Harold and Betty, factory workers who until this year prepared their own individual tax returns, purchased an investment from a broker last year. Although they reviewed the prospectus for the investment, the broker explained the more complicated features of the investment. Earlier this year, they struggled to prepare their individual return for last year but, because of the investment, found it too complicated to complete. Consequently, they hired a CPA to prepare the return.
The CPA deducted losses generated from the investment against income that Harold and Betty generated from other sources. The IRS audited the return for last year and contended that the loss is not deductible. After consulting their CPA, who further considered the tax consequences of the investment, Harold and Betty agreed the loss is not deductible and consented to paying the deficiency.
The IRS also contended that the couple owes the substantial understatement penalty because did not disclose the value of the investment on their return and did not have substantial authority for their position.
Assume you are representing the taxpayers before the IRS and intend to argue that they should be exempted from the substantial understatement penalty. Your tax manager reminds you to consult Sections 6662 and 6664 of the Internal Revenue Code, and the accompanying Treasury regulations, when conducting your research and preparing your analysis. She also recommends researching the Fifth Circuit's opinion in the Heasley case and the Tenth Circuit's opinion in the Mauerman case, which she says may be helpful in your analysis. Write a letter to the IRS auditor describing, in detail, based on the specific facts and applicable law, your position that Harold and Betty should not be subject to the penalty.