Taxpayer Reasonably Relied on CPA's Advice

The case of Doyle v. Commissioner, TC 2019-8 is remarkable not so much for the decision that Mr. Doyle owed additional tax, but for the Court’s analysis of why he should not face penalties.  The taxpayer in this case was able to prove had reasonably relied upon the advice of a tax professional.

Mr. Doyle attempted to argue that amounts he had received as a settlement received from his former employer for emotional distress could be excluded from income under IRC §104(a).  IRC §104(a)(2) provides:

(a) In general

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—

…(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;…

The Tax Court, noting that the award says it was for “emotional distress” found that this was sufficient to decide against the taxpayer’s attempt to exclude his award from income.  The Court noted:

This is enough for us to find that the $250,000 was for Doyle’s emotional distress, and leads us to the next question: Is Doyle’s “alleged emotional distress” a personal physical injury or physical sickness? The Code tells us it isn’t. Section 104(a) specifically commands that “emotional distress shall not be treated as a physical injury or physical sickness,” and caselaw tells us that emotional distress includes symptoms such as insomnia, headaches, and stomach problems that result from such distress. See Pettit v. Commissioner, T.C. Memo. 2008-87, 2008 WL 928090, at *4; see also H.R. Conf. Rept. No. 104-737, at 301 n.56 (1996), 1996-3 C.B. 741, 1041. If we stopped at the language in the settlement agreement, we would hold that the emotional-distress payments Doyle received in 2010 and 2011 are not excludable from income under section 104(a)(2). See, e.g., Hansen v. Commissioner, T.C. Memo. 2009-87, 2009 WL 1139469, at *7 (finding similar settlement-agreement language meant the payments were not excludable under section 104(a)(2)).

The taxpayers argued that the emotional distress lead to physical symptoms—but the opinion notes the Courts have previously rejected that view:

But Doyle’s list of ailments — e.g., nausea, vomiting, headaches, backaches — are included in the definition of emotional distress when they result from such distress, see Pettit, 2008 WL 928090, at *4; [*14] see also H.R. Conf. Rept. No. 104-737, supra at 301 n.56, 1996-3 C.B. at 1041, and he himself testified that his ailments are the consequence of the emotional distress he suffered when Wacom fired him. Doyle’s own testimony therefore undermines his eligibility for excluding this part of the settlement under section 104(a)(2). And while we have ourselves noted the crumbling barrier between psychiatry and neurology, see Alhadi v. Commissioner, T.C. Memo. 2016-74, where the Code itself assumes a dualist view of the mind and body we must assume such a view as well when we apply the Code to the facts of a particular case. The Doyles may well be right ontologically, but not legally.

The IRS argued that, in addition to the taxes and interest due, the taxpayers should also have penalties imposed under IRC §6662(a).  As the Court describes this provision:

Section 6662(a) imposes a 20% penalty for underpayments due to “any substantial understatement of income tax,” see sec. 6662(b)(2), (d), or “[n]egligence or disregard of rules or regulations,” see sec. 6662(b)(1), (c). The Commissioner says the Doyles are liable for accuracy-related penalties on both grounds, and it’s easy enough to see that there seems to have been a substantial understatement at least: Section 6662(d)(1)(A) says that an understatement is substantial if it is greater than $5,000 or “10 percent of the tax required to be shown on the return;” the Doyles’ tax understatements in 2010 and 2011 easily exceed both those marks.

The taxpayers argued that they should not subject to this penalties because they had reasonably relied in good faith on the advice of an experienced CPA that they provided all relevant information to.  As the opinion notes:

The Doyles argue, however, that they shouldn’t be held liable for the penalties because they had reasonable cause and acted in good faith. See sec. 6664(c)(1); sec. 1.6664-4(a)(1), Income Tax Regs. They explain that they hired Hunter — an experienced and outwardly qualified CPA — to prepare their 2010 and 2011 returns; they are not tax experts; they gave Hunter accurate and complete records; and they thought his advice was reasonable and relied on it in good faith.

