Understatement of Income Not Fraudulent

The Tax Court held that the IRS’s claim of a pattern of fraudulent conduct in a tax accountant’s preparation of his clients’ returns was not sufficient to prove that the underpayments of tax on his and his wife’s own returns were due to fraud.

Background

James and Rebecca Ericson filed joint returns for the years 2006 through 2008. Rebecca worked as a registered nurse and operated a side business that primarily involved the sale of fashion jewelry. James operated a business through which he provided tax preparation services, took and sold photographs, and sold merchandise.

Mr. Ericson had prepared tax returns as part of his business for over 20 years. Although he had a bachelor’s degree in business and a master’s degree, when he started preparing returns, he had little education and training specifically related to taxes and tax return preparation. Nonetheless, his tax preparation activity flourished, and during the years in question he prepared over 2,500 returns.

The IRS audited the Ericsons’ returns for the years 2006 through 2008. The Service found that the Ericsons had a liberal concept of what qualified as deductible business expenses for their activities, which they balanced out with a conservative approach to what qualified as taxable income of the activities. The IRS determined a deficiency in excess of $30,000 for each year and imposed a Sec. 6663 fraud penalty for each year. The Ericsons challenged the IRS’s determination in Tax Court.

The Fraud Penalties

Under Sec. 6663, if any part of any underpayment of tax required to be shown on a return is due to fraud, an amount equal to 75% of the portion of the underpayment that is attributable to the fraud is added to the tax. If any portion of an underpayment is attributable to fraud, the entire underpayment will be considered due to fraud except for the part of the underpayment that the taxpayer can prove is not due to fraud.

A determination of fraud will be sustained against an individual taxpayer only if the IRS can prove by clear and convincing evidence that the taxpayer underpaid his or her tax and at least some part of the underpayment was due to fraud. To prove fraud, the IRS must show that a taxpayer had the requisite fraudulent intent for each year in issue. A taxpayer has fraudulent intent if the taxpayer filed his or her tax returns for the years at issue intending to conceal, mislead, or otherwise prevent the collection of tax that the taxpayer knew he or she owed.

Whether fraud exists is based on the particular facts and circumstances of the case. Courts usually rely on certain indicia (or badges) of fraud in deciding whether a taxpayer had the requisite fraudulent intent. The badges of fraud include: (1) understated income; (2) maintaining inadequate records; (3) failing to file tax returns; (4) implausible or inconsistent explanations of behavior; (5) concealing income or assets; (6) failing to cooperate with tax authorities; (7) engaging in illegal activities; (8) dealing in cash; (9) failing to make estimated tax payments; and (10) filing false documents. However, these 10 badges are nonexclusive, and other factors may be considered. In addition, a taxpayer’s education and business background are relevant to a fraud determination.

Normally, the IRS will base an assertion of fraud solely on a taxpayer’s actions with respect to the taxpayer’s returns. However, in the Ericsons’ case, in addition to arguing that several badges of fraud were evident from the couple’s conduct with respect to their own returns, the IRS looked to bolster its fraud claim with evidence of Mr. Ericson’s conduct in the preparation of his clients’ returns.

Specifically, the IRS claimed that Mr. Ericson’s methodology in preparing his clients’ returns demonstrated a pattern of conduct that showed a clear intent to mislead because, in preparing tax returns for his clients, he consistently fabricated various schedules and forms that had no factual basis. From this pattern of conduct with respect to his clients’ returns, the IRS asserted a strong inference arose of his intent to deceive or mislead regarding his own income tax returns. Despite the fact that he had prepared over 2,500 returns during the years in question, the IRS based its claim of a pattern of conduct on his preparation of joint returns for two clients (referred to as the Ks and the Js) for 2007 and 2008.

The Tax Court’s Decision

The Tax Court concluded that the IRS had not clearly and convincingly proved that Mr. Ericson had filed any return for the years at issue with the intent to conceal, mislead, or otherwise prevent the collection of tax. Thus, the Sec. 6663 fraud penalty did not apply to the Ericsons’ returns for the years 2006 to 2008.

With regard to the returns prepared by Mr. Ericson, the Ericsons argued that information regarding those returns was not admissible. The court, however, found that the Ninth Circuit, to which an appeal of the case would lie, has held that evidence of other acts is admissible where the evidence (1) proves a material issue in the case, (2) if admitted to prove intent, is similar to the offense charged, (3) is based on sufficient evidence, and (4) is not too remote in time. Based on these criteria, the court concluded that the information about Mr. Ericson’s preparation of client returns was admissible.

