The Tax Court in Brief – September 12th – September 16th, 2022
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Tax Litigation: The Week of September 12th, 2022, through September 16th, 2022
- Fabian v. Comm’r, T.C. Memo 2022-94| September 13, 2022 | Halpern, Judge | Dkt. No. 25589-14
- Estate of Clemons v. Comm’r, T.C. Memo. 2022-95| September 16, 2022 | Buch, J. | Dkt. No. 25029-16
Degourville v. Comm’r, T.C. Memo. 2022-93 | September 12, 2022 | Wells, J. | Dkt. No. 4369-16
Short Summary: During the 2012 tax year, petitioner was married and resided in the same household with her husband. Petitioner solely owned and operated two businesses directly— a hair salon and a tax preparation business—and she and her husband jointly owned a restaurant. Petitioner and her husband kept bank accounts to manage cashflow from each of these businesses.
In 2012 and 2013, petitioner used cash to purchase four properties in Georgia for $23,000, $20,000, $52,000, and $90,000 respectively. On this last property, petitioner and her husband later paid $366,436 by personal and cashier’s checks for the construction of a home. Between 2010 and 2013, petition also used cash to purchase five automobiles and a motorcycle.
In 2014, the Internal Revenue Service (“IRS”) assessed a return preparer earned income tax credit (“EITC”) due diligence penalty of $45,000 for the 2012 taxable year under I.R.C. § 6695(g).
In 2016, the State of Georgia convicted petitioner of one count of state tax evasion (for failing to report income on her state individual income tax return) and one count of theft by taking (for improperly filing her tax preparation clients’ state income tax returns). At her state criminal trial, petitioner testified that her tax preparation business generated $552,865 in gross receipts in 2012 and that $168,466 of these gross receipts was reported as profit on her amended state income tax return for that year. She also testified that her hair salon generated $150,000 in revenues in 2012 and that her and her husband’s restaurant incurred a substantial loss that year.
Petitioner and her husband each separately filed their own Form 1040, U.S. Individual Income Tax Return, for 2012 electing the head of household filing status. Petitioner later conceded that the address she listed on the return was where her mother lived. Petitioner and her husband also each claimed the EITC for 2012 on their respective returns. In the two Schedules C, Profit of Loss from Business, attached to petitioner’s return, petitioner reported gross receipts of $20,316 for her hair salon and $15,811 for her tax preparation business. On these Schedules C, petitioner claimed various deductions, including $18,300 in rent/lease expenses for the hair salon and $5,000 in commission expenses for the tax preparation, resulting in reported net profits of $980 for the hair salon and $9,088 for the tax preparation business.
The IRS began an examination of petitioner’s 2012 return and requested that petitioner produce records of her income-producing activities in that year. Petitioner failed to provide such records, claiming that they were being held by Georgia state authorities as part of the state’s criminal investigation. In the absence of these records, the IRS conducted a bank deposit analyses on the bank accounts that petitioner held with her husband in order to determine petitioner’s 2012 adjusted gross income. These analyses showed that $1,054,255 was deposited into these bank accounts in 2012, of which $911,033 were unexplained. Based on this information, and after taking into account properly allowed business expenses and computational adjustments, the IRS determined that petitioner had unreported gross receipts of $439,705. The IRS also adjusted petitioner’s filing status from head of household to married filing separately, disallowed petitioner’s claim to the EITC, disallowed the lease/rent expenses claimed for the hair salon and the commission expenses claimed for the tax preparation business, and asserted the civil fraud penalty against petitioner.
- Were the IRS’s unreported income adjustments entitled to a presumption of correctness?
- Was the IRS’s determination that petitioner had unreported gross income in error?
- Was the IRS’s adjustment of petitioner’s filing status from head of household to married filing separately in error?
- Was the IRS’s disallowance of petitioner’s claimed EITC in error?
- Was the IRS’s disallowance of petitioner’s claimed Schedule C expenses in error?
- Was petitioner liable for the civil fraud penalty?
- Should the Tax Court “approve” the IRS’s EITC 10-year ban due to fraud?
