Opinion ID: 213362
Heading Depth: 2
Heading Rank: 2

Heading: The imposition of the fraud penalty

Text: We next address the Tax Court's finding that the Coles were liable for the fraud penalty. If any portion of an underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud. I.R.C. § 6663(a). Unlike the assessment of unreported income, courts do not presume the existence of fraud; rather, the Commissioner carries the burden of proving by clear and convincing evidence that an underpayment of taxes was due to fraud. Toushin v. Comm'r, 223 F.3d 642, 647 (7th Cir.2000) (citing I.R.C. § 7454(a); Pittman, 100 F.3d at 1319). If the Commissioner proves that any portion of an underpayment is attributable to fraud, the entire underpayment shall be treated as attributable to fraud, except with respect to any portion of the underpayment which the taxpayer establishes (by a preponderance of the evidence) is not attributable to fraud. I.R.C. § 6663(b). The fraud determination turns on whether the taxpayer had an actual, specific intent to evade a tax owed. Stephenson v. Comm'r, 79 T.C. 995, 1005 (1982), aff'd, 748 F.2d 331 (6th Cir.1984) (per curiam). Rarely does direct evidence exist of a taxpayer's fraudulent intent. Toushin, 223 F.3d at 647. But the IRS may establish fraudulent intent through circumstantial evidence. Id. Like our review of the findings regarding the Coles' unreported income, a tax court's fraud determination is a finding of fact that will not be set aside unless clearly erroneous. Id. (quoting Pittman, 100 F.3d at 1319). In Spies v. United States, 317 U.S. 492, 499, 63 S.Ct. 364, 87 L.Ed. 418 (1943), the Supreme Court noted that: Congress did not define or limit the methods by which a willful attempt to defeat and evade might be accomplished and perhaps did not define lest its effort to do so result in some unexpected limitation. Nor would we by definition constrict the scope of the Congressional provision that it may be accomplished in any manner. By way of illustration, and not by way of limitation, we would think affirmative willful attempt may be inferred from conduct such as keeping a double set of books, making false entries or alterations, or false invoices or documents, destruction of books or records, concealment of assets or covering up sources of income, handling of one's affairs to avoid making the records usual in transactions of the kind, and any conduct, the likely effect of which would be to mislead or to conceal. Courts have expanded these examples to include the understatement of income, failure to file tax returns, and implausible or inconsistent explanations of behavior. Bradford, 796 F.2d at 307 (citations omitted). Commingling assets in an attempt to avoid tax liability, filing late tax returns, and failure to maintain adequate personal or corporate business records have also been cited as indications of fraud. United States v. Walton, 909 F.2d 915, 926 (6th Cir.1990). Courts also consider relevant the taxpayer's education, intelligence, and tax expertise in determining fraudulent intent. See id. at 927; Stephenson, 79 T.C. at 1006. The Tax Court found the Coles liable for the fraud penalty citing a variety of factors, or badges of fraud, to show that the Commissioner proved with clear and convincing evidence that Scott and Jennifer fraudulently understated their 2001 tax liabilities. These findings were not clearly erroneous. The court started with the Coles' education and intelligence as illustrated by Jennifer's prior work as an accountant after earning a college degree and Scott's attorney's license, oath to uphold the law, and his legal practice that included tax law and preparing tax returns. The Coles cannot claim to be unsophisticated or unknowledgeable of the Code's principles. Thus, we reject their claim that the Tax Court used acts of negligence to show fraud, particularly considering the number of improper acts identified by the Tax Court. The Tax Court's finding that the Coles omitted $1,215,183 of income and $1,329,268 of self-employment income from their 2001 joint tax return is a longstanding sign of intent to evade taxation. See Spies, 317 U.S. at 499, 63 S.Ct. 364 (noting that covering up sources of income allows an inference of affirmative willful attempt to evade); Bradford, 796 F.2d at 308 (failing to report taxable income supported a fraud finding). Intensifying this indication of fraud is that Scott's attempt to avoid tax liability for his 2001 windfall took the form of an elaborate shell game through which Scott attempted (although ineptly) to use his knowledge of tax matters to place the income in a defunct entity purportedly free of tax responsibilities. See Walton, 909 F.2d at 926 (noting that implausible explanations of