Could Mark and Debra Stanger avoid New Mexico penalty after an IRS audit disallowed pension-plan deductions that an earlier IRS letter and their accountant had supported?

Plain-English summary

Mark and Debra Stanger owed interest on additional 2003-2005 personal income tax, but the AHO removed all negligence penalties. Their pension-plan deductions ultimately were wrong, yet they had relied on an accountant, obtained a favorable IRS determination letter, consulted a lawyer, and continued contesting the federal adjustment on reasonable grounds and in good faith.

The Stangers owned Biz MD, LLC. In 2003, the company established an IRC Section 412 defined benefit plan for them, funded through an insurance contract under Section 412(i).

Their accountant and financial adviser, Rudy Martinez, helped establish and fund the plan and prepared the deductions used on their federal and New Mexico returns. In February 2005, the IRS issued a favorable determination letter allowing Biz MD to deduct its plan contributions.

The IRS later audited the company, reversed its determination, and disallowed some contributions. A September 2006 Revenue Agent Report increased the Stangers' federal income for 2003 through 2005. Because New Mexico personal income tax starts with federal adjusted gross income and federal deductions, those changes also increased their state liability.

They accepted principal tax but disputed penalty and interest

In July 2009, New Mexico assessed:

• for 2003, $9,648 tax, $1,929.60 penalty, and $6,171.38 interest;
• for 2004, $6,458 tax, $1,291.60 penalty, and $3,164.44 interest; and
• for 2005, $7,107 tax, $1,421.40 penalty, and $2,413.06 interest.

The Stangers paid all principal tax as soon as they received the state assessments. Their protest concerned only penalty and interest.

Original-return reliance was reasonable

The decision first examined the returns as originally filed. The Stangers used the deductions calculated by Martinez, their accountant, after taking steps to confirm the plan's compliance and obtaining the favorable IRS letter.

Regulation 3.1.11.11(D) treated reasonable reliance on competent tax counsel or an accountant, after full disclosure, as evidence of nonnegligence. The hearing officer found that the Stangers reasonably relied on Martinez when filing their original 2003-2005 returns.

Their later failure to amend was a good-faith legal mistake

The Stangers did not amend their New Mexico returns or pay additional state tax when they received the 2006 federal Revenue Agent Report. Martinez had advised them to wait for an assessment, and they were actively contesting whether the plan contributions were deductible.

The decision noted that accountant reliance ordinarily does not excuse failure to file a return or amended return. But Section 7-1-69(B) separately barred penalty when nonpayment resulted from a mistake of law made in good faith and on reasonable grounds.

Those grounds existed here. The Stangers had the IRS's earlier favorable letter, consulted an attorney about compliance, and continued litigating the federal issue. They did not acknowledge that the plan failed federal requirements until they amended it in January 2010 and entered an IRS closing agreement in February 2010.

The hearing officer therefore found that their legal mistake was made in good faith on reasonable grounds. No penalty could be assessed for any protested year.

Interest was still mandatory

The good-faith finding did not eliminate interest. The Stangers agreed that the additional principal tax was due and had paid it. Section 7-1-67 required interest through the dates of those final principal payments because the tax had not been paid when originally due.

Result: protest granted in part and denied in part. All penalty was abated; the Department's calculated interest remained due through the principal-payment dates.

What this means for you

Taxpayers relying on retirement-plan advice

Keep the determination letters, professional advice, plan documents, and records showing what facts were disclosed. Those materials were central to the nonnegligence and good-faith findings here.

Taxpayers receiving an IRS adjustment

A federal change can flow through to New Mexico personal income tax. This decision noted that taxpayers ordinarily should amend, pay, and use the refund-claim procedure if they continue disputing the liability.

Taxpayers seeking penalty relief

An incorrect legal position is not automatically negligent. The evidence must show both reasonable grounds and actual good faith; professional advice and an official determination letter supplied that support here.

Common questions

Q: Did the Stangers win on the underlying deductions?
A: No. They ultimately acknowledged that not all plan contributions were deductible and paid the additional New Mexico principal tax.

Q: Why was penalty removed?
A: Their original returns relied on an accountant and a favorable IRS letter, and their later nonpayment arose from a good-faith legal dispute supported by reasonable grounds.

