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What's cheating? Determining the liability for tax fraud under Section 6653 (B) after Parks.

What's Cheating?

Determining Liability For TAX FRAUD Under Section 6653 (B) After Parks(1)

Tax liability has become an area of concern with the upswing of "white collar" crime and the increased emphasis society places on ethical issues. Tax liability may be understated in two obvious ways: income may be understated or deductions overstated. The Internal Revenue Service has the challenging job of trying to determine whether this has occurred. A recent tax court decision, Parks v. Commissioner(2) has just made the job a little easier. This paper reviews this recent decision and also surveys a number of other cases to determine the criteria the tax court considers in civil fraud cases.

Tax Fraud Provisions Involved

Under IRC Section 6653(b), the civil fraud penalty provision, the penalty for returns due prior to 1987 is the sum of 50% of the underpayment of tax due plus 50% of the interest since the due date of the return without extensions.(3) The 1986 Tax Reform Act increased this penalty for returns after 1986 from 50% to 75%.(4)

Burden of Proof

According to case law, the IRS has the burden of proving by clear and convincing evidence that there is an underpayment of tax for each year in question, and that some part of this underpayment is due to fraud. Until the Tax Reform Act of 1986, the penalty was applied to the entire amount of the underpayment for each year, so that the exact amount of under statement due to fraud was irrelevant. Since the Tax Reform Act of 1986, the 75% penalty is applied to the entire amount, except for any portion that the taxpayer can prove is not due to fraud. When unable to prove fraud, the IRS has three years after the due date of the return to assess the taxpayer.(5) In cases where the IRS can prove fraud, however, there is no statute of limitations.(6) In the event the Service is unable to prove fraud, the deficiency stands unless the taxpayer proves by a preponderance of the evidence that it is incorrect.(7)

Fraud may be defined as a matter of intent and refers to a deliberate action on the part of the taxpayer.(8) Fraud is a question of fact to be determined from the entire record.(9) Usually, fraudulent intent cannot be determined by direct evidence, so the defendant's entire course of conduct must be considered(10)

Parks v. Commissioner

Ruth B. Parks, ironically employed by the IRS Memphis Service Center, was what one would term loosely a "big spender." Although her monthly take-home pay was only about $800, Ms. Parks banked and spent tens of thousands of dollars. She made cash deposits of $11,635 in addition to her wages to four bank accounts during 1983. She purchased six cashier's checks during 1983 totaling $12,575 to make a down payment on a Cadillac, and paid the car off two months later with another $12,000 in cashier's checks. Moreover, during 1984 Ms. Parks made cash deposits of $8,585, purchased a $571 cashier's check, and paid doctors' bills of $1,925 in cash, without withdrawing any cash from her savings accounts or writing any checks to cash. None of this was reported on her 1984 tax return. After the IRS made a bank deposit and expenditure reconstruction of her unreported income, she was assessed deficiencies and fraud penalties for 1983 and 1984. The IRS, however, was unable to determine the source of this income.

Ms. Parks claimed that the source of this money was nontaxable -- a cash hoard of child-support money including a $40,000 lump sum child-support payment her ex-husband (a gambler) made in 1980. Ms. Parks received a divorce in 1975 for cruel and inhuman treatment as Mr. Parks beat her on several occasions, threatened to kill her and their daughter, and shot her. (Petitioner was later arrested for firing shots at Mr. Parks during another domestic battle.) Mr. Parks was ordered to pay $10 per week child support to the Clerk of the Circuit Court of Shelby County, Tennessee. As Mr. Parks was delinquent in his child support payments, Ms. Parks petitioned the court for a garnishment order and thus received $290 in child support because of this during 1976. Mr. Parks made no further child support payments through the court and the parties later stipulated in the tax case that no checks from Mr. Parks were deposited in Ms. Parks bank account during 1983 and 1984. In fact, during the initial audit of her tax return, Ms. Parks stated that she received no child support in 1983 or 1984 and failed to mention receipt of any cash child support payments for previous years which she used for expenditures in 1983 or 1984. Ms. Parks later invoked the Fifth Amendment after her case was referred to the Criminal Investigative Division of the IRS.

