- The penalty assessed for civil fraud is 75% of the portion of the taxpayer’s underpayment attributable to fraud. The penalty does not apply to any part of an underpayment that is due to reasonable cause if the taxpayer acted in good faith.
- Fraud can be proven through indirect audit methods such as the bank deposits and cash expenditure method and the net worth method.
- Any audit that uncovers a possible case of civil fraud has the potential of turning into a criminal investigation and prosecution of the taxpayer. Because of this potential of criminal prosecution, a CPA should advise a client facing allegations of civil fraud to retain a criminal tax attorney.
Over the past few years, the IRS has generally demonstrated a pattern of increasing both the number and the aggregate dollar amount of civil tax fraud penalty assessments in individual income tax cases, with a significant increase in fiscal years 2006 and 2007 (see the exhibit). 1 Although the number of corporate income tax cases in which the IRS has assessed the civil fraud penalty and the aggregate dollar amount of the penalty assessed each year during the same period have not followed the same (or apparently any) pattern, 2 the numbers are still significant. For example, in 2007 the Service assessed $222,278,000 in corporate fraud penalties. 3
Sec. 6663 governs the imposition of the federal civil tax fraud penalty. Given the overall increase in the Service’s assessment of this penalty, it is important for CPAs to understand when and how the penalty may be assessed and the relevant procedural considerations. Moreover, in any case in which the civil fraud penalty is or may be assessed, there is always the potential for a criminal tax fraud allegation. As a result, it is also important for CPAs to be aware of the interaction between civil and criminal tax fraud and to be able to recognize the warning signs that a civil tax fraud case may become a criminal case.
This article examines Sec. 6663 and the civil tax fraud penalty it imposes. After describing the substantive and procedural aspects of the penalty, it discusses the interaction of the civil tax fraud penalty with criminal fraud penalties and highlights possible indicators that a case may involve a criminal fraud claim or investigation. 4 A significant portion of the article is devoted to the CPA’s role in cases involving allegations of tax fraud.
The Civil Tax Fraud Penalty Imposed by Sec. 6663
Amount and Imposition of the Penalty
Sec. 6663(a) provides that “[i]f any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.” Thus, the penalty, imposed at the hefty rate of 75% plus interest, 5 is imposed on fraudulent underpayments of amounts required to be shown on a tax return. 6
The term “fraud” is not defined in Sec. 6663 or the regulations. For civil tax penalty purposes, fraud has been described as “conduct (1) the likely effect of which is to mislead or conceal and (2) in which the taxpayer voluntarily and intentionally engages to evade a tax he knows he has an obligation to pay.” 7 Consequently, proof that a taxpayer has intentionally attempted to evade tax involves presenting objective evidence from which the judge or jury may infer the taxpayer’s subjective intent of tax evasion.
Indications of tax fraud are commonly referred to as “badges” or “indicators,” and the IRS uses proof of one or more of these items to establish that an underpayment is attributable to fraud. The Internal Revenue Manual (IRM) lists six categories of fraud indicators, including income, expenses or deductions, books and records, allocations of income, taxpayer conduct, and methods of concealment.
The IRM lists several examples of potentially fraudulent activity under each category. 8 For example, indicators of fraud in the income category include omitting specific items of income or entire sources of income, failing to explain increases in net worth, making substantial personal expenditures in excess of available resources, making bank deposits from unexplained sources, and concealing bank and other accounts. 9 Each of the indicators is essentially a red flag to an IRS agent that the taxpayer may have engaged in tax fraud.
For purposes of Sec. 6663, Sec. 6664 defines the term “underpayment” as the amount by which the tax imposed exceeds the sum of the amount shown as tax by the taxpayer on his or her return plus amounts not so shown but previously assessed (or collected without assessment). 10 A key part of this definition is that the Sec. 6663 civil fraud penalty is assessable only for returns filed by the taxpayer. The IRS cannot impose the civil fraud penalty on a return it prepares and executes on behalf of a taxpayer who fails to file a return. 11 In that situation, the Service may instead assess the fraudulent failure-to-file penalty under Sec. 6651(f).
For purposes of determining the existence and amount of an underpayment, the amount of tax shown on the taxpayer’s return includes an amount listed as additional tax on certain amended returns. 12 This means that an amended return can have the effect of reducing the amount of the taxpayer’s underpayment. However, this rule does not apply in cases involving a fraudulent position on the taxpayer’s original return. 13 As a result, amending a fraudulent return does not negate the possibility of a civil fraud penalty assessment.
Reasonable Cause Exception to the Civil Fraud Penalty
Under Sec. 6664(c)(1), the civil fraud penalty imposed by Sec. 6663 does not apply to any part of an underpayment that is due to reasonable cause, provided that the taxpayer acted in good faith. The regulation regarding the reasonable cause exception for purposes of the accuracyrelated penalty imposed by Sec. 6662 14 and the discussion of reasonable cause in the Consolidated Penalty Handbook portion of the Internal Revenue Manual 15 are the primary sources of the Service’s approach to applying the reasonable cause exception.
