Incarceration and Embezzlement Weren't Reasonable Cause for Late Filed Tax Returns

(Parker Tax Publishing July 2021)

The Fifth Circuit held that, where a taxpayer who was incarcerated gave power of attorney to a friend to file his tax returns and the friend not only didn't file the returns but embezzled money from the taxpayer, the taxpayer did not have reasonable cause for failing to timely file his returns and timely pay the taxes due. Thus, the taxpayer was not entitled to a refund of the more than $425,000 in penalties paid as a result of the late filings. Lindsay v. U.S., 2021 PTC 207 (5th Cir. 2021).

Background

Jeffrey Lindsay was incarcerated from April 2013 to June 2015. In May 2013, Lindsay executed a Universal Power of Attorney (POA) appointing a friend, Keith Bertelson, as his attorney in fact. According to the terms of the POA, Bertelson had complete control of Lindsay's bank accounts and retained full authority to manage his affairs. While incarcerated, Lindsay directed Bertelson to file his tax returns and pay his taxes. Although Bertelson assured Lindsay that he was filing the returns and paying the taxes due, he was actually embezzling hundreds of thousands of dollars from Lindsay. Lindsay's tax returns for 2012 through 2015 were not timely filed, nor were his taxes or estimated quarterly taxes timely paid. While still incarcerated, Lindsay discovered Bertelson's malfeasance and revoked the POA in April 2014. Lindsay then sued Bertelson for embezzlement and after a jury trial in 2015, he was awarded $705,415 in actual damages and $1 million in punitive damages.

Once Lindsay was released from prison, he eventually filed all delinquent tax returns and paid the taxes owed, plus interest and more than $425,000 in penalties. In 2018, Lindsay was unsuccessful in obtaining a refund for the penalties. He filed suit in federal district court the following year. In his complaint, Lindsay argued that his failure to file his tax returns and pay his taxes was due to reasonable cause and not willful neglect. He alleged that his incarceration qualified as a "disability" and that, considering his unusual circumstances, penalizing him for late tax filings and payments would go against equity and good conscience. He demanded a jury trial and sought a refund of the penalties that he paid.

The IRS moved to dismiss Lindsay's suit for failure to state a claim upon which relief could be granted and, alternatively, for summary judgment. Relying on the Supreme Court's opinion in U.S. v. Boyle, 469 U.S. 241 (1985), the government argued that a taxpayer is not entitled to the reasonable cause defense for late filings when he relies on an agent to file a timely tax return and the deadline for filing is ascertainable by the taxpayer.

A magistrate judge issued a report and recommendation that the government's motion to dismiss be denied. The district court, in Lindsay v. U.S., 2020 PTC 402 (W.D. Tex. 2020), disagreed and issued an order rejecting the magistrate judge's report and recommendation. In its order, the district court explained that while it was sympathetic to Lindsay's specific circumstances, the "weight of authority indicates he has failed to state a claim upon which relief can be granted." Beginning with Boyle, the district court navigated the relevant caselaw and concluded that Lindsay was not entitled to assert the reasonable cause defense under Code Sec. 6651(a)(1), Code Sec. 6651(a)(2), or Code Sec. 6654(a).

Lindsay filed an appeal with the Fifth Circuit arguing that he exercised ordinary business care and diligence by giving Bertelson his power of attorney and by directing Bertelson to file his income tax returns and to pay his taxes. Lindsay noted that he routinely asked Bertelson whether he was handling Lindsay's tax obligations, and Bertelson said that he was. Thus, Lindsay contended, he had reasonable cause for late filings and delayed payments because he used ordinary business care and prudence but was nevertheless unable to file his returns and pay his income taxes due to circumstances beyond his control, i.e., Bertelson's malfeasance.

Lindsay also argued that his circumstances fit the IRS's internal definition of reasonable cause as spelled out in the IRS Manual. In Section 4.25.7.2.1, the Manual lists "the taxpayer's unavoidable absence" as a reasonable cause for relief from penalties. Lindsay also argued that Boyle does not control in cases where a taxpayer is not physically and mentally capable of knowing, remembering, and complying with a filing deadline. Relying on Brown v. U.S., 630 F.Supp. 57 (M.D. Tenn. 1985), Lindsay said that his incarceration rendered him incapable of complying with his filing deadline. In Brown, the district court concluded that Boyle did not govern the Code Sec. 6651(a)(1) analysis where an elderly man entrusted his tax responsibilities to an attorney, the attorney became ill and filed the return late, and the elderly man was incapable of meeting the criteria of ordinary business care and prudence given his age, health, and lack of experience.

Analysis

The Fifth Circuit affirmed the district court and held that Lindsay was not exempt from the penalties under Code Sec. 6651(a)(1) and Code Sec. 6651(a)(2) because the did not meet the reasonable cause criteria that would excuse him from those penalties. While the Code does not define "reasonable cause," the court noted that Reg. Sec. 301.6651-1(c)(1) does provide clarity in this area. To determine if a taxpayer had reasonable cause for not filing a tax return or paying a tax due, the court stated, the reasonable cause inquiry depends on the answer to the following questions: (1) whether the taxpayer used ordinary business care and prudence, and (2) whether the taxpayer was nevertheless unable to pay the tax.

In Boyle, the Fifth Circuit observed, the Supreme Court considered whether the executor of an estate could avail himself of the reasonable cause exception to tax penalties where he hired a lawyer who filed federal estate taxes three months late. The Court stated that while engaging an attorney to assist in probate proceedings is plainly an exercise of the "ordinary business care and prudence," that does not provide an answer to the question of reasonable cause. Though taxpayers may entrust certain duties to their agents, the Court said, Congress has placed the burden of prompt filing on the executor, not on some agent or employee of the executor. Congress, the Court noted, intended to place upon the taxpayer an obligation to ascertain the statutory deadline and then to meet that deadline, except in a very narrow range of situations.

The Fifth Circuit stated that, even if it read Boyle and Brown as creating an exception to the reasonable cause rule, Lindsay was not incapable of meeting the filing and payment deadlines. Lindsay could have used ordinary business care and prudence to assure that his taxes were filed and paid. The court concluded that Lindsay failed to act with such care.

With respect to the penalties under Code Sec. 6654, the court found that Lindsay also did not demonstrate reasonable cause for underpaying his estimated quarterly taxes for the same reasons he did not meet the reasonable cause requirements in Code Sec. 6651(a)(1) and Code Sec. 6651(a)(2).

For a discussion of abatement of penalties due to reasonable cause, see Parker Tax ¶262,127.

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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