Business Owner's Tax Background Supported Imposition of Fraud Penalty

(Parker Tax Publishing October 2021)

The Ninth Circuit affirmed the Tax Court's imposition of a fraud penalty under Code Sec. 6663 on a taxpayer who underreported income for several years, provided no adequate records to substantiate the figures reported on his tax returns, concealed constructive dividend income, and failed to cooperate with an IRS agent's investigation. In addition, the court found that the taxpayer's background as a tax return preparer and his specialized knowledge and experience on corporate and business taxation provided even stronger circumstantial evidence of fraud. Chico v. Comm'r, 2021 PTC 326 (9th Cir. 2021).

Background

Raymond Chico worked as a land surveyor for about 20 years. When outdoor work was light, he began preparing tax returns for several of his acquaintances. Eventually Chico established Ray's Tax Service as a side business. The IRS issued him a Preparer Tax Identification Number, and he was registered from 2003 through 2016 with the California Tax Education Counsel (CTEC) to prepare and file tax returns. His continuing education courses in federal income taxation included courses in business return preparation. At his busiest Chico prepared about 73 tax returns per year; during the years at issue he prepared about 40 tax returns per year.

In 2007, Chico was diagnosed with cancer, and he began chemotherapy treatments. Because of the severe side effects, he had to stop working as a land surveyor. To alleviate the side effects he began to use marijuana cigarettes. Once his cancer went into remission, he became an entrepreneur. During 2010 through 2012, he engaged in several business activities: (1) rental of portions of his and his wife's marital home to third parties; (2) Doobtubes, which marketed and sold marijuana cigarette containers; (3) Lakewood Patient Resource Center Inc., a marijuana dispensary; and (4) the aforementioned Ray's Tax Services. Chico prepared his and his wife's joint Forms 1040. Two Schedules C with respect to Doobtubes and Ray's Tax Service were attached to each year's Form 1040, as was a Schedule E, Supplemental Income and Loss, with respect to the Chicos' rental income.

The IRS selected the Chicos' 2010-2012 Forms 1040 for examination. Revenue Agent Ryan Scott began his audit by issuing an information document request (IDR) to the Chicos and their then attorney, Jerome Hanley. The IDR sought copies of tax documents, bank and other financial institution account information, and records regarding all of Chico's businesses. Although Chico provided some documents to Hanley, Scott never received any response to the IDR. After examining the information he had, Scott discovered that the Chicos held 13 bank accounts. After issuing summonses to the banks, Scott reconstructed the Chicos' income using the bank deposits method. Scott then sent summonses to Hanley and the Chicos for additional records and information. None of the requested information was provided. After additional requests to meet with the Chicos failed to elicit any response, the government began a summons enforcement action in a district court. The Chicos then agreed to meet with Scott. At this meeting the Chicos answered some of Scott's questions but declined to answer others, invoking their Fifth Amendment rights.

In a notice of deficiency, the IRS determined that the Chicos had underreported income with respect to (1) rental income received from the rental of portions of their marital home, (2) Doobtubes' gross receipts, and (3) dividends and passthrough income from Lakewood. Scott also determined that the Chicos were not entitled to deductions in the amounts claimed with respect to the rental of portions of their marital home and Doobtubes. The IRS also asserted that Chico was liable for the fraud penalty under Code Sec. 6663. Under Code Sec. 6663(a), if any part of an underpayment of tax required to be shown on a return is due to fraud, there is an addition to tax of 75 percent of the portion of the underpayment that is attributable to fraud. To establish fraud, the IRS must prove for each year that: (1) an underpayment of tax exists, and (2) the taxpayer had fraudulent intent, i.e., that the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. Fraudulent intent may be established using circumstantial evidence, or "badges of fraud," including the consistent understatement of income, inadequate records, failure to file tax returns, implausible or inconsistent explanations for behavior, concealment of income or assets, and failure to cooperate with tax authorities.

