State Tax Return. Illinois Court Rules Reliance On Outside Accountant Does Not Necessarily Abate Penalty

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1 February 2006 Volume 13 Number 2 State Tax Return Illinois Court Rules Reliance On Outside Accountant Does Not Necessarily Abate Penalty Stephen G. Harris Dallas (214) If you cannot rely on your CPA firm, what can you do? An Illinois appellate court recently concluded in Hollinger that reliance on the advice of an outside accountant for determining estimated income tax installment payments does not establish ordinary business care and prudence for purposes of abating underpayment penalties where the taxpayer is a sophisticated, experienced, and knowledgeable business entity with its own accountant employees capable of determining the proper application of clear and commonly available law. 1 Background Hollinger International, Inc. ( Hollinger ), a publicly-traded multinational publisher of English language newspapers and magazines, hired a regional Illinois accounting firm to prepare and file certain federal and Illinois tax returns. The certified public accountant and accounting firm partner who oversaw the Hollinger account had prepared federal and state income tax returns for 20 years, and had prepared hundreds of federal and state returns on Hollinger s behalf. At issue were Hollinger s Illinois estimated income tax installment payments calculated by the accountant for the first and second quarters of In 2000, the Illinois Department of Revenue (the Department ) notified Hollinger of proposed penalties for Hollinger s underpayment of estimated Illinois income taxes for the first and second quarters of Hollinger paid the proposed penalties and filed a refund claim, which the Department rejected. After an evidentiary hearing, the administrative law judge ( ALJ ) found that Hollinger failed to exercise ordinary business care when attempting to determine its estimated tax payments. A trial court reversed the ALJ s decision, finding no rational basis for the Department s insinuation that Hollinger knowingly allowed or directed its outside 1 Hollinger International, Inc. v. Bower, No , N.E.2d (Ill. App. Ct., 2005), 2005 WL (Ill. App. 1 Dist.), 2005 Ill. App. LEXIS 1213 (Ill. App. Ct. 1st Dist. Dec. 12, 2005). 1

2 accountant to underestimate its tax installments for the quarters in question. 2 Department appealed. The Overview of Estimated Tax Payments The Illinois Income Tax Act (the Act ) requires corporate taxpayers to pay estimated tax if the amount payable as estimated tax is reasonably assumed to exceed $400 for the taxable year. 3 Estimated tax due is calculated under Section 803 of the Act as the excess of: (1) the amount which the taxpayer estimates to be his tax under [the Act] for the taxable year, over (2) the amount which he estimates to be the sum of any amounts to be withheld on account of or credited against such tax. 4 Taxpayers who fail to make required estimated tax payments are subject to potential underpayment penalties. Underpayment is generally defined as the excess of: (1) the amount of the installment which would be required to be paid, over (2) the amount, if any, of the installment paid on or before the last date prescribed for payment. 5 In determining if a punishable underpayment exists, required installment payments are general calculated as 25% of the required annual payment. Section 804(c)(1)(B) defines the require annual payment as the lesser of (i) 90% of the tax shown on the return for the taxable year, or if no return is filed, 90% of the tax for such year, or (ii) 100% of the tax shown on the return of the taxpayer for the preceding taxable year if a return showing a liability for tax was filed by the taxpayer for the preceding taxable year and such preceding year was a taxable year of 12 months. Section 804(c)(1)(B) creates a statutory safe harbor from underpayment penalties if the actual installment payments made meet or exceed the thresholds established therein. Penalty Abated by Exercise of Ordinary Business Care and Prudence The Act provides for the abatement of underpayment penalties if the taxpayer can show that failure to file a return or pay the proper amount of tax at the required time was due to reasonable cause. 6 The existence of reasonable cause is determined on a case by 2 The trial court found no rational basis for the conclusion that Hollinger's reliance on its accountant to perform the tax calculations was unreasonable because the accountant had more than 20 years experience in preparing federal and state corporate income tax returns, had prepared hundreds of estimated tax calculations throughout his career, had extensive experience with Hollinger s federal and state income tax returns, had been a partner in charge of Hollinger for several years, and had never underestimated Hollinger s taxes ILCS 5/803(a) ILCS 5/803(b) ILCS 5/804. The specific rates of underpayment penalties are set forth in the Illinois Uniform Penalty and Interest Act. 35 ILCS 5/804(a); 35 ILCS 5/1005(a). For the periods at issue in Hollinger International, Section 3-3(b-5)(1) of the Uniform Penalty and Interest Act provides for a penalty equal to 20% of the tax required to be shown due on the return for failure to pay an amount of underpayment of estimated tax ILCS 735/3-8 2