- The Tax Court found that the IRS’s unreported income adjustments were entitled to a presumption of correctness. The IRS showed that petitioner directly operated two businesses and received distributions from a third business that she co-owned with her husband. These businesses were capable of producing the substantial amounts deposited into her and her husband’s bank accounts in 2012. Petitioner failed to provide evidence showing that the IRS’s determinations regarding her bank deposits were arbitrary or erroneous. Thus, the IRS had laid the requisite minimal evidentiary foundation for the unreported income adjustments, and they were entitled to a presumption of correctness.
- The Tax Court found the IRS’s determination that petitioner had unreported gross income was not in error. The IRS introduced credible evidence that petitioner failed to submit complete and adequate records for 2012 and that petitioner’s business interests were a likely source of the deposits made into her and her husband’s bank accounts. Thus, it was reasonable for the IRS to reconstruct petitioner’s income using the bank deposits method. Petitioner’s testimony in her state criminal trial supported the conclusion that her business interests likely produced the amounts deposited into her and her husband’s banks accounts. Moreover, petitioner did not assign error to the IRS bank account analyses and did not provide evidence to support her claims that the IRS’s determinations were in error because certain deductions should be allowed for fees paid and losses incurred by her businesses.
- The Tax Court found that the IRS’s adjustment of petitioner’s filing status from head of household to married filing separately was not in error. Petitioner and her husband lived within the same household in 2012 and were not legally separated during that time. Thus, petitioner did not meet the requirements for head of household status.
- The Tax Court found that the IRS’s disallowance of petitioner’s claimed EITC was not in error. Because petitioner and her husband were married, not legally separated, and shared the same household during the year in issue, they were required to file a joint income tax return to qualify for the earned income tax credit. Moreover, the Tax Court opined that petitioner likely would not have qualified for the earned income tax credit even if she had filed jointly with her husband because of the couple’s substantial unreported gross receipts.
- The Tax Court found that the IRS’s disallowance of petitioner’s Schedule C expenses was not in error. Petitioner failed to produce documentation relating to these expenses.
- The Tax Court found that petitioner was liable for the civil fraud penalty.
- First, the Tax Court used its broad discretion to grant the IRS’s request to reopen the record to admit as additional evidence to admit the IRS’s Civil Penalty Approval Form, finding the form was not cumulative, was material to the penalty issues in the case, and probably would change the outcome of the case. Because this form showed that the IRS group manager approved the civil fraud penalty for petitioner’s 2012 tax year before the IRS sent the notice of deficiency, the Tax Court determined that that the procedural requirements for the IRS to impose the civil fraud penalty were met.
- Second, the Tax Court found that the IRS had clearly and convincingly shown that petitioner failed to report income from her businesses in 2012, that this failure resulted in an underpayment of tax, and that petitioner had the required fraudulent intent. In particular, the IRS provided evidence of the following “badges of fraud”:
- the IRS’s bank deposits analysis showed that petitioner substantially understated gross receipts from her businesses resulting in a substantial understatement of income on her 2012 return;
- petitioner was engaged in more than one illegal activity in 2012, including petitioner’s repeated failure to comply with due diligence requirements when determining her clients’ eligibility to claim the EITC, which resulted in her being assessed the return preparer EITC due diligence penalty, and the conduct for which she was convicted in the state criminal case;
- petitioner filed documents intending to conceal, mislead, or prevent the collection of tax, namely her 2012 tax return omitted significant amounts of income, she listed a false address in order to claim the EITC, and she claimed head of household status when she was married and resided with her husband—each of which, as an experience tax return preparer, petitioner would have known was inappropriate; and
- petitioner concealed sources of income by failing to provide adequate business records during the examination and by extensively dealing in cash.
- The Tax Court declined to address whether it should “approve” the IRS’s EITC 10-year ban due to fraud because the IRS failed to provide sufficient pleading and supporting facts to allow the Tax Court to determine the issue. In addition, the Tax Court had already determined that petitioner was not entitled to claim the EITC on her 2012 return.
Key Points of Law
- Generally, the IRS’s determination of a taxpayer’s liability in a notice of deficiency is presumed correct and the taxpayer bears the burden of proving that the determination is incorrect. Tax Court Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
- However, if the taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the proper tax liability, the burden of proof shifts to the IRS. Tax Court Rule 142(a)(2); I.R.C. § 7491(a)(1).
- The IRS also has the burden of proof in respect of any new matter pleaded in the answer to a taxpayer’s petition before the Tax Court. See Tax Court Rule 142(a)(1).