Q: Did their accountant's advice alone excuse not amending?
A: No. The decision said the accountant-reliance regulation did not excuse failure to file an amended return. Relief instead came from the statute covering a good-faith mistake of law on reasonable grounds.

Q: Why did interest remain due?
A: Interest was mandatory compensation for tax paid after its due date, even though penalty was inappropriate.

Q: How long did interest run?
A: Through the dates when the Stangers made their final principal-tax payments.

Citations and references

Statutes and regulations:

• NMSA 1978, § 7-1-17(C) and Regulation 3.1.11.8(D) NMAC — assessment and penalty presumptions
• NMSA 1978, §§ 7-2-1 et seq. — New Mexico Income Tax Act
• Regulation 3.1.11.11(D) NMAC — reasonable reliance on tax counsel or an accountant
• NMSA 1978, § 7-1-69(A)-(B) — negligence penalty and good-faith mistake of law
• NMSA 1978, § 7-1-26 — refund claim procedure
• NMSA 1978, § 7-1-67(A) — mandatory interest

Case cited:

• State v. Lujan, 90 N.M. 103 (1977)

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Mark & Debra Stanger
• Decision PDF: D&O 11-22

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
MARK & DEBRA STANGER No. 11-22
TO ASSESSMENT ISSUED UNDER LETTER
ID NOs. L1356897664, L0919297408, L1912100224

DECISION AND ORDER

A formal hearing on the above-referenced protest was held on February 18, 2010, before

Monica Ontiveros, Hearing Officer. The Taxation and Revenue Department (“Department”) was

represented by Ida Lujan, attorney for the Department. Ms. Sylvia Sena appeared and testified as

a witness for the Department. Mr. Mark Stanger appeared at the appointed time and was

unrepresented by counsel. Mark and Debra Stanger are collectively known as “Taxpayers.” The

Department presented no exhibits and Taxpayers presented Exhibits A, B and C which were

admitted into the record. Based on the evidence and arguments presented, IT IS DECIDED AND

ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. On July 23, 2009, the Department assessed Taxpayers in the principal amount of

$9,648.00 in personal income tax, $1,929.60 in penalty and $6,171.38 in interest for tax year 2003.

2. On July 23, 2009, the Department assessed Taxpayers in the principal amount of

$6,458.00, in personal income tax, $1,291.60 in penalty and $3,164.44 in interest for tax year

2004.

3. On July 23, 2009, the Department assessed Taxpayers in the principal amount of

$7,107.00, in personal income tax, $1,421.40 in penalty and $2,413.06 in interest for tax year

2005.

4. On August 4, 2009, Taxpayers filed a protest to the assessments.

5. On August 7, 2009, the Department acknowledged the protest.

6. The Department requested a hearing in this matter on September 15, 2009.

7. On October 1, 2009, the Hearings Bureau mailed a Notice of Administrative

Hearing in this matter setting the hearing for February 18, 2010.

8. Biz MD, LLC is a company owned by Taxpayers that was incorporated on or about

March 1, 2003.

9. On April 1, 2003, Biz MD, LLC established a defined benefit plan (“plan”)

effective April 1, 2003 for the benefit of Taxpayers under I.R.C. Section 412 (2002). The plan

was funded with the purchase of an insurance contract pursuant to I.R.C. Section 412(i) (2002).

Exhibit C.

10. On February 24, 2005, Biz MD, LLC, received a favorable determination letter

from the Internal Revenue Commissioner allowing Biz MD, LLC to deduct its contributions to the

plan. Exhibit C.

11. In August 2005, the Internal Revenue Service conducted an audit of Biz MD, LLC

for tax years 2003 through 2007. Exhibit C.

12. As part of the audit, the Internal Revenue Service reversed its determination letter

as to the plan. Exhibit C.

13. In reversing the determination letter as to the plan, Biz MD, LLC was not allowed

to take certain deductions for the contributions it made on behalf of Taxpayers to the plan for tax

years 2004 and 2005. Exhibit C.

14. Taxpayers filed timely returns for tax years 2003, 2004 and 2005. By disallowing

In the Matter of Mark & Debra Stanger
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certain deductions for tax years 2003, 2004 and 2005, the income tax liability for Taxpayers

increased for tax years 2003, 2004 and 2005.