In general, whether the IRS treats the taxpayer as having reasonable cause for an underpayment of tax is determined based on all the facts and circumstances. Reasonable cause relief from a penalty “is generally granted when the taxpayer exercises ordinary business care and prudence in determining their tax obligations but nevertheless is unable to comply with those obligations.” 16
The IRS summarily rules out several possible explanations for an underpayment as not consistent with ordinary business care and prudence and therefore as not a basis for a reasonable cause exception. These explanations include claims that the taxpayer is ignorant of the obligation to file and/or pay taxes, claims that the taxpayer made a mistake, and claims of forgetfulness or oversight by the taxpayer. 17 Reasonable cause can include death, serious illness, unavoidable absence, and the inability to obtain records; 18 however, these would not appear relevant to a claim of fraud that involves an intent to evade tax.
Much more relevant to the question of whether the taxpayer had reasonable cause for an underpayment in the context of the civil fraud penalty is the taxpayer’s reliance on advice provided by the IRS or a tax professional. The Code requires the IRS to abate the portion of any penalty attributable to written advice furnished by an officer or employee of the Service acting in an official capacity. 19 However, a new or revised regulation or ruling resulting from a change in the law is treated as notice to the taxpayer that the prior written advice is no longer correct. 20 Penalty relief may also be granted based on oral advice from the IRS, with the Service considering whether the taxpayer exercised ordinary business care and prudence in relying on the oral advice, the relationship between the taxpayer’s situation and the advice provided, the taxpayer’s tax history, and supporting documentation. 21
Reliance on a tax professional’s advice may also be the basis of penalty relief. In this regard, the IRM specifically notes the potential for relief where the tax adviser “provides advice on a substantive tax issue” and limits such relief to advice relating “to issues generally considered technical or complicated” and not to those related to the taxpayer’s responsibility to file, pay, or deposit taxes. 22
The regulation regarding the reasonable cause exception for purposes of the accuracy-related penalty provides further guidance regarding reliance on an opinion or advice that should also be relevant in the context of the civil fraud penalty. This includes consideration of the taxpayer’s education, sophistication, and business experience and a requirement that the advice must be based on all pertinent facts and circumstances and not on unreasonable factual or legal assumptions. 23 As noted below, the tax adviser should retain proof of the facts and circumstances relied on in rendering advice to the client both to support a taxpayer’s reasonable cause defense and to protect the adviser from a malpractice or tax fraud allegation.
Burden of Proof and Methods of Proof
In a civil tax fraud case, the IRS has the burden of proving by clear and convincing evidence that an underpayment is attributable to fraud. 24 Under Sec. 6663(b), once the IRS establishes that any part of an underpayment is due to fraud, the entire underpayment is treated as fraudulent and is therefore subject to the 75% penalty. However, the taxpayer can rebut this presumption for any portion of the underpayment by establishing by a preponderance of the evidence that it was not due to fraud. 25
The IRS has an arsenal of indirect audit methods it uses to prove tax fraud. The indirect audit methods described in the Internal Revenue Manual include the bank deposits and cash expenditure method, the source and application of funds method, the markup method, the unit and volume method, and the net worth method. 26 Such indirect methods are to be considered “when the factual development of the case leads the examiner to the conclusion that the taxpayer’s tax return and supporting books and records do not reflect the total taxable income received and the examiner has established a reasonable likelihood of unreported income.” 27
The bank deposits and cash expenditure method may be used both to determine whether the taxpayer has unreported income and to find leads to sources of unreported income. By definition, this method involves an analysis of the taxpayer’s bank records and is based on the following theories and assumptions:
- If a taxpayer receives money, it can be either deposited or spent;
- Amounts deposited into bank accounts (after adjusting for nontaxable receipts, such as gifts) are taxable;
- Expenditures shown on the tax return were made and were paid by cash or credit; and
- Cash used to pay an expenditure comes from a taxable source unless the taxpayer proves it comes from a nontaxable source. 28
Under this method, if a contractor is paid “under the table” 29 for goods or services and makes bank deposits in excess of his or her reported gross income, the excess would be treated as taxable income unless it came from a nontaxable source. The IRM recommends the bank deposits and cash expenditure method when the taxpayer makes periodic deposits from an income-producing activity and pays most business expenses by check. 30 By contrast, use of this method would not make sense if the taxpayer typically dealt in cash and did not deposit significant gross receipts. 31
The source and application of funds method involves analyzing the taxpayer’s cashflow and comparing the taxpayer’s known receipts and expenditures for the period. Net changes in assets and liabilities are also taken into account in determining whether the taxpayer’s expenditures exceeded reported and nontaxable income. The excess, if any, is treated as unreported income. 32
Under this method, if a taxpayer’s personal expenditures during a year exceed 1. 2. 3. 4. reported income for the year plus the taxpayer’s accumulated funds, the excess would be treated as taxable income unless it came from a nontaxable source. For example, in the Johnson case, 33 the Supreme Court determined the taxpayer’s unreported gambling winnings to be the taxable source of funds used to pay personal expenditures in excess of the taxpayer’s reported income and declared accumulated funds.