The Tax Court set out a two-pronged test for a fraud penalty in cases involving indirectly reconstructed income. Under the Parks test, the IRS must satisfy by clear and convincing evidence both prongs. First, it must prove that an underpayment exists, by proving a likely source of income(11) or by disproving a nontaxable source alleged by the taxpayer.(12) Either will satisfy the first prong. To satisfy the second, the IRS must prove the taxpayer had the required fraudulent intent.

The IRS met the first prong in the Parks case by disproving the nontaxable source alleged by Parks. Direct testimony of Parks's ex-husband was not needed, as the IRS showed that the reconstruction of her unreported income was accurate, and the allegation of a cash reserve from the ex-husband was inconsistent, implausible and not supported by objective evidence in the record. Given the Parks' past relationship, the Court found it hard to believe that her ex-husband would appear at her door with cash child support money, or even pay child support. Furthermore, they did not believe that Ms. Parks would allow Mr. Parks in her home. The court also found it incredible that someone with four bank accounts would keep a hoard of $40,000 in her home. Since the IRS disproved the nontaxable source claimed by Parks, the Service did not have to prove a likely taxable source for the unreported income.

The Court in Parks looked at a number of factors in determining fraudulent intent. These were:

1. Parks' structuring of cash

transactions to avoid the filing of

currency transactions reports; 2. Parks' refusal to cooperate with

the IRS during the

investigation; and 3. The fact that Parks produced no

credible evidence to support her

claim that the source of this cash

reserve was child support.

The court said that these factors taken together constitute clear and convincing evidence that Parks had the required fraudulent intent to understate her income.

Factors Indicating Fraud

The rest of this article analyzes civil fraud tax cases in an attempt to determine recurring factors used by the courts in these types of cases. The factors identified were:

1. A consistent pattern of

underreporting income over a

period of years; 2. Failure to keep proper records or

manipulation of records; 3. Failure to cooperate with the IRS

and the credibility of the

taxpayer; 4. Taxpayer's education, training

and experience; and 5. Taxpayer's conviction under

certain criminal statutes.

Consistent Pattern of Underreporting Income Over a Period of Years

One of the most frequently cited factors considered in case law in determining taxpayer fraud is a consistent pattern of underreporting of income over a period of years. This is considered strong evidence of an intent to evade taxes.(13) It is quite common in cases involving taxpayers running small businesses. It the case of McDowell v. Commissioner(14), the taxpayer Mr. McDowell operated a small tour boat business which generated a large amount of cash receipts (snack bar sales and passenger fares). These receipts were collected in paper bags and were recorded at the end of the day in a receipt book. McDowell's tax returns for 1972-1975 equaled the amounts recorded in these receipt books. IRS agents, however, uncovered evidence of specific tour receipts and dock rental fees not reported by McDowell. They assessed deficiencies and additions to tax under IRC Section 6653(b) for the years 1972-1975.

The Court held that McDowell was liable for tax deficiencies for only two of the years, 1973 and 1974, as the court noted that the three-year period for assessment with respect to 1972-1975 had expired before the Service issued a notice of deficiency. Therefore, the Court concluded that the Service was required to prove that McDowell's returns were fraudulent with intent to evade tax with respect to 1972 through 1975 under IRC Section 6501(c). The IRS failed to prove by clear and convincing evidence any underpayment of tax for the years 1972 or 1975. The Court noted that the IRS offered no evidence for 1975, but claimed that McDowell must have understated his income in that year, as he had understated it in earlier years. Nevertheless, the court noted that the pattern of omitting items of taxable income such as interest, dividends, dock rental fees and gross receipts for the four years 1972 through 1975 as evidence of intent to evade tax. The Court further noted that these omitted items increased every year. The Service did establish by detailed third-party records that McDowell failed to report income from his tour business and his dock rental business for 1973 and 1974. The court also considered that McDowell failed to maintain proper records or gross receipts. Other factors in this case which the court considered indicative of fraud were the lies, misstatements and half-truths that McDowell told the IRS investigator when first interviewed.

Failure to Keep Proper Records or Record Manipulation

Structuring business affairs with cash transactions so that reconstruction of income is harder is often cited in fraud cases as indicating fraudulent indent. Furthermore, in Bradford v. Commissioner(15), the Court held that manipulation of records to mislead or conceal information is indicative of fraud. The Court also noted in this case that the taxpayer was an experienced attorney familiar with the Internal Revenue Code, and rejected the claim that he was simply an unlucky investor who invested on the advice of others in a series of deals which produced no profits but huge tax benefits. In another case involving an attorney taxpayer, Fried v. Commissioner(16), the Court found understatement of income where the taxpayer had actually backdated a lease and claimed losses based upon information that he knew to be incorrect.