15. As to the 2003 tax year, Mr. Stanger testified that the Internal Revenue Service

reversed its position as to the contributions not being deductible. He believed this was true

because of an application of an earlier law to the 2003 contributions.

16. On or about September 7, 2006, Taxpayers received a Revenue Agent Report from

the Internal Revenue Service that Taxpayers’ income tax liability for tax years 2003, 2004 and

2005 was increased due to disallowed deductions. (The page from the Revenue Agent Report

showing which specific deductions were disallowed was not tendered.) Exhibit A, page 2.

17. Taxpayers disputed or protested the federal assessment that was based on the

Revenue Agent Report from the Internal Revenue Service.

18. Sometime in 2007, the Department received a Revenue Agent Report which set out

the federal adjustments the Internal Revenue Service made to Taxpayers’ income for tax years

2003, 2004 and 2005. Exhibit C. The Department’s 2009 assessments are based on the

disallowed deductions stated on the Revenue Agent Report.

19. Taxpayers did not amend their New Mexico returns upon being notified by the

Internal Revenue Service through a Revenue Agent Report that their deductions had been

disallowed.

20. On January 11, 2010, Taxpayers amended the plan to comply with the Internal

Revenue’s direction on the funding of the plan. Exhibit C.

21. On or about February 2, 2010, Taxpayers entered into a closing agreement with the

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Internal Revenue Service setting out the amount of deductions Taxpayers were allowed to take on

the 2004 and 2005 returns.

22. Taxpayers paid the income tax principal on all of the New Mexico assessments as

soon as they received the assessments.

23. Taxpayers filed federal claims for refund for tax years 2004, 2005, 2006, 2007 and

2008.

24. Taxpayers’ accountant, Rudy Martinez, told Taxpayers to wait until an assessment

had been issued before paying the New Mexico liability.

25. At an informal conference, Mr. Stanger and Mr. Martinez met with Ms. Sena and

Mr. Breen, attorney representing the Department. Mr. Martinez acknowledged to Ms. Sena and

Mr. Breen that he had advised Taxpayers not to amend the return until an assessment had been

issued.

DISCUSSION

The issue to be determined is whether penalty and interest should be abated. Taxpayers are

not protesting the imposition of principal income tax for tax years 2003, 2004 and 2005.

Taxpayers paid the income tax principal on all the New Mexico assessments.

Burden of Proof.

Section 7-1-17(C) provides that any assessment of taxes made by the Department is

presumed to be correct. NMSA 1978, Section 7-1-17(C)(2007). In addition regulation

3.1.11.8(D) provides that “(t)he effect of the presumption of correctness of assessment of civil

penalty is that the taxpayer has the burden of coming forward with some evidence showing that

In the Matter of Mark & Debra Stanger
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the assessment made by the department is not correct. When not correct, the assessment shall be

abated by the secretary or secretary’s delegate as provided in Section 7-1-28 NMSA 1978.”

3.1.11.8(D) NMAC (2001).

Civil Penalty.

Civil penalty is imposed when a taxpayer is negligent or disregards the department’s rules

and regulations. Section 7-1-69(A) states that:

(e)xcept as provided in Subsection C of this section, in the case of failure due to
negligence or disregard of department rules and regulations, but without intent to
evade or defeat a tax, to pay when due the amount of tax required to be paid, to
pay in accordance with the provisions of Section 7-1-13.1 NMSA 1978 when
required to do so or to file by the date required a return regardless of whether a
tax is due, there shall be added to the amount assessed a penalty in an amount
equal to the greater of:

(1) two percent per month or any fraction of a month from the date the tax
was due multiplied by the amount of tax due but not paid, not to exceed ten
percent of the tax due but not paid;

NMSA 1978, Section 7-1-69 (A) (2003). The Department took the position at the

hearing that 20% penalty applied to the principal amount of tax owed because the

assessment had been issued after the effective date of the changes to Section 7-1-69.

The Department’s regulation provides that the following type of action is an indication of

nonnegligence:

the taxpayer proves that the failure to pay tax or to file a return was caused by
reasonable reliance on the advice of competent tax counsel or accountant as to the
taxpayer’s liability after full disclosure of all relevant facts; failure to make a
timely filing of a tax return, however, is not excused by the taxpayer’s reliance on
an agent;

3.1.11.11(D) NMAC (2001).