The markup method and the unit and volume method are used in determining or reconstructing the gross receipts of certain retail businesses. The markup method involves determining an appropriate markup percentage and applying it to the cost of goods sold to compute the taxpayer’s gross receipts. The examiner must use the taxpayer’s own markups, if known. 34
By contrast, the unit and volume method is used to determine gross receipts based on the number of units or volume of business done by the taxpayer. 35 For example, the IRS has successfully used the unit and volume method to determine a taxpayer’s gross pizza sales income by determining the number of pizza crusts produced per 100 pounds of flour multiplied by the average price per pizza; 36 the gross receipts of a bar based on a measurement of liquor used per drink, with an allowance for spillage; 37 and a cab driver’s gross receipts based in part on fuel expenses, miles per gallon, and occupancy rates. 38
The net worth method compares the taxpayer’s net worth (total assets less total liabilities) as of the end of the tax year with net worth as of the end of the preceding tax year. To determine net worth, nondeductible expenditures made during the tax year are added, and nontaxable income received during the tax year is subtracted. Use of the net worth method is based on the theory that any increase in net worth (after these adjustments) results from taxable income. 39 As a result, unless it can be adequately explained, if the amount of the increase in net worth significantly exceeds the taxpayer’s reported income for the year, the IRS will view the excess as unreported income. The net worth method is recommended when two or more years are under audit, there have been numerous changes to assets and liabilities during the period, or the taxpayer fails to either maintain or make available adequate books and records. 40
Example: Taxpayer Q has a net worth of $50,000 (with total assets worth $100,000 and total liabilities of $50,000) as of the end of 2007. During 2008, Q reports $40,000 gross income but purchases a new vehicle worth $25,000, pays off a $25,000 mortgage, and incurs no new debt. Q’s assets have increased to $125,000 and liabilities have decreased to $25,000, resulting in a year-end 2008 net worth of $100,000. The $50,000 increase in net worth exceeds Q’s reported income by $10,000, which would be treated as additional taxable income for 2008 absent an adequate explanation.
Is the Case Becoming Criminal?
Any audit that raises the possibility of a civil fraud penalty assessment has the potential to become a criminal fraud investigation and to lead to subsequent prosecution. Sometimes there may be warning signs that the IRS revenue agent is at least considering a referral to the Service’s criminal investigation division. First, the tax professional (as well as the client) should use common sense and recognize that if there are a large number of significant errors on the return, including items that could be viewed by the IRS as a badge or an indicator of fraud, such as substantial underreporting of income or overstating of deductions, there is always a possibility that the audit may become a criminal investigation. 41
Two telling signs of an audit’s potentially turning into a criminal investigation include a “long, unexplained period of silence after much investigative activity,” during which period the revenue agent may be consulting with an IRS fraud referral specialist regarding a potential criminal fraud referral, or the agent’s refusing to discuss the status or timing of closing the audit. 42 Other warning signs may involve the revenue agent’s seeking information from third parties (such as banks, suppliers, or customers) by interviewing or requesting affidavits from such third parties or requesting or summoning documents (such as bank records or invoices) from third parties. 43
As noted above, the taxpayer’s intent to evade tax may be inferred from the objective evidence regarding the existence of a badge or indicator of fraud. However, a revenue agent may attempt to obtain more direct proof of the taxpayer’s knowledge of, or intent with respect to, transactions constituting fraud indicators, such as unreported income or false deductions. Questions about the taxpayer’s knowledge or intent may also indicate that a criminal referral is being considered. 44
Other questions asked by the revenue agent may signal that the IRS is using, or at least considering using, an indirect method of proof to show unreported income. For example, questions about the taxpayer’s lifestyle and expenditures may indicate the possibility of a financial status audit, while a request for beginningand end-of-year assets and liabilities may indicate a net worth audit. 45
Interaction with Criminal Sanctions
A taxpayer convicted of criminal tax evasion under Sec. 7201 cannot litigate the issue of fraud in a subsequent civil tax proceeding because the elements the IRS must prove to obtain an evasion conviction are substantially identical to what the IRS must prove for the 75% fraud penalty. 46 This doctrine, referred to as collateral estoppel, does not apply to convictions under Sec. 7206(1), applicable to filing false returns, because the government is not required to prove fraudulent intent to evade tax in order to convict a defendant under that provision. 47
Collateral estoppel does not work in the reverse: An acquittal in a criminal tax evasion case does not serve as a bar to later imposition of a civil fraud penalty. This is because a “not guilty” verdict is not a finding of innocence but instead a finding that insufficient proof of guilt was presented at trial. 48
The amount of the tax deficiency typically differs for criminal and civil purposes. There are several reasons for this, including the fact that in criminal cases any doubts about the taxability of income are resolved in the defendant’s favor. 49 Even after an evasion conviction, a defendant can still litigate the amount of the deficiency. 50 Because the Sec. 6663 penalty is based on a percentage of the fraudulent underpayment, calculations demonstrating that a client owes less than what the IRS claims represent an important service that CPAs can provide. 51 Unfortunately, a taxpayer cannot offset the civil penalty by fines he or she is ordered to pay as part of any criminal case. 52
Not surprisingly, taxpayers facing fraud penalties have argued that Sec. 6663 is punitive in nature and therefore the IRS cannot assess it where the government has also obtained a conviction for evasion. This argument rests on the constitutional principle of double jeopardy, which protects citizens from being prosecuted twice for the same crime. 53 Courts have dismissed this contention, however, finding that the civil penalties imposed by the Code are remedial in nature rather than punitive. In other words, a taxpayer who bears whatever sentence is imposed following an evasion conviction and is then subjected to the Sec. 6663 penalty is not being punished twice. 54
Statute of Limitation
The statute of limitation for the assessment of tax and penalties is generally three years from the later of the due date (including extensions) of the tax return or the date the taxpayer actually filed the return. 55 However, as is the case when no return is filed, “[i]n the case of a false or fraudulent return with the intent to evade tax,” the tax, including the 75% penalty, may be assessed at any time. 56 In other words, there is no statute of limitation applicable to the assessment of the civil fraud penalty. This can cause problems for taxpayers who routinely dispose of records after three or six years.
