The Tax Court in Brief – May 2nd – May 6th, 2022
Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
Tax Litigation: The Week of May 2nd, 2022, through May 6th, 2022
- DelPonte v. Comm’r, 158 T.C. No. 7 | May 5, 2022 | Holmes, J. | Dkt. Nos. 1144-05, 1334-06, 20679-09, 20680-09, 20681-09
- Mighty v. Comm’r, TC Memo. 2022-44| May 4, 2022 | Lauber, J. | Dkt. No. 19064-21L
- Mazzei v. Comm’r, T.C. Memo 2022-43 | May 2, 2022 | Thornton, J. | Dkt. No. 16702-09.
- Wolfson v. Comm’r, T.C. Memo. 2022-46 | May 5, 2022 | Lauber, Judge | Docket No. 21343-21L
Podlucky v. Commissioner, TC Memo. 2022-45| May 5, 2022 | Lauber, J. | Dkt. No. 453-17
Summary: Greg Podlucky (Podlucky), a CPA, started a tea bottling business, Le-Nature’s, Inc. (LNI). Podlucky served as CEO, majority shareholder, and chair of the board. In its early years, LNI was successful, and eventually various private equity investors invested millions into LNI. In return, those firms were allowed seats on the LNI board. When it came time for those investors to consider liquidating their interest (or selling LNI altogether), Podlucky refused to allow access to books and records. So, the investors sued LNI, alleging that Podlucky intentionally obstructed their attempts to sell their stock by blocking access to books and records. They discovered that Podlucky was maintaining two sets of books: one set reported actual sales and profits, and another that reported fictitious sales and profits. The gap was in the hundreds of millions of dollars.
This prompted an involuntary bankruptcy and, eventually, LNI could not be salvaged—the minority shareholders lost their investments, and LNI’s lenders lost more than $600 million. A criminal investigation ensued. Through that, a “secret room” was discovered at LNI’s headquarters that contained $34million in jewelry. Ultimately, Podlucky was indicted on counts of mail fraud, conspiracy to commit money laundering, and attempting to evade or defeat tax in violation of section 7201. The tax charges were based on Podlucky’s failure to report near $35million of income, in the form of constructive distributions from LNI. Podlucky plead guilty and was sentenced to 20 years’ imprisonment. Karla was likewise found guilty of money laundering and sentenced to 51 months’ imprisonment.
Following the criminal proceedings, the IRS initiated a civil examination of the Podluckys’ 2003-2006 joint income tax returns in which the Podluckys reported between $350,000 and $600,000 of income. Relying on prosecutorial reports from the criminal tax evasion charges, the Revenue Agent determined that the Podluckys received near $35million in unreported income, in the form of constructive distributions from LNI. In all, the tax deficiencies totaled about $5million and fraud-related penalties of about $4million were assessed against Podlucky. The Podluckys timely petitioned and disputed the liability. They refused to cooperate and advanced frivolous arguments in the proceeding. Days before trial, the Podluckys announced they filed amended returns “to include all the audit adjustments as determined by [the IRS]” and that they were rescinding their petitions. The Podluckys asserted that no trial should thus be held. The case proceeded to trial. Podlucky testified, in part, that he purchased the luxury jewelry because LNI was “diversifying [its] product lines” and “dealing with Tibetan monks in Asia” who “want[ed] hard assets” rather than cash for purchase of valuable species of tea. The issues, findings, and key points of law from that proceeding are summarized below.
- Did the IRS abuse its discretion in computing Podluckys’ taxable gross income to include, by application of the constructive receipt principles, the value of the jewelry discovered in the secret room, funds expended on construction projects, tuition payments, $1million for a toy train collection, and other expenditures engaged by the Podluckys in the tax years in issue?
- Were fraud-related penalties appropriate?
- Was Karla entitled to innocent spouse relief?
- No. The IRS showed that Podlucky received from LNI constructive distributions (and unreported income) of almost $35 million, and the Podluckys failed to show that the IRS’s findings were arbitrary or erroneous.
- Yes. Podlucky touched just about every—at least 8 of 11—“badge of fraud” applicable to the fraud analysis.
- No. A requesting spouse is not eligible for innocent spouse relief if the understatement of tax is attributable to that spouse’s own erroneous items. In this case the understatements arose out of Greg’s extraction of funds from LNI, which he used to finance his and Karla’s lavish lifestyle. Although Greg directed the scheme, causing LNI to make constructive distributions of property, Karla played a crucial role.
