack’s acted negligently. The Tax Court points out that in the Ninth Circuit (where this appeal would lie), “[in] cases involving a deduction for loss that results from an investment [a determination as to negligence] depends on both the legitimacy of the underlying investment, and due care in claiming the deduction."
Mr. Pack attempts to show reasonable reliance on his CPA to avoid the negligence penalty. He relies on a three-prong test set out by the Third Circuit in Neonatology Associates, P.A. v. Comissioner, 299 F.3d 221, (3d Cir. 2002). The three prongs are:
(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.
As to the first prong, The Tax Court cites the CPA’s lack of investment experience to show Mr. Pack’s reliance was unjustified. The second prong was not an issue. The Tax Court also agrees with the IRS’s on the third prong; Mr. Pack knew of his CPA's conflict of interest. Lastly, the documents that accompanied the Platte investment contained several warnings regarding the tax risks that should have resounded loudly in Mr. Pack’s head.
Mr. Pack loses because the document he received in connection with the Platte investment was a clear warning, and he ignored it.
At first glance, the Tax Court’s application of Neonatology’s first prong appears incorrect. Based on the context of the Third Circuit's opinion, the first prong refers to the professional’s expertise as a tax adviser not as an investment adviser. In Neonatology, the taxpayer received tax advice from their insurance agent, “rather than from a competent, independent tax professional.” Neonatology, 299 F.3d at 234. Here, the IRS attacked the CPA’s expertise as an investment adviser and said nothing of his expertise as a tax adviser.
But as stated above, the standard for negligence here is defined by the Ninth Circuit. The Ninth Circuit requires a showing that the underlying investment was legitimate to avoid the negligence penalty. This has the impact of turning Neonatoloty's three-prong test into a six-prong test. Now, Mr. Pack has to show he acted reasonably not only with respect to taking the deduction, but also with respect to investing in Platte in the first place. Since Mr. Pack did not seek independent investment advice he fails the test.
My only policy argument against the Ninth Circuit's negligence test is that it is different than the test used in the Fifth Circuit. The Tax Court cites the Ninth Circuit's opinion in Saks v. Commissioner, 82 F.3d 918 (9th Cir. 1996). The Saks Court rejects the Fifth Circuit's opinion in Chamberlain v. Commissioner, 66 F.3d 729, (5th Cir. 1995). In Chamberlain, the issue of negligence is based solely on whether the taxpayer acted negligently in claiming the loss.
While I think the Fifth Circuit is the better approach, it seems wholly unfair that taxpayers in the ninth circuit should be subjected to a more stringent negligence test than taxpayers in the fifth circuit.