The Role of the CPA
For many clients, a CPA is their primary, if not their only, tax adviser. That means the accountant’s assessment of a potential fraud case usually represents the first professional analysis of the taxpayer’s situation, including the potential for criminal prosecution. Although it may ultimately be limited, the CPA’s role at this point is extremely important in ensuring that no steps are taken that worsen the client’s case. 57 An accountant also must bear in mind, however, that the scope of a fraud investigation can extend to the client’s tax preparer, either because of government suspicions or client attempts to shift blame. For that reason, it is also extremely important for an accountant to consider his or her own situation when handling a fraud client.
Statements on Standards for Tax Services
Regardless of the potential for criminal prosecution or application of the 75% penalty, it is always advisable for CPAs to follow the AICPA’s Statements on Standards for Tax Services (SSTS). 58 These statements and their predecessors, the Statements on Responsibilities in Tax Practice, have been widely influential 59 and in some cases closely align with the language of other authoritative guidance. For example, Circular 230, which governs practice before the IRS, generally permits preparers and tax advisers to rely in good faith on information furnished by clients without verification. 60 The language of this provision is very similar to that found in SSTS No. 3, Certain Procedural Aspects of Preparing Returns, which also allows the use of information in some cases without verifying its accuracy.
In general, compliance with the SSTS can help a CPA avoid the application of sanctions and prevent miscommunication. 61 Following the guidance found in the statements can also help clients avoid tax problems. For example, SSTS No. 1, Tax Return Positions, directs that disclosure be made where a return position fails to meet certain standards.
The Jarvis case illustrates in general the benefits of disclosing information. 62 In that decision, the Tax Court threw out a fraud penalty where a partnership return was filed that fully disclosed the firm’s income. On his individual return, the taxpayer reported the amount of income shown on the firm’s return as his distributive share of the firm’s income. The court found “no evidence whatever” in the record sufficient to support a finding of fraudulent intent.
Advise Client to Retain Legal Counsel
For cost and other considerations, a taxpayer may be more comfortable working with a CPA rather than an attorney even where a matter raises fraud issues. In some cases, clients are eager to see investigations conclude rather than face the embarrassment that may arise when IRS agents contact business associates and others in the course of their examination. This may mean that the taxpayer will direct the accountant to cooperate. 63 However, because of the potential for criminal prosecution, a CPA must instruct the client to retain a criminal tax attorney 64 early in the course of the proceedings and before voluntarily providing significant information. 65
The advice to hire a lawyer is mandated not by differences in the expertise of attorneys and accountants but because of the rules regarding privileged communications. Sec. 7525, which extended the attorneyclient privilege to communications with “federally authorized tax practitioners,” does not apply in criminal matters. 66 Thus, in a criminal tax case the privilege covers only attorney-client communications. Once retained, the attorney will represent the interests of the taxpayer, not the tax preparer. As a result, a CPA with concerns about his or her own conduct in a matter would be well advised to retain separate counsel. 67 However, if an IRS special agent attempts to interview a CPA in connection with tax compliance work, he or she may request that the client’s legal counsel also attend the meeting. While not acting as the accountant’s attorney, the presence of the taxpayer’s counsel would allow better monitoring of the progress of the IRS investigation. 68
Regardless of the CPA’s tax expertise or experience with a client, after an attorney is hired the accountant’s role should be limited. Because of the limitations on the tax practitioner privilege described above, it is important for the accountant to stop all inquiries and investigations in order to avoid developing harmful knowledge that he or she may later have to surrender to the government. 69 A practitioner should not file delinquent 70 or amended returns unless directed by counsel. 71
Although an ongoing criminal investigation is not a defense for failure to file a current return, even that should be done only when instructed by and in consultation with the taxpayer’s lawyer. 72 There are two important reasons for this. First, information on a current return may provide evidence damaging to the client. 73 Second, the IRS usually looks for a pattern of fraudulent conduct extending over several years before making the decision to prosecute. It is important not to provide the additional periods that may trigger criminal action through a current filing that later proves to include harmful information. 74
Lawyers frequently retain a CPA when representing clients in criminal tax cases. The Kovel decision 75 held that the work of an accountant hired by a lawyer to assist in providing legal advice can be shielded from disclosure by the attorney/client privilege. However, most experts advise against retaining the client’s tax preparer as the so-called Kovel accountant. In part, this is because the government may argue that it is entitled to certain information from the accountant on the grounds that the material was obtained or developed while the CPA was performing tax compliance work rather than while working for the client’s attorney. 76 Kovel accountants are used frequently to check IRS calculations and also to look for unclaimed deductions or other items that could be used to offset additional income or tax liability that the government claims exist. 77
