IRS Fails to Establish Fraud; Adjustments Barred by Statute of Limitations

(Parker Tax Publishing September 2024)

The Tax Court held that the IRS failed to establish that a trust and its trustee filed false or fraudulent tax returns with the intent to evade tax and thus the extended statute of limitations period in Code Sec. 6501(c) did not apply. However, the court concluded that, because the trustee had not filed a return for one of the years at issue, the statute of limitations remained open for that period and thus penalties for late filing and payment of tax applied for that year. Scenic Trust, Dennis Simpson, Special Trustee v. Comm'r; Simpson v. Comm'r, T.C. Memo. 2024-85.

Facts

Dennis Simpson participated in a direct-mail subscription business for approximately two decades. The business consisted of several related entities, including an irrevocable trust, Scenic Trust. The business provided customer service data management, and direct mail marketing to customers. Subsequently Jeffrey Hoyal became involved in the business and he and Simpson became partners. Together, Simpson and Hoyal formed multiple entities to provide specific services, which mainly included acting as mailing agents, clearing entities call center, or payment distributors. They also formed entities to hold specific assets. During the years in issue, the relevant entities included Reality Kats, LLC (Reality Kats), Maximillian, Inc. (Maximillian), and Scenic Trust.

Reality Kats was controlled by Simpson and he made and monitored all important financial decisions for the entity. Noel Parducci was the nominal president and secretary of Maximillian. While on paper Parducci seemingly controlled Maximillian, in reality she was subordinate to Simpson and Hoyal, who directed the actions to be taken through the entity. While Simpson did not have a role with Scenic Trust other than as the settlor, those who interacted with him or the trust viewed him as indistinguishable from Scenic Trust and considered him to be the beneficiary and primary decision maker for all matters relating to Scenic Trust.

The Scenic Trust Agreement (Trust Agreement) named Hoyal as trustee and its beneficiaries as Hoyal's heirs. Also as part of the formation of Scenic Trust, certain agreements were entered into between Simpson and Hoyal including a Private Annuity Agreement designating Simpson as an annuitant for the sale of property to Scenic Trust. The property sold (Reality Kats units) was assigned a fair market value of $16.2 million. Additionally, a Unit Purchase Agreement was executed between Simpson and Hoyal. It had an execution date of January 15, 2006, but purported to have been signed on January 1 and 2. It was intended to be read in connection with the Private Annuity Agreement. The Unit Purchase Agreement identified the property to be transferred as the 100 units of Reality Kats owned by Simpson and stated that the 100 units represented "100% of the LLC units of said company". The property was transferred for an aggregate price of $16.2 million. Upon being audited by the IRS, this agreement was provided during discovery.

However, a different Unit Purchase Agreement was provided to the IRS during its audit. The revised version had an execution date of January 15, 2006, with a signature date of January 1, 2006. The terms in the revised version were significantly different from those of the version provided in discovery. Simpson did not consider the revised agreement authentic, but he believed the Trust Agreement, the Private Annuity Agreement, and the version of the Unit Purchase Agreement provided during discovery to be authentic documents.

Returns prepared by a CPA were filed for Simpson and his related entities for 2012 and 2013 (the years at issue). More than three years after the filing of the returns for Simpson and Scenic Trust (the taxpayers), the IRS issued notices of deficiency to the taxpayers for the years at issue, determining income tax deficiencies, additions to tax, and civil fraud penalties. In so doing, the IRS relied on the fraud exception in Code Sec. 6501(c)(1) to the general three-year statute of limitations period. The IRS argued that the periods to assess income tax due from the taxpayers for 2012 and 2013 had not expired because the IRS had established fraud by clear and convincing evidence. According to the IRS, the taxpayers engaged in a pattern of conduct to mislead by, among other actions, presenting altered or backdated documents and this conduct showed an intent to mislead and supported a finding of fraud.

As a preliminary matter, the Tax Court noted that the statute of limitations question did not apply for Simpson's 2013 liability because, in Parducci v Comm'r, T.C. Memo. 2023-75, the Tax Court held that Simpson's 2013 return was not signed by him or by anyone authorized by him and thus that return was not a valid return and, under Code Sec. 6501(a) and 6501(c)(3), the IRS may make an assessment at any time.

Analysis

The Tax Court held that the IRS failed to establish that the taxpayers filed false or fraudulent returns with the intent to evade tax, and thus the extended statute of limitations did not apply. Accordingly, the court concluded that the IRS's determinations and adjustments relating to the taxpayers for 2012 and to Scenic Trust for 2013 were barred by the statute of limitations.

The court reviewed the IRS's arguments that various badges of fraud existed with respect to the taxpayers' tax returns. Regarding the IRS's contention that the taxpayers failed to maintain adequate records to report income, the court said that the evidence in the record did not clearly show such a failure. The court noted that it had, in the evidentiary record, (1) the taxpayers' tax returns; (2) profit and loss statements for Reality Kats and Scenic Trust for 2013; (3) balance sheets and bank records for Reality Kats and Scenic Trust; and (4) receipts, deeds, invoices, and other transactional statements to substantiate certain transactions and expenses. The court said that, while the IRS may disagree with how items were reported, the taxpayers had provided enough documentation to reconcile their reporting on their tax returns.

The court observed that a pattern of substantially underreporting income over several successive years can be strong evidence of fraudulent intent and that such a pattern evidences fraudulent intent even where the record is devoid of the usual indicia of fraud. The court noted that the IRS's support for this badge of fraud was predicated on its position that the income of Reality Kats and Scenic Trust should be reattributed to Simpson. However, the court said, when the relevant returns were considered as a group, there was no pattern of understating income.

The court also rejected IRS's arguments that Simpson exhibited implausible or inconsistent explanations of behavior such as Simpson's not recalling revisions to documents while also being included in an email relating to such documents. The court noted that the revisions to the documents were to clean up typos, which would easily be unremarkable and forgettable after more than a decade had passed.

However, because Simpson's 2013 return was not valid, the period of limitations did not expire for that year and the court therefore considered Simpson's liability for additions to tax for failure to timely file and failure to timely pay. The court agreed with the IRS that Simpson was liable for the taxable items assigned to Reality Kats and Scenic Trust. The court noted that Reality Kats was a single member LLC and found that Simpson had total control over every financial decision and transaction that occurred within it. The court further found that, although being characterized as merely the settlor of Scenic Trust, Simpson had full control of the trust.

For a discussion of when the statute of limitations may be extended, see Parker Tax ¶260,130. For a discussion of the badges of fraud, see Parker Tax ¶262,125.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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