The IRS auditor working on the Ericsons’ case claimed that he discerned a consistent pattern of fraudulent conduct based on his belief that each of the four returns prepared by Mr. Ericson for the Ks and the Js in 2007 and 2008 had at least one fictitious Schedule C, Profit or Loss From Business (Sole Proprietorship), as well as sometimes inflated business expenses and unallowable education credits. Looking at the returns in light of this claim, however, the court found that “the probative value of the four returns and their preparation is weak” and, consequently, that the IRS had not proved clearly and convincingly a consistent pattern of fraudulent conduct.

Regarding the Ks’ returns, the court acknowledged that they did tend to prove a pattern of fraudulent conduct because the IRS determined on examination that the Ks’ Schedule C business reported on their 2007 return was fictitious and that the IRS had disallowed employee business expenses claimed by the Ks in both 2007 and 2008. However, the weight of the returns was lessened by the fact that the evidence introduced by the IRS did not establish whether the Schedule C business had been found to be fictitious on examination in 2008.

In contrast, the court found that the Js’ returns tended to disprove rather than support a finding of a pattern of fraudulent conduct because the evidence presented by the IRS about the returns did not prove that the Schedules C for either year were for fictitious businesses. For the 2007 Schedule C, the court determined the record did not establish whether an auto racing business the Js’ reported was a trade or business engaged in for profit or that the IRS actually disallowed any of the expenses on the Schedule C. In addition, for the Js’ claimed education credits on the 2007 return, the court found that the IRS had not proved that they were invalid because the record showed Mrs. J had taken some dance classes that might qualify for the credit and did not establish that the IRS had disallowed the credits on examination. For the Js’ Schedules C filed for 2008, which included a pool maintenance business, the court stated it was precluded from finding that the Schedules C were for a fictitious business because of Mrs. J’s undisputed trial testimony that she provided administrative assistance in the pool maintenance business.

Besides the fact that the returns did not establish a pattern of fraudulent conduct, the court also observed that the Ericsons’ alleged fraudulent conduct on their own returns for the most part did not match up with the pattern of fraudulent conduct that the IRS claimed the returns Mr. Ericson prepared showed. The parties agreed that the businesses reported on the Ericsons’ Schedules C were legitimate businesses, and the IRS disallowed the Ericsons’ education credits because it had upwardly adjusted the couple’s income, not because the credits were claimed for expenses that were fictitious or not eligible for the credit. While the Ericsons’ employee business expenses were disallowed for the same reasons the ones on the Ks’ returns were disallowed, the court stated that this alone was not enough to establish a fraudulent pattern of conduct.

The court then analyzed the badges of fraud as they applied to the Ericsons’ returns, giving no regard to the IRS’s claimed pattern of conduct. The court concluded, based on the record before it, that the IRS had not proved that any of the standard 10 badges of fraud existed. The IRS also argued that education and sophistication (in tax matters) were also circumstantial factors establishing fraud, but the court rejected the IRS’s argument. The court noted that Ericson had only a minimal education in income tax preparation before he started his business, and that his work preparing taxes had not significantly increased his knowledge, stating that “Mr. Ericson is misguided in his understanding of many areas of tax law.” Thus, the court held that the IRS had failed to prove that the Ericsons had filed fraudulent returns for 2006 to 2008.

Reflections

While the IRS only presented a hodgepodge of evidence regarding Mr. Ericson’s pattern of preparing fraudulent returns, apparently there was much more evidence that the IRS could have and arguably should have presented. As the court said in a footnote, a federal district court, based on “considerably more extensive proof concerning Mr. Ericson’s return preparer activity,” had permanently enjoined Mr. Ericson from acting as a paid preparer of federal tax returns, but the Tax Court was only able to consider the evidence in the record. Because the regular statute of limitation for the Ericsons’ 2006 and 2007 returns had already passed, the IRS’s failure to prove that the fraud penalties applied means that for those years, the Ericsons are not only off the hook for the fraud penalties, but also for the additional taxes assessed for those years (over $70,000).

Ericson, T.C. Memo. 2016-107