Screw up on your tax return that’s due next week, and you may be subject to any number of civil penalties. For example, if you understate your income by more than the greater of $5,000 or 10% of the correct tax liability, and you’ll pay an additional 20% of the liability as penance under Section 6662.
Relief is provided, however, in the form of Section 6664, which provides that the accuracy-related penalty of Section 6662 does not apply to any portion of an underpayment if you can show there was “reasonable cause,” for the position and you acted in good faith.
What constitutes “reasonable cause” is intentionally left vague by the statute. The relevant caselaw, however, allows for a scapegoat, providing that in limited situations, good-faith reliance on a competent professional can satisfy the reasonable cause exception.
The key word in that exception, of course, is “competent.” Hire a licensed, ethical CPA who complies with the rigors of Circular 230 in preparing your return, and you’ll probably be OK. Hire some asshole who calls himself the “Tax Doctor” and magically makes your tax liability disappear, and things aren’t going to end so well.
Just ask Derek Somogyi. Now, by all measures, Somogyi was a bright dude.
Majored in mechanical engineering? Smart.
Worked as a management consultant for Andersen Consulting? Smart.
Ditched Andersen to go work at Jackson Hole ski resort? Really, really smart.
So where did Somogyi go wrong? While in Jackson, Somogyi made extra cash by testing and training in relation to the implementation of SAP software. During 2007 he earned $125,113 from his part-time gig, and because this likely placed him among the highest-earning half-dozen people in all of Wyoming, Smogyi suddenly had the need for some sophisticated tax planning. And that is what led him to the “Tax Doctor.”
Dr. Lawrence Murray, who was likely as much a doctor as Julius Erving, ran the “Tax Doctor Corporation.” Murray told Smogyi that by setting up a two corporations, he could greatly reduce Smogyi’s anticipated $80,000 tax liability. And all for the low, low price of $20,000.
Smogyi bit on Murray’s proposal, despite the objections of Smogyi’s CPA. He paid the Tax Doctor the $20K, and when tax return time came around he suddenly found himself with two corporations and zero tax liability.
As you’ve probably surmised, the Tax Doctor wielded no gift for taxes; rather, the corporations were a sham, and the zero tax balance unwarranted. The IRS came calling, and Smogyi quickly accepted his fate, paying an additional $26,000 in taxes related to 2007.
The Service wasn’t done with Smogyi, however, as it tacked on the 20% understatement penalty under Section 6662. Smogyi, in turn, pointed the finger squarely at the Tax Doctor, arguing that he was “tricked” into an improper tax strategy.
The Tax Court didn’t buy it. As the court explained, “When a transaction has obviously suspect tax savings, it should put a reasonable taxpayer under a duty of inquiry to make a good-faith investigation of the underlying viability…”
Smogyi had this duty of inquiry, the court explained, and failed to exercise it by not asking the Tax Doctor how his entire tax liability had disappeared. As a college graduate with significant business experience, Smogyi should have been prepared to sniff out the Doctor’s shenanigans. Instead, he admitted at trial that Dr. Lawrence Murray was more criminal than competent tax preparer, while also confessing that he never bothered to learn whether the Doctor’s proposed structure was legal for tax purposes, or even how the structure worked.
The Tax Court concluded that by ignoring the cautionary advice of his CPA and refusing to gain a clear understanding of how an $80,000 tax liability could be made to vanish, Smogyi’s reliance on the Tax Doctor was not reasonable, leaving him subject to a 20% penalty on the understatement.
In 2010, Dr. Lawrence Murray was convicted of Federal crimes associated with the preparation of his own return as well as the returns of countless others like Derek Smogyi. Like the mythical hydra, however, with the demise of one Tax Doctor, two more emerged to take his place.
Consider yourself warned.