CA-11: preparer’s fraudulent intent sufficient to keep limitations period open
Finnegan, (CA 11 6/11/2019) 123 AFTR 2d ¶ 2019-770
Affirming the Tax Court’s decision, the Eleventh Circuit Court of Appeals has ruled that the fraud exception to the 3-year statute of limitations on assessments applied where a married couple’s returns were fraudulently prepared by their preparer. The court also rejected the couple’s argument that the Tax Court abused its discretion by accepting the preparer’s out-of-court statement admitting his culpability.
Background. Code Sec. 6501(a) generally provides that a valid assessment of income tax liability may not be made more than 3 years after the later of the date the tax return was filed or the due date of the tax return. However, under one of several exceptions, Code Sec. 6501(c)(1) provides that the assessment period remains open indefinitely “in the case of a false or fraudulent return with the intent to evade tax” (the fraud exception).
In Allen, (2007) 128 TC No. 4, the Tax Court held that the limitations period for assessment is extended indefinitely under Code Sec. 6501(c)(1) if the return is fraudulent, even though it was the preparer rather than the taxpayer who had the intent to evade tax. The Court found that the plain meaning of Code Sec. 6501(c)(1) doesn’t require the fraud to be the taxpayer’s. Rather, the Code keys the unlimited extension of the limitations period to the fraudulent nature of the return, not to the identity of the perpetrator of the fraud.
The U.S. Court of Federal Claims has ruled that the Code Sec. 6501(c)(1) open limitation period is restricted to instances in which the taxpayers themselves have the intent to commit fraud. On appeal, the Federal Circuit affirmed. That Court said that the “intent to evade tax” is confined to the taxpayer’s intent. (BASR Partnership v. U.S., (CA Fed Cir 2015) 116 AFTR 2d 2015-5432, affg (Ct Fed Cl 2013) 112 AFTR 2d 2013-6313)
Facts. Tipped off by an informant, IRS discovered a tax return preparer and his associates had prepared hundreds of fraudulent returns every year for 11 years. The fraudulent returns had several common features. They showed large refunds and partnership losses. The large partnership losses flowed through to the individual returns, and there were deductions for contributions to retirement plans. The bogus returns also reflected payments between partnerships and their partners.
The returns of John and Joan Finnegan, prepared by the same return preparer, fit the fraudulent-return mold. For example, they formed a partnership to hold rental property but never transferred ownership of the property to the partnership, nor entered into a partnership agreement. They never wrote checks to the partnership nor did the entity write checks to them. But their returns showed a capital contribution, and large losses caused in part by a guaranteed payment to the partners.
The return preparer was indicted and pled guilty to conspiring to defraud the U.S. and to interfering with the administration of the internal revenue laws. He then testified against one of his former business associates and declared that “[e]ach and every one” of the returns he prepared during the relevant time “contain[ed] some fraudulent entries.” The Finnegans were not part of the grand jury investigation into the return preparer and his associates. Nor were their returns used to support the indictments against the return preparer and his associates.
Roughly five years after the dust settled in the criminal proceedings, IRS issued a notice of deficiency to the Finnegans for the eight years that they submitted fraudulent returns. In their petition to the Tax Court, the Finnegans claimed that IRS had missed the three-year collection window and thus was too late. They claimed the fraud exception didn’t apply because IRS didn’t have enough evidence to show that the Finnegans’ fraudster return preparer had falsely or fraudulently prepared their returns. Citing Allen, IRS responded that the fraud exception to the three-year window applied because there was clear evidence that the return preparer had fraudulently prepared the Finnegans’ returns with intent to evade tax. The Finnegans never challenged Allen.
While the Finnegans’ case was submitted, but before the Tax Court issued its decision, the Federal Circuit affirmed the U.S. Court of Federal Claim’s BASR Partnership holding (see discussion above). IRS notified the Tax Court, and the Finnegans, about the Federal Circuit’s decision.
Tax Court. Relying on Allen, the Tax Court concluded that the fraud exception indeed was triggered, and the three-year window suspended, by the return preparer’s fraudulent intent. (Finnegan, TC Memo 2016-118) The Tax Court didn’t consider whether BASR Partnership undermined the result in Allen, and found that the latter case was controlling. The Tax Court also found that IRS had proven fraud with clear and convincing evidence. The Finnegans’ returns had many of the common elements that the fraudulent return preparer used when filling out bogus returns.
The Finnegans appealed, on two grounds. First, they argued that the fraud exception was triggered only when the taxpayer intended to evade tax; thus, they claimed the Tax Court erred when it found that the fraud exception was triggered by the return preparer’s intent to evade tax. In other words, they again argued Allen was wrongly decided. Second, they argued that the Tax Court abused its discretion by admitting the return preparer’s out-of-court statements (appearing as a witness in another proceeding against a former business associate, he said every return he prepared during the relevant period had some fraudulent entries), and by accepting the preparer’s affidavit testimony, in which he swore he had knowingly prepared false returns for the Finnegans.
Appeals Court. The Eleventh Circuit Court of Appeals rejected both arguments and affirmed the judgment of the Tax Court. The first argument failed because the Finnegans waived it before the Tax Court. They knew that IRS was relying on Allen and its holding, and they chose not to challenge it. They didn’t challenge it before, during, or after trial. In fact, in testimony, they explicitly told the Tax Court they accepted the result in Allen and were not challenging it.
As to the second argument, the appellate court agreed with the Tax Court that although the statements by the return preparer were hearsay, they satisfied the statement-against-interest exception to the ban on hearsay.
Under this exception, (1) the declarant must be unavailable to testify, (2) the statement must be “so contrary to the declarant’s proprietary or pecuniary interest” that a reasonable person would have made the statement only if he believed it was true, and (3) the statement must be “supported by corroborating circumstances that clearly indicate its trustworthiness, if it is offered in a criminal case as one that tends to expose the declarant to criminal liability.”
The appellate court ruled that each of these three elements was present. The return preparer wasn’t available to testify, his statements exposed him to criminal and civil liability from former clients, and his statements were corroborated by the Finnegans’ own testimony regarding the preparer’s role, his former business associates’ testimony, and IRS’s investigating agent’s testimony about the preparer’s modus operandi. Thus, the Eleventh Circuit ruled that the Tax Court didn’t abuse its discretion by admitting the return preparer’s out-of-court statements.
References: For when the assessment period remains open indefinitely, see FTC 2d/FIN ¶ T-4127; United States Tax Reporter ¶ 65,014.13.