In Ward v. Commissioner, T.C. Memo. 2013-133 (May 29, 2013), Mr. Ward sought redetermination of an IRS proposed deficiency on a number of grounds. This post addresses only his disputation of the civil fraud penalty proposed.  Judge Kerrigan’s decision contains a clear summary of the factors justifying imposition of the civil fraud penalty under Section 6663 which provides:

Sec. 6663. Imposition of fraud penalty
    (a) Imposition of penalty
      If any part of any underpayment of tax required to be shown on a
    return is due to fraud, there shall be added to the tax an amount
    equal to 75 percent of the portion of the underpayment which is
    attributable to fraud.
    (b) Determination of portion attributable to fraud
      If the Secretary establishes that any portion of a underpayment
    is attributable to fraud, the entire underpayment shall be treated
    as attributable to fraud, except with respect to any portion of the
    underpayment which the taxpayer establishes (by a preponderance of
    the evidence) is not attributable to fraud.
    (c) Special rule for joint returns
      In the case of a joint return, this section shall not apply with
respect to a spouse unless some part of the underpayment is due to the fraud of such spouse

What is fraud?

“Fraud is an intentional wrongdoing on the part of a taxpayer with the specific purpose to evade a tax believed to be owed. Sadler v. Commissioner, 113 18*18 T.C. 99, 102 (1999).”

Why is the penalty imposed?

 The penalty in the case of fraud is a civil sanction provided primarily as a safeguard for protection of revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer’s fraud. Helvering v. Mitchell, 303 U.S. 391, 401 (1938); Sadler v. Commissioner, 113 T.C. at 102.

Who bears the burden of proof?

“The Commissioner has the burden of proving by clear and convincing evidence an underpayment for each year in issue and that it is due to fraud. Sec. 7454(a); Rule 142(b). The Commissioner must show that the taxpayer intended to conceal, mislead, or otherwise prevent the collection of taxes. Katz v. Commissioner, 90 T.C. 1130, 1143 (1988).”

What portion of the tax liability will be deemed attributable to fraud?

 “If the Commissioner establishes that any portion of the underpayment is attributable to fraud, the entire underpayment shall be treated as attributable to fraud and subject to a 75% penalty, unless the taxpayer establishes that some part of the underpayment is not attributable to fraud. Sec. 6663(a) and (b).”

How are spouses who filed jointly treated?

“In the case of a joint Federal income tax return, the section 6663 penalty “shall not apply with respect to the spouse unless some part of the underpayment is due to the fraud of such spouse.” Sec. 6663(c).”

How is civil fraud established?

“The existence of fraud is a question of fact to be resolved upon consideration of the entire record. King’s Court Mobile Home Park, Inc. v. Commissioner, 98 T.C. 511, 516 (1992). Fraud may be proved by circumstantial evidence and inferences drawn from the facts because direct proof of a taxpayer’s  intent is rarely available. Niederinghaus v. Commissioner, 99 T.C. 202, 210 (1992). The taxpayer’s entire course of conduct may establish the requisite fraudulent intent. DiLeo v. Commissioner, 96 T.C. at 874; Stone v. Commissioner, 56 T.C. 213, 223-224 (1971). Fraudulent intent may be inferred from various kinds of circumstantial evidence, or “badges of fraud”, including the consistent understatement of income, inadequate records, implausible or inconsistent explanations of behavior, concealing assets, and failure to cooperate with tax authorities. Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), aff’g T.C. Memo. 1984-601.”

What facts, in the court’s own words, established fraudulent intent in the Ward case?

• Petitioner (Mr. Ward) had a pattern of underreporting his income for all tax years in issue. (Note IRS and Mr. Ward agreed that Mrs. Ward was entitled to innocent spouse relief as to items in return attributed to Mr. Ward).
• Petitioner’s bank deposits did not match the income reported on petitioners’ Federal income tax returns.
• There was also a discrepancy in the amounts of income on the Federal income tax returns filed and the tax returns provided to banks as part of a loan application.
• The pattern of understatement is evidence of fraud.
• Petitioner failed to maintain records, as required by law, that would disclose his correct taxable income.
• Petitioner was unable to explain deposits made into his bank accounts.
• Petitioner has a background in tax return preparation and was in the business of preparing tax returns. He was a member of the National Association of Tax Practitioners.
• Given his education and work experience the court assumed that he would have a working knowledge of the tax laws and understands that records should be kept.
• IRS investigated petitioners for filing fraudulent tax returns, and petitioner was convicted of tax evasion. (Note: criminal tax evasion requires a higher burden of proof on the government, “beyond a reasonable doubt.”  At trial petitioner stated: “I will admit that we did abuse section 179.” With respect to a fictitious section 1031 like-kind exchange petitioner stated: “We screwed up and we missed a deadline and we didn’t handle that one right.”
• IRS showed that there was a repeated history of underpayment of tax due to underreported income. Petitioner’s bank deposit income did not match the income reported on his tax returns.
• IRS proved by “clear and convincing” evidence that petitioner intended to avoid taxes by concealing income through the S corporations.
• Petitioner had no plausible explanation for why the income was not reported.
• Also, obviously a factor was the large dollar amount of the deficiencies:

YEAR

$ TAX DEFICIENCY 

$ FRAUD PENALTY 

2002

426,983

320,237

2003

357,051

267,788

2004

608,247

452,991

2005

1,133,907

851,968

2006

1,092,585

820,280

2007

1,082,079

827,927

The IRS will always assert the civil fraud penalty following a criminal tax conviction for evasion.  IRS will also assert the penalty when appropriate, when “clear and convincing” evidence of fraud is felt to exist which may not rise to the level of “beyond a reasonable doubt,” the burden of proof imposed upon the government for a criminal conviction.  The above table illustrates how financially devastating the penalty can become.

Fraud, civil or criminal, is usually sniffed-out by IRS agents from indirect proof, when bad facts start to pile-up into a mountain of evidence exhibiting willful conduct and intent to evade taxes, not file a return or falsify a filed return.  That is why tax filers should pay attention and avoid careless errors in returns, which taken alone may be innocent enough, but not thought so, when other more serious items or actions are also discovered. 

Copyright 2013 by Robert S. Steinberg, Esquire
All rights reserved