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In determining whether Taxpayers were negligent in failing not to pay the entire tax due,

the first issue examined is whether at the time the returns were originally due, did Taxpayers

reasonably rely on an accountant in preparing their returns. The second issue is whether in

September 2006, were Taxpayers negligent in not filing amended returns and not paying the

additional income tax due when they received the Revenue Agent Report with the federal

adjustments.

Taxpayers’ history regarding the Internal Revenue Service’s Revenue Agent Report is

fairly lengthy and detailed. It all began when Taxpayers’ company, Biz MD, LLC, established a

defined benefit plan effective April 1, 2003 for the benefit of Taxpayers under I.R.C. Section 412

(2002). The plan was funded with the purchase of an insurance contract pursuant to IRC Section

412(i) (2002). Exhibit C. Taxpayers purchased the plan based on representations by their

financial advisor and accountant, Rudy Martinez. In setting up the plan, Biz MD, LLC, requested

and received on February 24, 2005, a favorable determination letter from the Internal Revenue

Commissioner allowing Biz MD, LLC to deduct its contributions to the plan. Exhibit C. When

Taxpayers filed their 2003, 2004 and 2005 New Mexico State returns, Mr. Martinez filed their

returns based on amounts, including the itemized deductions, reported on their federal returns.

Payment of New Mexico personal income taxes is governed by the Income Tax Act,

Sections 7-2-1, et seq., NMSA 1978. New Mexico is among the majority of states that "piggy-back"

or use the federal income tax system as the basis for calculating State income taxes. New Mexico

taxable income is calculated by starting with the taxpayer's federal adjusted gross income, deducting

the taxpayer's federal personal exemption and itemized deductions, and making certain adjustments

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reflected on Schedule A. The amount of tax is taken from the tax rate table or tax schedule. If there

is a federal adjustment made, the adjustment impacts the State income tax liability of a taxpayer.

Regulation 3.1.11.11(D) NMAC (2001) defines nonneglience as when a taxpayer

reasonably relies on the advice of an accountant as to his liability after full disclosure of all

relevant facts. In this case, Mr. Stanger testified that he relied on Mr. Martinez, an accountant,

who introduced Taxpayers to the concept of a defined benefit plan and who encouraged them to

establish a defined benefit plan. Mr. Stanger testified that Mr. Martinez assisted Taxpayers in

funding the plan.

At the time Taxpayers filed their returns for 2003, 2004 and 2005, Taxpayers believed that

the amount of tax due was correctly stated on their returns. Taxpayers took a number of steps to

determine whether the contributions and the plan met the requirement of I.R.C. 412(i) (2002).

They requested and received a determination letter from the Internal Revenue Service allowing the

plan and deductions for the contributions made to the plan. Mr. Martinez was their accountant at

the time that they filed their 2003, 2004 and 2005 returns and the amount of itemized deductions,

which would have included the contributions to the plan, were amounts calculated by Mr.

Martinez. Therefore, when Taxpayers filed their New Mexico State returns for tax years 2003, 2004

and 2005, they relied on an accountant, Mr. Martinez, for the correct amounts of itemized

deductions. Therefore, as to the original returns filed, Taxpayers were not negligent in filing those

returns.

The Department argued that Taxpayers were negligent because they failed to file amended

returns and pay the adjusted income tax after receiving the Revenue Agent Report in September

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2006. The Department argued that regulation 3.1.11.11(D) NMAC (2001) provides that the

indications of nonnegligence do not apply to taxpayers who fail to file a return or an amended

return, even if the accountant told them not to file the return. The Hearing Officer agrees that

regulation 3.1.11.11(D) does not apply to taxpayers who fail to file returns. The Hearing Officer

also agrees that an amended return must be filed and additional taxes to the State of New Mexico

must be paid, in almost all situations when a Revenue Agent Report is issued. (Taxpayers had the

option of amending their returns, paying the additional tax and then filing a claim for refund under

Section 7-1-26. In this case, Taxpayers paid the principal income taxes but did not file the

returns.) However, if a taxpayer does not file an amended return and pay the additional tax based

on a “good faith” belief and based on “reasonable grounds” that he correctly reported and

deducted, then the Department shall not assess penalty.

