The Tax Court recently upheld the assessment of a civil fraud penalty against an incarcerated/disbarred attorney. Robert L. Schwartz v. Commissioner, TC Memo 2016-144. The petitioner, who was also a former examiner with the IRS, had maintained a successful law practice specializing in personal injury for nearly 40 years before being convicted of mail fraud and of filing a false tax return. Following the criminal proceedings, which resulted in a restitution order of $3.2 million (including a tax-based restitution component of $935,000), the IRS made a civil assessment against the petitioner, relying in part on a bank-deposit-method analysis to estimate/calculate his unpaid taxes. The IRS ultimately determined that the petitioner had understated his income by over $800,000 during the period at issue, and upheld a civil fraud penalty to boot. The petitioner challenged the proposed assessment by filing a petition with the Tax Court. At the time that the petition was filed, the petitioner was still serving a 48-month sentencing in a prison facility in Kentucky.
The Tax Court, relying in part of the IRS’s bank deposit analysis and the taxpayer’s failure to rebut that analysis, agreed with the IRS that the taxpayer substantially understated his income during the year at issue. The court adopted the IRS’s figures, and determined that the taxpayer had understated his income by over $800,000 during the period. Accordingly, the court upheld the assessment of tax on the unreported income.
As mentioned, the IRS also assessed a civil fraud penalty against the taxpayer under I.R.C. section 6663. Under section 6663, if any part of an underpayment on a return is due to fraud, the Code imposes a penalty equal to 75% of the underpayment attributable to fraud. To prove that the taxpayer is liable for the penalty the IRS is required to prove that (1) an underpayment of tax exists, and (2) some part of the underpayment is due to fraud. 26 U.S.C. Sec. 7454(a); Tax Court Rule 142(b). And if the IRS proves that any portion of the underpayment is attributable to fraud, the entire underpayment is treated as attributable to fraud unless the taxpayer can demonstrate (i.e., the taxpayer bears the burden to prove) that a portion was not so attributable. Sec. 6663(b).
In this context, civil fraud is defined as intentional wrongdoing by the taxpayer with the specific purpose of avoiding tax believed to be owed. Stoltzfus v. United States, 398 F.2d 1002, 1004 (3d Cir. 1968); Neely v. Commissioner, 116 T.C. 79, 86 (2001). In other words, to support a civil fraud penalty, the government must make a showing that the taxpayer intended to evade taxes that he believed to be owing through conduct that was designed to conceal, mislead, or otherwise prevent the collection of taxes. DiLeo v. Commissioner, 96 T.C. at 874.
Whether fraud exists in any given case is a question of fact, and in order to establish fraud, the government must present independent evidence of fraudulent intent. Recklitis v. Commissioner, 91 T.C. 874, 909-910 (1988). However, direct proof of intent is not required. Instead, fraud can be established by circumstantial evidence and the government may draw inferences from that circumstantial evidence about the taxpayer’s intent. Scallen v. Commissioner, 877 F.2d 1364, 1370 (8th Cir. 1989), aff’g T.C. Memo. 1987-412.
In fact, the IRS often establishes fraud through circumstantial evidence—often by arguing that so-called “badges of fraud” exist, and that the existence of these factors supports drawing the conclusion that fraud existed. Common badges of fraud include: (1) understating income; (2) maintaining inadequate records; (3) failing to file tax returns; (4) offering implausible or inconsistent explanations of behavior; (5) concealing income or assets; (6) failing to cooperate with tax authorities; (7) engaging in illegal activities; (8) dealing in cash; (9) failing to make estimated tax payments; and (10) filing false documents, including filing false income tax returns. Robert L. Schwartz v. Commissioner, TC Memo 2016-144.
Under the facts of the Schwartz case, the court found no trouble upholding the civil fraud penalty. The court specifically cited unidentified (and presumably unreported) deposits into the petitioner’s bank account, an understatement of income, the taxpayer’s failure to adequately maintain records, and the taxpayer’s failure to offer plausible explanations. The court, of course, also found the taxpayer’s conviction under section 7206(1) “highly probative” of the existence of civil fraud.
This case, while not reaching a surprising outcome on the facts, demonstrates the perils that taxpayers face in civil proceedings following a criminal tax conviction. It also demonstrates a common approach used by the IRS to impose civil fraud penalties.
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