In McDowell(17), mentioned earlier, the Court noted that the tour operator kept his records in an unusual manner for a cash business. Besides collecting the daily receipts in a bag, the taxpayer commingled the receipts from the snack bar with the receipts from the passenger fares. Sometimes as many as 12 daily bags of such receipts were allowed to accumulate and then dumped into a monthly bag. The bags were not always dated. Although the taxpayer maintained a checking account, he made deposits only to cover checks written on the account. The taxpayer kept the books personally and did not do so on a regular basis.

In an interesting case, Douge v. Commissioner(18), the Second Circuit reversed the Tax Court's default judgment upholding the fraud penalty where the taxpayer did not present evidence to rebut the IRS's claim of underreporting and inadequate records. The taxpayer in this case was a doctor who claimed he was unable to produce records relating to his income from his medical practice, as his accountant had died during the audit and the records were either lost or misplaced. The IRS had asserted deficiencies due to the taxpayer's failure to report bank deposits as income. The Second Circuit's reasoning in this case was that consistent, significant underreporting of income and failure to maintain and produce adequate records does not by itself amount to fraud.

Failure to Cooperate with the IRS and Credibility of Taxpayer

Courts also consider a taxpayer's failure to cooperate with the IRS during the course of an investigation to be a telltale sign of fraud. In the case of Engner v. Commissioner(19), the Court found that, while a taxpayer's willful failure to file does not of itself establish fraud, he is subject to the fraud penalty because his overall course of conduct which includes failure to cooperate with the IRS is evidence of an intent to evade taxes. The Court went further in Zell v. Commissioner(20), and said the taxpayer's efforts to forestall the collection of taxes by raising frivolous arguments were further evidence of fraud.

Of course, a taxpayer who cooperates with the IRS will be seen to be more credible than one who changes his story during every step of the investigation. In Light v. Commissioner(21), the taxpayer's memory became a little clearer every time the IRS agent pointed out an inconsistency in his story. Similarly, the taxpayer in Parks(22) changed her story during several successive interviews with the IRS investigator and later refused to cooperate.

Taxpayer's Education, Training and Background

Courts also consider the education, training and background of the taxpayer in determining fraudulent intent. Only then can the court be sure that the understatement of income is not due to ignorance or carelessness on the part of the taxpayer. In Light v. Commissioner(23) the taxpayer had been working since he was six and had only a sixth grade formal education. The Court found that he possessed "street smarts" as he owned his own discount store where he sold adult books and films and drug paraphernalia. Mr. Light opened his store in 1972 and dealt almost exclusively in cash. He was very successful and purchased certificates of deposit totalling $150,000, an antique car, a new home, and still had a large amount of cash on hand. The IRS found deficiencies in Light's 1979, 1980 and 1981 returns by reconstruction of income and determined the amount of tax due and assessed fraud penalties under IRS Section 6653(b). Light argued that this reconstruction was incorrect, as he had a large cash hoard on hand before this reconstruction and claimed to have received $75,000 in cash from his grandfather. The Court found the Services' reconstruction of income to be accurate and Light's testimony self-serving, and observed that petitioner was a businessman of reasonable intelligence despite his lack of education. The Court further noted that Light's stories contained many contradictions and observed that he had little regard for the truth.

Conversely, a taxpayer's knowledge of tax law is an important factor in determining whether he has committed fraud.(24) In Scallen v. Commissioner(25), the taxpayer was an attorney and a law professor with extensive experience in income tax matters. Scallen also operated an extensive real estate business and reported net operating losses for each tax year from 1971 through 1981, although his business had sizable revenues during these years. The IRS imposition of the 50% fraud penalty for years 1976 through 1981 was upheld by the Tax Court. The Tax Court noted several typical "badges" of fraud in this case. These included not only the taxpayers extensive knowledge of tax matters, but also consistent and sizable underreporting of income, failure to keep adequate records, failure to produce many records during discovery and the structuring of his business affairs in a cash manner that made the tracing of income difficult.