Section 7-1-69(B) provides that:

(n)o penalty shall be assessed against a taxpayer if the failure to pay an amount of
tax when due results from a mistake of law made in good faith and on reasonable
grounds.

NMSA 1978, Section 7-1-69(B) (2003). In Taxpayers’ case, they had a “good faith” belief based

on “reasonable grounds” that they were complying with the federal law. They did not pay the

additional taxes and file amended State returns because they were embroiled in litigation in which

they were arguing with the Internal Revenue Service whether the contributions were deductible.

The reasonable grounds relied on by Taxpayers were that they believed that the plan and the

funding of the plan were in compliance with the requirements of the Internal Revenue Service

since they had received a favorable letter of determination from the Internal Revenue Service.

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They had consulted with a lawyer, Kathleen Barrow, from the Jackson Lewis law firm, to

determine whether the plan was in compliance or not. Mr. Stanger testified, extensively, on the

steps he took to make sure that he was following the federal law. In September 2006, Taxpayers

made a mistake of law, but believed they had paid the correct amount of income tax to the State.

Eventually, they paid the correct amount of income tax due to the State.

It wasn’t until January and February 2010 that Taxpayers acknowledged that the plan was

not in compliance with the federal law and that not all the contributions taken were deductible.

Taxpayers have met their burden in proving that at the time they received the Revenue Agent

Report in September 2006, that they failed to pay the adjusted income tax amounts for tax years

2003, 2004 and 2005 based on “reasonable grounds” and a “good faith” belief that the original

returns were accurate and that they did not need to file amended returns. For this reason, penalty

was not properly imposed.

While it was not argued that Taxpayers should have been on notice that they needed to pay

the State income tax amounts, the Hearing Officer notes that the Revenue Agent Report states that

“(t)he Internal Revenue Service has agreements with state tax agencies under which information

about federal tax, including increases or decreases, is exchanged with states. If this change affects

the amount of your state income tax, you should amend your state return by filing the necessary

forms.” Exhibit A, page 2.

Interest.

At the hearing, the Hearing Officer explained to Mr. Stanger that once a taxpayer agrees to

the amount of principal tax due, then interest must be assessed. In this case, since Taxpayers paid

In the Matter of Mark & Debra Stanger
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the principal tax due, interest must be assessed and is only accrued through the date of the final

payment of the principal amount of tax due. Interest “shall be paid” on taxes that are not paid on or

before the date on which the tax is due. NMSA 1978, § 7-1-67 (A). The word “shall” indicates that

the assessment of interest is mandatory, not discretionary. See State v. Lujan, 90 N.M. 103, 105, 560

P.2d 167, 169 (1977). The assessment of interest is not designed to punish Taxpayers, but to

compensate the State for the time value of unpaid revenues. Because the principal amount of tax

was not paid when it was due, interest was properly assessed.

CONCLUSIONS OF LAW

A. Mark and Debra Stanger filed a timely written protest to the penalty and interest

assessed under Letter ID Nos. L1356897664, L0919297408, and L1912100224 and jurisdiction lies

over the party and the subject matter of this protest.

B. Mark and Debra Stanger reasonably relied on an accountant to prepare their returns

for tax years 2003, 2004 and 2005. Mark and Debra Stanger were not negligent in claiming

certain deductions for the funding of their defined benefit plan for tax years 2003, 2004 and 2005.

C. Mark and Debra Stanger had reasonable grounds and a good faith belief that at the

time they received the Revenue Agent Report in September 2006 that they had filed their returns

for 2003, 2004 and 2005 in accordance with the law. Penalty shall not be assessed on any of the

tax years in protest.

D. Mark and Debra Stanger made a mistake of law in taking certain deductions on

their personal income tax returns.

E. Mark and Debra Stanger owe the interest amount calculated by the Department

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until the date that the final payments were made by Mark and Debra Stanger.

F. Interest should be applied to the principal amount of tax due in accordance with

this Decision and as calculated by the Department.

For the foregoing reasons, Mark and Debra Stanger’s protest is GRANTED IN PART

AND DENIED IN PART.

DATED: September 20, 2011.

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