Taxapayer's Unsuccessful Attempt to Find a Preparer to Confirm Their Own Preparer's Advice Not Reasonable Cause for Omitting Income

The tax laws are complicated and, at times, the results are not what a taxpayer might like. The combination of these two facts cause some taxpayers to start “opinion shopping” when they receive an answer they don’t like. In the case of Mallory v. Commissioner, TC Memo 2016-110, the taxpayers ended up casting about for someone who would tell them what they wanted to hear.

The Mallories had purchased a single premium variable life insurance policy on Mr. Mallory for $87,500 in 1987. The policy provided that Mr. Mallory could borrow from the carrier and the loan would be secured by the policy, with any unpaid interest on the loan being added to the loan amount. Beginning in 1991 Mr. Mallory took advantage of this “tax free” source of funds, eventually taking out cash of over $133,000 by the end of 2001.

While Mr. Mallory ceased taking money from the policy in 2001, he did not make any interest payments. On October 17, 2011 the carrier wrote Mr. Mallory indicating that the cash value of the policy was now less than the outstanding balance of the loan and that unless he paid $26,061.67 by December 17, 2011 the policy would be terminated. The letter also warned Mr. Mallory that such a termination would create taxable income in the amount of $155,119.16 for Mr. Mallory.

Mr. Mallory did not pay the amount necessary to keep the policy in force and thus a 1099R showing a revised taxable amount of $150,397.25 was issued for 2011.

The taxpayer consulted with their tax preparer on this matter—and he didn’t have much good news:

Before filing their 2011 income-tax return, Larita Mallory spoke with Steve Miller of Liberty Tax Services about the income that Monarch Life had reported on the Form 1099-R. Miller told Larita Mallory that she “was going to owe a bunch of money”. Miller prepared the Mallorys’ 2011 Form 1040, “U.S. Individual Income Tax Return”. The Mallorys did not file their 2011 Form 1040 until around March 8, 2013.

However, when they finally filed the return it did not contain this income. Rather the Mallorys attached a handwritten note to the return:

Paid hundreds of $. No one knows how to compute this using the 1099R from Monarch — IRS could not help when called — Pls send me a corrected 1040 explanation + how much is owed. Thank you.

At trial the taxpayers clarified what that note meant:

Larita Mallory's testimony clarifies the meaning of the note attached to the return. She testified that before the Mallorys filed their return, she telephoned several [*7] persons other than Miller to ascertain whether the Form 1099-R was correct. The persons she telephoned consisted of two groups: (1) people who advertised themselves in the telephone directory as tax professionals (and whom she did not pay, unlike Miller) and (2) various IRS personnel. None of the persons she contacted was willing to confirm whether the Form 1099-R was correct.

Not surprisingly the Tax Court found that the amount was taxable to the taxpayer—and that included the portion of the gain that represented the accrued interest since, as the Court pointed out, personal interest (which is the default treatment for interest unless the taxpayer can trace the proceeds elsewhere) is generally not deductible under IRC §163(a)--and the taxpayer’s testimony clearly indicated the money was taken to cover short-term needs and no evidence was presented that these were other than living expenses. Even though not deductible, the liability for the interest was real and the policy value was used to pay off that liability, thus triggering taxable gain.

The real question, though, was whether the taxpayers had reasonable cause for their failure to properly report the income. In the case of substantial understatement of tax (that is, an understatement of the greater of $5,000 or 10% of the tax properly due with the return), the penalty is automatically presumed to apply. [IRC §6662]

A taxpayer can only escape that penalty if the position of the taxpayer had substantial authority (not an argument the taxpayer made in this case—and not one they would have succeeded with anyway), was disclosed and had a reasonable basis (the Court noted the rather odd disclosure but found the position had no reasonable basis under the law) or if the taxpayer had reasonable cause for the understatement and acted in in good faith.

For the last exception the taxpayers pointed out that they had asked numerous preparers and called the IRS and, in each case, the person on the other end of the line was unable to tell them the taxable portion of what they had received.

But it wasn’t correct no one had given the taxpayers an answer (which was also the correct answer) to the question. Rather, as the Court pointed out:

The Mallorys received the letter from Monarch Life informing them that the policy debt on Kenneth Mallory's variable life insurance policy had exceeded its cash value, that the termination of the policy would result in a taxable event, and that any taxable gain in the policy would be reported to Kenneth Mallory and the IRS on a Form 1099-R. The Mallorys received the Form 1099-R from Monarch Life before the April 15, 2012 filing deadline. The only tax adviser that they paid, Miller, suggested there would be a tax liability. Although various IRS employees and unpaid tax professionals declined to confirm whether the Monarch Life Form 1099-R was correct, it was unreasonable for the Mallorys to conclude from this unwillingness that they had no income from Monarch Life.

Thus, the Court sustained the penalties in this case.