I may be showing my age, but I remember the Natalie Wood, Steve McQueen and Edie Adams 1963 movie so entitled.  The “proper stranger” problem arose for Seven W. Enterprises, Inc., 136 T.C. 26, filed 6/7/11, when they rehired their former Vice-President for Taxation after he had resigned and freelanced while attending law school.

The VP had been a CPA with Deloitte. Seven W. hired him and made him VP for Taxation, in which capacity he served for ten years, until he went back to school full-time, at which point he consulted with Seven W.  per separate agreement but was no longer on the payroll.

While freelancing, VP prepared one year’s returns for Seven W. Thereafter, he came back to Seven W. as VP for Taxation and prepared the next several years’ returns, signing each of them on behalf of Seven W. as VP of Taxation.

But for several years, both when freelance and in-house, VP erroneously concluded that interest on a $4 million-plus promissory note came from within Seven W.’s group of companies, and wasn’t taxable as personal holding company income. Wrong, says IRS and Tax Court; it was from a proper stranger and thus taxable as personal holding company income, so deficiency, interest and accuracy (substantial understatement) penalties rained down on Seven W.

Seeking to duck the Section 6662 understatement penalties, Seven W. raises the standard Section 6664(c)(1) flag: “We relied on our expert preparer.”

OK, says Judge Foley, but only for the freelance year,  not for the years that VP was back in the fold as VP for Taxation. He begins with the basics:  “The determination of whether a taxpayer acted with reasonable cause and in good faith depends upon the facts and circumstances, including the taxpayer’s efforts to assess his or her proper tax liability; experience, knowledge, and education; and reliance on the advice of a professional tax advisor. Sec. 1.6664-4(b)(1), Income Tax Regs.” 136 T.C. 26, at pp. 7-8.

IRS  initially claims the freelance year wasn’t truly freelance, because VP did the same work whether in-house or out-of-house. Wrong, says Judge Foley; there was a real consulting agreement, VP had resigned, the consulting agreement provided that Seven W. did not supervise VP, and Seven W. relied in good faith, so no penalty for the freelance year.

Not so for the in-house years. Aside from what Judge Foley described as Seven W.’s “myriad of mistakes… the result of confusion, inattention to detail, or pure laziness, but we are convinced that petitioners and [VP] failed to exercise the requisite due care.” 136 T.C. 26, at p. 9, VP wasn’t independent.

VP was no longer an independent freelancer, so Seven W.’s case runs hard aground on Reg. 1.6664-4(c)(2): “advice” is “any communication… setting forth the analysis or conclusion of a person, other than the taxpayer”. (Emphasis added.). VP wasn’t a person other than the taxpayer. Corporations can only act through their officers, VP was an officer, and he signed the returns he prepared during the in-house years as VP for Taxation.

Seven W.’s reliance on the foundation excise tax regulations and the REIT regulations to bring VP into the ambit of the house counsel’s opinions exceptions doesn’t fly, because those regulations deal with willful conduct, and also require a “reasoned written opinion”, which VP never supplied.

So Seven W. gets hit for the understatement penalties for the years that VP was under their roof. I have no idea whether VP will remain under their roof after this decision.

Takeaway–Love with the proper stranger. If you want to rely on an expert, find one from outside your shop.