Failure to Possess Rudimentary Reading Comprehension Skills Spares Taxpayer from Understatement Penalty
Benny Nipps was named the beneficiary of his cousin’s IRA. (Ed note: While the court did not disclose the cousin’s name, let’s all just agree it was Seymour so we can giggle through the remainder of the post)
Unfortunately for Nipps — or fortunately, depending on his financial circumstances -his cousin died in 2007, leaving Nipps approximately $45,000 in inherited IRA moneys.
Upon receipt of the distribution from his cousin’s IRA, Nipps received a “Beneficiary’s Distribution Notice and Certification Form and Payment Instruction,” which stated that by signing, Nipps certified that he was aware that the distribution was subject to Federal income tax.
The Notice also stated that Federal income tax would be withheld by the distributor unless an election was made otherwise. Nipps signed and returned the notice but did not elect out of any withholding.
Nipps then deposited the funds into a newly established IRA account. Though on the surface this may constitute a successful “rollover” of the IRA distribution, the funds were taxable to Nipps in 2007 for two reasons:
1. While an IRA distribution is not includable in gross income if the entire amount received is paid into a qualified IRA within 60 days of the distribution, rollover contributions from inherited IRAs are specifically excluded from tax-free rollover treatment under Section 408(d)(3)(C). An individual can still avoid being taxed on the inherited IRA if the funds in the IRA are transferred from one account trustee to another account trustee without the IRA owner or beneficiary ever gaining control of the funds, but that was not the case here, as Nipps temporarily had control of the funds before depositing them in his own IRA.
2. On the same day he received the rollover contribution and deposited them in his IRA, Nipps inexplicably withdrew the $45,000, thereby defeating the purpose of establishing the IRA in the first place and rendering the entire previous paragraph moot, as IRA distributions are generally taxable.
Despite these two rather important pieces of information, Nipps failed to report the $45,000 as income on his 2007 tax return. The IRS predictably assessed a tax deficiency as well as an accuracy-related penalty under section 6662(a) and (b)(2) for a substantial understatement of income tax.
This is where the case took a rather unexpected turn, as the Tax Court sustained the deficiency assessment, but held that Nipps had reasonable cause for not reporting the income, despite the fact that he..you know…signed an affidavit certifying that he understood that the IRA distribution was included in taxable income. Thus, Nipps was not subject to the underpayment penalty.
The court explained its rather bizarre decision as follows:
Petitioner, who lacked knowledge and experience in tax law,reasonably believed that the correct Federal income tax would be withheld by Landmark Bank. He reasonably relied on Landmark Bank’s lack of withholding of Federal income tax as basis for his position that the distribution was not taxable…the Court finds that he had a reasonable basis to believe that the correct withholding would occur and that absent that withholding, the amount was not taxable.
So to summarize, Nipps’ inability to comprehend a one-page document that expressly provided that the funds he was receiving were taxable spared him from being assessed an understatement penalty. While this isn’t exactly groundbreaking, as taxpayer stupidity has always supported a reasonable cause defense to some degree, this would seem to establish a new low in what can best be described as the “slack-jawed yokel defense.”
Nipps v. Commissioner, TC Memo 2011- 267
