Tax Court Reverses Fraud Penalty

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Tax Court Reverses Fraud Penalty

In a decision earlier this year in Ugorji Timothy W. Onveani v. Commissioner, (2020) T.C. Memo 2020-15, the tax court reversed the IRS’s assessment of fraud penalties against a taxpayer. The decision demonstrates that, for purposes of assessing fraud penalties against a taxpayer, the existence of fraudulent activity is not necessarily dispositive.

The case arose from suspected fraudulent banking activity on the part of Mr. Onveani, a Nigerian-born U.S. citizen. Mr. Onveani’s company, American Hope Petroleum & Energy Corp. (AHPE), falsely claimed to be an independent crude oil purchasing and selling broker and entered fraudulent purchase agreements. The IRS was informed by the U.S. Secret Service that Mr. Onveani was being investigated for fraud due to suspicious banking activity, and assessed a §6851(a) termination of Mr. Onveani’s bank accounts.

After using a bank deposits analysis to reconstruct Mr. Onveani’s income, the IRS determined he had received gross income of at least $802,083 based on deposit activity. The IRS concluded he owed $288,546 plus estimated interest, prompting the IRS to issue a levy for $289,043 to Harris bank, where Mr. Onveani had an account. The bank withdrew this amount and placed it into escrow pending resolution of Mr. Onveani’s challenge to the levy. Mr. Onveani withdrew the remaining funds from his account. The District Court held that the termination assessment and levy were reasonable, and Harris paid the funds in escrow to the IRS.

On August 15, 2015, Mr. Onveani sent a wire transfer of $400,000 from his company’s TCF account to Pierre Yenokian, a buyer who alleged he had been defrauded, to settle his obligations to him. Mr. Onveani also made two wire transfers totaling $35,000 to unknown recipients.

After examining Mr. Onveani’s 2015 tax return and relying on the original bank deposits analysis, the IRS determined that he had failed to report $802,083 of taxable income and issued to Mr. Onveani and his wife a notice of deficiency in the amount of $273,407, assessed a civil fraud penalty of $205,055 against Mr. Onveani, and in the alternative, an accuracy-related penalty of $54,681. Mr. Onveani petitioned for a redetermination of the deficiency and penalties.

Bank Deposit Analysis

As Mr. Onveani’s records did not clearly reflect his income, the court noted that the bank deposits method was appropriate to reconstruct his income, noting that “[t]he bank deposits method assumes that all money deposited in a taxpayer’s account during a given period constitutes taxable income, but the Government must take into account any nontaxable source or deductible expense of which it has knowledge.”

The court analyzed the banking deposits analysis conducted by the IRS. Mr. Onveani’s Bank of America accounts were terminated due to suspected fraud, and Mr. Onveani deposited the cashier’s checks he received into an account at Harris Bank. The analysis noted that all funds in Mr. Onveani’s Harris account were derived from AHPE’s Bank of America accounts, which had received deposits of at least $806,985 from companies and a personal check. The court agreed that this constituted prima facie evidence of income. However, the court determined that the IRS had erred by not reducing Mr. Onveani’s 2015 income by the $400,000 payment he wired to a Pierre Yenokian.

Assessment of Fraud Penalty

After determining that the assessment of the fraud penalty had met the proper predicate approval requirements, the court analyzed whether the penalty assessment was proper.

The court noted that to impose a fraud penalty, the IRS “must show that there was ‘an underpayment of tax’ on petitioner’s 2015 return.” “Underpayment” is defined under §6664(a)(1) as “the amount by which tax imposed for the year . . . exceeds the sum of ‘(A) the amount shown as the tax by the taxpayer on his return, plus (B) amounts not so previously assessed (or collected without assessment).’” Sec. 1.6664-2(a) further defines “amounts not so shown previously assessed” as “amounts assessed before the return is filed that were not shown on the return, such as termination assessments under section 6851.” (citations omitted).

The court determined that there was no underpayment of tax for 2015, as the aggregate of the “amount shown as tax” of $2,2721 and the “amount not so shown previously assessed” — the termination assessment of $288,546 — exceeded Mr. Onveani’s 2015 tax liability of $276,128. Thus, the court concluded the fraud penalty did not apply.

Further, the court determined that the IRS failed to prove fraud by clear and convincing evidence, which required the Commissioner to demonstrate that the taxpayer “intended to evade taxes that he knew or believed were owed.” (citations omitted.)  The court noted that as funds to pay the tax were being held in escrow, it was not realistically possible to evade the tax. By omitting $802,083 on his 2015 return, the court stated that Mr. Onveani was merely preserving the position that he was taking in court that the assessment was improper, even if his arguments were ultimately rejected by the court.

The court also noted that, though the IRS contended that Mr. Onveani satisfied certain “badges of fraud” that may indicate fraudulent intent — including failure to maintain accurate books and records, a history of failing to file tax returns, and many suspect transactions — for the purposes of assessing a fraud penalty, the issue was whether any underpayment on the 2015 tax return was due to fraud against the IRS rather than whether third parties were defrauded. No fraud against the IRS was found, as the court had deemed the omission of the $802,083 a preservation of Mr. Onveani’s argument against the assessment. Because the court determined there was no underpayment, the court also declined to hold Mr. Onveani liable for accuracy-related penalties.

This decision demonstrates that fraudulent behavior or schemes to defraud a third party are not sufficient to determine fraud for the purposes of assessing civil fraud penalties. Rather, the question is whether there is an underpayment of tax on a tax return and whether such underpayment is due to fraud against the IRS. While fraudulent activity with respect to other parties may be at issue for other types of tax-related actions, for the purposes of fraud penalties, it is not dispositive.