An IRS notice of examination of a tax return brings great anxiety to our clients. It also takes us to the great unknown as to how the process will play out. We have all worked with aggressive revenue agents, agents that move at the pace of molten lava, and efficient agents simply trying to get their job done. As Congress reduces the IRS budget, revenue agents are asked to do more with less. In this scenario, beware of an increase in allegations of civil fraud, which if upheld, keep the statute of limitation for proposed adjustments to tax open indefinitely.
Statute of Limitations
IRC §6501 states:
“(a) General rule.--Except as otherwise provided in this section, the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed…”
“(c) Exceptions.--
(1) False return.--In the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time.
(2) Willful attempt to evade tax.--In case of a willful attempt in any manner to defeat or evade tax imposed by this title (other than tax imposed by subtitle A or B), the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time.”
If you can show that your case does not fall under any of the exceptions in Section 6501, the IRS is barred from adjusting a taxpayer’s tax liability after three years, or six years if there is an alleged “substantial understatement” of income.1 One key is a taxpayer’s cooperation with the agent throughout the audit process, including the extent of the documentation provided. This cooperation helps avoid willful intent to evade tax, which the IRS must prove in order to make the fraud penalty stick, and keep the statute open.
Wilfull Intent to Defraud
If the three or six year statute of limitations time frame has expired, the only avenue left for the IRS to pursue additions to tax against a taxpayer is by assertion of the civil fraud penalty under IRC §6663. Otherwise, the statute of limitations has run. In a Tax Court proceeding, the IRS must prove by clear and convincing evidence that a taxpayer acted with willful intent to evade taxes, for each year of proposed adjustments. If it fails, no adjustments may be made due to the expiration of the statute of limitations. When multiple years are involved, fraud must be established for each year.2
Fraud may be proven by an underreporting of income or an overstating of deductions where there is an absence of an alternative explanation for the taxpayer's conduct such as reasonable cause or merely willful neglect.3 IRS evidence must do more than merely raise the suspicion of fraud, it must establish its existence clearly and convincingly.4 Even though a taxpayer's conduct with respect to the keeping of proper business records and the preparation of returns may be clearly negligent, perhaps even grossly so, such negligence is not the equivalent of fraud.5 There are cases where although a taxpayer underreported income and maintained poor records, the Service did not prove by clear and convincing evidence that the taxpayer had the requisite fraudulent intent.6
The U.S. Tax Court has found that “circumstantial evidence which may give rise to a finding of fraudulent intent includes: (1) Understatement of income; (2) inadequate records; (3) failure to file tax returns; (4) implausible or inconsistent explanations of behavior; (5) concealment of assets; (6) failure to cooperate with tax authorities; (7) filing false W–4's; (8) failure to make estimated tax payments; (9) dealing in cash; (10) engaging in illegal activity; and (11) attempting to conceal illegal activity.”7 An analysis of these factors in any case will give you an indication of whether the IRS has met its burden of proving the requisite willful intent to evade taxes.
Burden of Proof
In Tax Court, the burden of proving the false or fraudulent-return exception to three-year limitations period (or six-year under certain circumstances) for assessing tax falls to the IRS to establish by clear and convincing evidence that a taxpayer filed false and fraudulent returns with the intent to evade tax.8 The IRS must prove the taxpayer intended to commit fraud in the preparation of these returns.9 If the Service satisfies its burden of proving that a portion of an underpayment is attributable to fraud, the burden of proof then shifts to the taxpayer to show otherwise.10 The burden of proof upon the Service and taxpayers is different, however. If the burden shifts to the taxpayers, their standard of proof is a preponderance of the evidence.11 Under the clear and convincing standard, the evidence presented by a party during the trial must be more highly probable to be true than not. Under the preponderance of evidence standard, a party need only to show that there is sufficient evidence to make it more likely than not that the facts it seeks to prove are true.
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The IRS has a stiff burden of proof in asserting a civil fraud penalty against a taxpayer. In situations where such a penalty may be in play, a practitioner should undertake a detailed analysis of the factors considered before succumbing to this burdensome exposure.
1. 26 U.S.C.A. §6501(e)
2. Gleis v. Commissioner, 24 T.C. 941, 1955 WL 784 (T.C. 1955), acq., 1956-2 C.B. 4 and decision aff'd, 245 F.2d 237.
3. Bozied v.Commissioner, T.C. Memo. 1969-142.
4. Id.
5. Id.
6. Gagliardi v. U.S., 81 Fed. Cl. 772, 101 A.F.T.R.2d 2008-2257 (2008).
7. Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).
8. 26 U.S.C.A. §§6501(c)(1), 6663, 7454(a); Tax Court Rule 142(b); Harlan v. Commissioner, 116 T.C. 31, 39, 2001 WL 40098 (2001).
9. Niedringhaus, at 210; Beaver v. Commissioner, 55 T.C. 85, 1970 WL 2247 (1970); Griffiths v. Commissioner, 50 F.2d 782, 10 A.F.T.R. (P-H) P 106 (7th Cir. 1931).
10. Sclafani v. Commissioner, T.C. Memo. 1963-298, 1963 WL 1529 (T.C. 1963).
11. IRC §7454; Niedringhaus v. Commissioner, 99 T.C. 202, 1992 WL 190129 (1992).
Kathleen Lach is a Partner in the Tax and Litigation Departments of Arnstein & Lehr LLP. She represents clients before a variety of different tax authorities, including the Internal Revenue Service, the Illinois Department of Revenue, and the Illinois Department of Employment Security.
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