After the California Angels dropped a tough 7-6 decision to the Kansas City Royals (normally reliable reliever Rudy May had a rare bad game, giving up two runs in the bottom of the eleventh inning), baseball great Frank Robinson sagely remarked that “Close don’t count in baseball. Close only counts in horseshoes and hand grenades.” Since he first turned the phrase in the summer of 1973, others have added a few additional items to the list, most notably dancing and nuclear weapons.

Some may find it surprising, myself included, that “close” might also count in certain tax cases. So, for those of us, myself included, who are still wrestling with our 2016 income tax returns, the vexing questions are: How does the IRS distinguish between a person who makes an honest mathematical errorand someone who is trying to pull a fast one, and perhaps more importantly, how does the Tax Court separate the sheep from the goats?

Establishing Accuracy

The stated intent of tax penalties is to “encourage voluntary compliance by supporting the standards of behavior expected by the Internal Revenue Code.” In other words, by their very nature, penalties should only apply if the taxpayer’s behavior fell below the standard of care implicit in the Tax Code. In a general sense, the taxpayer has a duty to:

• Request a tax identification number,
• File all required returns on or before the due date,
• Pay the proper amount of tax at the proper time,
• Provide supporting documentation as required, and
• Cooperate with any investigation or inquiry.

Not surprisingly, most penalties are designed to “encourage” paying on time. But in most cases, the proper amount of tax is somewhat subjective. The former is based on the taxpayer’s conduct, while the latter, at least at first blush, is strictly mathematical.

Defending Penalty Cases

Much to the chagrin of some lawmakers, who would prefer an entirely subjective analysis, the Service looks at two basic areas to determine if the taxpayer is a sheep or a goat:

• Negligence/Disregarding the Rules: The law assumes that reasonably well-educated people who have filed tax returns before are aware of the rules and therefore are liable for breaking them.
• Substantial Understatement or Overstatement: 10 percent is usually the magic number. Typically, the penalty rate is 20 percent, although it can be as high as 40 percent in a few cases. In all scenarios, the deficiency must be related to a trigger and not to something else, like fraud, for the accuracy penalty to apply.

Negligence is a case-by-case decision, so the issue is not the standard of care for the universe of taxpayers but for that particular taxpayer. If the taxpayer is relatively unsophisticated or uneducated, the tax court must take these deficiencies into account. That argument often cuts both ways, because the Service sometimes argues that if the taxpayer was such a hick, then a failure to obtain tax filing assistance was itself negligence.

Section 6662 throws out phrases like “reasonable attempt to comply” and “ordinary business care and prudence” when discussing negligence, but these terms are not really defined. The best approach is to go look at tax court cases, legislative history, revenue rulings, and anything else which indicates that the taxpayer’s conduct was in line with the standard of care for those particular facts.

To overcome the substantial understatement trigger, the taxpayer must show:

• Substantial authority for the understatement (e. other people have made the same error), and
• A reasonable basis for the mistake.

So, although this trigger seems mechanical, there are some subjective elements. If a taxpayer can convince a factfinder to look less at the calculator and more at the facts and circumstances, there is a very good chanced that the penalties will at least get reduced.

Burden of proof is nearly always the best defense in these cases, because the Service has the burden to prove that the taxpayer’s conduct fell so far below the relevant standard of care that a penalty is the only way to encourage compliance, and that’s not an easy thing to establish