As the budget crisis has unfolded, the tax community has been predicting that the IRS would get aggressive about imposing penalties in order to raise more revenue. And we are starting to see just that happen.
The IRS has discretion when imposing penalties for taxpayer mistakes and has historically exercised that discretion to the taxpayer’s benefit. One area where the IRS has traditionally been lenient is when the error was based on bad advice from an accountant or attorney upon which the taxpayer relied. In that circumstance, we have often seen the IRS only charge interest on top of the unpaid taxes, but not penalties as well.
However, we have recently heard of several instances where late filing penalties were upheld against decedents’ estates even though the error was based on bad legal advice. In one, the executor’s attorney incorrectly advised that an automatic six month extension of time to file an estate tax return was instead for one year, and the return was filed late. In another, the executor’s attorney incorrectly advised that the executor could wait an extended period of time after the resolution of litigation to file a completed return. The IRS determined that the return had not been filed within a “reasonable time” after the conclusion of the litigation and was therefore late. In both cases, the maximum 25% penalty for failure to timely file the returns was assessed and upheld against the estates.
While taxpayers have been able to have a “no harm, no foul” mentality in the past with tax filings, they can’t any more. In this new environment, taxpayers need to be aggressive about making sure they are getting good advice. At the same time, attorneys and accountants need to be more careful about the advice they give. And this is especially true in light of the IRS’s current stance because while taxpayers generally don’t recover the additional taxes or interest from their accountant or attorney, they may be able to recover penalties assessed as a result of relying on the attorney’s or accountant’s bad advice.