The Tax Court in the case of Finnegan v. Commissioner, TC Memo 2016-118 a question the court had dealt with before in the 2007 case of Allen v. Commissioner, 128 TC No. 4. If the taxpayer hires a “less than fully ethical” tax preparer that, in an effort to gain and retain business, prepares returns that fraudulently understate the taxpayer’s tax, can the IRS use the fraud rule to argue that the statute of limitations on that return never closes—even if the taxpayer was never aware of the fraudulent nature of the return?
In Allen the Tax Court held that the answer was yes—a fraudulent return keeps the statute open even if the taxpayer him/herself did not have the required fraudulent intent in filing the return to evade the payment of tax. So you’d expect this would be a simple question for the Court to answer—but in the interim a federal appeals court in the case of BASR Partnership v. United States, CA FC (2015), 116 AFTR 2d ¶2015-5100 had rejected that view in dealing with flow through items from a partnership return where there had existed fraudulent intent at the partnership level.
Or, I should say, had sort of rejected that view. In reality the three judge panel each wrote opinions that separately arrived at an answer of whether the statute was open, with one completely rejecting the Allen analysis, another writing a narrow opinion that held the statute wasn’t open due to technical details relating to this flowing from a TEFRA partnership and the third agreeing with the Allen analysis.
Nevertheless the Finnegan case presented the Tax Court with its first chance to revisit the issue following the issuance of the BASR opinion. Those who thought the Tax Court might be persuaded to change its views would be quickly disappointed, as the Tax Court made clear in a footnote that it doesn’t consider BASR to be reason to revisit the idea of who must have the fraudulent intent it had dealt with in Allen.
As opinion notes in footnote 6:
We see no reason to revisit Allen v. Commissioner, 128 T.C. 37 (2007), on account of BASR P'ship v. United States, 113 Fed. Cl. 181 (2013), aff'd, 795 F.3d 1338 (Fed. Cir. 2015). In the Court of Appeals for the Federal Circuit's opinion, a persuasive dissent was filed, as well as a concurring opinion that relied on sec. 6229, a provision inapplicable in the instant case. Accordingly, even in cases appealable in the Federal Circuit, it is unclear whether, in the absence of the application of sec. 6229, which interpretation of sec. 6501(c)(1) would prevail. Moreover, there is no jurisdiction for appeal of any decision of the Tax Court to the Court of Appeals for the Federal Circuit. Sec. 7482(a)(1). Additionally, the parties have not cited BASR P'ship and do not contend we should revisit Allen. Thus, Allen is controlling precedent in the instant case, and we do not revisit the analysis and conclusion in that Opinion.
In this case the preparer that the taxpayer had used had been indicted for his actions in preparing the returns and had entered into plea agree in 2007 where he plead guilty to such conduct. Like a number of other preparers who stopped worrying about troubling details like the actual facts or the state of the law, his returns for each taxpayers tended to have a number of identical items that related to the fraudulent attempt to reduce the tax.
As the Court pointed out:
During the investigation, the special agents ordered and examined the original individual income tax returns and the related partnership returns of Mr. Howell's clients, as well as transcripts from the Internal Revenue Service's Integrated Data Retrieval System. The special agents were able to identify common characteristics on returns prepared by Mr. Howell, including: (a) large refunds and partnership losses; (b) purported payments between partnerships and their respective partners; (c) the filing of partnership returns with different Internal Revenue Service Centers from year to year; (d) partnerships whose addresses changed every year; and (e) the issuance of Forms 1099-MISC to partners or other partnerships.
Other common characteristics of returns prepared fraudulently by Mr. Howell included repeating numbers, such as expenses of $312, $364, $499, $572, $4,896, all of which were created by Mr. 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.
Some of these steps, like filing with multiple IRS Service Centers and varying the name of the paid preparer, were meant to frustrate any IRS attempts to link the returns together to realize what was actually happening. And some were just plain laziness (using the exact same numbers for nonexistent expenses), presumably making it easier to “automate” the fraud.
In the case of the taxpayers in this case, the preparer had suggested they form a partnership with their rental property where each spouse would be a partner, and then fund a Keogh plan based on the rental income. Of course, there’s the minor problem that the rental income doesn’t represent earned income on which a Keogh deduction can be claimed. He eventually also “created” another partnership, this one wholly fictitious, which generated losses and a flurry of fictitious information returns (including 1099-MISC) to make it appear like a truly functioning partnership.