Conviction Under Criminal Tax Statutes

A taxpayer conviction under criminal tax statutes is another factor used in determining civil fraud. While IRC Section 7201 makes it a felony to willfully attempt to evade or defeat any tax, IRC Section 7206(1) makes it a felony to file a false tax return. If the taxpayer is found guilty of violating IRC Section 7201, he is estopped from denying guilt under IRC 6653(b) for civil fraud for the same tax years.(26) If a taxpayer is convicted of a violation of IRC Section 7201, this is just an additional factor to be considered by the court in determining fraud, as the intent to evade taxes is not an element of IRC Section 7206(1), but is an element of IRC Section 6653(b).(27)

Conclusion

Almost all civil fraud cases cite the factors above as indicative of fraudulent conduct, as the courts determined fraud from the overall conduct of the taxpayers. Of course, not all of these factors need be present in each case, and in some cases courts have ruled that the presence of a few of these factors alone with no additional evidence not enough for a civil fraud conviction. The recurring factors used by the courts in the cases reviewed in this article were:

1. A consistent pattern of

underreporting income over a

period of years; 2. Failure to keep proper records or

manipulation of records; 3. Failure to cooperate with the IRS

and credibility of the taxpayer; 4. Taxpayer's education, training

and experience; and 5. Taxpayer's conviction under

certain criminal statutes.

It is interesting that the taxpayers involved in these cases have varied education, training and backgrounds. While ignorance of the law is said to be no excuse, it is a factor in determining intent. It is also disturbing that too much familiarity with the Code can work against the taxpayer. It seems that when it comes to "tax cheats," there are no economic, sociological and/or racial boundaries. However, with the Parks(28) decision, the IRS gained a valuable tool in catching these cheaters.

Footnotes

(1)The author acknowledges the assistance of Mead Data Central's Lexis legal database in this research, funded through a UAH Mini-Grant. (2)94 T.C.__, No. 38 (1990). (3)IRC Section 6653 (b) (1985). (4)Id. (5)IRS Section 6501 (a) (1990). (6)IRS Section 6501 (c)(1) (1987). (7)Mosteller v. Commissioner, 52 T.C.M. (CCH) 758, 762 (1986). (8)Id. (9)Mensik v. Commissioner, 328 F.2d 147, 150 (7th Cir. 1964), affd. 37 T.C. 703 (1962), cert. denied 389 U.S. 912 (1967). (10)Spies v. United States, 317 U.S. 492 (1943); Gajewski v. Commissioner, 67 T.C. 181, 200, (1976). (11)Holland v. United States, 348 U.S. 121 (1954). (12)United States v. Massei, 355 U.S. 595 (1958). (13)Merritt v. Commissioner, 301 F.2d 484, 487 (5th Cir. 1962); Brooks v. Commissioner, 82 T.C. 413, 431 (1984). (14)T.C.M. (Lexis) 186 (1987). (15)796 F. 2d 303 (9th Cir. 1986). (16)T.C.M. (Lexis) 430 (1989). (17)T.C.M. (Lexis) 186 (1987). (18)__F.2d____(2nd Cir 1990). (19)T.C.M. (Lexis) 247 (1989). (20)763 F.2d 1139 (10th Cir. 1985). (21)T.C.M. (Lexis) 572 (1987). (22)Parks v. Commissioner, 94 T.C.__, No. 38 (1990). (23)T.C.M. (Lexis) 572 (1987). (24)Solomon v. Commissioner, 732 F.2d 1459 (6th Cir. 1984). (25)877 F. 2d 1364 (8th Cir. 1989). (26)Votsis v. Commissioner, 55 T.C.M. (CCH) 175, 187 (1988). (27)Jordan v. Commissioner, 52 T.C.M. (CCH) 235, 238 (1986). (28)Parks v. Commissioner, 94 T.C.__, No. 38 (1990).

Patricia Wall is an assistant professor of accounting and business legal studies at the University of Alabama in Hunstville. She received her JD from the University of Tennessee in 1979 and her MBA from the University of Tennessee (Chatanooga) in 1987. She has been licensed to practice law in Tennessee since 1979 and in New York since 1988. She has taught at Hofstra University and St. John's University in New York. Professor Wall's research interests include international and corporate law, accounting and taxation.
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Title Annotation:case of Ruth B. Parks
Author:Wall, Patricia S.
Publication:The National Public Accountant
Date:Jan 1, 1992
Words:3287
Previous Article:Timely-mailed equals timely-filed.
Next Article:Closing the tax gap: alternatives to enforcement.
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