No Penalty When Taxpayer Relied on Bad Advice from Preparer

In the case of Longoria v. Commissioner, TC Memo 2009-162, Emblez Longoria was a state trooper that had received a settlement from the state of New Jersey for employment related discrimination. While he had suffered certain injuries on the job that appeared to be related to actions that Mr. Longoria asserted were part of the discriminatory treatment, the award was agreed to with a release that stated it settled all claims Mr. Longoria might have against the state of New Jersey.

When Mr. Longoria inquired of his attorney whether any or all of the award would be taxable, the attorney advised Mr. Longoria that he should consult with a CPA on this matter. Mr. Longoria retained a CPA with 25 years of experience to advise him on the taxability of his award. The CPA met with Mr. Longoria and prepared the return that excluded the damages. When Mr. Longoria met with the CPA, the CPA testified that he inquired of Mr. Longoria about the details of the settlement. He found that Mr. Longoria had not brought the agreement with him, but inquired of Mr. Longoria about the nature of the settlement.

Mr. Longoria told the CPA about the background of the case. The CPA asked if the settlement was on account of physical injuries, the basis upon which such proceeds could be excluded from income under §104(a)(2). Mr. Longoria told him this was part of the overall situation for which he had sought relief, but the settlement did not specifically allocate a portion to physical injuries. The CPA did not require Mr. Longoria to return with the actual settlement, but rather concluded the amounts could be excluded, concluding that if Mr. Longoria had actually suffered physical injuries and “comfortable” saying it was part of the overall package, he would exclude it on the return.

The IRS and the Tax Court disagreed with that conclusion, finding the amount was clearly taxable. But the Tax Court allowed that Mr. Longoria had reasonably relied on the advice of a professional. He had taken the attorney’s advice to seek additional advice from a tax expert on the matters, the expert he retained had the apparently level of experience and expertise to competently advise him on the matter, and he provided the professional with full disclosure. Even though he had not brought the agreement with him to the meeting, the CPA did not ask him to provide such an agreement before he could render the advice.

The Court noted “it was reasonable for Mr. Longoria to rely on that advice, even if the C.P.A. acted unreasonably in dispensing it.”

While the result on the penalties was good news for the taxpayer, as professionals we should note that this sort of victory is precisely the reason why Congress and the IRS have sought to “crack down” on tax professionals who, in their view, have been too willing to give taxpayers the answers that they might prefer without proper regard to the true status of the law. While the client received relief, the adviser may find that in today’s environment the IRS might become more interested in pursuing action against the preparer.