Fraud Penalty Affirmed: In Not-So-Chic Fashion, the Ninth Circuit Upholds Fraud Penalties in Chico

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Jason B. Freeman

Jason B. Freeman

Managing Member

214.984.3410
jason@freemanlaw.com

Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine , a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

In Chico v. Commissioner, the taxpayers challenged the Tax Court’s assessment of a fraud penalty.  The Tax Court had imposed civil fraud penalties against the married taxpayers, finding clear-and-convincing evidence of fraud based on circumstantial evidence—i.e., “badges of fraud,” such as an understatement of income, inadequate records, or concealing assets—and the taxpayer-husband’s specialized knowledge and experience as a tax preparer.

Our firm, of course, covers every substantive Tax Court opinion in our weekly Tax Court in Brief series, in which we have repeatedly covered the topic of fraud penalties, and educates tax professionals about the topic through our Tax Court Exam course.

Fraud Penalties and the Badges of Fraud

In the context of fraud penalties, the Tax Court looks to a number of established “badges of fraud.”  Because fraudulent intent is rarely established by direct evidence, courts typically infer fraudulent intent from various kinds of circumstantial evidence referred to as “badges of fraud,” including:

(1) understatements of income;

(2) inadequate records;

(3) failure to file tax returns;

(4) implausible or inconsistent explanations of behavior;

(5) concealing assets

These—and other—badges (or “flags” or indicators) of fraud may be used by the IRS as a basis to infer the existence of the level of intent necessary to assert a civil fraud penalty under Section 6663 of the Internal Revenue Code or, worse yet, to support criminal tax charges.

The Fraud Penalties in Chico

In the Chico case, the appellate court noted that the record supported the Tax Court’s findings that the Chicos:

(1) understated their income by more than $275,000 over three years;

(2) produced no “adequate records” to substantiate the figures reported on their tax returns;

(3) failed to file tax returns for Lakewood Patient Resource Center even after being asked to do so by the Revenue Agent with the IRS in 2016;

(4) implausibly attributed their underreported income to nontaxable investments from an inheritance when the Revenue Agent accurately characterized the majority of these transfers as nontaxable;

(5) concealed income from Lakewood by failing to report constructive dividends received in 2011 and reporting only some of the income they received in 2010; and

(6) failed to cooperate with the Revenue Agent’s investigation by ignoring his early requests for interviews and blaming their attorney for failing to produce adequate records.

In evaluating the existence of fraud, courts look to the taxpayer’s entire course of conduct and no particular “badge” or indicator is essential or determinative.  One badge, in and of itself, may be deemed sufficient.  However, a combination of multiple badges strengthens the government’s case for fraud penalties.

Here, the appellate court further noted that “[t]he Tax Court also considered these badges of fraud in the context of Mr. Chico’s specialized knowledge and experience on ‘corporate and business taxation’ as a tax preparer himself to find even stronger circumstantial evidence of fraud.”  Of course, a taxpayer’s background as a tax preparer generally results in the taxpayer being held to a higher standard of knowledge and conduct.  Based on its review of the badges of fraud and evidence in the record, the Ninth Circuit upheld the Tax Court’s imposition of fraud penalties, finding “no clear error in the Tax Court’s finding that the total weight of these badges provided clear and convincing evidence of the Chicos’ ‘specific intent to avoid a tax known to be owing.’”

 

For more information about our firm’s tax litigation practice, click here.