Reference no: EM132664465

Problem - Lopez always had taken his Form 1040 data to the franchise tax preparers in a local mall, but this year, his friend Cheryl asked to prepare his return. Cheryl quoted a reasonable fee, and Lopez reasoned that, with finances especially tight in Cheryl's household, she could use the money.

Lopez delivered his Forms W-2, 1099, and other documentation and said, "I'll pick up the finished return from you on Monday." Cheryl completed the return by that deadline, and without signing and reviewing the forms, Lopez allowed Cheryl to e-file it that day. The arrangement was that Cheryl would receive the refund through a special bank account and write Lopez a check for that amount, minus her fee. When the refund came through about three weeks later, Cheryl wrote Lopez a check for $2,400, and all parties were satisfied. Lopez gladly used Cheryl to e-file the next year's return using the same procedures.

To his surprise, Lopez received a letter from the IRS about 18 months later. The auditor had found that the return Cheryl had e-filed vastly overstated deductions and wrongly calculated the earned income tax credit. According to the audit report, the refund issued was $4,500-Cheryl had pocketed the difference. Thus, the corrected tax liability meant that Lopez now owed $7,000 in tax, before considering interest and penalties.

Lopez contends that he relied on Cheryl's expertise in the tax law and e-filing procedures. Consequently, there was reasonable cause for the underpayment of tax, and the IRS should waive the understatement and negligence penalties. The IRS has expressed sympathy for Lopez's position, but it maintains that the penalty should stand. What do you think? Summarize your findings in a memo for the tax research file.