The Tax Court in Brief – September 12th – September 16th, 2022

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Tax Litigation: The Week of September 12th, 2022, through September 16th, 2022

Estate of Clemons v. Comm'r, T.C. Memo. 2022-95| September 16, 2022 | Buch, J. | Dkt. No. 25029-16


Short Summary: Brett Clemons (Clemons) was a successful computer programmer and owned various computer programming businesses. In 2001, he opened a Swiss bank "numbered" account. However, he hid the transfer and existence of the foreign account from his then-wife because he intended to divorce her. When opening his foreign account, he acknowledged his U.S. tax liability in opening documents and requested that the Swiss bank account hold his mail. After the bank account was opened, he used it to deposit significant funds and to make investments overseas.

Clemons prepared and filed his own income tax returns. For 2003 through 2007, he did not report all of his earnings from his computer programming business, and he did not report investment gains from his investments overseas. He also did not disclose foreign accounts on Schedule B of his returns, nor did he file FBARs each year.

In October 2008, Clemons was advised of a United States investigation into the Swiss bank. When Clemons was informed of a "new business model" the bank intended to use, he directed the Swiss bank to liquidate his investment portfolio, depositing those funds into another Swiss bank account. On his 2008 Schedule B, he reported that he held foreign financial accounts, although he did not disclose the Swiss bank account. Clemons did not file a 2008 FBAR.

For his 2009 tax year, Clemons reported on Schedule B that he held a foreign financial account in the Netherlands, but he did not disclose the Swiss bank account. Similar to all of his prior tax years, he did not file a 2009 FBAR.

During the examination of his 2003 through 2009 tax years, Clemons provided false testimony to the IRS and submitted false FBARs. The IRS later issued a notice of deficiency to Clemons for his 2003 through 2009 tax years. In the notice of deficiency, the IRS sought to impose fraud penalties with respect to Clemons' filings for his 2003 through 2009 tax years. The notice of deficiency further determined that Clemons had omitted substantial amounts of gross income for those tax years. After filing his petition and after trial, Clemons passed away, and his estate was replaced as the true party in interest.

Key Issues:

  • Whether the IRS is barred under the statute of limitations from assessing tax related to Clemons' 2003 through 2009 tax years?
  • Whether Clemons is liable for enhanced fraud penalties for 2003 through 2009 under section 6663?
  • Whether the IRS's determinations increasing Clemons' gross income and disallowing certain Schedule C deductions are correct?

Primary Holdings:

  • The IRS is not time barred from assessing taxes against Clemons for his 2003 through 2009 tax years because Clemons filed fraudulent tax returns, extending the statute of limitations indefinitely.
  • Based on various "badges of fraud," Clemons is liable for fraud penalties for his 2003 through 2009 tax years under section 6663.
  • Because the IRS's determinations in the notice of deficiency are presumed correct, and because Clemons has not offered sufficient evidence to rebut this presumption, the adjustments proposed in the notice of deficiency are sustained in full except to the extent Clemons offered evidence regarding his investment expense deductions.

Key Points of Law:

