Memo Addresses Treatment of Fraudulently Altered Returns

Procedure & Administration

In a program manager technical advice memorandum, the Office of Chief Counsel (OCC) advised on a number of issues regarding returns where a preparer, after issuing the taxpayers refund anticipation loans, increased the amount of the charitable contribution deductions claimed on the returns without the taxpayers’ knowledge or consent to increase the refund received from the IRS.

Background

A tax preparer (dubbed “Horse” in the memo to preserve confidentiality) was a CPA preparing individual income tax returns. Horse prepared approximately 700 returns for tax year 2002, of which approximately 450 were e-filed. Horse prepared the returns with the information provided by the client, printed a copy of that return to give to the client, and gave the clients a check for the refund amount less his $50 fee. These checks were actually refund anticipation loans (RALs) from a financial institution that Horse obtained without the clients’ consent.

Prior to transmitting a client’s return to the IRS and without the client’s knowledge, Horse increased the charitable contribution amount on Schedule A, Itemized Deductions, in order to increase the refund received from the IRS. Horse kept the additional refund amount. His clients were unaware that he had altered their returns.

In some cases, the IRS froze the refunds and did not send the refund amounts to the financial institution that Horse used to provide the RALs. In those cases, the financial institution made demands to the taxpayers for the refund amounts. Many of these taxpayers paid the financial institution the amount of the check they received, and many paid the entire amount of the RAL, including the fraudulent portion that Horse received without their knowledge. The taxpayers were completely unaware that they had received RALs and that their refunds were routed through the financial institution.

Evidence obtained in the IRS’s investigation of Horse showed that he also reported fraudulent business expenses for several of his clients on Schedule C, Profit or Loss from Business. Horse reported legal and professional fees paid to him on these Schedules C that in fact were never paid and generated fraudulent invoices for expenses never paid by the Schedule C businesses. It appeared that these fraudulent expenses were created with the clients’ knowledge.

OCC’s Advice

The OCC addressed the following questions regarding the returns prepared by Horse:

Is a return a nullity if a return preparer increased the charitable contribution amount on a taxpayer’s return to inflate a refund, and the taxpayer was unaware of the increased charitable contribution and did not benefit from that part of the refund? The OCC advised that a return in this situation is a nullity because the electronic file submitted to the IRS was unknown and unverified by the taxpayer. The OCC reasoned that where the taxpayer is unaware of fraudulent inflated charitable contribution expenses added by the return preparer, the taxpayer has not executed his or her return under penalties of perjury, because what the preparer submitted to the IRS was not the document the taxpayer signed. Thus, the document does not constitute a return, has no status under the Code, and is a nullity. In addition, because the taxpayer has not filed a return under Sec. 6664(b), the IRS cannot impose accuracy-related or civil fraud penalties against the taxpayer. However, criminal fraud penalties under Sec. 7206 may apply.

If a return is a nullity but the taxpayer received a refund anticipation loan for the correct amount of his or her refund (minus normal preparation fees), does the taxpayer receive another refund when his or her true return is filed? Where the taxpayer had received a RAL that he or she did not return for the correct amount based on his or her withholding and tax liability, there was no overpayment, and therefore a second refund should not be issued. Where the taxpayer returned the refund anticipation loan to the financial institution because the IRS had frozen the taxpayer’s refund, the OCC advised that there is an overpayment and no unjust enrichment, and the IRS should send the taxpayer the correct amount of refund.

Is a return a nullity if a taxpayer willingly allowed the preparer to add fraudulent expenses to his or her Schedule C to gain a larger refund, but the preparer also increased the charitable contribution amount on the Schedule A, and the taxpayer was unaware of the inflated charitable contribution amount and did not benefit from that part of the refund associated with the inflated charitable contribution? Even though the taxpayer was aware of and consented to the fraudulent inflation of the Schedule C expenses, the taxpayer was not aware of the addition of the charitable contribution. Therefore, for the same reasons described above, the OCC advised that the return is a nullity.

In both situations, should the taxpayer correct his or her account by filing a new return or an amended return? The OCC advised that the taxpayer should file a new return to report the correct tax information for the year. The taxpayer should not file a Form 1040X because the electronic return was a nullity and thus the taxpayer has not filed a return that he or she can amend.

Reflections

The OCC was also asked about the propriety of a plan for auditing a certain number of the Schedule C returns Horse prepared. The OCC advised that the percentage of Horse’s returns audited was a business decision the IRS campus and operating divisions involved should make, but again pointed out that the IRS could not assert accuracy-related or civil fraud penalties against the taxpayers. The OCC further noted that when a potential criminal fraud case is identified, the Internal Revenue Manual mandates that a timely fraud referral to the Criminal Investigation division is necessary.

PMTA 2011-013