In general, a taxpayer is well advised not to cooperate with the government in a criminal tax investigation. Although cooperation may affect sentencing matters, assistance from the taxpayer typically does not discourage the government from launching a criminal prosecution. 78 A client who consents to certain investigatory techniques may later withdraw his or her permission. However, the government can use information obtained during the period when the consent was effective. For example, in Jones v. Berry, 79 Mrs. Jones consented to an IRS search, which permission her husband later revoked. In subsequent proceedings, the court denied a motion to suppress evidence that the IRS seized on the grounds that the IRS had completed its search before the consent was revoked.
A CPA whose client is the subject of a criminal investigation generally should not answer IRS questions or provide documents until he or she has received a subpoena or summons. 80 Once one is received, an accountant should comply carefully, documenting all steps taken to satisfy the order’s requirements, since a deliberate failure to produce a summoned document can lead to criminal consequences. 81 The accountant should keep copies of all items produced. When directed by the client’s attorney, a CPA should be prepared to supply information to the government without legal process. Although an accountant may be providing material regularly to a client’s legal representative, he or she should not expect to receive updates from the lawyer, since the attorney/client privilege is lost when information is provided to a nonclient. 82
As the Case Proceeds
No matter how careful and knowledgeable a CPA may be, the prospect of a fraud investigation involving a client for whom compliance work was performed can be daunting. In part, this is because the accountant, as the tax preparer, is a potential witness and may be required to testify at trial. 83 Even under the best of circumstances, a courtroom is not where most CPAs want to find themselves. In addition, there is always the risk that a taxpayer will attempt to defeat a fraud penalty by blaming his or her tax preparer for any inaccuracies found on a return. In Farber, this strategy failed. 84 The Tax Court in that case upheld the imposition of an addition to tax based on fraud in part because the taxpayer had concealed substantial amounts of business receipts from his accountants.
As noted above, reliance on the advice of a tax professional may represent “reasonable cause” and therefore serve as a defense to a finding of fraud. 85 However, in order to use this argument, a taxpayer must be able to demonstrate that the reliance was reasonable and also that he or she made full and adequate disclosure to the professional who provided the tax services in question. 86 The existence of this defense underscores the importance of careful recordkeeping. In particular, a CPA who provides compliance work must document all information received from a client—because this material represents the basis on which the accountant’s work product and advice rest—and must also document the authorities and materials consulted to give the advice in question.
Whether or not the client attempts to blame his or her CPA, a fraud investigation also raises the specter of malpractice. 87 Accountants who have followed the guidance of the tax law and the SSTS and have appropriately documented their work may nonetheless be sued even though they should not ultimately bear liability. However, in cases of improper conduct, CPAs may be subject to both malpractice exposure and sanctions from the government.
In Baisden, 88 for example, the court found that a CPA had engaged in numerous improprieties, including preparation of returns that mischaracterized income and claimed deductions to which the taxpayers were not entitled. The court issued an injunction against the CPA’s providing further tax services, finding that Baisden had likely violated Secs. 6694, 6700, and 6701. Sec. 6694 applies to understatements of taxpayer liability by a return preparer and includes penalties for willful or reckless conduct. Sec. 6701 imposes a penalty for aiding and abetting in the understatement of tax liability, while Sec. 6700 in general applies to promoters of abusive tax shelters. The Baisden court cited numerous instances in which the CPA had “inaccurately advised customers.” Inaccurate advice is also one of many grounds on which a client can bring a malpractice lawsuit.
Although most CPAs encounter tax fraud only infrequently, the statistics suggest that the government is paying increased attention to this area. Because the consequences can be extremely serious, practitioners must be able to recognize potential fraud situations and handle them properly. In most cases this will mean advising the client to retain a criminal tax attorney because of the limitations of the privilege given in the Code to federally authorized tax practitioners. Regardless of when a lawyer enters the case, however, practitioners are well advised to follow the guidance found in the SSTS and to document carefully all work done in connection with the client’s file, including efforts undertaken to comply with subpoenas and other legal processes.
