Overcoming Accuracy-Related Penalties With Reasonable Cause

Abstract

According to the national taxpayer advocate’s annual reports to Congress, the most litigated federal tax issue in recent years has been the application of the accuracy-related penalty (ARP). Section 6662 imposes an ARP on persons who have underpaid their income tax in specific circumstances, the most frequently litigated being underpayments attributable to negligence or disregard of rules and underpayments that exceed a computational threshold — called a "substantial understatement."

Taxpayers will succeed in removing or reducing an ARP if they can establish that they acted with “reasonable cause and good faith” as set forth in section 6664. We will refer to this as the “reasonable cause defense.” In one report, the national taxpayer advocate found that although the underlying tax deficiency (or portions thereof) was upheld in all cases they reviewed in 2017, there was a greater than 20 percent overall success rate for challenging an ARP imposed under section 6662(b)(1) and (2), attributable to the taxpayer having shown “a reasonable and good faith attempt to ascertain the correct amount of tax due.”

Moreover, presenting complete and accurate records and proving a reasonable reliance on a competent tax professional strengthened a taxpayer’s reasonable cause defense considerably. In those 2017 cases, the taxpayer was wholly or partially successful 32 percent of the time.

The ARP and the applicability of the reasonable cause defense appear poised to continue to be the most litigated tax issue each year. Blue J Tax catalogs over 1,500 federal tax cases involving ARPs and the reasonable cause defense litigated since 1990. In a quarter of those decisions, the taxpayer prevails regarding reasonable cause.

But Blue J can reveal more than summary statistics. Blue J uses machine-learning techniques to identify the factors driving the availability of the reasonable cause defense for taxpayers. These insights can help users raise a stronger defense to the ARP by positioning their cases in the most effective way possible. We are pleased hereby to offer the machine-learning guide to overcoming ARPs with the reasonable cause defense. To animate our machine-learning analysis of the reasonable cause defense, we will scrutinize the ongoing litigation in Soni. Blue J predicts with 88 percent confidence that the taxpayer’s reasonable cause defense against the ARP will not be successful in the appeal. Our principal findings emphasize the importance of maintaining complete and accurate financial records and relying on competent tax professionals.

Keywords: accuracy related penalties, income tax, machine learning