Wife Escapes Liability for Fraud Penalties with Respect to Husband's Illicit Business

(Parker Tax Publishing April 2017)

The Tax Court held that the wife of a taxpayer, who ran a business which specialized in the unauthorized duplication of copyrighted works and who significantly underreported his 2008 and 2009 business income, was not liable for the 75 percent fraud penalty for 2008 and 2009. Further, the court concluded that neither the husband nor the wife was liable for the fraud penalty for 2010 because the deficiency for that year was a run-of-the-mill deficiency arising from a failure to substantiate expenses underlying claimed deductions, and not the existence of fraud. Ballard v. Comm'r, T.C. Memo. 2017-57.

Facts

Bradley Ballard operated a sole proprietorship under the name Quik Copy. As Quik Copy, Mr. Ballard operated a print and copy business wherein he specialized in the unauthorized duplication of copyrighted works. To conceal his piracy, Mr. Ballard dealt mostly in cash, kept no financial or business records, and maintained numerous bank accounts.

Mr. Ballard and his wife filed separate tax returns for 2008. Ms. Ballard filed timely, reporting herself as a head of household, independently supporting her three children. Mr. Ballard filed as single with no dependents. Mr. Ballard, however, filed his return nearly five months late.

For 2009, Mr. Ballard filed as a head of household, claiming Ms. Ballard's children as dependents. Again Mr. Ballard failed to file timely, filing this return on May 3, 2010. Ms. Ballard neither signed this return nor filed separately.

For 2008 and 2009, Mr. Ballard reported portions of Quik Copy's receipts and expenses on his individual tax returns using Schedules C, Profit or Loss From Business. However, he did not report any gross receipts or expenses associated with his illicit activities.

IRS Audit

In 2010, the IRS audited Mr. Ballard's 2007 tax return. The IRS then expanded the audit to Mr. Ballard's 2008 and 2009 tax returns, for which an IRS revenue agent performed a bank deposits analysis. This analysis led the IRS to determine that Mr. Ballard had underreported Quick Copy's gross receipts by approximately $1,100,000 and $741,000 for 2008 and 2009, respectively.

During the audit, Mr. and Ms. Ballard provided the IRS with professionally prepared amended joint returns for 2008 and 2009 (amended returns) and their joint 2010 return, which at that time was approximately seven months late. They also consented to an extension of the statute of limitations on assessment. While the couple's amended returns purported to correct Mr. Ballard's reporting of Quik Copy's gross receipts for 2008 and 2009, the IRS found that the amended returns still exhibited significant underreporting when compared with the IRS's bank deposits analysis. Additionally, the couple failed to substantiate the business expenses and capital losses for which they claimed deductions in their amended 2008 and 2009 returns and in their newly filed 2010 return.

The IRS issued the Ballards a notice of deficiency for years 2008-2010 disallowing deductions for all unsubstantiated expenses and capital losses for years 2008-1010. On the basis of the bank deposits analysis, the IRS increased the couple's Schedule C gross receipts for 2008 and 2009. Finally, the IRS determined additions to tax, under Code Sec. 6651, for failure to file timely and fraud penalties, under Code Sec. 6663, for years 2008-2010 for both Mr. and Ms. Ballard.

Liability for Fraud Penalty

When any part of an underpayment of tax is attributable to fraud, Code Sec. 6663(a) imposes a penalty equal to 75 percent of that underpayment. To prove fraud, the IRS must establish that: (1) an underpayment of tax exists and (2) a portion of the underpayment is attributable to the taxpayer's fraudulent intent to evade tax thereon.

Under Code Sec. 7454, the IRS bears the burden of proof and must prove fraud by clear and convincing evidence for each year. Various kinds of circumstantial evidence or "badges of fraud" may combine to support a finding of fraudulent intent, including: (1) a taxpayer's consistent pattern of understating income and filing false returns, (2) failure to maintain adequate records, (3) concealment of assets, (4) dealing in cash, (5) implausible or inconsistent explanations of behavior, (6) and failure to cooperate with tax authorities. While spouses are jointly and severally liable for the total tax due arising from their joint federal income tax return, Code Sec. 6663(c) provides that the fraud penalty does not apply with respect to a spouse unless some part of the underpayment is due to the fraud of such spouse.

Tax Court's Decision

The Tax Court upheld the tax deficiencies for 2008-2010, finding that undisputed facts showed that Mr. Ballard understated his Schedule C gross receipts for 2008 and 2009 and that he failed to maintain any business records. Additionally, the court said, the couple failed to substantiate their business expenses and capital losses in excess of the amounts that the IRS allowed for 2008-2010.

With respect to the fraud penalties, the court separately evaluated the actions of Mr. Ballard and Ms. Ballard for 2008 and 2009. The court noted that Mr. Ballard derived unreported gross receipts from his unauthorized duplication and sale of DVDs and CDs and conducted this portion of his business in cash and neglected to keep any books or records thereof. Further, the court said, Mr. Ballard trafficked these cash funds in and among multiple bank accounts and intermingled this cash with his personal assets. These actions indicated to the court that Mr. Ballard ultimately desired to conceal this income and the income's illicit sources by filing false returns with the IRS. Although Mr. Ballard ostensibly cooperated with the IRS during the audit by submitting amended returns prepared by a professional those returns, the court observed, continued his trend of underreporting Schedule C gross receipts. The court concluded that Mr. Ballard's actions with respect to his 2008 and 2009 tax years were clearly undertaken with an intent to conceal income and prevent the collection of tax and thus the IRS satisfied its burden of proof with respect to Mr. Ballard's fraudulent intent for 2008 and 2009.

However, the court held that Ms. Ballard bore no liability for the fraud penalties for 2008 and 2009. According to the court, there was insufficient evidence in the record to justify holding that Ms. Ballard acted fraudulently or intended to evade tax for 2008 or 2009. Citing its decision in Stone v. Comm'r, 56 T.C. 213 (1971), the court noted that the actions of Mr. Ballard may not be imputed to Ms. Ballard. The paucity of evidence relating to Ms. Ballard, the court said, contrasted with the overwhelming evidence showing that Mr. Ballard acted with fraudulent intent throughout 2008 and 2009. For 2008, Ms. Ballard individually filed a return whose accuracy the IRS had not questioned.

Similarly, the court said, no facts indicated that Ms. Ballard knew about or aided in the preparation of Mr. Ballard's fraudulent 2009 head of household return, of which she was not a signatory. The court also noted that the IRS did not allege, and the facts did not indicate, that Ms. Ballard made a habit of underreporting her income or underpaying her tax liabilities. The court said that the facts suggested she was not involved in her husband's business activities legitimate or illicit. Similarly, the court said, the bank deposits analysis examined only the accounts of Mr. Ballard and gave rise to no inference that Ms. Ballard knew of, had an interest in, or was authorized to draw upon those accounts.

With respect to the fraud penalty assessment for 2010, the Tax Court held that neither Mr. Ballard nor Ms. Ballard were liable for the penalty. According to the court, there was no clear and convincing evidence of an underpayment for 2010. Neither, the court said, was there any evidence that either Mr. Ballard or Ms. Ballard acted with the requisite fraudulent intent in 2010. The court noted that, for 2010, unlike 2008 and 2009: (1) the IRS did not allege that Mr. Ballard maintained bank accounts for subterfuge or the intermingling of business and personal assets; (2) the couple did not file a flagrantly false return; and (3) the IRS did not determine that the couple underreported gross income or overstated deductions. The facts with respect to 2010, the court said, established a run-of-the-mill deficiency arising from a failure to substantiate expenses underlying claimed deductions, not the existence of fraud.

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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