Last September, the LTA blog discussed a line of Tax Court cases in which taxpayers unsuccessfully attempted to defend themselves from I.R.S. penalties by arguing that their reliance on tax preparation software amounted to reasonable cause and good faith. After this line of consistent taxpayer defeats, the Tax Court recently ruled in favor of a taxpayer who used tax preparation software to self-prepare his tax return and mistakenly omitted a large amount of trust fund income from his taxable income. See Olsen v. Commissioner. T.C. Summ. Op. 2011-131. While Olsen is notable because a taxpayer who relied on a tax return preparation program was able to assert a successful defense against I.R.S. penalties, it is especially interesting because the successful taxpayer argument in this case was more nuanced than those in previous cases.
Generally, when a taxpayer substantially understates his tax liability by more than $5,000, the I.R.S. asserts a substantial omission penalty against the taxpayer. I.R.C. §6662(b)(2), I.R.C. §6662(d). When faced with this substantial omission penalty, a taxpayer may argue that he qualifies for an exception to the penalty because he had a reasonable cause for the understatement and he acted with good faith. I.R.C. §6664(c). In determining whether a taxpayer acted with reasonable cause and good faith, a court will look at all the pertinent facts and circumstances. Treas. Reg. § 1.6664-1(b)(1).
In the past, taxpayers who relied on software programs to help them prepare their tax returns had a hard time proving reasonable cause and good faith and the Tax Court upheld the penalty, reasoning that tax return preparation software is only as good as the information a taxpayer puts into it. See e.g. Bunney v. Commissioner, 114 T.C. 259, 267 (2000), Lam v. Commissioner, T.C. Memo 2010-82, Anyika v. Commissioner, T.C. Memo 2011-69.
In Olsen, the taxpayer made a more nuanced argument to explain why he should not be liable for penalties. The regulations establishing the reasonable cause and good faith exception to the substantial omission penalty state, “An isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith.” Treas. Reg. §1.6664-4(b). The taxpayer used this regulation to argue that he had exercised reasonable care when he entered his tax information into the software program, but he made an isolated transcriptional error in the process. See Olsen v. Commissioner, Summ. Op. 2011-131.
The court found this argument convincing. The court noted that the most important factor in deciding whether a taxpayer has acted with reasonable cause an in good faith is the extent of the taxpayer’s effort to assess the proper tax liability. See id. Because the taxpayer had correctly reported that he had received a Schedule K-1, but failed in input the amount of income from the Schedule K-1, the court found that the taxpayer’s error was an isolated transcriptional error. Id.
While Olsen seems to open the door for isolated transcriptional error arguments, taxpayers should understand that the Tax Court heard this case under ‘S’ case rules. This means that the published opinion in Olsen v. Commissioner does not have precedential effect. I.R.C. § 7463(b). While the case does not have precedential effect, it does indicate that the isolated transcriptional error argument may be successfully used in future penalty cases addressing the use of tax preparation software.