Analysis

The Chicos took their case to the Tax Court. In Chico v. Comm'r, T.C. Memo. 2019-125, the Tax Court upheld most of the deficiencies and the fraud penalties. The court found that the IRS was justified in reconstructing the Doobtubes' income through the bank deposits method since Chico failed to respond to Scott's request for information. Chico testified that he maintained adequate books and records using QuickBooks, but he never presented any such documents to the IRS or to the Tax Court. At trial, Chico asserted that Scott's bank deposits analysis failed to take into account a $353,000 inheritance that he received immediately before the years at issue. Chico asserted that portions of this inheritance were periodically transferred from the couple's Charles Schwab account to their bank accounts. However, the court found that Scott had correctly classified these transfers as credits for nontaxable inflow transactions and excluded them from the Chicos' taxable income.

The court also disallowed Doobtubes' claimed cost of goods sold for 2011 and 2012 because Chico provided no information regarding the company's beginning and ending inventories for either year. The Tax Court also found that Chico received constructive dividends from Lakewood in 2011 and 2012 in the form of direct cash transfers and payments of Chico's personal expenses. The court noted that Scott discovered Chico's interest in Lakewood in the course of performing his bank deposits analysis and the Chicos failed to respond to Scott's requests for information regarding Lakewood or to his requests that they file tax returns on the corporation's behalf. The Tax Court agreed with the IRS's determination that the Chicos underreported their rental income for 2010-2012. The court found that the Chicos failed to respond to Scott's request for information or otherwise to cooperate with his examination. Although Chico testified that the difference between the Chicos' reported income and the IRS's determination was due to the tenants' payments toward shared utilities expenses, they produced no evidence to substantiate the amounts of any such shared expenses or to show whether the rental agreements included or excluded utilities in the agreed-upon rental amounts.

In upholding the fraud penalty, the Tax Court found that Chico's fraudulent intent could be inferred from the badges of fraud that were present in this case. The court noted that the Chicos consistently and substantially understated their income over the three years at issue by understating their gross receipts by more than $180,000. The court found that the Chicos' records were inadequate and that Chico failed to file corporate tax returns for Lakewood despite being a 50 percent owner and the chief financial officer. The court reasoned that although Chico reported a portion of his dividend income from Lakewood, he did so in such a manner as to avoid disclosing the true nature and source of the dividends while omitting significant amounts of constructive dividends. Further, the court found that the Chicos were uncooperative during Scott's examination in that they failed to provide documentation or respond to questions until the IRS began a summons enforcement action. The court also noted that Chico was a tax professional who had familiarity with corporate filing procedures. The court said that Chico's business experience and knowledge of the tax laws constituted circumstantial evidence that he was aware of his tax reporting obligations and that in consistently underreporting his income, he did so with fraudulent intent. The Chicos appealed the Tax Court's imposition of a fraud penalty to the Ninth Circuit.

The Ninth Circuit affirmed the Tax Court and held that it did not clearly err in its finding of fraud. According to the Ninth Circuit, the record supported the Tax Court's findings that the Chicos: (1) understated their income by more than $275,000 over three years; (2) produced no adequate records to substantiate the amounts reported on their tax returns; (3) failed to file tax returns for Lakewood even after being asked to do so by Scott; (4) implausibly attributed their underreported income to nontaxable investments from an inheritance when Scott accurately characterized the majority of such transfers as nontaxable; (5) concealed income received from Lakewood by failing to report constructive dividends; and (6) failed to cooperate with Scott's investigation by ignoring his early requests for interviews and blaming their attorney for failing to produce adequate records. The Ninth Circuit noted that the Tax Court also considered these badges of fraud in the context of Chico's specialized knowledge and experience on corporate and business taxation as a tax preparer himself to find even stronger circumstantial evidence of fraud. According to the Ninth Circuit, there was no clear error in the Tax Court's finding that the total weight of these badges provided clear and convincing evidence of the Chicos' specific intent to avoid a tax known to be owing.

For a discussion of the fraud penalty for underpayments of tax, 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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