Taxpayer Had Reasonable Cause for Late Filing and Payment Due to Erroneous Conclusion on Year of Deduction

As we are all aware, the Internal Revenue Code imposes penalties for the late filing of a tax return (IRC §6651(a)(1)) as well as for the late payment of taxes due on a return (IRC §6651(a)(2)).  The penalty does not apply, though, in either case if the failure is due to “reasonable cause and not due to willful neglect.”  In the case of Rogers v. Commissioner; T.C. Memo. 2016-152 the Tax Court found that the taxpayer had such reasonable cause when she mistakenly believed she was not required to file a return, and such a mistaken belief was found to be reasonable in her case.

As the Court notes in this case, “reasonable cause” is inherently very much a facts and circumstances situation and merely believing no return is required to be filed is not sufficient in and of itself—rather, the taxpayer must have arrived at this conclusion via a good faith effort to determine his/her responsibilities under the tax law.  But the taxpayer’s overall situation and their level of sophistication are taken into account to see if the taxpayer’s conduct meets the reasonableness standard.

In this the taxpayer had been suffering from numerous disruptive events in her life.  She had been operating a business out of her apartment until a fire in November 2006 rendered her apartment uninhabitable.  At that time she had to shutter the business because she no longer had a home office or necessary storage space to operate the business.

But things got worse.  In March of 2007, while she was working by candlelight in her old apartment packing items to be put into storage another fire broke out.  She was then barred from re-entering her apartment by the city until was declared safe.  Her fire problems was also written up in a story in the local newspaper that had a negative slant, causing her to be harassed by people in her neighborhood. 

She obtained housing with a local YWCA, but had considerable problems dealing with the board and other residents, with the police called on occasion to settle things down.  Obviously she was unhappy with that living arrangement.

Adding to her woes, in February 2009 she fell off a subway platform and fractured her skull, resulting in being hospitalized in intensive care for five days.

During this period she was negotiating with her insurance carrier for her claims related to the fire.  Based on her understanding of the tax law, she did not claim a casualty loss on her 2007 or 2008 returns.  However, in 2009 when she entered into a final settlement with her insurer on the 2007 fire she believed she could claim a casualty loss on her 2009 return related to that fire which would have wiped out any tax liability she might have had.  Thus, she concluded she did not need to file a 2009 tax return.

The IRS, likely looking at a stack of Forms 1099, concluded otherwise and prepared a substitute for return for her.  She met with the IRS to settle the case and during that meeting realized she had been in error about the year of deduction, agreeing to the imposition of tax.  However she argued that she should not owe the penalties due to reasonable cause.

The Tax Court notes that the determination of the year in which to deduct a casualty loss is not a simple one to discern under the tax law, noting:

At the time her 2009 return was due, petitioner believed the loss was deductible for 2009 because that was the year her claim was resolved. If an insurance claim is not paid in the year of the loss and the taxpayer has a reasonable prospect of recovery, the deduction for the loss is deferred until it can be ascertained whether such reimbursement will be received. Sec. 1.165-1(d)(2)(i), Income Tax Regs. However, if or to the extent there is no reasonable prospect for compensation for the loss through insurance, the loss is deductible for the year incurred. Sec. 165(a); sec. 1.165-1(d)(2)(ii) and (iii), Income Tax Regs. The parties’ settlement of this issue suggests that there was no reasonable prospect of recovery of a portion of the loss under petitioner's insurance policy.

The taxpayer had undertaken very specific steps over the years to determine her proper tax liability, as the Court notes:

Petitioner knew at relevant times that tax returns are due on April 15 of the following year in the absence of an extension; that if there is an extension, then the tax return is due on October 15 of the following year unless that date falls on a weekend or holiday; and that no return is required if the taxpayer's income for the year is below minimal amounts.

Generally, petitioner made significant efforts to correctly prepare her income tax returns. She consulted books and electronic sources describing tax rules she thought applied to her, and she sometimes contacted the Internal Revenue Service for information. Petitioner did not have an accountant or use the services of tax preparers to prepare her tax returns.

This method of handling her taxes had worked well for her in the past, and she had obviously not simply always decided issues in her favor—after all, not claiming a loss deduction in 2007 from the fire caused her to pay tax in 2007 she should not have paid.

The Court found that although she had made an error, her circumstances met the “reasonable cause” test.  The Court noted this was not someone who had taken steps in the past to evade paying taxes that were due:

Petitioner’s error (regarding the proper year of deduction of the portion of a casualty loss for which there is no prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic. Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique, especially compared with chronic failure to file tax returns.

As well, the Court also found that her rather stressful personal circumstances in this time frame should also be taken into account when determining if she acted reasonably:

Petitioner’s life was in a state of upheaval after the second fire and through the period when the return was due. She was barred from reoccupying her apartment and, during the times relevant to the 2009 return, she was living under conditions she found to be dehumanizing at a YWCA; later, she experienced bouts of depression, a fall from a subway platform in 2009, and a skull fracture. She was subject to continuous monitoring and psychiatric examination while hospitalized. She did not resume conduct of the business she had operated from her apartment (Talk of the Town Singles). Her living conditions and the resulting bouts of depression make reasonable her not understanding the correct year of deduction.

Advisers must note that this case is very fact specific, as are all cases in the area of “reasonable cause” but the holding still provides useful guidance on the sorts of factors that a Court is (and is not) likely to view favorably in a request for relief from penalties which have a reasonable cause relief option.