The Tax Court held that the extended statute-of-limitation period under Sec. 6501(c)(1) applied to the taxpayers' returns because the IRS had proved clearly and convincingly that the taxpayers' preparer had prepared the returns falsely or fraudulently with the intent to evade tax.
Background
Joan Finnegan worked at a community college and her husband, John, worked as a plumber. The Finnegans, who lived in New York, owned a condominium in Daytona Beach, Fla. During the years in question (1994 through 2001), the Finnegans did not use the condo themselves but rented it out through a real estate rental company in Daytona.
After their original accountant moved, the Finnegans hired Duane Howell to prepare their tax returns. Howell advised the couple to form a partnership to report the condo rental activity, claiming (incorrectly) that this would allow them to contribute income they received from renting the condo to a Keogh plan account. The Finnegans agreed and with Howell's help set up a partnership named Jomarjen, through which the rental activities of the condo were reported on Schedule E, Supplemental Income and Loss, of the Finnegans' returns for all the years in question. The Finnegans, however, did not transfer title to the condo to the partnership and otherwise did not change anything concerning the operation of the condo rental.
Between 1994 and 2001, the Finnegans did contribute some money to a Keogh account. Howell told the Finnegans how much to contribute each year, but they did not always contribute those amounts, and Joan Finnegan testified that she could not recall whether Howell entered his suggested contribution amounts on their returns.
Howell also invented another partnership, Gannan Co., to help out the Finnegans. For five of the tax years in question, partnership returns for Gannan were filed showing the Finnegans as its sole owners, and the partnership was listed on Schedule E of the couple's returns. The Finnegans, apparently not the inquisitive sort, claimed that they had never heard of Gannan Co. until the IRS examined their returns.
On examination, the IRS noticed a peculiarity on the Finnegans' returns that it had also noticed on returns of other clients of Howell. The returns included amounts for certain expenses that were identical over returns and years, for the most part with vague descriptions, and for each Form 1040, U.S. Individual Income Tax Return, the Finnegans showed $2 of net income on Schedule C, Profit or Loss From Business. Also, the returns did not list Howell as the preparer and listed a different preparer and address for each year. In addition, there were various peculiarities related to the partnerships and their returns, including a Form 1099, Miscellaneous Income, from Gannan Co. to John Finnegan for nonemployee compensation of $86,000, money he testified at trial that he did not recall receiving.
Duane Howell: Howell prepared approximately 750 to 800 returns for the years 1992 to 2003. In another trial, he testified that every return he prepared included at least some fraudulent entries. As he had for the Finnegans, he commonly set up false partnerships for clients because he believed that the IRS was less likely to investigate partnerships than other entities, and he advised many clients to set up Keogh plans and took deductions for contributions to the plan accounts without verifying if they had been made. For all his clients, Howell did not list his own name as preparer, instead using a variety of entity names for which he had different P.O. box addresses. Howell did this to ensure that returns for different client years went to different IRS service centers and that a client's individual and related partnership returns for a particular year did not go to the same service center.
Howell's misdeeds did not begin in 1992, however. Previously, Howell had been a CPA but had lost his license in the 1980s due to a conviction for preparing false returns. After catching wind of Howell's continuing shenanigans, the IRS opened a new investigation. The investigation ended with Howell pleading guilty to conspiring to commit an offense or to defraud the United States and attempting to interfere with the administration of internal revenue laws.
As part of the investigation, IRS special agents were able to identify common characteristics on returns prepared by Howell, including (1) large refunds and partnership losses; (2) purported payments between partnerships and their respective partners; (3) the filing of partnership returns with different Internal Revenue Service Centers from year to year; (4) partnerships whose addresses changed every year; and (5) the issuance of Forms 1099-MISC to partners or other partnerships.
Other common characteristics of returns prepared fraudulently by Howell included repeating numbers for expenses, all of which were created by Howell and not supplied by his clients; income on Schedules C that netted to exactly $2; deductions for Keogh/self-employment retirement plans, along with guaranteed payments based upon a client's desired retirement plan contribution or deduction; and purported transfers between Schedules C and related partnerships that were reported as expenses.
As part of its investigation of Howell, the IRS reviewed the Finnegans' returns. As a result of this review, the IRS issued the Finnegans a notice of deficiency for taxes and accuracy-related penalties related to the couple's reported Schedule E partnership losses, Schedule C deductions, and Keogh plan deductions on their returns for 1994 through 2001. The Finnegans challenged the IRS's determination in Tax Court, arguing that the limitation period had expired for those years and that the open-ended assessment period under Sec. 6501(c)(1) for a false or fraudulent return with the intent to evade tax did not apply.
