Tax Court in Brief | Sestak v. Commissioner | Badges of Fraud, Bribery, and Violation of Sharply Defined Public Policy
The Tax Court in Brief – April 25th- April 29th, 2022
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Tax Litigation: The Week of April 25th, 2022, through April 29th, 2022
Sestak v. Comm’r, TC Memo. 2022-41| April 25, 2022 | Weiler, J. | Dkt. No. 17285-18
Short Summary: In 2012, Michael Sestak was employed as a consular officer by the State Department at the U.S. Consulate in Ho Chi Minh City, Vietnam. Sestak was responsible for reviewing U.S. visa applications and issuing U.S. visas to applicants. Sestak devised a scheme whereby he would receive compensation in exchange for facilitating approval of nonimmigrant visas to the U.S. through his position as a consular officer. From February to September 2012, Sestak approved 410 visa applications directed to him, and Sestak received payments—that were ultimately wired to his bank accounts—totaling $3,227,501. In an attempt to hide his bribery proceeds, Sestak acquired real property in Thailand for a total of approximately $3.2 million.
In 2013 Sestak timely filed his 2012 Form 1040, U.S. Individual Income Tax Return, reporting therein wages of $122,029 as an employee of the State Department. He did not report the $3,227,501 in bribery proceeds he received.
The State Department uncovered the fraudulent scheme, and ultimately, Sestak pleaded guilty to conspiracy to commit offenses against the U.S. and to defraud the U.S., bribery of a public official, and conspiracy to engage in a monetary transaction in property derived from specified unlawful activity. In a plea deal, Sestak executed a preliminary consent order of forfeiture imposing a forfeiture money judgment of $6,021,441 in favor of the U.S., which included forfeiture of his real estate holdings in Thailand, all of which represented bribery proceeds traceable to the fraudulent visa scheme and were subject to forfeiture pursuant to 18 U.S.C. § 981(a)(1)(C), 18 U.S.C. § 982(a)(1) and (6), 21 U.S.C. § 853(p), and 28 U.S.C. § 2461.
Sestak was permitted—under U.S. supervision and approval—to sell the real estate holdings in Thailand, with portions of the proceeds to be used to pay any of Sestak’s federal income tax due for tax years 2012 and 2013. Ultimately, Sestak sold his real estate holdings at a loss, but the U.S. received $1,551,134. The IRS then audited Sestak’s 2012 return, and through IRS Letter 950, along with Form 4549–A, Income Tax Examination Changes, the IRS asserted the civil fraud penalty against Sestak. A Revenue Agent made an initial determination to assert the civil fraud penalty under section 6663, and prior written supervisory approval was obtained to assert the civil fraud penalty pursuant to section 6663. Then, those decisions were formally communicated to Sestak.
- Whether petitioner is entitled to a tax deduction for the financial loss against his bribery proceeds received for the tax year in question?
- Whether Sestak is liable for the civil fraud penalty under section 6663?
- Loss deductions are disallowed where the deduction would frustrate a sharply defined federal or state policy. To allow Sestak a deduction for losses arising out of forfeited proceeds obtained through illegal activities would undermine public policy by permitting a portion of the forfeiture to be borne by the Government, thus taking the “sting” out of the forfeiture. In this case, Sestak is not entitled to a loss deduction for the proceeds from the real estate sales that Sestak later forfeited pursuant to the forfeiture agreement with the United States.
- And, yes, Sestak touched just about every “badge of fraud,” and he is liable for the civil fraud penalty under section 6663.
Key Points of Law:
- Burdens of Proof. The taxpayer bears the burden of proving that the Commissioner’s determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under section 7491(a)(1), “[i]f, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B, the Secretary shall have the burden of proof with respect to such issue.” See Higbee v. Commissioner, 116 T.C. 438, 442 (2001). Petitioner has not introduced credible evidence sufficient to shift the burden of proof to respondent under section 7491(a) as to any relevant issue in dispute.
- Gross Income. Section 61 provides that gross income from whatever source derived is subject to federal income taxation. Gross income specifically includes income from illegal sources, such as bribes. Traficant v. Commissioner, 89 T.C. 501 (1987), aff’d, 884 F.2d 258 (6th Cir. 1989). Taxable income means gross income minus those deductions allowed by law. 26 U.S.C. § 63.
- Loss Deduction. Section 165(a) allows a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” In the case of an individual, the deduction is limited to losses incurred in a trade or business or in any transaction entered into for profit or to certain theft or casualty losses. 26 U.S.C. § 165(c). A deduction arising from a loss on the sale or exchange of a capital asset can be claimed only to the extent allowed by sections 1211 and 1212. 26 U.S.C. § 165(f).
- A deduction for property forfeited, if allowed, falls under section 165 and not under section 162. See, e.g., Holmes Enters., Inc. v. Commissioner, 69 T.C. 114 (1977); Holt v. Commissioner, 69 T.C. 75 (1977), aff’d per curiam without published opinion, 611 F.2d 1160 (5th Cir. 1980).