- A matter raised in an amendment to an answer that was not included in a notice of deficiency and that requires the presentation of different evidence is a new matter for which the IRS bears the burden of proof. See Achiro v. Comm’r, 77 T.C. 881, 890 (1981); Sanderling, Inc. v. Comm’r, 66 T.C. 743, 757–58 (1976), aff’d in part, 571 F.2d 174 (3d Cir. 1978).
- The efficient and harmonious judicial administration requires the Tax Court to follow the law of the Court of Appeals to which appeal of the Court’s decision directly lies. Golsen v. Comm’r, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971).
- A Tax Court decision involving a request for redetermination made by an individual taxpayer may be reviewed by the United States court of appeals for the circuit in which the taxpayer legally resides unless there is a stipulation in writing that the decision may be reviewed by another United States court of appeals. I.R.C. § 7482(b)(1)(A), (2).
- For cases appealable to the U.S. Court of Appeals for the Eleventh Circuit, the IRS’s determination of unreported income is entitled to a presumption of correctness only if the determination is supported by a minimal evidentiary foundation linking the taxpayer to an income-producing activity. See Blohm v. Comm’r, 994 F.2d 1542, 1549 (11th Cir. 1993), aff’g, T.C. Memo. 1991-636.
- Once the IRS produces evidence linking the taxpayer to an income-producing activity, the presumption of correctness applies and the burden of production shifts to the taxpayer to rebut that presumption by establishing that the IRS’s determination is arbitrary or erroneous.
- Gross income includes “all income from whatever source derived, including (but not limited to) . . . [g]ross income derived from business.” I.R.C. § 61(a).
- The definition of “gross income” is construed broadly and extends to all accessions to wealth, clearly realized, over which the taxpayer has complete control. See Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).
- A taxpayer is required to keep books and records establishing the amount of his or her gross income. I.R.C. § 6001.
- If a taxpayer fails to maintain and produce the required books and records, the IRS may determine the taxpayer’s income by any method that clearly reflects income. See I.R.C. § 446(b); Petzoldt v. Comm’r, 92 T.C. 661, 693 (1989); Treas. Reg. § 1.446-1(b)(1).
- The IRS’s reconstruction of income “need only be reasonable in light of all surrounding facts and circumstances.” Petzoldt, 92 T.C. at 687.
- The bank deposits method is a permissible method of reconstructing income. See Clayton v. Comm’r, 102 T.C. 632, 645 (1994); see also Langille v. Comm’r, T.C. Memo. 2010-49, aff’d, 447 F. App’x 130 (11th Cir. 2011).
- Bank deposits are considered prima facie evidence of a taxpayer’s receipt of income. Tokarski v. Comm’r, 87 T.C. 74, 77 (1986).
- The IRS need not show the likely source of a deposit treated as income, but the IRS “must take into account any nontaxable source or deductible expense of which [he] has knowledge” in reconstructing income using the bank deposits method. See Clayton, 102 T.C. at 645–46. After the IRS reconstructs a taxpayer’s income and determines a deficiency, the taxpayer bears the burden of proving that the Commissioner’s use of the bank deposits method is unfair or inaccurate. See id. at 645. The taxpayer may prove that the reconstruction is in error, in whole or in part, by proving that a deposit is not taxable.
- A special tax rate is provided to an individual who qualifies as head of household. I.R.C. § 1(b).
- A taxpayer qualifies for head of household filing status if he or she (1) is not married at the close of the taxable year and (2) maintains as his or her home “a household which constitutes for more than one-half of such taxable year the principal place of abode” of a son or daughter. I.R.C. § 2(b)(1)(A).
- A taxpayer who is married may still qualify as not married for head of household filing purposes if (1) the taxpayer files a separate tax return, (2) the household is, for more than one-half of the taxable year, the principal place of abode of the taxpayer’s child for whom the taxpayer would be entitled to claim a dependency exemption, (3) the taxpayer “furnishes over one-half of the cost of maintaining such household during the taxable year,” and (4) the taxpayer’s spouse is not a member of the household during the last six months of the taxable year. I.R.C. § 7703(b).
- Certain “eligible individuals” may qualify for an earned income tax credit against that individual’s income tax liability. I.R.C. § 32(a)(1). The credit is calculated as a percentage of the individual’s earned income. Id.
