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This is a two-part article intended to cover the challenges facing a taxpayer whose return is audited, producing a tax deficiency, on top of which the I.R.S. asserts a penalty.
First, a little bit of history. Until 1982, outside of situations where the I.R.S. could prove an affirmative attempt to evade tax, the only sanction for errors on returns was the negligence penalty of I.R.C. § 6653(a). That penalty was imposed at the rate of five percent and did not bear any interest, so that in the view of many it was an encouragement for people to play the "audit lottery," since owing the tax, that penalty and interest (for the use of the money) wasn't a high risk operation. As a result, the penalty has been transformed over the years into the current version of I.R.C. § 6662, which is the penalty statute presently in existence. That penalty applies at the rate of 20% to negligence, including intentional disregards of rules and regulations; a valuation overstatement in excess of 150% of the correct value; or for a "substantial understatement of tax," which means a deficiency in excess of 10% of the amount of tax which should appear on the taxpayer's return, or $5,000, and the absence of either a disclosure statement filed with that return, or "substantial authority" for the reporting position.
With that in mind, let’s focus on how this scheme works in practice. In perhaps the most basic situation, we have a taxpayer who seeks to avoid the accuracy penalty because he relied on tax preparation software. Recently, a gentleman named David Parker found himself liable for taxes and asserted that the penalty should be waived on the basis of "reasonable cause" for that reason, and even claimed to consult with experts at the software company. Unfortunately, when the Tax Court reviewed the evidence, it was unpursuaded that Mr. Parker had in fact followed the protocols of the software, used it properly, and believed in the accuracy of what was produced.
He is not the first taxpayer whose claimed reliance on software has been rebuffed, several who lost their cases could not show that they used the software correctly and made no mistakes themselves, such as entering personal expenses as if they were deductions. Ronald Thompson, whose case is reported at T.C. Memo 2007-174, prevailed on the “software defense” because he showed that he made no mistakes and reasonably relied on the product to prepare an accurate return.
In other words, a “do it yourselfer” can avoid the accuracy penalty, but must do more than point to the software if something goes wrong as if it provides a complete defense.