Citing the Tax Court’s opinion in Neonatology Assocs., PA v. Commissioner, 115 TC 43 (2000), affd 299 F.3d 221 (3d Cir 2002), the opinion lists the following three factors to be considered when determining if the taxpayer has a valid reliance in good faith defense to penalties:

  • Was the adviser a competent professional with sufficient expertise to justify reliance;

  • Did the taxpayer provide necessary and accurate information to the adviser; and

  • Did the taxpayer actually, and in good faith rely on the adviser’s judgment?

The opinion first considers the qualifications of the CPA on whose advice they claimed to rely—and the Court found that the individual’s resume was more than strong enough to justify reliance by the taxpayers:

Hunter appeared more than competent to advise the Doyles. He’s an Ivy League-educated CPA with over forty years of experience preparing tax returns, and he’d done the Doyles’ returns for a decade. Hunter is licensed to practice his profession in four states, teaches college accounting classes, and gave the impression that he stays current with federal tax issues. Even if the Doyles were knowledgeable about tax law — which they’re not — we’d find that Hunter seemed competent enough to justify their reliance.

The taxpayers were also found to meet the second prong of the test:

We also find that the Doyles provided Hunter with all the information he needed to accurately prepare their returns. Hunter credibly testified that he’d reviewed the settlement agreement and other documents about the settlement — documents that we find exist, but which the Doyles failed to introduce into evidence. He also explained, and we believe him, that Doyle’s “wife provide[d] very extensive logs and records,” and that he and Doyle “conversed quite a bit on all of his returns.” The Doyles easily satisfy the first and second factors for their reliance defense.

Note that the CPA in question testified for the taxpayers regarding the information he had been given.  Such testimony most often is found in cases where taxpayers mount a successful reliance defense.

The third test, looking at whether their reliance was reasonable and in good faith, had one potentially fatal fact.  If a taxpayer does not actually consider the advice given to see if it “makes sense” quite often the Courts find that there was not reasonable reliance.  In this case the taxpayer admitted that he had essentially just looked to see how big a refund he was getting.

But in this case the Court did not ultimately find this admission to be fatal to the claim of reliance:

Although Doyle is a sophisticated businessman, his testimony left us with the distinct impression that he lacks tax experience or knowledge. That gives some much-needed color to his admission that he only briefly reviewed the returns Hunter prepared. “Probably like most people,” Doyle testified, “you look at the bottom line and see how much you have to pay or how much you’re getting back, to be quite honest.” Doyle’s testimony on this point was honest, and we find it reasonable given his lack of tax expertise — he had “a lot of confidence in Mr. Hunter” and “so [he] trusted” him. So we find that Doyle actually relied on Hunter’s advice.

And the Court found the nature of the issue did not make the CPA’s advice itself inherently unreasonable:

And we find that the Doyles’ reliance on Hunter’s advice was reasonable and in good faith. We’ve recognized that the line between excludable and includable damages under section 104(a)(2) is a thin one, see Blackwood v.Commissioner, T.C. Memo. 2012-190, 2012 WL 2848677, at *6 (there is some “level of uncertainty regarding when physical manifestations of emotional distress give rise to a physical injury or physical sickness”), and even erroneous professional advice about that is good enough to prove reasonable cause, see Longoria v. Commissioner, T.C. Memo. 2009-162, 2009 WL 1905040, at *10-*12 (finding reasonable reliance even though CPA failed to consider nature of claims and terms of settlement). We’ve even held that advice in this area from individuals who lack “specialized knowledge in tax law” can be relied on to avoid accuracy-related penalties. See Stadnyk v. Commissioner, T.C. Memo. 2008-289, 2008 WL 5330828, at *7, aff’d, 367 F. App’x 586 (6th Cir. 2010). Hunter’s reporting method was odd — including settlement payments and offsetting deductions on Schedules C — but his explanation for it was innocent enough; he advised the Doyles that the emotional-distress payments were not taxable, and he credibly testified that he reported them the way he did so that the Doyles were “reporting all the information but explaining why we treated them as nontaxable.” There’s nothing in the record that indicates the Doyles should’ve been skeptical about this advice. Under these circumstances, we wouldn’t expect the Doyles to second-guess their CPA’s advice. See Boyle v. Commissioner, 469 U.S. 241, 251 (1985). The Doyles had reasonable cause and acted in good faith, and they are therefore not liable for the accuracy-related penalties