- A married individual is only eligible for the earned income tax credit if a joint return is filed for the taxable year. See id. 32(d); Treas. Reg. § 1.32-2(b)(2).
- A married individual whose spouse did not live with him or her for the last six months of the taxable year is not considered to be married for federal income tax purposes. I.R.C. § 7703(b)(3).
- Deductions are a matter of legislative grace, and the taxpayer generally bears the burden of proving entitlement to any deduction claimed. Tax Court Rule 142(a); INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
- A deduction is allowed for ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. I.R.C. § 162(a). Such expenses must be directly connected with or pertain to the taxpayer’s trade or business. Treas. Reg. § 1.162-1(a).
- A taxpayer must substantiate deductions claimed by keeping and producing adequate records that enable the IRS to determine the taxpayer’s correct tax liability. I.R.C. § 6001; Hradesky v. Comm’r, 65 T.C. 87, 89–90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976); Treas. Reg. § 1.6001-1(a).
- When a taxpayer establishes that she paid or incurred a deductible expense but does not establish the amount of the expense, we may estimate the amount allowable under limited circumstances. See Cohan v. Comm’r, 39 F.2d 540, 543–44 (2d Cir. 1930). However, there must be sufficient evidence in the record to permit us to conclude that the taxpayer paid or incurred the deductible expense in at least the amount allowed. See Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957).
- The IRS bears the burden of production with respect to an individual taxpayer’s liability for any penalty, requiring the Commissioner to come forward with sufficient evidence indicating that the imposition of the penalty is appropriate. See I.R.C. § 7491(c); Higbee v. Comm’r, 116 T.C. 438, 446–47 (2001).
- As part of this burden, the IRS must produce evidence of compliance with the procedural requirements of section 6751(b)(1). See Graev v. Comm’r (“Graev III”), 149 T.C. 485, 492–93 (2017), supplementing and overruling in part Graev v. Comm’r (“Graev II”), 147 T.C. 460 (2016).
- The initial determination of certain penalties to be “personally approved (in writing) by the immediate supervisor of the individual making such determination.” See I.R.C. 6751(b)(1); Graev III, 149 T.C. at 492–93; see also Clay v. Comm’r, 152 T.C. 223, 248 (2019) (quoting section 6751(b)(1)), aff’d, 990 F.3d 1296 (11th Cir. 2021).
- The decision to reopen the record to admit additional evidence is within the Tax Court’s broad discretion. Zenith Radio Corp. v. Hazeltine Rsch., Inc., 401 U.S. 321, 331–32 (1971); Butler v. Comm’r, 114 T.C. 276, 286–87 (2000).
- The Tax Court “will not grant a motion to reopen the record unless, among other requirements, the evidence relied on is not merely cumulative or impeaching, the evidence is material to the issues involved, and the evidence probably would change the outcome of the case.” Butler, 114 T.C. at 287.
- The Tax Court also balances the moving party’s diligence against the possible prejudice to the nonmoving party, and particularly considers whether reopening the record after trial would prevent the nonmoving party from examining and questioning the evidence as it would have during the proceeding. Estate of Freedman v. Comm’r, T.C. Memo. 2007-61, 2007 WL 831802, at *12.
- Section 6663(a) imposes a penalty equal to 75% of a taxpayer’s underpayment of federal income tax that is due to fraud.
- Fraud is an intentional wrongdoing on the part of the taxpayer with the specific purpose of evading a tax believed to be owing. Petzoldt, 92 T.C. at 698; Minchem Int’l, Inc. v. Comm’r, T.C. Memo. 2015-56, at *43, aff’d sub nom. Sun v. Comm’r, 880 F.3d 173 (5th Cir. 2018).
- If any portion of the underpayment is attributable to fraud, the entire underpayment will be treated as attributable to fraud unless the taxpayer establishes by a preponderance of the evidence that part of the underpayment is not due to fraud. I.R.C. § 6663(b).
- The IRS has the burden of proving fraud by clear and convincing evidence. See I.R.C. § 7454(a); Tax Court Rule 142(b).
