Reference no: EM132741979

Question: James had used the franchise tax preparers in a local mall for several years, but this year, his friend Kathy asked to prepare his return. Kathy quoted a reasonable fee to prepare the return, and James reasoned that, with finances especially tight in Kathy's household, she could probably use the money.

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

To his surprise, James received a letter from the IRS about 18-months later. The auditor had found that the return Kathy had e-filed vastly overstated deductions and wrongly calculated the earned income tax credit. According to the audit report, the refund issued was $5,500 - Kathy had pocketed the difference. As a result, the corrected tax liability meant that James now owed $8,000 in tax, before considering interest and penalties.

James contends that he relied on Kathy's expertise in the tax law and e-filing procedures. Consequently, there was reasonable cause for the underpayment of tax, and the IRS should give the IRS should waive the understatement and negligence penalties. The IRS has expressed sympathy for James's position, but it maintains that the penalty should stand.

Research the facts from both the IRS and James's positions. Summarize your findings in a memo for the tax research file.