Taxpayer Did Not Have Fraudulent Intent

Procedure & Administration

The Tax Court held that a taxpayer who used an “agent-principal” scheme to avoid paying taxes on income from his business was not liable for a civil fraud penalty because the IRS had failed to prove that the taxpayer had fraudulent intent.

Background

David Carreon and his wife were equal owners of a credit card processing business, originally as Bancard Solutions LLC and later as Merchants Payment Processing Inc. (collectively, Merchants Inc.). In 1999, pursuant to the advice of a financial adviser, the Carreons began using an asset management protection and financial strategy referred to as the “agent-principal” relationship. Under this scheme, the Carreons took net gross receipts from their credit card processing business after business expenses including their salaries and put those funds into various trusts. One of the trusts, designated the management trust, was managed for a fee by a company named Builders.

The Carreons employed a CPA, referred to them by the financial adviser, to prepare their business and personal income tax returns. The financial adviser told the CPA about the “agent-principal” relationship. The CPA accepted the adviser’s assurances that the scheme was valid and prepared the returns for the Carreons in accordance with the scheme.

During the years in question, the Carreons transferred Merchants Inc.’s net income after expenses to Builders’ bank accounts. Mr. Carreon kept a QuickBooks file with detailed records of the transfers. However, Merchants Inc. did not report the amounts that it transferred to the Builders’ bank accounts as income.

The Carreons also opened several bank accounts not directly related to Merchants Inc. Either Mr. Carreon or the couple jointly had signature authority. The Carreons had money transferred from the Builders’ accounts to these accounts. Although Mr. Carreon kept careful records of the transfers from Merchants Inc. to the Builders’ accounts in his QuickBooks files, he did not keep any records of the transfers from the Builders’ accounts to these other accounts, and the checks themselves (which were signed by the financial adviser) were labeled in a way that made them appear to be charitable contributions of some type. The Carreons also deposited income from rental properties in these accounts, and they used funds transferred to these accounts to pay personal expenses. However, they did not report any of the funds transferred to these accounts as income on their federal income tax returns.

The IRS audited Merchants Inc. and the Carreons and issued notices of deficiency based on the underreporting of income due to the use of the agent-principal relationship. It also assessed Sec. 6663 civil fraud penalties. Merchants Inc. and the Carreons challenged the IRS’s determinations in Tax Court.

Eventually, the Tax Court consolidated the cases for Merchants Inc. and David Carreon; a separate case for his wife (who was at that point divorced from Carreon) was not included. After Carreon and Merchants Inc. conceded the underpayments due to unreported income, the only issue left for the Tax Court to decide was whether Carreon and Merchants Inc. were liable for the civil fraud penalty.

The Tax Court’s Decision

The Tax Court held that Carreon and Merchants Inc. were not liable for the fraud penalty. The court found that their underpayments of tax were not due to fraud because they did not have the requisite intent for fraud.

To prove fraud with intent to evade tax, the Tax Court explained, the IRS must show by clear and convincing evidence that a taxpayer underpaid tax for the year in question and that some part of the underpayment was due to fraud. Both Carreon and Merchants Inc. had conceded underpayments of their tax liabilities. Therefore, the IRS only needed to prove that part of the underpayment was due to fraud. To do this, the IRS was required to prove that Carreon and Merchants Inc. acted with fraudulent intent.

The Tax Court noted that because direct evidence of intent for fraud rarely exists, it may be established by circumstantial evidence. To determine whether there was enough circumstantial evidence to support a finding of fraudulent intent, the court reviewed the evidence for “badges of fraud.” In the Ninth Circuit, to which Carreon’s and Merchants Inc.’s cases would be appealable, the Tax Court found that the badges of fraud are (1) understatement of income; (2) inadequate maintenance of records; (3) failure to file tax returns; (4) offering implausible or inconsistent explanations of behavior; (5) concealment of income or assets; and (6) failure to cooperate with tax authorities. To this list the court added the following badges that other courts have included in their analysis: (1) engagement in illegal activities; (2) cash transfers; (3) filing false documents; and (4) offering false or incredible testimony.

The court analyzed the evidence for fraud separately for Carreon and Merchants Inc. In Carreon’s case, it found that three of the factors favored a finding of fraud, six were against, and one was neutral and concluded that the IRS had not proved that Carreon had the requisite intent for fraud. In Carreon’s favor, the court found that his understatement of income was due to his reliance on his advisers and that while this reliance was not necessarily reasonable, it was not fraudulent; he had filed his tax returns; his explanations of his behavior were generally consistent and plausible; he did not engage in any outside illegal activities; he did not use cash transfers; and he did not give false or incredible testimony. In its discussion of his explanations of his behavior, the court admitted that some of his behavior was suspicious, but asserted that suspicious circumstances alone do not sustain a finding of fraud.

In Merchants Inc.’s case, the Tax Court also found that the IRS had not proved fraudulent intent, but the opinion only discussed five of the 10 fraud factors, four of which it determined were against finding fraud. It once again concluded that the company’s understatement of income was merely due to unreasonable reliance on its advisers, that the company had filed its tax returns, and that it was not engaged in any illegal activities. The court also found that the company had not filed any false statements with the IRS because the IRS had not alleged the company had. According to the court’s discussion of its analysis for Carreon, the IRS had not alleged that Carreon had filed any false statements either, but in Carreon’s case this badge weighed in favor of a finding of fraud because Carreon filed incorrect and thereby false returns when he did not report or disclose that Builders paid his personal expenses. The only thing the court found that weighed in favor of a finding of fraud was that the company maintained inadequate records because the company did not keep details of why its payments to Builders were deductible and why some of the funds it paid to Builders were used to pay the Carreons’ personal expenses.

Reflections

Based on the applicable law and Tax Court precedent, the court arguably came to the correct conclusion in this case. Even though the magnitude of the taxpayer’s underpayments suggest that he must have known that he was not properly reporting his income, his actions did not prove that he knew: Ignorance and bad advice may have been to blame for his tax underpayments.

Regardless of whether the Tax Court reached the correct result in this case, it has once again approached the weighing of the badges of fraud in a way that does not make sense. In cases such as this one, the court weighs the various badges of fraud equally, so that the absence of a particular badge of fraud counterbalances an established indication of fraud. A taxpayer with only a few indications of fraud will never be found to have acted with fraudulent intent under this approach no matter how strong those indications are.

Rather than counting up the badges of fraud and seeing if they outnumber the nonfactors, the court should use the list of the badges of fraud only as a guide for the evidence the court should consider. After determining which factors point to fraud and how strongly they do, the court should evaluate the taxpayer’s entire conduct as a whole in making its decision. Under this approach, strong evidence of a few badges of fraud would be enough to convince a court that the taxpayer acted with fraudulent intent.

Carreon, T.C. Memo. 2014-6