A recent Tax Court decision addresses the “reasonable cause” standard — a frequent issue in the IRS-penalty context.  As the case demonstrates, whether a taxpayer acted with reasonable cause and in good faith is determined on a case-by-case basis. Woll highlights the fact that a taxpayer who has an advanced degree, such as an attorney, will likely have more difficulty demonstrating reasonable cause. Based on the Woll decision, reliance on a computer program or failure to read a tax form, such as a Form 1099-R, is not sufficient without more to prove reasonable cause.

Woll v. Comm’r, Bench Opinion| April 29, 2021 | Holmes, J. | Dkt. No. 7024-20

Short Summary: Petitioner Molly Woll was laid off from her employer in 2017, resulting in the termination of her 401(k) savings plan that had a balance of more than $86,000. Ms. Woll and her husband spent part of the proceeds from the plan on paying back a loan, as well as paying medical expenses, student loan payments, mortgage bills, house expenses, and other bills. This resulted in a taxable distribution.

Ms. Woll prepared the couple’s 2017 tax return and reported the taxable distribution but did not add the extra 10 percent tax imposed by I.R.C. § 72(t). This triggered an IRS audit, which resulted in the assessment of the 10 percent tax, as well as a substantial understatement penalty. Mr. and Mrs. Woll timely filed their tax court petition.

Key Issues:

• (1) Whether the taxable distribution is subject to the 10 percent tax imposed by I.R.C. § 72(t); and
• (2) Whether the substantial understatement penalty applies to the Wolls’ 2017 tax return.

Primary Holdings:

• (1) Because an exception did not apply, the taxable distribution was subject to the 10 percent tax imposed by I.R.C. § 72(t).
• (2) The substantial understatement penalty applies to the Wolls’ 2017 tax return.

Key Points of Law:

• If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer’s tax for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income, unless an exception applies. I.R.C. § 72(t).
• The increase in tax on withdrawn amounts from retirement accounts imposed by Section 72(t) is not in fact a penalty, but an increase in tax. See Grajales v. Comm’r, 156 T.C. 3 (Jan. 25, 2021).
• The penalty determined mathematically by computer software without the involvement of a human IRS examiner is one that is “automatically calculated through electronic means”, Section 6751(b)(2)(B) is the plain text the statutory exception requires. See Walquist v. Comm’r, 152 T.C. 3 (Feb. 25, 2019).
• The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances . . . . generally the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” See 26 C.F.R. § 1.666-4(e)(1).

Insight: Whether a taxpayer acted with reasonable cause and in good faith is determined on a case-by-case basis. Woll highlights the fact that a taxpayer who has an advanced degree, such as an attorney, will likely have more difficulty showing reasonable cause. Reliance on a computer program or failure to read a tax form, such as a Form 1099-R, are not sufficient alone to prove reasonable cause.

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