- To carry this burden, the IRS must show that (1) an underpayment of tax exists for the year in issue, and (2) some part of the underpayment is attributable to fraud. See I.R.C. §§ 6663(a), 7454(a); DiLeo v. Comm’r, 96 T.C. 858, 873 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
- The existence of fraud is a question of fact to be resolved upon consideration of the entire record. See DiLeo, 96 T.C. at 874. Fraud is never presumed and must be established by independent evidence of fraudulent intent. See Baumgardner v. Comm’r, 251 F.2d 311, 322 (9th Cir. 1957), aff’gC. Memo. 1956-112. However, fraud may be shown by circumstantial evidence because direct evidence of a taxpayer’s fraudulent intent is seldom available. See Petzoldt, 92 T.C. at 699; Gajewski v. Comm’r, 67 T.C. 181, 199–200 (1976), aff’d without published opinion, 578 F.2d 1383 (8th Cir. 1978).
- The taxpayer’s entire course of conduct may establish the requisite fraudulent intent. See Niedringhaus v. Comm’r, 99 T.C. 202, 210 (1992).
- The circumstantial evidence by which the IRS may prove fraud includes various “badges of fraud” on which courts often rely. See Bradford v. Comm’r, 796 F.2d 303, 307 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; DiLeo, 96 T.C. at 875.
- These badges focus on whether the taxpayer engaged in certain conduct that is indicative of fraudulent intent, such as: (1) understating income; (2) failing to maintain adequate records; (3) offering implausible or inconsistent explanations; (4) concealing income or assets; (5) failing to cooperate with tax authorities; (6) engaging in illegal activities; (7) providing incomplete or misleading information to the taxpayer’s tax return preparer; (8) offering false or incredible testimony; (9) filing false documents, including filing false income tax returns; (10) failing to file tax returns; and (11) engaging in extensive dealings in cash. See Bradford v. Comm’r, 796 F.2d at 307–08; Parks v. Comm’r, 94 T.C. 654, 664–65 (1990); Recklitis v. Comm’r, 91 T.C. 874, 910 (1988); Lipsitz v. Comm’r, 21 T.C. 917 (1954), aff’d, 220 F.2d 871 (4th Cir. 1955).
- The existence of any one badge is not dispositive, but the existence of several badges is persuasive circumstantial evidence of fraud. Niedringhaus, 99 T.C. at 211.
- The Tax Court may also consider a taxpayer’s intelligence, education, and tax expertise in deciding whether the taxpayer acted with fraudulent intent. Iley v. Comm’r, 19 T.C. 631, 635 (1952).
- Fraudulent intent may be inferred when a taxpayer files a document intending to conceal, mislead, or prevent the collection of tax. Durland v. Comm’r, T.C. Memo. 2016-133, at *79.
- Filing false documents with the IRS constitutes “an ‘affirmative act’ of misrepresentation sufficient to justify the fraud penalty.” Zell v. Comm’r, 763 F.2d 1139, 1146 (10th Cir. 1985), aff’gC. Memo. 1984-152.
- Intent to evade tax may be inferred from the “concealment of assets or covering up sources of income.” Spies v. United States, 317 U.S. 492, 499 (1943).
- When a taxpayer’s dealings in cash are accompanied by attempts to conceal transactions, that course of conduct is probative evidence of fraud. See Valbrun v. Comm’r, T.C. Memo. 2004-242.
- A taxpayer’s tax knowledge, training, and course instruction weigh heavily against her claim that underreporting significant amounts of gross income was a mistake. See, e.g., Becker v. Comm’r, T.C. Memo. 2018-69, at *49.
- Section 32(k)(1)(B) provides that no EITC “shall be allowed . . . for any taxable year in the disallowance period.” The “disallowance period” is defined in relevant part as “the period of 10 taxable years after the most recent taxable year for which there was a final determination that the taxpayer’s claim of credit under this section was due to fraud.” I.R.C. § 32(k)(1)(B)(i).
- The Tax Court’s rules require full, rather than incomplete, fragmentary, or vague, pleading by the parties. Klein v. Comm’r, 45 T.C. 308, 311 (1965).
Insights: This case provides a good illustration of the analysis that the Tax Court uses in determining whether the civil fraud penalty should be imposed. In particular, the Tax Court’s analysis shows the type of evidence that may be persuasive in establishing certain “badges of fraud” indicating fraudulent intent on the part of a taxpayer.