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Reasonable Cause/Good Faith Defense: Even if the taxpayer did not have substantial authority for a position and failed to make adequate disclosure, the substantial understatement penalty does not apply if the taxpayer had reasonable cause for the tax underpayment and acted in good faith [IRC Sec. 6664(c); Reg. 1.6664-4]. This defense is applied on a “facts and circumstances” basis [Reg. 1.6664-4(b)]. However, the key factor seems to be whether the taxpayer made a reasonably energetic attempt to determine the correct tax liability. For example, an honest misunderstanding of fact or law, an isolated computational error, reliance on professional tax advice, or reliance on information returns all indicate reasonable cause/good faith. However, if the taxpayer should have known better, the defense will not apply.

Observation: According to IRM 20.1.5.6, the most important factor in determining whether the taxpayer has reasonable cause and acted in good faith is the extent of the taxpayer’s effort to report the proper tax liability. For example, reliance on erroneous information reported on an information return indicates reasonable cause and good faith, provided the taxpayer did not know or have reason to know that the information was incorrect. Similarly, an isolated computational or transcription error may indicate reasonable cause and good faith. Other factors to consider are the taxpayer’s experience, knowledge, sophistication, education, mental and physical condition, and reliance on the advice of a tax advisor.