3 case basis taking into account all relevant facts and circumstances. Factors for determining if a taxpayer acted with reasonable cause are provided in regulations promulgated by the Department. The most important factor to be considered in making a determination to abate a penalty will be the extent to which the taxpayer made a good faith effort to determine his proper tax liability and to file and pay his proper liability in a timely fashion. A taxpayer will be considered to have made a good faith effort to determine and file and pay his proper tax liability if he exercised ordinary business care and prudence in doing so. The exercise of ordinary business care and prudence is dependent upon the clarity of the law or its interpretation and the taxpayer s experience, knowledge, and education. Reliance on the advice of a professional does not necessarily establish that a taxpayer exercised ordinary business care and prudence. 7 Review of Outside Accountant s Calculation of Estimated Tax Payments An accountant employed by a Hollinger subsidiary as Group Controller testified he was responsible for various internal and external financial reporting, including preparation of state and local financial statements. The Controller testified that the outside accountant prepared estimated tax returns for various Hollinger divisions and submitted these returns for filing. In order to assist the outside accountant, the Controller and his staff provided the outside accountant with financial information and statements. The outside accountant then took that information and prepared a form for Hollinger to sign. The Controller said that Hollinger relied on the outside accountant s calculations to determine the payment of taxes, and he never had any reason to believe that the outside accountant s methods for calculating estimated payments were unreliable. For his part, the outside accountant testified that he calculated Hollinger s first quarter 1998 estimated tax installment using what he called the safe harbor rules under section 804(c)(1)(B)(ii). Since Hollinger s 1997 tax returns had not yet been finished, the outside accountant estimated Hollinger s 1997 Illinois income tax liability before calculating the estimated tax payment for the first quarter of The outside accountant testified that he used the information provided by Hollinger and by two other accounting sources that Hollinger employed to complete different parts of its federal and state income tax returns to estimate Hollinger s 1997 tax liability. Because this information indicated an estimated overpayment from Hollinger s projected taxes for 1997, the outside accountant determined that Hollinger need not make any estimated tax payment for the first quarter of The outside accountant again followed the safe harbor calculation to compute Hollinger s estimated tax installment payment for the second quarter of 1998 even though the 1997 tax returns had not yet been filed. Relying upon his prior projection of Hollinger s 1997 Illinois income tax liability, the outside accountant advised Hollinger to make a second quarter installment payment of $62, See 86 Ill. Admin Code

4 In August of 1998, the outside accountant completed Hollinger s federal and Illinois tax return for 1997 and found that the Illinois return showed that Hollinger had a loss for the year, rather than the income the outside accountant previously estimated. Because the 1997 Illinois return showed a loss, the outside accountant admitted he should not have used a safe harbor calculation under section 804(c)(1)(B)(ii) for calculating Hollinger s first and second installments for Hollinger Not Permitted to Rely on the Advice of Its Outside Accountant As a preliminary matter, the court concluded that the law was interpretable without confusion, and that the clear language of Section 804 shows that it is a penalty provision for failure to pay (or underpay) estimated taxes, and not a general provision to calculate estimated tax. Rather, Section 803 provides the formula for calculating estimated taxes based on projected income for the taxable year. Thus, the court ruled that Hollinger was not entitled to use the safe harbor calculation under Section 804(c)(1)(B)(ii) to calculate its estimated taxes. Further, Hollinger, through its outside accountant, erroneously computed the 1998 estimated taxes based on an estimation of Hollinger s 1997 tax return. 8 Hollinger argued that the underpayment penalty should be abated because it exercised ordinary business care and prudence when it properly relied on its accountant to calculate the estimated taxes and that such reliance was reasonable. The court rejected Hollinger s argument and ruled that there was ample evidence in the record to support the Department s imposition of penalties. According to the court, Section 803(a) imposes the responsibility to pay the proper amount of estimated taxes on Hollinger, and reliance on a tax expert cannot function as a substitute for compliance with an unambiguous statute. The accountant s testimony that Hollinger was aware he was using the safe harbor rules to calculate its 1998 estimated tax installments appears to be particularly relevant to the court. Further, the court accepted the ALJ s findings that Hollinger was an experienced, knowledgeable, and educated taxpayer, and as a result of Hollinger s business experience in preparing tax returns, the basic filing requirements of Section 803 could be considered common knowledge and readily available to Hollinger. The court also noted that Hollinger employed experienced accountants like (the Controller) who could have determined that Section 803 should have been applied and that the safe harbor rule in Section 804(c)(1)(B) could only be used to offset an otherwise mandatory penalty if a return showing a liability for the previous year had been filed. Thus, in the eyes of the court, the fact that Hollinger ignored the clear language of the Act did not amount to reasonable cause sufficient to abate the underpayment penalty. 8 The court also agreed with the ALJ s finding that Hollinger could not take advantage of either of the Section 804(c)(1)(B) safe harbors because Hollinger did not attempt to calculate its estimated tax installments by reference to its 1998 income (as required by the section 804(c)(1)(B)(i) safe harbor) and because Hollinger s 1997 return did not show tax due for the year as required for the Section 804(c)(1)(B)(ii) safe harbor. 4

5 Sophisticated Taxpayers Have Higher Standard Experienced corporate taxpayers should use caution in relying on outside accounts for tax calculations and filings. Tax-sophisticated taxpayers in Illinois will likely be deemed knowledgeable in commonly understood filing and payment requirements and expected to satisfy those requirements regardless of their reliance on outside professionals to complete accurate and timely computations and filings. Particularly if you review the accountant s work without correcting what may be viewed as obvious errors, do not count on penalty relief in Illinois. This article is reprinted from the State Tax Return, a Jones Day monthly newsletter reporting on recent developments in state and local tax. Requests for a subscription to the State Tax Return or permission to reproduce this publication, in whole or in part, or comments and suggestions should be sent to Susan Ervien (214/ or shervien@jonesday.com) in Jones Day s Dallas Office, 2727 N. Harwood, Dallas, Texas Jones Day All Rights Reserved. No portion of the article may be reproduced or used without express permission. Because of its generality, the information contained herein should not be construed as legal advice on any specific facts and circumstances. The contents are intended for general information purposes only. 5