Key Points of Law:
- Rescission of Petition. In deficiency cases brought pursuant to section 6213, a taxpayer may not withdraw a petition in order to avoid a decision. Davidson v. Commissioner, 144 T.C. 273, 274 (2015). “[A] taxpayer may not unilaterally oust the Tax Court from jurisdiction which, once invoked, remains unimpaired until it decides the controversy.” Estate of Ming v. Commissioner, 62 T.C. 519, 521 (1974). Under Rule 123(d), dismissal of a case, other than a dismissal for lack of jurisdiction, operates as an adjudication on the merits. Thus, if the Tax Court were to dismiss a case, the Court is required to enter a decision against the petitioning taxpayer in the full amounts of the deficiencies and penalties determined in the notice of deficiency.
- Unreported Income. Section 61(a) provides that “gross income means all income from whatever source derived.” A shareholder “must include in gross income payments the corporation made on the shareholder’s behalf”. Hacker v. Commissioner, T.C. Memo. 2022-16, at *17. In cases of unreported income, the IRS must establish an evidentiary foundation connecting the taxpayer to the income-producing activity, Weimerskirch v. Commissioner, 596 F.2d 358, 361 (9th Cir. 1979), rev’g 67 T.C. 672 (1977), or demonstrate that the taxpayer actually received income, Edwards v. Commissioner, 680 F.2d 1268, 1270–71 (9th Cir. 1982). Once the IRS has met that threshold burden, the burden shifts to the taxpayer to show that the IRS’s determinations are arbitrary or erroneous. See Hardy v. Commissioner, 181 F.3d 1002, 1004–05 (9th Cir. 1999), aff’gC. Memo. 1997-97; Anastasato v. Commissioner, 794 F.2d 884, 887–88 (3d Cir. 1986), vacating and remanding T.C. Memo. 1985- 101.
- Reconstruction of Income. The IRS has great latitude in reconstructing a taxpayer’s income, and the reconstruction “need only be reasonable in light of all surrounding facts and circumstances”. Petzoldt v. Commissioner, 92 T.C. 661, 687 (1989).
- Admissions by Return. An amended return may constitute an admission by the submitting taxpayer. Badaracco v. Commissioner, 464 U.S. 386, 399 (1984). “Statements made in a tax return signed by a taxpayer may be treated as admissions.” Lare v. Commissioner, 62 T.C. 739, 750 (1974), aff’d, 521 F.2d 1399 (3d Cir. 1975).
- Assessment of Fraud Penalties. Section 6501(a) generally requires the IRS to assess a tax within three years after the return was filed. The period of limitations is extended to six years where the taxpayer omits from gross income an amount “in excess of 25 percent of the amount of gross income stated in the return.” 26 U.S.C. § 6501(e)(1)(A)(i). However, section 6501(c)(1) provides that, where a taxpayer has filed “a false or fraudulent return with the intent to evade tax,” there is no period of limitations, and the tax “may be assessed . . . at any time.” In the case of a joint return, fraud by either taxpayer suspends indefinitely the period of limitations for both taxpayers. Vannaman v. Commissioner, 54 T.C. 1011, 1018 (1970).
- “No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination.” 26 U.S.C. § 6751(b)(1). The IRS must show that it complied with section 6751(b)(1), which is typically contained in a letter by which the IRS formally notifies the taxpayer that the examination is complete and a definite decision to assert penalties has been made. See Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017). Once the IRS introduces evidence sufficient to show written supervisory approval, the burden shifts to the taxpayer to show that the approval was untimely, i.e., “that there was a formal communication of the penalty [to the taxpayer] before the proffered approval” was secured. Frost v. Commissioner, 154 T.C. 23, 35 (2020).
- “If any part of any underpayment of tax required to be shown on a return is due to fraud,” section 6663(a) imposes a penalty of 75% of the portion of the underpayment attributable to fraud. The IRS has the burden of proving fraud by clear and convincing evidence. See 26 U.S.C. § 7454(a); Rule 142(b). The IRS must establish two elements: (1) that there was an underpayment of tax for each year at issue and (2) that at least some portion of the underpayment for each year was due to fraud. See Hebrank v. Commissioner, 81 T.C. 640, 642 (1983). Where the IRS determines fraud penalties for multiple tax years, the burden of proving fraud “applies separately for each of the years. Vanover v. Commissioner, T.C. Memo. 2012-79, 103 T.C.M. (CCH) 1418, 1420. If the IRS proves that some portion of an underpayment for a particular year was attributable to fraud, then “the entire underpayment shall be treated as attributable to fraud” unless the taxpayer shows, by a preponderance of the evidence, that the balance was not so attributable. 26 U.S.C. § 6663(b).