Arlene Hibschweiler is an adjunct associate professor in the Department of Accounting and Law of the School of Management at the State University of New York at Buffalo. Martha Salzman is an adjunct assistant professor in the Department of Accounting and Law of the School of Management at the State University of New York at Buffalo. For more information about this article, contact Ms. Hibschweiler at firstname.lastname@example.org or Ms. Salzman at email@example.com.
1 See IRS Data Book 2004, Publication 55B, Table 27, Civil Penalties Assessed and Abated, by Type of Penalty and Type of Tax, www.irs.gov/pub/irs-soi/ 04db27cc.xls; IRS Data Book 2005, Publication 55B, Table 27, Civil Penalties Assessed and Abated, by Type of Tax and Type of Penalty, Fiscal Year 2005 (Revised September 2007), www.irs.gov/pub/ irs-soi/05db27cc.xls; IRS Data Book 2006, Publication 55B, Table 17, Civil Penalties Assessed and Abated, by Type of Tax and Type of Penalty, Fiscal Year 2006 (Revised September 2007), www.irs.gov/ pub/irs-soi/table_17_2006_dp.xls; IRS Data Book 2007, Publication 55B, Table 17, Civil Penalties Assessed and Abated, by Type of Tax and Type of Penalty, Fiscal Year 2007, www.irs.gov/pub/ irs-soi/07db17cp.xls.
2 The number of corporate income tax cases in which the IRS assessed the civil fraud penalty dropped from 217 in 2005 to 158 in 2006 and down to 140 in 2007, but the aggregate civil fraud penalty assessed dropped from $27,419,000 in 2005 to $9,229,000 in 2006 and then jumped to $222,278,000 in 2007. IRS Data Books 2005, 2006, and 2007.
3 IRS Data Book 2007, Table 17.
4 A full discussion of the federal criminal tax fraud penalties is beyond the scope of this article. For an analysis of some of the criminal provisions of the Internal Revenue Code, see Hibschweiler, “Can Your Tax Client (or You) Go to Jail? (Part I),” 37 The Tax Adviser 216 (April 2006); Part II, 37 The Tax Adviser 280 (May 2006). An examination of some of the federal penal code’s provisions that can be used against taxpayers can be found in Hibschweiler, “Tax Practice and the Federal Criminal Code,” 39 The Tax Adviser 216 (April 2008).
5 Interest on the civil fraud penalty is generally imposed at the underpayment rate mandated by Sec. 6621. Interest on the civil fraud penalty imposed by Sec. 6663 runs from the due date (including extensions) for the tax return on which the penalty is imposed until the date of payment of the penalty (Sec. 6601(e)(2)(B)). This is in contrast to the rule for calculating interest on certain other penalties, which starts on the date of notice and demand for payment per Sec. 6601(e).
6 Sec. 6663 is silent on how it interacts with the accuracy-related civil tax penalties that are generally imposed at the rate of 20% on underpayments attributable to negligence or substantial understatements of tax, among other things. However, Secs. 6662 (regarding the imposition of the accuracy-related penalty) and 6662A (regarding the imposition of the accuracy-related penalty on understatements of reportable transactions) each provide that the accuracyrelated penalty does not apply to any portion of an underpayment on which the Sec. 6663 fraud penalty is imposed (Sec. 6662(b); Sec. 6662A(e)(2)(A)).
7 Saltzman, IRS Practice and Procedure, ¶7B.02 (WG&L 2002–4). The Internal Revenue Manual notes that “[t]ax fraud requires both: a tax due and owing; and a fraudulent intent.” IRM Section 188.8.131.52.
8 IRM Section 184.108.40.206.
10 Less the amount of rebates (abatements, credits, refunds, or other repayments) made. See also Regs. Sec. 1.6664-2.
11 Sec. 6664(b) makes this even clearer by stating that “[t]he penalties provided in this part shall apply only in cases where a return of tax is filed (other than a return prepared by the Secretary under the authority of section 6020(b))” (emphasis added).
12 The regulations use the term “qualified amended return.” See Regs. Sec. 1.6664-2(c)(3) for the definition of “qualified amended return.”
13 Regs. Sec. 1.6664-2(c)(2).
14 Regs. Sec. 1.6664-4.
15 IRM Sections 220.127.116.11.1–18.104.22.168.1.2.5.
16 IRM Section 22.214.171.124.1.
17 IRM Sections 126.96.36.199.1.2.1, 188.8.131.52.1.2.2, and 184.108.40.206.1.2.3. IRM Section 220.127.116.11.1.2.1 does note, however, that ignorance of the law may constitute reasonable cause in certain circumstances, with the taxpayer’s education and tax history being particularly relevant to the determination.
