Procedure & Administration
The IRS nonacquiesced to the Tax Court’s decision in Norris, T.C. Memo. 2011-161, in which the Tax Court held that husband and wife taxpayers were not liable for fraud penalties on their unreported income. The IRS believes that the Tax Court improperly used a “rigid” 11-factor test to determine the existence of fraud instead of making the determination by considering the taxpayer’s entire course of conduct.
Background—The Norris Case
William Norris and his wife, Sharon, were natives of Nashville, Tennessee. Mr. Norris initially worked strictly as a self-employed specialty welder. Later, the couple bought a convenience store, which Mrs. Norris managed and Mr. Norris also worked at in addition to his welding business. For the years in question, 1996 and 1998, the couple ran an illegal video poker operation in a back room in the store. They also gambled frequently in Las Vegas and, in 1996, in addition to cash winnings, won a car valued at $35,800.
The Norrises were not model taxpayers. Mr. Norris’s welding business was largely cash-based, and, allegedly, he did not report all his income from the business. Mrs. Norris, who kept the books for the convenience store, made a gross error in calculating its receipts, leading to an understatement of income from the legal portion of its operations in 1996. The IRS alleged that the Norrises did not pay tax on either any or all of the income from their illegal gambling operation, though it was not able to prove the allegation conclusively because of the state of the couple’s records. The couple reported their cash winnings from legal gambling, but failed to report the value of the car that they won in 1996.
In 2005, the government indicted Mr. Norris for two counts of criminal tax evasion, one for 1996 and one for 1998. He pled guilty to the 1998 charge, and the government, as part of the plea deal, dismissed the 1996 charge. Mr. Norris was sentenced to 15 months in jail and ordered to pay restitution of the amount of tax he admitted to underpaying for both years.
The IRS also conducted a civil audit of the Norrises, using the indirect method to determine their income. The audit resulted in the IRS’s issuing a notice of deficiency in 2008 for 1996 and 1998, assessing deficiencies for tax owed and fraud penalties against the couple for both years. Although the notice of deficiency was not issued until long after the Sec. 6501(a) deadline for assessing tax had passed, the IRS relied on Sec. 6501(c)(1), which allows the IRS to assess tax at any time “in the case of a false or fraudulent return with the intent to evade tax.” The Norrises challenged the IRS’s determination that they were guilty of fraud and the validity of the assessments for 1996 and 1998 in Tax Court.
The Tax Court’s Decision
With regard to Mr. Norris and the fraud and related statute of limitation issues, the Tax Court treated the two years at issue separately because Mr. Norris had pled guilty to criminal fraud for 1998. Because he admitted to evading tax in his plea, the court held Mr. Norris was collaterally estopped from denying the civil fraud penalties for that year and the statute of limitation for assessment for that year remained open. However, because he made no admissions about his conduct in 1996 in his criminal plea, the Tax Court was required to determine whether he had committed civil fraud with respect to his 1996 taxes.
To be guilty of fraud, a taxpayer must intend to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of tax (Parks, 94 T.C. 654, 660–661 (1990)). The Tax Court found that, to determine whether the taxpayers have the requisite fraudulent intent, it should perform a weighing test using 11 factors (badges of fraud) that had been outlined in Niedringhaus, 99 T.C. 202, 211 (1992). The 11 factors from Niedringhaus are: (1) Understating income, (2) maintaining inadequate records, (3) implausible or inconsistent explanations of behavior, (4) concealment of income or assets, (5) failing to cooperate with tax authorities, (6) engaging in illegal activities, (7) an intent to mislead which may be inferred from a pattern of conduct, (8) lack of credibility of the taxpayer’s testimony, (9) filing false documents, (10) failing to file tax returns, and (11) dealing in cash.
In applying the test, the Tax Court gave each factor equal weight. It found that factors (1), (6), (7), and (10) favored a finding of fraud, factors (3), (4), (5), (8), and (11) did not favor a finding of fraud, and factors (2) and (9) were neutral. Because it treated each factor equally, the Tax Court held that Norris was not liable for fraud penalties for 1996. Without going through the entire weighing test, the court also found that Mrs. Norris had not committed fraud with respect to the 1996 taxes. Consequently, it also held that the assessment for the 1996 tax year was invalid because the statute of limitation for assessment under Sec. 6501(a) had run and the unlimited period under Sec. 6501(c)(1) did not apply.
The IRS Response
In Action on Decision 2011-5, the IRS announced its nonacquiescence to the Norris decision. The IRS stated in the AOD that “[t]he Tax Court’s approach in evaluating the evidence employed an artificial and rigid system of scoring in place of a consideration of the taxpayer’s entire course of conduct as reflected in the entire record.” While the IRS agreed that the Niedringhaus factors were valid, it argued that they are not the only factors that can be considered and pointed to a number of other factors that the Tax Court had considered in other fraud cases. The IRS also criticized the Tax Court’s equal weighting of the factors, stating that strong evidence of only a few factors is sufficient to prove fraudulent intent, again citing previous Tax Court cases to support this point.
The IRS asserted in the AOD that it would continue to examine all the relevant conduct of a taxpayer when evaluating evidence of fraud. In particular, it stated it would continue to follow the guidelines in Internal Revenue Manual Section 184.108.40.206. Finally, the IRS expressed its intent to “continue to argue that a determination of fraud is based on the taxpayer’s entire course of conduct, giving each badge of fraud the weight appropriate to the particular case.”
The Tax Court determined that “[n]o single factor or combination of factors adverse to the petitioner is sufficient in this case to establish fraud for 1996.” However, it is unclear why the Tax Court then decided to perform a balancing test and to weigh each badge of fraud equally.
A badge of fraud has been defined as a “circumstance which does not alone prove fraud, but which warrants inference of fraud, especially where there is a concurrence of many such badges” (Black’s Law Dictionary (West 1979), citing Brennecke v. Reimann, 102 S.W.2d 874, 877 (Mo. 1937)). This definition reveals a better approach to fraud determination than equal weighting of the badges of fraud.
The cumulative weight of more and more badges of fraud increases the likelihood that fraud exists—and the mere absence of a particular badge of fraud should not counterbalance an established indicator of fraud. Furthermore, the badges of fraud should not carry equal weight. Why, for example, would “maintaining inadequate records” weigh the same as “engaging in illegal activities”? Therefore, as the IRS argued in the AOD, the taxpayer’s entire conduct should be evaluated—and strong evidence of a few indicators should be sufficient to establish fraudulent intent.
Action on Decision 2011-05; Norris, T.C. Memo. 2011-161