The implications of the provision found in IRC §6501(c) regarding the statute of limitation on assessing tax when the IRS is faced with a fraudulent tax return is generating much action and disagreement among the courts about exactly whose fraudulent intent can trigger the extended statute and what the nature of such a fraud must be to do so. Since triggering §6501(c) gives the IRS an unlimited period of time in which to assess the tax, the matter is one of true concern if, truly, a taxpayer may find him/herself stuck with the statute due to a fraud committed that they weren’t aware of.
The case that began this saga is the 2007 case of Allen v. Commissioner, 128 TC No. 4. In the Allen case the preparer had prepared a return containing false and fraudulent deductions which served to reduce the taxpayer’s tax. While the taxpayer signed the returns, the IRS conceded that the taxpayer did not have fraudulent intent, apparently not reviewing these items on his return.
In Allen the Court held that as the return itself was fraudulent, the taxpayer had to face the consequences of that fact with regard to the assessment. The court noted that:
“We do not find it unduly burdensome for taxpayers to review their returns for items that are obviously false or incorrect. It is every taxpayer's obligation. Petitioner cannot hide behind an agent's fraudulent preparation of his returns and escape paying tax if the Government is unable to investigate fully the fraud within the limitations period.”
As such, the IRS was given the benefit of the unlimited statute for assessing the tax. The court held that “to find otherwise would allow a taxpayer to receive the benefit of a fraudulent return by hiding behind the preparer.”
Advisers must note that this is a published Tax Court decision (see the citation above) and thus the Court indicates that it will apply this standard for all future similar cases. This has significant implications when an adviser takes on a taxpayer who may have unwittingly used a “less than honest” adviser in prior years.
CITY WIDE TRANSIT CASE
In the case of City Wide Transit, Inc. v. Commissioner, TC Memo 2011-279, the Tax Court attempted to limit the implications of fraud on the part of a tax preparer on the statute of limitations for the IRS to assess a tax—but the Second Circuit disagreed with the Tax Court, finding that the IRS could proceed with assessing unpaid payroll taxes (2013-1 U.S.T.C. ¶50,211).
In City Wide Transit we again have a fraudulent preparer, but a number of different facts lead the Tax Court to a different conclusion. In this case the taxpayer had run into difficulties with the IRS regarding unpaid payroll taxes. The taxpayer engaged an individual who claimed to be a certified public accountant, though it turns out he was not. However this would not be the last, or the most significant, falsehood this representative would put before this taxpayer or the IRS.
The accountant had the taxpayer sign a blank power of attorney form. The accountant informed the taxpayer that he had negotiated a settlement with the IRS, but that a condition of that settlement was that the accountant would have to personally deliver the Forms 941, along with certified checks for the tax due, to the IRS each quarter from now on. In reality nothing of the sort had taken place.
Each quarter the accountant would receive the properly prepared and signed Form 941 from the taxpayer along with a check for the balance due, payable to the IRS. The accountant would prepare a substitute Form 941 he would sign that showed the taxpayer had paid a large sum in advance earned income credit to employees in the quarter and thus show a much smaller balance due. The accountant then altered the check he received, deposited it into an account he controlled, and wrote a check to go with the Form 941 for the much smaller amount of tax due.
He also “solved” the problem of the unpaid earlier taxes by preparing amendments to the prior Forms 941, again claiming large amounts of advance earned income tax credit payments. He then paid out of the funds from the account he was depositing the checks into the much reduced balance.
In reality, the accountant was simply running an embezzlement scam on the taxpayer, a scam that eventually netted him $280,000 of diverted funds. Eventually he was caught and convicted of a number of crimes, including violating of IRC §7206(1) of the IRC regarding tax fraud.
The IRS opened up a civil case against the taxpayer to recover the lost funds, eventually issuing assessment after the end of standard three year limitation on assessing the tax. The IRS argued, relying on Allen, that the statute remained open due to the fraudulent returns filed on behalf of the taxpayer.
The IRS argued that the statute remained open, relying on IRC §6501(c)(2) that the accountant’s actions represented a willful attempt to evade tax. The Tax Court disagreed. The Court found that the accountant had filed false tax forms, but not primarily with the goal of evading taxes, but rather solely to cover up the embezzlement program he was carrying out. The goal had been to steal from the taxpayer, and only incidental to that primary goal was the IRS deceived.
However, the Second Circuit found that the Tax Court had clearly erred in determining that the accountant intended to evade City Wide’s taxes, even though it was to benefit himself rather than the taxpayer. The Second Circuit found fault with the Tax Court’s determination that evading the tax was a secondary or incidental effect of the scam—rather, it was crucial that the taxes be evaded in order for the accountant to pocket those funds that his client believed had been used to pay payroll taxes.
The appellate panel did outline what it found was an example of a different sort of fraud that would not lead to this conclusion. The court stated:
This would be another case if, for example, Beg falsely recorded certain personal expenses as corporate expenses on City Wide's ledger that in turn caused City Wide to file a tax return that fraudulently understated its income. If that had been the case, Beg's fraud on the company would have caused the company to file a false return, and we would not assume that the company intended to evade a tax by filing that false return. Here, however, Beg's actions were not as secondary or remote to the fraudulent returns as the tax court suggested; Beg was not a third party unrelated to the preparation and filing of the returns.