  • Generally, the IRS's determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving error. Rule 142(a); Welch v. Helvering,, 290 U.S. 111, 115 (1933).
  • A special rule applies to determinations of unreported income. In these cases, the IRS's determinations of unreported income are presumptively correct if supported by a minimal evidentiary foundation linking the taxpayer to an income-producing activity. Blohm v. Comm'r, 994 F.2d 1542, 1549 (11th Cir. 1993), aff'gC. Memo. 1991-636. If the IRS produces evidence linking the taxpayer to an income-producing activity, the burden shifts to the taxpayer to prove the determinations are arbitrary or erroneous. Id.
  • PFIC income is taxed under section 1291, unless a taxpayer elects otherwise. R.C. §§ 1291(a)-(c), 1295, 1296. Taxpayers may, however, elect mark-to-market treatment, but taxpayers who wish to make the election must make an election by the due date for filing an income tax return for the first year in which the election will apply. Treas. Reg. § 1.1296-1(h)(1); Prop. Treas. Reg. § 1.1296-1(h)(1). Whether a taxpayer is eligible to make a retroactive election under section 1296 turns on general rules regarding extensions for regulatory elections. Treas. Reg. § 1.1296-1(h)(1)(iii); see also Treas. Reg. § 301.9100-1. Automatic extensions of six months may be available to taxpayers who take certain corrective action during that period. See Treas. Reg. § 301.9100-2(b). If a taxpayer does not meet the requirements for an automatic extension, his request for retroactive relief will be granted if he shows that he "acted reasonably and in good faith" and that "the grant of relief will not prejudice the interests of the Government." Treas. Reg. § 301.9100-3(a). A taxpayer is deemed to not have acted reasonably or in good faith when he uses hindsight in requesting relief. Treas. Reg. § 301.9100-3(b)(3)(iii). If a change in circumstances after the original due date for an election makes the election more advantageous, the IRS will not ordinarily grant relief. Id.
  • Taxpayers bear the burden of proving their entitlement to deductions and credits. Rule 142(a); INDOPCO, Inc. v. Comm'r, 503 U.S. 79, 84 (1992). Taxpayers must maintain records sufficient to establish the amount of each deduction, and failure to produce such records counts heavily against a taxpayer's attempted proof. Rogers v. Comm'r, T.C. Memo. 2014-141; see also Reg. § 1.6001-1(a), (e).
  • Section 162(a) generally allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. The taxpayer bears the burden of proving that business expenses were actually incurred and were "ordinary and necessary." R.C. § 162(a); see also Rule 142(a). If the taxpayer establishes that an expense is deductible but cannot substantiate the precise amount, the Tax Court may estimate the amount. See Cohan v. Comm'r, 39 F.2d 540, 543-44 (2d Cir. 1930). However, the taxpayer must provide some basis for an estimate. See Vanicek v. Comm'r, 85 T.C. 731, 742-43 (1985).
  • The test for whether a taxpayer is engaged in a trade or business is whether his primary purpose and intention in engaging in the activity is to make a profit. Zell v. Comm'r, 763 F.2d 1139, 1142 (10th Cir. 1985), aff'g C. Memo. 1984-152.
  • Generally, a U.S. citizen can claim a credit in the amount of any income taxes paid or accrued during the tax year to any foreign country. R.C. § 901(a), (b). When a taxpayer claims a credit for foreign income taxes withheld at the source, he must establish that the tax was withheld and that it was paid over to the foreign tax authority. Norwest Corp. & Subs. v. Comm'r, T.C. Memo. 1995-453; see also I.R.C. § 905; Treas. Reg. § 1.905-2.
  • Section 911 permits a qualified individual to exclude a percentage of his foreign earned income and housing cost amount from gross income. R.C. § 911(a), (c)(1), (3). When the housing cost amount is not employer provided, it is generally treated as deductible, subject to a limitation. I.R.C. § 911(c), Treas. Reg. § 1.911-4(e).
  • Section 7491(c) provides that the IRS bears the burden of production "with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed" under the Internal Revenue Code. To meet this burden, the IRS must produce evidence regarding the appropriateness of imposing the penalty or addition to tax. Higbee v. Comm'r, 116 T.C. 438, 446-47 (2001). Where applicable, this includes evidence of compliance with section 6751(b). See Carter v. Comm'r, T.C. Memo. 2020-21. Once the IRS carries his burden of production, the taxpayer must come forward with persuasive evidence that the IRS's determinations are incorrect or that the taxpayer had reasonable cause. See Higbee, 116 T.C. at 447.
  • If the IRS asserts fraud, the IRS must prove fraud by "clear and convincing evidence." Rule 142(b); I.R.C. § 7454(a); Castillo v. Comm'r, 84 T.C. 405, 408 (1985).
  • Section 6751(b) requires managerial approval of certain penalties, including penalties under sections 6662 and 6663. Section 6751(b)(1) provides that the initial determination to assert penalties must be approved (in writing) by the immediate supervisor of the person who made that determination. An "initial determination" occurs the earlier of when the IRS issues a notice of deficiency or formally communicates a decision to determine penalties. Belair Woods, LLC v. Comm'r, 154 T.C. 1, 14-25 (2020); Clay v. Comm'r, 152 T.C. 223, 248-49 (2019), aff'd, 990 F.3d 1296 (11th Cir. 2021). A Letter 5153 accompanied by an RAR can be an initial determination. Oropeza v. Comm'r, 155 T.C. 132, 140-41 (2020); Patel v. Comm'r, T.C. Memo. 2020-133.