18 IRM Sections 18.104.22.168.1.2.4 and 22.214.171.124.1.2.5.
19 Sec. 6404(f).
20 IRM Sections 126.96.36.199.2.4.1 and 188.8.131.52.2.4.
21 IRM Section 184.108.40.206.2.4.2.
22 IRM Section 220.127.116.11.2.4.3.
23 Regs. Sec. 1.6664-4(c).
24 Sec. 7454(a); Tax Court Rule 142(b).
25 Sec. 6663(b). In addition, for joint returns filed by spouses, Sec. 6663(c) provides that the civil fraud penalty does not apply to a spouse “unless some part of the underpayment is due to the fraud of such spouse.” A spouse who did not commit civil tax fraud is not personally liable for the Sec. 6663 penalty but is liable for the underlying tax underpayment (for which the penalty is imposed), unless he or she qualifies for innocent spouse relief under Sec. 6015. Saltzman, IRS Practice and Procedure, at ¶7B.10. See Rev. Proc. 2003-61, 2003-2 C.B. 296, for guidance on obtaining innocent spouse relief. Although the innocent spouse is not personally liable for the penalty, it may be collected from community property of the spouses in community property states. Kwong, 65 T.C. 959 (1976); Lollis, 595 F.2d 1189 (9th Cir. 1979). 26 IRM Section 18.104.22.168.
27 IRM Section 22.214.171.124.2.1.
28 IRM Section 126.96.36.199.4.
29 That is, not reported on Forms W-2 or 1099.
30 IRM Section 188.8.131.52.4.2.
32 IRM Section 184.108.40.206.3. The source and application of funds method of proof was approved by the Supreme Court in Johnson, 319 U.S. 503 (1943).
33 Johnson, 319 U.S. 503 (1943).
34 IRM Section 220.127.116.11.5.
35 IRM Section 18.104.22.168.6.
36 Maltese, T.C. Memo. 1988-322.
37 Stanoch, T.C. Memo. 1959-132.
38 Salami, T.C. Memo. 1997-347; Irby, T.C. Memo. 1981-399.
39 IRM Section 22.214.171.124.7. The Supreme
Court approved the use of the net
worth method of proof in Holland, 348 U.S. 121 (1954).
40 IRM Section 126.96.36.199.7.2.
41 Muller, Helmsing, Gelfand, and Silets, “Representing the Client Prior to and During a Criminal Investigation: Effective Defense Strategies and Tactics,” 24th Annual National Institute on Criminal Tax Fraud, C-47 (ABA 2007).
42 Perez and Hochman, “How the IRS Distinguishes Civil and Criminal Tax Fraud: Fraud Referral Specialists Play the Key Role in Identifying What Cases to Prosecute,” 26 Los Angeles Lawyer 12 (October 2003).
43 Id. at 13–14; Muller et al., “Representing the Client,” at C-47–48.
44 Perez and Hochman, “How the IRS Distinguishes Civil and Criminal Tax Fraud,” at 14.
46 IRM Section 188.8.131.52. See also Perez and Hochman, “How the IRS Distinguishes Civil and Criminal Tax Fraud.”
47 IRM Section 184.108.40.206. The doctrine also does not apply where a defendant pleads no contest to a criminal charge. Raby and Raby, “Effect of Criminal Tax Fraud Case on Civil Liability,” 113 Tax Notes 561 (November 6, 2006). A taxpayer who pleads guilty to criminal tax charges can still face civil penalties, even if in the plea agreement the government promised not to initiate further prosecution. Bickham Lincoln-Mercury, Inc., 168 F.3d 790 (5th Cir. 1999). 48 An acquittal in a criminal case means the government lacked sufficient evidence to meet the “beyond a reasonable doubt” burden of proof required for a conviction. Helvering v. Mitchell, 303 U.S. 391 (1938). A lesser standard, “clear and convincing” evidence, applies to the civil fraud penalty. Richardson, 509 F.3d 736 (6th Cir. 2007). Proof insufficient to meet the reasonable doubt test might nonetheless satisfy the clear and convincing evidence requirement.
49 IRM Section 220.127.116.11.1, Criminal v. Civil Tax.
50 Perez and Hochman, “How the IRS Distinguishes Civil and Criminal Tax Fraud.”
51 Note that under Sec. 6663(b), once any portion of an underpayment is established as attributable to fraud, the entire deficiency is characterized as fraudulent, unless the taxpayer can show otherwise. But see the discussion below of the limited role a CPA/tax preparer should play while criminal charges are pending against a client.
52 Schachter, 255 F.3d 1031 (9th Cir. 2001).
53 U.S. Constitution, Amendment V.
54 Mertens, Law of Federal Income Taxation, §55:72 (Callaghan 2004).
55 Sec. 6501(a).
56 Sec. 6501(c)(1). Sec. 6665(a) generally
provides that a penalty, including
the civil fraud penalty imposed by Sec. 6663, is treated the same as tax for purposes of the Code and assessment of the penalty. As a result, there is no statute of limitation applicable to the assessment of the civil fraud penalty.
