Originally published on Forbes.com Jan 26th, 2014
There are some really bad things that can happen to you if you are not tax compliant. Depending on what you do, you could be subject to a 75% fraud penalty or even forfeit your liberty – an all-expense-paid stay at Club Fed. The chance of either of those things happening though is rather remote.
Not so the 20% accuracy penalty. It is routinely, practically automatically, assessed if your understatement of tax crosses the threshold (greater of 10% of correct tax or $5,000). When you are in Tax Court, the IRS starts with a presumption in its favor. Sometimes the Tax Court will rule against the taxpayers on the issue in dispute, but then rule that there was a reasonable basis and let them go on the accuracy penalty. I don’t have statistics, but my impression from reading most of the cases is that the accuracy penalty is usually upheld.
H&R Block brags about how if you bring them your prior your returns they will often find something that will save you tax, so you can file for a refund. Of course, it is also possible that if you had somebody look at your return, they would notice things that would cause you to owe more money.
There are a lot of mistakes that are very easy to make, particularly if you have somebody who is technically challenged working on your return – at-risk rules, basis limitations, pass-through entities. If a CPA in doing a current return notices that there was a mistake on a prior return, that would cost you if it were fixed, she is ethically obligated to point the error out to you. If you decline to have the CPA prepare an amended return for you, she is required to reflect on whether she wants to continue to do business with you.
Why Amend?
Putting aside your desire to be a good citizen and to look like a mensch to whoever pointed out the error, why would you amend a return that had an error on it? The reason is that a “qualified amended return” will avoid the 20% accuracy penalty. Operating from a purely cynical perspective and ignoring interest, if you think that the chance that the IRS will catch the mistake is greater than 20%, the percentage more would be to amend.
I’m actually thinking this through as I am writing this rather than reflecting on how I have practiced over the year. It would seem that if you are living a pretty plain vanilla life and the error is something that will be picked up by document matching – an overlooked or mistranscribed 1099 or W-2 – you should file the amended return because you are likely going to get caught. More subtle errors, like taking a deduction for which you are not at risk, you can probably run for luck, since audit coverage is so low. Of course, if you were my new client, I would have to think about whether I still wanted you as a client.
What Makes It A Qualified Amended Return?
The calculus that, I just described, amend if you think the chance that you will get caught is greater than 20% gives you the clue as to what makes a “qualified amended return” “qualified”. Simply stated, an amended return is not qualified, once the IRS has let you know that they are planning to be looking at the original return. It is, of course, more complicated than that, but that is the essence of it. Jeffrey Bergmann was before the Ninth Circuit arguing that the Tax Court had gotten some of the fine points of the principle wrong. It did not go well for him.
My Favorite Source Of Schadenfreude
The story behind the story is the nineties to turn of the millennium phenomenon that Jack Townsend calls the raid on the fisc engineered by the Big Four Accounting firms. If the deals they designed actually worked, the income tax had truly become optional for the 1% at least on large capital gains. Instead of paying the government 20%, you paid KPMG 3%.
I was vaguely embarrassed that I did not understand those deals. When I finally got it though, I realized it was because fundamentally, they did not even make good nonsense. What most offended me was that they relied on unbalanced entries. I called it “Debit by the window, credit out the window”.
Jeffrey Bergman like Sy Sperling decided that he would drink some of the Koolaid that KPMG had blended for its clients on his own returns:
Jeffrey Bergmann, a tax partner at KPMG, LLP, and his wife Kristine Bergmann used a tax strategy known as the “Short Option Strategy” (“SOS”) that KPMG developed and promoted to clients. These SOS transactions artificially inflated the taxpayer’s basis in foreign currency, allowing the taxpayer to claim falsely high losses or low profits on sales of that currency. The Bergmanns engaged in SOS transactions in 2000 and 2001. They timely filed their original 2001 joint tax return, claiming ordinary and long-term capital losses for the two transactions.
Mr. Bergmann had a heads up that the IRS might be interested in his return.
The IRS served two summonses on KPMG on March 19, 2002 for its role in promoting SOS transactions. In March 2004, shortly after KPMG gave the IRS a list of SOS participants including the Bergmanns, they filed an amended return for 2001 removing all the previously-claimed losses and reporting and paying an additional $205,979 in taxes. At no point did the Bergmanns concede that the losses were improperly reported or foreclose themselves from taking another position on a later amended return.
So Mr. Bergmann was looking for a “mulligan” on his original return to avoid the penalty, but if turned out that the original shot had actually been a good one, he was positioned to “unmulligan” by re-amending. Of course the latter never happened, so the stakes in this litigation were limited to the $41,196 penalty that had been assessed. Mr. Bergmann was arguing that the notice to KPMG did not preclude his still filing a qualified return.
The Tax Court didn’t buy his argument and the Ninth Circuit backed them up:
We agree with the Tax Court that the terminating event described in Treasury Regulation § 1.6664-2(c)(3)(ii) is completed when the IRS first contacts a person concerning liability under § 6700 for an activity with respect to which the taxpayer claimed a tax benefit. This interpretation is supported by the purpose of QARs: encouraging and rewarding taxpayers who voluntarily disclose abusive tax practices, thereby saving IRS resources. See T.D. 9186, 2005-1 C.B. 790. In this case, once KPMG had been told of an investigation and given the Bergmanns’ names to the IRS, the record fails to demonstrate that their amended return was voluntary or saved IRS resources. For these reasons, we affirm the decision by the Tax Court.
Jack Townsend wrote an analysis of the original Tax Court decision, where he discussed the “qualified amended return” gambit in some detail.
You can follow me on twitter @peterreillycpa.
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