Navaid, TC Memo 2016-37
The Tax Court has ruled that a taxpayer who failed to report the court-ordered liquidation of his bank-held IRA for restitution payments was liable for the accuracy-related penalty for substantial understatements of income tax. Although the taxpayer was never notified of the court’s action and never received a Form 1099-R, the fact that the IRA was liquidated was enough to put him on notice that he had a duty to report the information on his return and to report the court’s action to his return preparer. Click here for the Opinion of the Court.
Background. Code Sec. 6662(a) imposes an accuracy-related penalty with respect to any portion of an underpayment of income tax attributable to one of the items listed in Code Sec. 6662(b), which includes, among other things, underpayments attributable to negligence or any substantial understatement of income tax. However, under Code Sec. 6664(c), there is an exception to the accuracy-related penalty for any portion of an underpayment if the taxpayer shows that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect to that portion.
The determination of whether a taxpayer acted with reasonable cause and in good faith “is made on a case-by-base basis, taking into account all pertinent facts and circumstances.” (Reg. § 1.6664-4(b)(1))
Generally, the most important factor is the extent of the taxpayer’s effort to assess his proper tax liability. Courts have held that circumstances that may also indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.
Facts. Mr. Sayed Navaid, a pharmacist trained in Pakistan, ran a small pharmacy in addition to working at a federal government hospital. In 2001, he was charged, with other codefendants, with diverting pharmaceuticals from the Department of Veterans Affairs (VA), and in 2006 he pled guilty and was sentenced to jail. He also was jointly and severally liable, along with his codefendants, for restitution of $670,000 to be paid for the benefit of the VA. Navaid was released from prison in 2008, and by 2010 there was a balance of $454,700 owing on the restitution. In 2010, the district court entered a “Turnover Order” directing a bank to liquidate Navaid’s IRA certificate of deposit and submit its full liquidated value, approximately $117,786, to the court. Citing the Tax Court’s opinion in Murillo, TC Memo 1998-13TC Memo 1998-13, holding that involuntary distributions aren’t subject to the 10% additional tax on early distribution from IRAs, the order specified that “This court-ordered distribution shall not be subject to any additional tax or penalty.”
The bank that liquidated the IRA reported to IRS that it had issued a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the IRA distribution of $109,154. However, Navaid never received a Form 1099-R from the bank and was never notified of the IRA liquidation or distribution by the District Court.
Navaid first learned of the IRA liquidation when he received a statement from his bank and saw a zero balance in his IRA. After getting stonewalled at the bank, he finally inferred that the IRA funds had been paid over to the District Court. At some point, however, it appeared that he did get a copy of the “Turnover Order.” As he had in previous years, Navaid hired a paid preparer for his 2010 tax return, and provided him with his business receipts and Forms 1099-MISC, Miscellaneous Income, for his pharmacy activities. However, he didn’t give the preparer a copy of the “Turnover Order”.
After concessions, the issue before the Tax Court was whether Navaid was liable for the Code Sec. 6662(a) accuracy-related penalty for 2010.
Parties’ arguments. IRS contended that Navaid did not exercise ordinary care and prudence in attempting to determine his proper tax liability for 2010. He was aware of the “Turnover Order,” knew that his IRA had in fact been liquidated, and still made no attempt to determine whether the amount was taxable. Navaid was a highly educated professional and his experience, knowledge, sophistication, and education showed that it would be reasonable for him to realize that the “Turnover Order” had tax implications for the IRA distribution. IRS also said Navaid did not act in good faith because he failed to provide all the relevant information, including the “Turnover Order,” to his paid preparer.
Navaid said he didn’t show the “Turnover Order” to his paid preparer because he did not believe that it was a tax document, and he did not want to show an embarrassing unrelated document disclosing his criminal history. Navaid asserted that he qualified for the Code Sec. 6664(c) exception because, at the time he filed his tax return, he didn’t realize that there would be any tax implications from the court-ordered seizure of the IRA. He did not receive any monetary distribution from the liquidation of the IRA certificate of deposit; the bank officers were never able to explain how the account was liquidated; and he never received a Form 1099-R from the bank, nor was notified by the district court that the funds had been applied to the restitution account.
Finally, Navaid asserted that he qualified for the reasonable cause exception because he had an honest misunderstanding of the tax law at the time he filed his 2010 tax return. He asserted that it was the lack of knowledge, and not the lack of good faith, that resulted in the omission of the IRA distribution from his tax return. Navaid claimed that this honest misunderstanding of the tax law, in addition to his history of tax compliance, good recordkeeping habits, and hiring a paid preparer, show that he acted reasonably and in good faith.
Penalty imposed. The Tax Court found that Navaid reasonably believed that the “Turnover Order” was not a tax document. However, the Court found that Navaid did not act with reasonable cause and in good faith because he never took any additional steps to determine whether the court-ordered IRA distribution was taxable when he found out his IRA of $109,154 had been liquidated.
Navaid should have disclosed the IRA liquidation even if he did not understand the tax ramifications. Even though he never received a Form 1099-R, his nonreceipt of any Form 1099 did not convert a taxable item to a nontaxable item. The liquidated IRA itself was enough to put Navaid on notice that he had a duty to report the information on his tax return.
In sum, the Court found that although Navaid did not act negligently per se, he did not act with reasonable cause and good faith when he failed to adequately disclose on his return the relevant facts affecting the item’s tax treatment. Accordingly, Navaid was liable for an accuracy-related penalty for an underpayment due to a substantial understatement of income tax for 2010.