Tax Preparer Escapes Fraud Penalty; Requisite Intent Not Found

(Parker Tax Publishing June 2016)

The Tax Court held that a tax return preparer and his wife were not liable for fraud penalties because the IRS did not prove that either of the taxpayers filed any return for the years at issue intending to conceal, mislead, or otherwise prevent the collection of tax. Although the IRS determined that many of the couple's business expenses were inflated because of a lack of substantiation and an inability to show the requisite business purpose, the Tax Court declined to find that this fact, standing alone, established a fraudulent pattern of conduct. Ericson v. Comm'r, T.C. Memo. 2016-107.

James and Rebecca Ericson, a married couple, filed joint tax returns for 2006 through 2008. Rebecca worked part time as a registered nurse and also operated a sole proprietorship that manufactured and sold fashion jewelry, bought and sold clothes, and manufactured and sold notions. The Ericsons did not keep a formal set of books for, or retain receipts underlying the expenses of, Rebecca's sole proprietorship. James periodically looked at the couple's bank and credit card statements and characterized (but did not separately record) for federal income tax purposes each expense shown on the statements. James, who had a bachelor's degree in business and a master's degree, also operated several business activities. One activity was providing accounting services, which consisted almost entirely of preparing income tax returns. Another activity was taking and selling photographs. The remaining activity was selling Hawaiian aloha shirts and jewelry. James prepared 700, 850, and over 1,000 federal income tax returns for his clients during 2006, 2007, and 2008, respectively. Some clients paid him in cash and, rather than depositing the cash receipts in his bank account, he used the receipts to pay business expenses.

James's tax return preparation clients included two couples for whom James prepared joint federal income tax returns for 2007 and 2008. He prepared those returns primarily on the basis of a wide range of information that he elicited from the couples, as to their finances and activities, and in meetings with them. The couples gave James very few documents to support information reported on the tax returns. For one couple, James prepared a Form 2106 for 2007 detailing employee business expenses of approximately $16,500 without receiving any documentation from the couple. Similarly, in 2008, James prepared a Form 2106 for the couple reporting approximately $9,000 in employee business expenses without receiving any documentation. James also prepared a Form 8863 claiming an education credit relating to the wife's dance lesson expenses. When the IRS examined those returns, they disallowed the claimed employee business expense deductions and the education credit. The IRS also made adjustments to the second couple for whom James prepared federal income tax returns for 2007 and 2008, disallowing some of the expenses James had reported on the returns.

James made numerous cash withdrawals from automated teller machines (ATMs) to pay individuals who worked for his sole proprietorship. He characterized most of these individuals as independent contractors, and he generally paid them in cash. He kept no formal records of his ATM or cash transactions, but for each month he characterized his ATM and cash transactions as personal or business related.

The Ericsons' daughter and son sometimes worked in their sole proprietorships. The daughter was paid for her services with cash or her parents paid her rent or other personal expenses. The son was paid by check. James and his son played golf together twice a week, and James paid for these outings. The Ericsons deducted these payments as business expenses because in James's view, the deductions were appropriate because he and his son discussed businesses during these outings.

James's Schedule Cs reported net income of $10,404, $10,207, and $21,595, for 2006, 2007, and 2008, respectively. Rebecca's Schedule C reported net losses of $10,776, $8,166, and $8,912 for 2006, 2007, and 2008, respectively.

The IRS audited the Ericsons' returns for 2006 through 2008. The auditor, Carl Van Zweden, had previously examined 15 of the returns prepared by James and concluded that the returns tended to have at least one questionable Schedule C and often times inflated employee business expenses and unallowable education credits. As a result, the auditor concluded that James was a "problem return preparer" and audited the Ericsons' personal tax returns. Van Zweden performed a bank deposits analysis to ascertain the Ericsons' gross receipts from their sole proprietorships. In connection with that analysis, he also estimated James' gross receipts from his tax preparation activity for each year at issue by consulting IRS records and documents regarding the number of income tax returns that James prepared. Van Zweden concluded from his audit that the Ericsons had unexplained deposits and, thus, that James's sole proprietorship had unreported gross receipts.

The IRS also disallowed all of the Ericsons' claimed itemized deductions for 2006 and 2007, and $92,564 of their deductions in 2008, on the grounds that the couple did not show that the expenses were paid or incurred or, where relevant, had the requisite business purpose. As a result, the IRS issued a notice of deficiency assessing additional income taxes, as well as accuracy-related and fraud penalties. According to the IRS, the fraud penalties were appropriate, in part, because James prepared tax returns that claimed expenses for which he received no documentation. James' preparation of returns showed a consistent pattern of preparing returns for clients that included fabricated or inflated schedule and this pattern of conduct, the IRS said, was indicative of James' clear intent to deceive or mislead the IRS with regard to his clients' returns.

Before the Tax Court, the IRS conceded that the assessment periods for 2006 and 2007 were closed to the extent that the court found that the fraud penalties did not apply for those years. Because the court found that such penalties did not apply, the only year before the court was the Ericsons' 2008 tax year.

The Tax Court agreed with the IRS that the Ericsons failed to maintain adequate records for their sole proprietorships and failed to substantiate their reported expenses for 2008. The court thus disallowed the Ericsons' deductions of $92,564 in sole proprietorship expenses for 2008. While the court considered it reasonable to assume the Ericsons incurred many deductible expenses in operating their businesses, the Ericsons provided an insufficient evidentiary basis for the court to conclude that they were entitled to any deduction greater than the IRS allowed. The court also found that the couple failed to report $5,552 of sole proprietorship income for 2008 and disallowed $3,816 of employee business expenses for 2008.

With respect to the 2008 penalty assessments, the court held that the couple was not liable for the fraud penalty but was liable for the accuracy-related penalty. The court began by examining the IRS's most significant indicia of fraud - the returns prepared by James - and noted that the IRS rested its assertions of a consistent pattern of fraudulent conduct on its review of only four of the over 2,500 federal income tax returns prepared by James. According to the court, the four client returns did not clearly and convincingly lead to a finding that the Ericsons' returns were tainted by fraud. Indeed, the court said, there was substantial evidence that the businesses reflected on one of those returns was not fictitious, as claimed by the IRS, and that the documentation regarding that clients' education credit was muddled at best.

Additionally, while the court agreed with the IRS that the Ericsons failed to maintain adequate contemporaneous records for their sole proprietorships, the court disagreed with the IRS's position that such failure was with the requisite intent to evade federal income tax. Rather, the court found that it was the result of the couple's negligent or reckless behavior. While the IRS determined that the Ericsons' business expenses were inflated because of a lack of substantiation and the inability to show the requisite business purpose, the court declined to find that this fact, standing alone, established a fraudulent pattern of conduct.

For a discussion of the various badges of fraud that would support the assessment of a fraud penalty, 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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