Now that tax-filing season is over, ask yourself one simple question: How satisfied are you with your tax adviser?
Hopefully, your tax professional provides enough tax-saving strategies to more than pay his or her fee. But, as importantly, a good tax adviser can provide "insurance" against some of the most severe IRS penalties.
How? While the tax law typically presumes that you—not your preparer—are responsible for your return, one of the best defenses against IRS penalties is to show that you relied on the advice of a competent tax professional. (Note: As you'll see in the page 2 story, using a tax preparer won't always insulate you from penalties.)
And this issue is particularly timely as Congress is pushing legislation to revise the IRS penalty structure. (See box at right.)
4 penalties ... and how to avoid them
While small businesses face a staggering variety of potential IRS penalties, here are four of the most frequently imposed, plus ways your taxpayer's advice can help you escape them:
1. The substantial understatement penalty. If you understate your tax bill by at least $5,000, or by 10 percent, you can get hit with a 20 percent penalty on the understated amount.
If you're hit with such a penalty, you can defend yourself by proving that you relied on "reasonable cause and good faith." You can meet this test if you hired a competent professional and kept the person fully updated on your financial dealings. Of course, you also have to follow the advice given.
In one case, the IRS let a taxpayer off the penalty hook because he relied on the advice of a CPA, who made a mistake. The court said the taxpayer supplied all the correct information and had no reason to doubt the CPA's judgment. (Albert J. Henry v. Commissioner, 9th Cir., 1999)
2. The 20 percent negligence penalty. This 20 percent penalty is often assessed when taxpayers don't keep decent tax records, fail to substantiate travel and entertainment write-offs and take "too good to be true" tax-return positions. Hiring a tax professional can also provide insurance against the negligence penalty.
3. The intentional disregard penalty. The IRS doles out this punishment to taxpayers who knowingly thumb their noses at the law. The penalty equals 20 percent of the tax understatement resulting from disregarding the tax rules.
For this purpose, "tax rules" include everything including the Internal Revenue Code itself to IRS Revenue Rulings and IRS Notices.
You obviously can't keep up with all these changes; but you can expect your tax adviser to do it. So if you keep your tax pro fully informed, you once again create a defense against paying a penalty.
4. The fraud penalty. The IRS imposes the fraud penalty only in extreme cases—less than 2 percent of all audits. But it's meant to really hurt, equaling 75 percent of the tax underpayment.
What constitutes fraud? It usually involves taxpayers concealing assets and income, destroying documents or lying to IRS agents. In some cases, fraud involves a pattern of substantially understating income or overstating deductions.
You may think that having a tax professional wouldn't do you much good in erasing fraud penalties. But it can.
How? Even if the IRS says you acted fraudulently, it's still a judgment call for the courts.
For example, the IRS charged a man with fraud because he allegedly overvalued charitable donations. The taxpayer dodged the penalty because he had hired appraisal and accounting professionals to handle the paperwork. (S. Robert Davis, TC Memo 1999-250)
Final note: While this article illustrates how relying on a tax pro can help protect you from IRS penalties, remember this point: Even if you qualify for penalty relief, you'll still owe the unpaid tax and usually the interest too. Escaping penalties only amounts to avoiding the insult after the injury.
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