Tax Court rejects proposed addition to tax for fraudulent failure to file

In Kernan v. Commissioner, T.C. Memo. 2014-228, the Tax Court sustained the IRS's proposed deficiencies and additions to for tax years 2001 through 2006 due to the taxpayer's failure to file income tax returns. However, the Court rejected the IRS's proposed penalties for fraudulent failure to file these same returns.

During the years at issue, the taxpayer sold income tax avoidance products and performed paralegal functions, and deposited the income from these activities into a personal checking account. However, the taxpayer didn't file tax returns to report this income.

The IRS initially conducted a promoter investigation of the taxpayer with respect to his participation in sales of tax avoidance products, and it later examined the taxpayer with regard to his individual income tax liabilities for tax years 2001 through 2006. During the income tax examination, the IRS obtained the taxpayer's bank records through the issuance of summonses (which summonses the taxpayer unsuccessfully attempted to quash), and performed a bank deposits analysis to determine unreported income. The IRS then prepared substitutes for returns pursuant to I.R.C. sec. 6020(b), and issued a notice of deficiency.

I.R.C. sec. 6651(f) imposes an addition to tax in the amount of 75% of the amount of tax required to have been shown on an unfiled tax return where the failure to file is fraudulent. In court proceedings, the IRS is required to show that the underpayment of tax is attributable to fraud by clear and convincing evidence. As with cases involving the fraud penalty under I.R.C. sec. 6663(a), because direct evidence of fraudulent intent is rare, courts rely upon "badges of fraud" as circumstantial evidence in determining whether the requisite fraudulent intent is present.

The badges of fraud include: (1) failing to file returns;(2) failing to make estimated tax payments; (3) maintaining inadequate records; (4) failing to cooperate with tax authorities; (5) filing false documents; (6) engaging in illegal activities; (7) concealing income or assets; (8) evidencing an intent to mislead; (9) dealing in cash; (10) providing implausible or inconsistent explanations of behavior; (11) understating income; (12) failing to be forthright with one's tax preparer; (13) evidencing intelligence, education, and tax expertise; and (14) demonstrating a lack of credibility.

While the IRS was able to establish a few of these badges, it was unable to prove at trial by clear and convincing evidence some of the badges that it had alleged. For example, the taxpayer did not file false documents, and while he promoted tax avoidance products in the past, the IRS did not prove that he was involved in illegal activity or that he was indicted or convicted of any crimes.

The Tax Court also found that a few facts mitigated the taxpayer's failure to file. First, the taxpayer publicly declared that he was not required to file a tax return without prior notice, and sent letters to the IRS asking whether he was mistaken about that belief. The Court found that this disclosure was a mitigating factor. Similarly, the Court also found that the taxpayer had a good-faith belief that he was not required to file, even though such a belief is objectively unreasonable. The fact that the taxpayer espoused frivolous arguments was not enough to establish fraudulent intent by clear and convincing evidence.

The Court likewise refused to impose sanctions under I.R.C. sec. 6673(a), which section provides for a penalty of up to $25,000 for instituting court proceedings primarily for delay and for taking positions that are frivolous or groundless.

This case demonstrates that the Tax Court will not uphold additions to tax or penalties based upon fraud absent a showing by clear and convincing evidence that the badges of fraud are present, even in cases involving tax protestors or tax defiers.

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