Tax Deficiencies and Automatic Penalties: Challenging by Reasonable Cause?

Increasingly, taxpayers are seeing the imposition of penalties on deficiency assessments. In fact in a number of situations the imposition of the penalty is automatic upon the issuance of the assessment. The penalties, which may range from 20% to 25% of the liability, are imposed for late payment or underpayment of taxes. Such penalties are generally imposed without taking into consideration the fact there is a lack of guidance or legal authority with respect to the substantive issue which gave rise to the tax underpayment. Absent legal authority or guidance, the taxpayer is left to his own devices to interpret statutory changes or guess at policies when preparing and filing returns. Should the interpretation be inconsistent with that of the taxing authority, the taxpayer is rewarded with a penalty. The imposition of a non-deductible penalty leaves the taxpayer with basically two choices: pay the penalty and move on, or challenge the penalty citing reasonable cause.

A logical person would conclude that if there is no legal authority or guidance addressing the underlying issue, the taxpayer acted reasonably when preparing and filing its return. This is precisely what the New Jersey Supreme Court concluded in United Parcel Services General Services Co. v. Director Division of Taxation. The court noted the absence of legal authority or guidance gives rise to a genuine question of law and fact. A taxpayer who interprets a statute based on his knowledge in light of the lack of legal authority has demonstrated reasonable cause.  The New Jersey Supreme Court’s approach is logical and more importantly fair. Although not precedent outside of New Jersey, one could hope that other Departments review the court’s rationale and re-evaluate their penalty policies particularly in those instances where legal authority or regulatory guidance is nonexistent.