conduct is a strong indication of fraud). Failing to maintain accurate records is a strong indicum of fraud with intent to evade taxes. Toushin, 223 F.3d at 647 (quoting Estate of Upshaw v. Comm'r, 416 F.2d 737, 741 (7th Cir.1969)). The Tax Court found that although Scott claimed that he diverted most of his income from his Bentley Group-related legal fees to others ostensibly as loans, the transactions lacked documentation. The Coles also failed to document the alleged transfer of the Bentley Group interest to SCC or his deposits into the Bentley Group account. The lack of records also supported the Tax Court's finding that Scott failed to respect the existence of different entities or the partners in the Bentley Group. The Coles' defense is that the records were lost or misplaced or discarded due to the passage of time and that an August 19, 2005, storage building fire consumed many of the records of the Bentley Group. Regardless of these excuses, Scott testified that he did not retain billing invoices or save the papers he used to prepare his tax returns. And the IRS began auditing their 2001 tax return in 2003, well before the 2005 fire and not long after the Coles filed their joint 2001 income tax return on April 11, 2002. The Coles also do not elaborate on what records they would produce but for the fire or why they did not attempt to reproduce the records. Nor do they explain why the loan recipients did not have records of the transactions or why the Coles did not keep at least some of the records in Scott's home office. And some documents survived as evidenced by the inclusion in the Tax Court record of the Bentley Group partnership agreement and handwritten minutes from an October 5, 1999, meeting of Cole Law Offices partners Darren and Scott Cole. The Tax Court's finding that the absence of records suggested fraud was not clearly erroneous. The Coles also commingled business and personal assets. Scott deposited some of his earnings from his legal practice into the JAC account and Jennifer's personal account. Jennifer wrote checks from these accounts to pay for personal expenses, such as school tuition, landscaping, and music lessons. Scott also withdrew $1.17 million from the Bentley Group in 2001 and loaned it to friends and family. The Tax Court did not clearly err in finding that Scott showed little respect for business formalities and effectively made the Bentley Group nothing more than a checking account. The Coles also concealed assets by funneling income into multiple business entities that lacked any business purpose. The entities served, as found by the Tax Court, as conduits to hide income Scott earned from providing legal services and preparing tax returns. Instead of reporting the income from his law practice, Scott attempted (after the IRS audit began) to assign his interest in his law practice to his personal corporation (for which he disclaimed all but 1% of the ownership) that later that year became defunct. This scheme, as found by the Tax Court, was an attempt to conceal the true nature of the earnings subject to income and self-employment taxes. Scott also misrepresented his occupation (and thus his source of income) by stating on the Coles' 2001 return that he was an investor. Scott directed his income through several entities he undoubtedly controlled. By attempting to minimize his ownership, Scott thought he could report only $505 in tax liability despite earning more than $1.2 million in tax year 2001. This scheme, given Scott's apparent knowledge of tax and business planning matters, is a striking badge of fraud that Scott endeavors to further by advancing spurious arguments on appeal. Walton, 909 F.2d at 927 (agreeing with the district court that the taxpayer's most incredible, . . . most nonsensical, child-like story, despite his college education and business experience, supported a fraud finding). Finally, the Coles argue that the Tax Court may have used acts by Darren Cole and Lisa Cole and an investment company to cross contaminate Scott and Jennifer Cole, JAC, or Bentley Group and to conclude fraud. The Coles do not show where the Tax Court confused anything. Putting aside that the Coles raise this issue as a mere possibility, the Tax Court explicitly delineated between Scott and Jennifer's acts and Darren and Lisa's acts suggesting fraud. The Coles' claim that some of the acts suggesting fraud were on account of the Bentley Group or JAC ignores that Scott was a Bentley Group partner and Scott managed JAC's affairs. Thus, the Coles fail to show where the Tax Court committed clear error in finding that the Commissioner proved by clear and convincing evidence that Scott and Jennifer each fraudulently understated their tax liabilities for 2001. [5]