Tax Return Preparers Win Partial Victory in Fraudulent Credit Scheme Case

A district court found that two tax return preparers who had participated in a fraudulent scheme involving credits for fuel from nonconventional sources did not know the scheme was fraudulent and dismissed the IRS’s requests for injunctions against the preparers. The court found that such relief would require a showing that the preparers had actual knowledge that the scheme was fraudulent. However, the court refused to dismiss the IRS’s claims for injunctive relief that the court could grant if it found after trial that the preparers had reason to know that the scheme was fraudulent.

Background

In 2003, Louis Powell began promoting a fraudulent scheme (originally developed by two other men) involving the sale of excess credits for fuel from nonconventional sources (FNS credits). Powell claimed that he had secured the rights to millions of dollars of FNS credits that allegedly had been generated by several methane gas production facilities located on landfills. According to Powell, taxpayers could purchase an interest in one of several partnerships he had created that qualified for FNS credits due to their ownership interests in these fuel production facilities, which would entitle the clients to take FNS credits on their federal income tax returns based on their percentage ownership of the fuel sold by the facilities.

Powell enticed Sally Hand-Bostick (Hand) to sell these interests in return for a commission and to recruit other preparers to sell the credits in return for a commission on the interests that those preparers sold. Hand did not fully understand the FNS credits but was assured by Powell and the materials and documentation that he provided that the credits were valid. Hand was successful in promoting the scheme to other tax return preparers and sold $2.4 million worth of the credits from 2004 to 2006, all of which the IRS disallowed.

Hand referred her co-defendant Elizabeth Spinelli, a CPA with 23 years of experience, to Powell in 2004. Spinelli, like Hand, was duped by Powell about the FNS credits and began to sell them to her customers at her tax preparation business. She sold over $450,000 worth of the credits, all of which the IRS also disallowed.

The IRS began investigating the FNS credit scheme in 2004 and performed audits of Hand’s and Spinelli’s customers. By 2008, the government had informed the preparers of the ownership problems related to the FNS credits. Beginning in 2009, Hand and Spinelli began claiming thousands of dollars in long-term capital loss deductions on their customers’ 2008 federal income tax returns, relating to their customers’ purported interests in gas-producing properties. The returns stated that the loss represented the disallowed FNS credit interest purchased by their customers. Hand continued asserting a long-term capital loss in 2010 for the tax year 2009, and Spinelli started asserting theft loss deductions relating to the disallowed FNS credits on her customers’ tax returns in mid-2008.

The IRS brought an action requesting an injunction against Hand and Spinelli under Secs. 7402, 7407, and 7408. Sec. 7402 allows the government to seek an injunction “for the enforcement of the internal revenue laws.” Sec. 7407 allows the government to seek an injunction against a defendant who has engaged in conduct subject to penalty under Sec. 6694 or in any other fraudulent or deceptive conduct that substantially interferes with the proper administration of the internal revenue laws. Sec. 7408 allows the government to seek an injunction against a defendant who has engaged in conduct subject to penalty under Secs. 6700 or 6701. Hand and Spinelli brought a motion for summary judgment, asking the court to dismiss the IRS’s claims for injunctive relief on the grounds that the government had offered no evidence to establish that they knew or should have known that the FNS credit scheme was fraudulent.

The District Court’s Decision

Because these claims required that Hand and Spinelli have had actual knowledge that the credit scheme was fraudulent, the district court granted the preparers summary judgment and dismissed:

• The IRS’s claim for injunctive relief under Sec. 7408, alleging that Hand and Spinelli engaged in conduct subject to penalty under Sec. 6701;
• The IRS’s claim for injunctive relief under Sec. 7407, alleging that Hand and Spinelli acted “willfully” under Sec. 6694(b); and
• The IRS’s claim for injunctive relief under Sec. 7407, alleging that Hand and Spinelli engaged in fraudulent or deceptive conduct that substantially interferes with the proper administration of the internal revenue laws.

However, the court refused Hand and Spinelli’s request to dismiss the IRS’s other claims for injunctive relief that it could grant based on a finding that the preparers had reason to know of the fraudulent nature of the FNS credit scheme rather than actual knowledge of it.

The court found that Hand and Spinelli did not have actual knowledge that the FNS credit scheme was fraudulent. It based this decision on the testimony of the investigating IRS agent in the case, who testified that she did not believe that the women had knowingly deceived or defrauded their clients, and on an IRS memo stating that they and other preparers who had participated in the FNS credit scheme did not know of the true landfill ownership, which the court called a “critical fact.” The IRS attempted to overcome this testimony by pointing to the numerous examples of “red flag” evidence that it claimed should have made it obvious that the scheme was fraudulent. However, the court refused to impute actual knowledge to the women based on what they should have known due to this evidence.

The court was less accommodating on whether an injunction was warranted based on what Hand and Spinelli had reason to know about the FNS credit scheme. The preparers argued that, due to the complexity of the legal questions involved in the case and their lack of legal expertise, the red flag evidence did not prove that they had reason to know that the scheme was fraudulent. After reviewing the red flag evidence cited by the IRS, the court concluded that there was a genuine issue as to whether Hand and Spinelli had reason to know that the scheme was fraudulent and held that whether an injunction should be issued on this basis should be determined at trial.

Reflections

The court will decide the issue at trial, but given the abundance of evidence that they had reason to know that the FNS credit scheme was not legitimate, Hand and Spinelli may have won a short-lived victory in this case. This case should remind tax practitioners that, although the tax issues involved in tax savings plans may be complicated, the manner in which promoters market the plans may signal that the whole scheme may not be legitimate and should prompt further inquiry by the practitioner. The fact that even tax practitioners can fall for a fraudulent scheme does not absolve them from the standards of care they owe their clients—or from the consequences stemming from failure to adhere to those standards of care.

Hand-Bostick, No. 3:09-CV-1075-L (N.D. Tex. 9/12/11)