As the Court noted:
Mr. Howell (the preparer) also set up false partnerships that were not connected with any existing businesses or activities. Mr. Howell believed partnerships were less vulnerable to audits than sole proprietorships reported on Forms 1040, Schedule C, and so he placed false income and expenses on partnership returns and used the partnership form to avoid scrutiny from the Internal Revenue Service. The false expense deductions that Mr. Howell placed on the partnership returns created large losses that flowed through to the clients' individual income tax returns, thereby lowering their income tax liabilities. Mr. Howell prepared Forms 1099-MISC and Forms 1096, Annual Summary and Transmittal of U.S. Information Returns, that maintained the appearance of legitimate partnerships, and reported purported payments made by the partnerships to related partnerships or partners.
The taxpayer’s main defense was that the IRS did not have the preparer testify in this case, thus they argued the IRS could not show the requisite fraudulent intent. The Tax Court did not agree, nothing that most often fraud is shown by extrinsic evidence, not a full-blown confession by the misbehaving party. And, in any case, the preparer had testified elsewhere that “every return he prepared included at least some fraudulent entries, and because of these false entries, was ‘dirty’.”
The Court noted that the taxpayer’s returns showed a number indications of fraud, including:
- The repeating figures that were a key part of the fraudulent return scheme of the preparer
- The creation of false partnerships with losses flowing on the return that created similarly false information returns that were also a key component of the preparer’s fraudulent scheme
- The random changes in the paid preparer organization (all of which were really the same preparer) and IRS Service Center in which returns were filed to avoid detection
The Court distinguished these facts from those in the case of Eriksen v. Commissioner, noting:
Comparing the instant case to Eriksen v. Commissioner, 2012 WL 2865875, is instructive. Eriksen involved six taxpayers whose return preparer was convicted of preparing false and fraudulent returns with the intent to evade tax. In Eriksen, the taxpayers’ returns were not included among the 51 returns considered as part of the preparer's guilty plea. Id. at *4. Although the preparer testified in Eriksen, he was unable to recall at trial preparing any of the returns there in issue. Id. at *2. The Court held for five of the taxpayers but against the sixth. The key distinction of the sixth taxpayer, although she had not committed fraud herself, was her testimony that her return included deductions for expenses she had not in fact incurred. Id. at *12. The Commissioner then established that the expenses were of the type the preparer had pleaded guilty to fabricating. Id. Viewing these facts in conjunction with other badges of fraud, the Court determined that the sixth taxpayer's returns were false or fraudulent. Id.
While the taxpayers were citing Eriksen as standing for the proposition that they shouldn’t be held liable, the Court noted they were like the one taxpayer who was found to be subject to the open fraud statute—the IRS was able to link the return to the fraudulent pattern of the preparer because of similar deductions. So the Court found that, in fact, Eriksen supported the methods the IRS had use to establish the applicability of the fraud statute in this case.
The Court also decided that the taxpayers should be subject to accuracy related penalties, as their ignorance of the preparer’s fraud existed principally because they had shirked their duty to actually review the returns they received.
As the Court noted:
For purposes of section 6662, the term "negligence" includes any failure to make a reasonable attempt to comply with the income tax provisions of the Code. Sec. 6662(c). This includes failing to make "a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a [*29] reasonable prudent person to be 'too good to be true' under the circumstances". Sec. 1.6662-3(b)(1)(ii), Income Tax Regs. Taxpayers should be able to show, at a minimum, that they fulfilled a duty of inquiry with regard to whether their return properly reported their tax liability. Eriksen v. Commissioner, 2012 WL 2865875.
Petitioners testified that they signed and filed the returns Mr. Howell prepared for them without reading them. We do not doubt this testimony, as petitioners filed returns for an entire partnership, which was also reflected on their personal return, without noticing that it was wholly unrelated to their affairs. Petitioners were unfamiliar with even the most basic line items on the returns, such as their professions, addresses, and total income. Respondent has shown that petitioners failed to fulfill their duty of inquiry. See id. Petitioners' failure to review the returns is especially reckless considering that the sizes of their returns and refunds grew significantly when they became clients of Mr. Howell. These were signals that Mr. Howell's changes may have been "too good to be true" and petitioners should have made reasonable attempts to ascertain the correctness of the new deductions. See sec. 1.6662-3(b)(1)(ii), Income Tax Regs. Petitioners, in fact, recognize that a lack of review can give rise to an inference of negligence, and are silent as to any defense against the penalties. Consequently, we conclude [*30] that respondent has met his burden of production for determining accuracy-related penalties due to negligence or disregard of rules or regulations.