  • Section 6651(a)(1) imposes an addition to tax for the failure to file a return on or before the due date (including extensions) unless the taxpayer can establish that such failure was "due to reasonable cause and not due to willful neglect." To demonstrate reasonable cause, a taxpayer must show that he exercised ordinary business care and prudence but was nevertheless unable to file on time. S. v. Boyle, 469 U.S. 241, 246 (1985); Treas. Reg. § 301.6651-1(c)(1).
  • A taxpayer's selective inability to meet his tax obligations when he can otherwise carry on normal activities does not excuse late filing. Wilkinson v. Comm'r, T.C. Memo. 1997-410.
  • Section 6662(a) and (b)(1) impose a 20% accuracy-related penalty on any portion of an underpayment of tax that is due to negligence or disregard of rules. "Negligence" includes any failure to make a reasonable attempt to comply with the provisions of the Code, and "disregard" includes any careless, reckless, or intentional disregard. R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1) and (2). A taxpayer is also negligent if he fails to maintain sufficient records to substantiate the items in question. Treas. Reg. § 1.6662-3(b)(1); see also Mileham, T.C. Memo. 2017-168.
  • Section 6663 imposes a penalty of 75% of an underpayment of tax if any part of the underpayment of tax is due to fraud. If the IRS establishes that part of an underpayment is due to fraud, the entire underpayment is "attributable to fraud," except to the extent the taxpayer establishes that some part of it is not. R.C. § 6663(b). The existence of fraud is a factual question to be resolved by considering the entire record. See DiLeo, 96 T.C. at 874.
  • To prove fraud, the IRS must prove two elements of fraud by clear and convincing evidence: (1) an underpayment of tax; and (2) fraudulent intent. Castillo, 84 T.C. at 408-09. A taxpayer's failure to meet his burden of proof as to an issue does not satisfy the clear and convincing evidence standard. DiLeo, 96 T.C. at 873. The burden applies separately for each tax year. Castillo, 84 T.C. at 408-09.
  • For fraud purposes, an underpayment is defined as the amount by which the tax imposed by the Internal Revenue Code exceeds the amounts shown as the tax by the taxpayer on his return. R.C. § 6664. The courts may infer fraudulent intent from circumstantial evidence, which may be given more weight depending on the taxpayer's sophistication. Clark v. Comm'r, T.C. Memo. 2021-114. Thus, various "badges of fraud" may indicate fraudulent intent. Niedringhaus v. Comm'r, 99 T.C. 202, 211 (1992).
  • A pattern of substantially underreporting income over several successive years can be strong evidence of fraudulent intent. See Zhadanov v. Comm'r, T.C. Memo. 2002-104. Such a pattern evinces fraudulent intent "even where the record is 'devoid of the usual indicia of fraud.'" Isaacson v. Comm'r, T.C. Memo. 2020-17.
  • A taxpayer's concealment of income or assets may indicate fraudulent intent. See Spies v. U.S., 317 U.S. 492, 499 (1943). And opening a Swiss bank account can indicate concealment. See Harrington v. Comm'r, T.C. Memo. 2021-95. This is because Switzerland's practices and legal framework make it difficult for other countries to obtain disclosure of Swiss bank accounts. See Ryan v. Comm'r, 58 T.C. 107, 109-10 (1972).
  • Filing false documents indicates a taxpayer's intent to evade income tax. Harrington, T.C. Memo. 2021-95. This includes filing an FBAR that is incomplete or filing a return that omits income or contains a false response.
  • A taxpayer's failure to cooperate with tax authorities, including his failure to cooperate with revenue agents during an examination, can indicate fraudulent intent. Grosshandler v. Comm'r, 75 T.C. 1, 19-20 (1980). Misleading statements during an audit, even from an unsophisticated taxpayer, may indicate fraudulent intent. Clark, T.C. Memo. 2021-114.
  • Implausible or inconsistent explanations for a taxpayer's behavior can indicate fraudulent intent. Bradford v. Comm'r, 796 F.2d 303, 307 (9th Cir. 1986), aff'g C. Memo. 1984-601.
  • Taxpayers must maintain records sufficient to determine their tax liability, and a failure to do so can indicate fraudulent intent. R.C. § 6001; Bradford v. Comm'r, 796 F.2d at 307-08. A taxpayer's choice not to receive UBS account statements may be seen as a "tax-avoidance strategy that he implemented with UBS, hoping that the absence of records, coupled with Swiss bank secrecy laws, would shield the account from discovery. Harrington, T.C. Memo. 2021-95.
  • Generally, the IRS must assess tax within 3 years from the later of when a return is filed or when it is due. R.C. § 6501(a). However, if a taxpayer files a false or fraudulent return with the intent to evade tax, tax may be assessed at any time. I.R.C. § 6501(c)(1).

Insight: The Estate of Clemons decision shows the dangers of not filing FBARs and other information returns with the IRS on a timely basis. Indeed, in cases such as these, the IRS often points to the non-filing as evidence that the taxpayer was attempting to conceal the foreign assets from the IRS, which can support a finding of fraud penalties. Taxpayers who have not timely filed FBARs or other information returns (e.g., Forms 8938, 3520, etc.) should consult with tax professionals to regain compliance and mitigate the risks of a fraud finding.

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