57 For example, a tax practitioner should advise a client not to destroy or alter evidence in order to defeat a tax investigation because these steps can lead to other criminal charges, including obstruction of justice (18 U.S.C. Section 1512). Falsifying or destroying documents also may be treated as a badge of fraud, bolstering the prosecution’s case. IRM Section 18.104.22.168, Indicators of Fraud.
59 See, e.g., Swails, “A New Standard of Tax Practice,” Journal of Accountancy (November 2000), available at www.journalofaccountancy.com/Issues/2000/Nov/ANewStandardOfTaxPractice.
60 Circular 230, §10.34, Standards with Respect to Tax Returns and Documents, Affidavits, and Other Papers.
61 See Hibschweiler, “Can Your Tax Client (or You) Go to Jail? (Part II).”
62 Jarvis, 5 T.C.M. (CCH) 459 (1946). Note that voluntarily providing information after the fraud will not help a client. MacLean, 238 F.3d 422 (6th Cir. 2000). In MacLean, the 75% penalty was upheld despite a subsequent voluntary disclosure by the taxpayer. “Merely filing an amended return is not enough, however, to rebut strong evidence of fraud. ‘[A] taxpayer who submits a fraudulent return does not purge the fraud by subsequent voluntary disclosure; the fraud was committed and the offense completed when the original return was prepared and filed’” (quoting Badaracco, 464 U.S. 386 (1984)). Badaracco involved a statute of limitation issue under Sec. 6501.
63 Saltzman, IRS Practice and Procedure, at ¶12.09.
64 It is important that legal counsel be
expert in both criminal and tax matters.
For example, an attorney with a general criminal background may not realize the civil tax consequences—specifically, the likely imposition of the Sec. 6663 75% penalty arising from a plea in a criminal case involving tax evasion.
65 Because of recent changes, the basic elements of the criminal case are now established before a matter is referred for criminal investigation. See Muller, Helmsing, Gelfand, and Silets, “Defending the New IRS Audit: Stealth Fraud Exams,” 24th Annual National Institute on Criminal Tax Fraud, C-91 (ABA 2007). In fact, the Internal Revenue Manual instructs agents to exploit the initial interview in order to obtain information that may not be available later (IRM Section 22.214.171.124). This means a client is better served by hiring an attorney early in the investigatory process.
66 Sec. 7525(a)(2).
67 See, e.g., Baisden, No. 1:06-cv-1368 OWW TAG (E.D. Cal. 2007), discussed below, which upheld an earlier preliminary injunction against a tax preparer who promoted abusive tax shelters, prepared returns understating client liabilities without reasonable basis, and intentionally disregarded tax laws and regulations.
68 Muller et al., “Representing the Client,” at C-85.
69 Muller et al., “Defending the New IRS Audit,” at C-97.
70 Muller et al., “Representing the Client,” at C-52.
71 In general, filing amended returns is not advised because of the risk of admitting elements necessary for a criminal prosecution. See Muller et al., “Defending the New IRS Audit,” at C-103.
72 Silver, “The Tax Crime Exception to Taking the Fifth Does Not Exist,” 86 J. Tax’n (April 1997).
73 See, e.g., Chesterfield Textile Corp., 29 T.C. 651 (1958), where the court found the tax return filed for 1945, which included sales unreported in prior years, to be evidence of fraud for the 1943 and 1944 return years.
74 Silver, “Tax Crime Exception.”
75 Kovel, 296 F.2d 918 (2d Cir. 1961).
76 Saltzman, IRS Practice and Procedure, at ¶12.09.
78 Id. at ¶12.09. But see Dajos, T.C. Memo. 1986-330, where the court threw out civil fraud penalties, in part based on the taxpayer’s cooperation with the IRS.
79 Jones v. Berry, 722 F.2d 443 (9th Cir. 1983).
80 Muller et al., “Representing the Client,” at C-50.
81 Id. at C-82.
82 Leathers, 250 F.2d 159 (9th Cir. 1957). This means a CPA should also be careful not to request information about an ongoing criminal matter from the client.
83 Saltzman, IRS Practice and Procedure, at ¶12.09[a].
84 Farber, 43 T.C. 407 (1965), modified, 44 T.C. 408 (1965).
85 Bobbitt, T.C. Memo. 1987-328. See text accompanying notes 22–23 above.
86 Mertens, Law of Federal Income Taxation, §55.89.
87 For example, in C. J. Enters., Ltd. v. Rattenbury & Assocs., Inc., No. 165164 (Mich. Ct. App. 7/9/96), the plaintiffs brought a negligence suit after receiving an IRS notice of various penalties to be assessed against them because of returns the defendants prepared.
88 Baisden, No. 1:06-cv-1368 OWW TAG (E.D. Cal. 2007). In Medieval Attractions N.V., T.C. Memo. 1996-455, the Tax Court threw out fraud penalties against a taxpayer. The opinion suggested a link between backdated documents used by the government as evidence of fraud and the work of the taxpayer’s accountants.