- Collateral Estoppel. Where a taxpayer is convicted of tax evasion for a particular tax year, the taxpayer is collaterally estopped from denying that the underpayment for the tax year was due to fraud. See DiLeo v. Commissioner, 96 T.C. 858, 885 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
- Fraud and Its Badges. Fraud is intentional wrongdoing designed to evade tax believed to be owing. Neely v. Commissioner, 116 T.C. 79, 86 (2001). The existence of fraud is a question of fact. Estate of Pittard v. Commissioner, 69 T.C. 391, 400 (1977). Fraud is not presumed or based upon mere suspicion. Petzoldt, 92 T.C. at 699–700. The IRS satisfies its burden of proof by showing that “the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes.” Parks v. Commissioner, 94 T.C. 654, 661 (1990). Circumstances that may indicate fraudulent intent—“badges of fraud”— include: (1) understating income, (2) keeping inadequate records, (3) giving implausible or inconsistent explanations of behavior, (4) concealing income or assets, (5) failing to cooperate with tax authorities, (6) engaging in illegal activities, (7) supplying incomplete or misleading information to a tax return preparer, (8) providing testimony that lacks credibility, (9) filing false documents, (10) failing to file tax returns, and (11) dealing in cash. See Schiff v. United States, 919 F.2d 830, 833 (2d Cir. 1990) among other authorities cited.
- Innocent Spouse Relief. Married taxpayers may elect to file a joint income tax return. 26 U.S.C. § 6013(a). After making this election, each spouse is jointly and severally liable for the entire tax due for that year. at § 6013(d)(3).
- Section 6015(b) specifies procedures for relief from liability for all joint filers, and subsection (c) specifies procedures to limit liability for taxpayers who are no longer married or are living separately. Section 6015(b)(1) provides that a requesting spouse shall be relieved of joint and several liability for a particular year if: (1) the requesting spouse filed a joint return, (2) the return contains an understatement of tax attributable to an erroneous item of the non-requesting spouse, (3) the requesting spouse did not know and had no reason to know about the understatement, (4) it would be inequitable to hold the requesting spouse liable for the deficiency attributable to the understatement, and (5) the requesting spouse’s claim for relief is timely. Failure to meet any one of these requirements precludes relief under section 6015(b).
- The “reason to know” test is subjective and is resolved by consideration of several factors, such as the requesting spouse’s involvement in the events leading to the understatement and the existence of expenditures that are lavish or unusual when compared to the family’s past income levels. Butler v. Commissioner, 114 T.C. 276, 284 (2000).
- Equitable Considerations for the “Innocent Spouse.” A requesting spouse may be eligible for relief if the spouse establishes, based on “all the facts and circumstances,” that it would be “inequitable” to be held liable for the tax. 26 U.S.C. § 6015(b)(1)(D). Factors to consider: (1) marital status, (2) economic hardship, (3) significant benefit, (4) subsequent compliance with tax laws, (5) legal obligation to pay the outstanding tax liability, (6) knowledge or reason to know about the understatement, and (7) mental or physical health. See Proc. 2013-34, § 4.03(2), 2013-43 I.R.B. 397, 400–03; Treas. Reg. § 1.6015-2(d). If the understatement enabled the requesting spouse to purchase “luxury assets” or live a “lavish lifestyle,” then this factor weighs against relief. See, e.g., Rev. Proc. 2013-34, § 4.03(2)(e).
Insights: This Podlucky opinion illustrates the confluence of criminal and civil tax proceedings and how the former can influence outcomes in the latter. Podlucky defrauded investors and the United States Department of the Treasury; hundreds of millions were squandered. Perhaps the minority shareholders should be congratulated for pursuing their rights to access LNI’s books and records, rather than simply acquiesce to Podlucky’s actions contrary to the shareholders’ rights; otherwise, Podlucky’s fraud and tax evasion may have continued without legal or tax accountability. The opinion is also a reminder of the uphill burden of those claiming innocent spouse relief when that spouse is a primary beneficiary of the financial gains and luxurious lifestyle secured by the underreporting of the joint-filers’ income.