The case emphasizes problems that arise when a taxpayer gets involved with a “bad apple” adviser. It also suggests that keeping a watchful eye on any third parties involved with tax filings for an individual or organization is a key responsibility of the taxpayer. This case makes clear that a “rogue” payroll service could expose the organization to liability for taxes going back for as long as the rogue service can continue to keep a lid on the problem.
Advisers that inherit clients who have been in such situations need to counsel the client about this issue hanging over the taxpayer, and the implications of the continuing daily compounding of interest on the tax that was not paid—compounding that can make paying off the balance due much more costly if the taxpayer decides to “hope” the issue is never raised, only to find their hope misplaced years down the line. Thus advisers must be sure to document that they both advised the client of the option to amend and pay the tax due. Failure to document that fact can lead to problems not only with various regulatory agencies should the client claim never to have been informed of the possibility to amend (the Office of Professional Responsibility for one would be interested), but also exposes the CPA to a civil liability claim raised by the taxpayer looking to be reimbursed for the “excess” interest that is going to pile up under daily compounding.
As well, the IRS has now released a “Fact Sheet” (Fact Sheet FS-2013-9, http://www.irs.gov/uac/Newsroom/Tips-for-Employers-Who-Outsource-Payroll-Duties) describing what steps businesses should take to protect themselves from a situation like this.
BASR PARTNERSHIP CASE
However, there is not agreement that the question of fraud on the part of someone other than the taxpayer is relevant. The Court of Claims voiced its contrary opinion, specifically rejecting the City Wide Transit and Allen analysis in the case of BASR Partnership v. United States, 2013-2 USTC ¶50,527, US Ct. Claims.
The BASR case involved a partnership tax shelter where the deal had been structured by an attorney who, it was conceded for the case, had the requisite fraudulent intent in structuring a deal leading to the return in question. It was also conceded that the individual partners in this case did not have such fraudulent intent.
Since the normal three year statute had lapsed, the IRS was attempting to save the case by arguing that the return itself, due to the work of the advising attorney, was fraudulent, thus triggering the extended statute of limitations under IRC §6501(c)(1).
The taxpayers had a couple of arguments against this. They first pointed out that this was a partnership proceeding which also brought IRC §6229 into the analysis of the statute of limitations. IRC §6229(c)(1) provides its own fraud rule, which provides that:
(1) False return.—If any partner has, with the intent to evade tax, signed or participated directly or indirectly in the preparation of a partnership return which includes a false or fraudulent item—
(A) in the case of partners so signing or participating in the preparation of the return, any tax imposed by subtitle A which is attributable to any partnership item (or affected item) for the partnership taxable year to which the return relates may be assessed at any time, and
(B) in the case of all other partners, subsection (a) shall be applied with respect to such return by substituting “6 years” for “3 years”.
Thus, they argued, since this statute specifically requires that a PARTNER have intent to evade tax, it should override the standard rule at §6501(c).
The Court of Claims rejected this analysis, noting that §6229 provides a minimum period for the statute, but does not override IRC §6501’s general statute of limitations. Thus, effectively, it can only extend the statute but cannot shorten it. Under this view, if the Allen and City Wide analysis is correct, the taxpayer would be out of luck.
But the Court of Claims did not accept the view that the question was whether the return was fraudulent, not whether the taxpayer had fraudulent intent. The Court rejected the analysis in Allen and City Wide and instead found that the statute clearly contemplated a fraudulent intent on the part of the taxpayer in order to open the statute.
The Court agreed with the IRS complaint that the existence of fraud, regardless of who perpetuated it, made it much more difficult to uncover tax understatements, but held that fixing that problem was not a matter for the courts. Rather, the IRS must go to Congress to get the statute changed.
Not unexpectedly the IRS decided to appeal this case, but the Federal Circuit, in a split decision, upheld the lower court ruling (116 AFTR 2d ¶2015-5100). Of interest, though, is that each member of the panel wrote his own opinion and two agreed in result but not in how to arrive at that position, while the third member of the panel concluded that the Tax Court had come to the proper conclusion in Allen.
The main opinion in this case follows the logic of the Court of Federal Claims and decided that §6501 requires the taxpayer to be complicit in the fraud. However the concurring opinion determined that since this was a case of a partnership item, §6501 does not control and rather the statute is governed by §6229. The concurring opinion argues that in the case of fraud related to a partnership governed by the TEFRA rules, §6229(c)(1)’s requirement that there be an intent to evade tax by at least partner is the key issue.
Since, in this case, the conceded fraudulent intent was on the part of the attorney for the partnership and there was no allegation of fraudulent intent on the part of a partner, there was no authority. Unlike the trial court and the main opinion, the concurring holds that §6501 simply isn’t relevant to this case—that is, §6501 fraud must be “separate from any fraud on or flowing from the partnership return.”
As a practical matter that means that, in fact, the concurring opinion never addressed the question of whether §6501 requires fraudulent intent on the part of the taxpayer. There was a majority agreement in result only but not to the issue of whether non-taxpayer fraud can trigger §6501—and, outside a partnership context, it is clear that §6501 would be the governing statutes.
Because of the odd nature of the ruling in this case advisers will need to take care attempting to argue that it overrides Allen or City Wide. But it also means that we may see other courts decide to strike out against the Allen analysis, as it seems that even the Tax Court decided that it produces utterly unfair results when that Court tried (unsuccessfully) to extract the taxpayer in City Wide from its application.