In a Memorandum Tax Court opinion issued on April 19, 2010, the Tax Court found taxpayers liable for negligence penalties despite their claimed reliance on TurboTax and what has been referred to as the "Geithner Defense." See Aileen Yat Muk Lam and Shaoping Chang v. Commissioner, T.C. Memo. 2010-82 (April 19, 2010). The years in issue were 2004 and 2005. http://www.ustaxcourt.gov/InOpHistoric/LAM2.TCM.WPD.pdf.
The Commissioner of Internal Revenue determined deficiencies of $5,069 for 2004 and $4,339 for 2005 against Ms. Lam and Mr. Chang (the taxpayers). The taxpayers stipulated that they were liable for the deficiencies, but they contested the penalties in the United States Tax Court. Ms. Lam prepared the tax returns using the software program TurboTax. She had reported both rental losses and unrelated trading losses on a single Schedule C. The rental losses were disallowed because her father lived in the rental property "rent free." The trading losses were recharacterized by the IRS as capital losses and moved to a Schedule D.
Internal Revenue Code 6662 contains the "accuracy-related penalties" on underpayments. The penalty is 20 percent of any underpayment that is attributable to the causes listed in 6662(b). Two of the causes are "substantial understatement" and "negligence or disregard of rules of regulations." See 6662(b)(2) and (1). The Court found that the 2004 underpayment potentially fell within the "substantial understatement of income tax" because it exceeded $5,000, but the 2005 understatement did not. IRC 6662(d). The IRS relied on the negligence penalty for both years as well as the substantial understatement penalty for the year 2004.
With respect to the substantial understatement penalty, the understatement is reduced if there "is or was substantial authority" for the treatment of the item, or the treatment was adequately disclosed on the return or an attached statement and there is a reasonable belief for the tax treatment of the item. The Court found that neither of these provisions applied and it found the taxpayers liable for the substantial understatement penalty for 2004. The Court then turned its attention to the negligence penalty for the year 2005.
Negligence is defined by IRC 6662(c) as "any failure to make a reasonable attempt to comply with the provisions of this title," and the term disregard "includes any careless, reckless, or intentional disregard." At trial, the IRS argued that the taxpayers had not used a tax professional, failed to visit the IRS' web site, did not read the instructions for Schedule C, and thus had not acted reasonably. The taxpayers stipulated that they did not use a tax professional, and had not visited the IRS website for instructions about filing a Schedule C.
The Tax Court stated "At trial, Ms. Lam did not attempt to show a reasonable cause for petitioners' underpayment of taxes. Instead, she analogized her situation to that of the Secretary of the Treasury, Timothy Geithner. Citing a Wikipedia article, Ms. Lam essentially argues that, like Secretary Geithner, she used TurboTax, resulting in mistakes on her taxes."
In early-January of 2009, Treasury Secretary Geithner's confirmation hearing was delayed when the Senate Finance Committee learned that he had failed to pay $34,000 in taxes for the years 2001 to 2004 based on compensation paid to him by the International Monetary Fund. Because the IMF is an international organization, it is exempt from having to withhold payroll taxes. The employees are treated as self-employed and are paid an additional amount so that they pay the payroll taxes. Geithner prepared his own returns in 2001 and 2002 (using TurboTax) and had an accountant prepare his 2003 and 2004 returns. See Lisa Lerer, Geithner Taxes for Dummies, Politico.com News, January 15, 2009. Secretary Geithner realized the error when he was audited in 2006. He paid the taxes plus interest (apparently no penalties were asserted by the IRS). Secretary Geithner apologized to the Senate Finance Committee for "careless mistakes." See Maura Reynolds, Treasury Secretary Nominee Geithner Apologizes for "Avoidable Mistakes" on Taxes, Los Angeles Times, January 22, 2009. He acknowledged that he received instructions (in initial documents, quarterly statements, and annual tax forms) from the IMF about the correct treatment of the compensation. Id. Mr. Geithner, when questioned by Senator Chuck Grassley of the Senate Finance Committee, took full responsibility for the error, but did indicate he used the TurboTax software to prepare his returns. Mary Lu Carnevale, TurboTax Responds to Treasury Nominee's Disclosure, Wall Street Journal Washington Wire, January 21, 2009.
The Tax Court has previously rejected reliance on TurboTax as a defense to the negligence penalty. See Hopson v. Commissioner, T.C. Summ. Op. 2009-130 (August 25, 2009). Lam v. Commissioner is the first case where a reference to Secretary Geithner was made. The Tax Court found Ms. Lam and Mr. Chang liable for the negligence penalty for both 2004 and 2005 because "it was not a flaw in the TurboTax software which caused petitioners' tax deficiencies." It is clear that the Court found that the taxpayers input tax information incorrectly into the TurboTax program.
It goes without saying that the complexity of filling out tax returns has increased dramatically over the past few years. In 1913, the original Form 1040 plus instructions to complete it comprised four pages. Christopher Neefus, Original 1040 Tax Form: Only 3 Pages and 1 Page of Instructions, CNSNews.com, April 15, 2010. "Today, the instructions for the basic 1040 tax form total 101 pages, and there are 76 lines that taxpayers must fill-in with information." Id. It seems to this author that at some point, either the complexity of the tax system needs to change, or the standard for negligence needs to be altered. It is particularly troubling that the IRS made the argument in Court that the taxpayer should have consulted a tax professional or visited the IRS website. With the size of the Internal Revenue Code, it is inconceivable that anyone (even this author, a tax law professor) could be charged with knowing all of the rules and regulations of the tax system.