- Federal courts consistently disallow loss deductions where the deduction would frustrate a sharply defined federal or state policy. See, e.g., Wood v. United States, 863 F.2d 417 (5th Cir. 1989); United States v. Algemene Kunstzijde Unie, N.V., 226 F.2d 115, 119–20 (4th Cir. 1955); Fuller v. Commissioner, 213 F.2d 102 (10th Cir. 1954), aff’g 20 T.C. 308 (1953). The test of “nondeductibility on public policy grounds under section 165” is the severity and immediacy of the frustration of a “sharply defined national or state policy” that would result from allowance of the deduction. Stephens v. Commissioner, 905 F.2d at 670; Wood, 863 F.2d at 417.
- Trade or Business Deduction. Section 162(a) “allow[s] as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Neither the Code nor the regulations provide a generally applicable definition of a “trade or business.” Commissioner v. Groetzinger, 480 U.S. 23, 27 (1987). Determining the existence of a trade or business requires a review of the facts of the case, with a focus on: (1) whether the taxpayer undertook the activity intending to earn a profit; (2) whether the taxpayer is regularly and actively involved in the activity; and (3) whether the taxpayer’s activity has actually commenced. See Groetzinger, 480 U.S. at 36; Weaver v. Commissioner, T.C. Memo. 2004-108, 2004 WL 938293, at *6.
- Civil Tax Fraud. “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. 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. Hebrank v. Commissioner, 81 T.C. 640, 642 (1983).
- Section 6751(b)(1) provides that “[n]o 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.” As a threshold matter, the IRS must show compliance with section 6751(b)(1).
- Under section 7491(c), the IRS carries “the burden of production in any court proceeding with respect to the liability of any individual for any penalty.” This burden requires the IRS to come forward with sufficient evidence indicating that imposition of the penalty is appropriate. See Higbee, 116 T.C. at 446. The IRS’s burden of production under section 7491(c) includes establishing compliance with section 6751(b)(1). See Chai v. Commissioner, 851 F.3d at 217, 221–22.
- To allow a taxpayer a deduction for losses arising out of forfeited proceeds obtained through illegal activities would undermine public policy by permitting a portion of the forfeiture to be borne by the U.S. Government, thus taking the “sting” out of the forfeiture. See Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 35 (1958); Wood, 863 F.2d at 422.
- There is a distinction between possible deductions relating to income received from an unethical business practice and income received by violation of some federal or state law or, by virtue of their illegality, frustrate federal or state policy. See Lilly v. Commissioner, 343 U.S. 90 (1952). And, a deduction for (for example) legal fees incurred in the unsuccessful defense of a criminal prosecution relating to a business may constitute ordinary and necessary business expenses that are deductible without frustrating public policy. See Commissioner v. Tellier, 383 U.S. 687 (1966). In sum, a taxpayer may be allowed to deduct legitimate (i.e., ordinary and necessary) business expenses in the operation of an illegitimate enterprise, provided that the allowance of a loss deduction does not undermine the impact of any sharply defined policy, such as, against bribery of a government official.
- Civil Fraud Penalty. The IRS must prove an underpayment of tax in support of the fraud penalty, but such proof need not be the precise amount of the underpayment attributable to fraud. Rather, the IRS must prove only that a part of the underpayment is attributable to fraud. Estate of Beck v. Commissioner, 56 T.C. 297, 363–64 (1971). When the fraud is intertwined with unreported income and indirectly reconstructed income, the IRS may prove an underpayment by proving a likely source of the unreported income. at 361.
- When a taxpayer fails to report bribery proceeds, it is established by clear and convincing evidence that the taxpayer has an underpayment. Then, the IRS must prove fraudulent intent.
- Fraudulent Intent. 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 to be resolved upon consideration of the entire record. Estate of Pittard v. Commissioner, 69 T.C. 391, 400 (1977). Fraud is not to be presumed, nor should a finding of fraudulent intent be based upon mere suspicion. Petzoldt v. Commissioner, 92 T.C. 661, 699–700 (1989).
- Direct proof of fraud is rarely available; thus, fraudulent intent is usually established by circumstantial evidence. at 699. This may be shown 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).
- The taxpayer’s entire course of conduct may be examined to establish the requisite intent, and an intent to mislead may be inferred from a pattern of conduct. Webb v. Commissioner, 394 F.2d 366, 379 (5th Cir. 1968), aff’gC. Memo. 1966-81.
- “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 (including false tax returns), (10) failing to file tax returns, and (11) dealing in cash. See, e.g., Schiff v. United States, 919 F.2d 830, 833 (2d Cir. 1990). No single factor is dispositive, but the existence of several factors is “persuasive circumstantial evidence of fraud.” Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).
- Fraud occurs upon the filing of a false return with the requisite fraudulent intent, and that conduct cannot be subsequently purged through the filing of an amended return. See Badaracco v. Commissioner, 464 U.S. 386, 394 (1984).
Insights: There is a fine—but sometimes precise—line between a possible tax deduction arising from income derived from an unethical business practice versus from violation of state or federal law. The former may afford a basis for a taxpayer to claim and receive legitimate loss deduction on income so received; for the latter, loss deductions are disallowed where the deduction would frustrate a sharply defined federal or state policy. The test of non-deductibility on public policy grounds is the severity and immediacy of the frustration of a sharply defined national or state policy that would result from allowance of the deduction. Accepting bribes in exchange for visas to enter the United States is one such example where a sharply defined federal policy is frustrated, and as such, a deduction for losses incurred from the sale of property purchased with such bribed funds will, more likely than not, be disallowed.