The Tax Court's Decision
The Tax Court held that a portion of each of the Finnegans' underpayments for 1994 through 2001 was attributable to fraud and, therefore, the Sec. 6501(c)(1) extended limitation period applied for those years. The court, after reviewing the evidence, found that part of the underpayment for each year was due to fraud because the IRS had proved by clear and convincing evidence that Howell placed false entries on the Finnegans' returns with the intent to evade tax.
The court explained that as it had previously held in Allen, 128 T.C. 37 (2007), Sec. 6501(c)(1) applies even if the preparer of a return, and not the taxpayer, falsely or fraudulently prepares the return with the intent to evade tax. Also, the definition of fraud for purposes of Sec. 6501(c)(1) is the same as it is for purposes of the Sec. 6663 fraud penalty, and thus the IRS must prove that (1) an underpayment of tax exists and that (2) the intention (of the taxpayer, or as in the Finnegans' case, the return preparer) was to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of tax.
The court further explained that fraud cannot be presumed and must be proved by clear and convincing evidence, and its existence is a factual determination based on the entire record. However, the IRS does not have to prove intent by direct evidence, and a finding of fraud can be based on indicia of fraud such as understatements of tax, inadequate books and records, implausible or inconsistent explanations of behavior, and making false entries or alterations.
With regard to the underpayment of tax element, the Finnegans stipulated that if the court concluded the Sec. 6501(c)(1) assessment period applied, they would concede the determined deficiencies. Thus, the court was not required to look for further proof of an underpayment, although the court stated that the evidence showed that there were erroneous entries on the returns that resulted in underpayments.
To prove the existence of the second element, the IRS relied on the characteristics of the Finnegans' returns that matched Howell's modus operandi in cases in which he admitted to preparing fraudulent returns. Although Howell did not testify at the Finnegans' trial about his procedures, he had testified about them in another taxpayer's trial. The IRS argued it could be inferred from these similarities, as well as the evidence introduced by the IRS and the testimony of IRS agents, that Howell prepared each return in issue with the intent to evade tax.
The Tax Court agreed with the IRS, finding that the Finnegans' returns included many of the characteristics of returns that Howell had admitted to preparing fraudulently. The first example the court cited was the nonexistent Gannan Co. partnership. The Finnegans claimed that the inclusion of the partnership in their returns could have been a simple mistake by Howell. The court however, found this to be implausible given that Howell had testified that one of his methods for producing fraudulent returns involved fabricating partnerships with guaranteed payments.
The Finnegans also contended that the fact that their individual and partnership returns were "consistent with" other fraudulent returns prepared by Howell was subjective and not proof of fraud. The Tax Court, however, concluded it was, noting that the IRS had shown that specific elements of the Finnegans' returns matched Howell's modus operandi, including (1) Schedule C income of $2 (the balance being transferred over to a partnership), (2) two new partnerships that the Finnegans did not form until engaging Howell's services, (3) an entire partnership with which the Finnegans were unfamiliar, (4) repeating entries of certain figures that Howell testified he routinely used when fabricating returns, (5) large partnership losses, and (6) deductions for Keogh/self-employed retirement accounts when the Finnegans earned wages. The court also found that the existence of repeating figures and Howell's use of multiple preparer names and addresses on the Finnegans' returns were probative evidence of fraudulent intent.
The court asserted that the case was similar to Eriksen, T.C. Memo. 2012-194, in which it held that one of six taxpayers' returns had been fraudulently prepared. In that case, the court held against the one taxpayer because that taxpayer, unlike the others, had testified her return included deductions for expenses she had not incurred. That testimony, along with evidence showing that the expenses were of the type the preparer had been guilty of fabricating and other badges of fraud, was enough proof for the court that the returns were false or fraudulent.
The Finnegans posited that the Eriksen case stands for the proposition that the IRS must established a direct link between the commission of fraud and the return in question, and they implied that only way to establish the direct link in their case was through Howell's testimony. The court disagreed, stating that the case showed that "there are ways of providing an evidentiary link that do not involve a preparer's specific testimony as to a particular taxpayer."
Reflections
While honest tax practitioners will presumably never be involved directly in a situation like the one in this case, they may run into similar circumstances with new clients who previously worked with unscrupulous preparers. In advising a client in such a situation about his or her responsibilities with respect to a fraudulently prepared return, the practitioner should make sure that the client understands that due to the open-ended statute of limitation for returns with even partial underpayments due to fraud, the problem will not go away with the passage of time.
Finnegan, T.C. Memo. 2016-118
