The Tax Court, applying the Chevron “deference” for Service issued interpretative regulations test, held that the §6664 definition of underpayment is ambiguous but that Treas. Reg. §1.6664-2(c)(1) is a permissible construction of the statute and therefore a valid regulation. The court also held that the tax evasion exception to the statute of limitations in §6015 applies and that the taxpayer is subject to fraud penalties based on application of the regulation in question to the facts in the case. .
Summary of Facts
Petitioner-Feller was a CPA and a partner in his accounting firm. In Rick D. Feller was a CPA and partner in his accounting firm. In 2004 Feller and two members of his firm became 100% owners of the stock of a corporate which owned and operated two nursing homes. Feller served as president, was active in the business operations of the corporation and also prepared the corporation’s tax returns. On his income tax returns for prior periods, i.e.., 1992-1997, both actual and false W-2 reporting of his wages were attached. He also filed Schedules E claiming false losses from his CPA firm and false Schedules A claiming inflated deductions for state and local taxes based on his false W-2s. He then claimed refunds for all 7 years in issue. Following an audit, Feller was charged criminally with preparing and filing a false return for 1997. In 2003, he pleaded guilty to preparing and filing a false return for 1997 and admitted he intentionally filed false returns for all the years at issue and had filed false claims for refund when in fact he owed taxes. The Service issued notices of deficiency in 2006 but ignored prepayment tax credits in its calculation. Section 6664 requires that excess withholding tax credits be used in determining a section 6663 overpayment. The IRS later sent Feller corrected notices shortly thereafter. Feller then sought a redetermination by the Tax Court, arguing that the statute of limitations in section 6501 barred the assessments and that section 6664 is invalid.
Tax Court Rules in Favor of Commissioner
The Tax Court rejected Feller’s arguments. The Tax Court, per Judge Haines, first addressed the statute of limitations argument. Petitioner argued that the statutory notice was not filed within the normal 3 year period set forth in §6501(a). The government countered that because the petitioner’s returns that were filed were “false” and with an intent to evade taxes, that the unlimited period for assessment under §6501(c)(1) was controlled. that the issuance of the notices of deficiency was barred by section 6501(a). Section 6501(a) provides the general rule that the amount of any tax imposed must be assessed within 3 years after the return is filed. An exception to the 3-year rule is provided in section 6501(c)(1). As per §7454(a) and Tax Court Rule 142(b), the government had the burden of proof of the intent to evade to keep the statute open. See Petzoldt v. Comm’r, 92 T.C. 661, 699 (1989).
By virtue of the petitioner’s guilty plea under §7206(1) for filing a false return in 1997 and further admitted, in his plea agreement, that by attaching to his returns fictitious Forms W-2 which overstated income tax withheld, he engaged in a pattern of filing false returns and fraudulent conduct. Through his conduct he obtained $320,078 in Federal refunds to which he was not entitled over the 6-year period. Based on the record, the Tax Court held that the Service met its burden of proof by clear and convincing evidence that petitioner filed his returns for the years at issue with the intent to evade tax. See Brister v. U.S., 35 Fed. Cl. 214 (1996) (involving an accountant and bookkeeper who overstated withholding credits to obtain refunds). Thus, the unlimited period for assessment under §6501(c)(1) applied for all years in which such fraudulent conduct arose.
The next argument made by petitioner was to the imposition of the civil fraud penalty. Under §§6663 and 6664, along with Treas. Reg. §1.6664-2(c), the Service must prove respondent must also prove that the fraud resulted in underpayments of tax required to be shown on the returns. The term “underpayment” per §6664(a) is the amount of tax imposed by this title exceeds the excess of: (i) the sum of (A) the amount shown as the tax on the taxpayer’s return, plus (ii) the amounts no so shown previously assessed (or collected without assessment), less: (i) the amount of rebates, i.e., abatements, credits, refunds or other repayment.
The Court disagreed that §6664 can into play. It looked at Treas. Reg. §1.6664-2(c)(1), which interprets the definition of "underpayment" in §6664 by stating that the tax shown on the return is reduced by the excess of: (i) the amounts shown by the taxpayer on his return as credits for tax withheld under §31 (relating to tax withheld on wages) * * * over (ii) the amounts actually withheld, * * * with respect to a taxable year before the return is filed for such taxable year. The regulation extends the meaning of "underpayment" to include a taxpayer's overstated credits for withholding. See Treas. Reg. §1.6664-2(g), Ex.(3). Where a taxpayer overstates prepayment credits, e.g., credits for wages withheld, the overstatement decreases the amount of tax shown on the return and increases the underpayment of tax. Citing. Sadler v. Comm’r, 113 T.C. 99, 103 (1999).
In response the Petitioner contends that Treas. Regs. §1.6664-2(c)(1) and (g), Ex. (3), are invalid because the statute which it interprets, §6664, does not refer to credits for tax withheld, and it was not Congress' intent to include withholding credits in the calculation of an underpayment. Feller’s counsel also looked at other parts of the procedural rules to argue that the legislative history to the definition of an “underpayment” in §6664(a) in effect during the years in issue supported its argument. The Serviced argued that when Congress enacted a new penalty regime and significantly reworded the definition of "underpayment" for income tax purposes, it justified the Secretary's clarification of the treatment of overstated prepayment credits.
The fraud penalty would involve a determination of whether the regulations were entitled to judicial deference. The Court of Appeals for the Sixth Circuit, which was the applicable appellate court under the Tax Court’s Golsen Rule, held that regulations issued under the general authority of the Secretary to promulgate necessary rules, with notice and comment procedures, are entitled to judicial deference as outlined by the U.S. Supreme Court in Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). See sec. 7482(b)(2); Golsen v. Comm’r, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971).
In Chevron, the Supreme Court addressed the circumstances in which the judiciary is to afford an agency discretion to interpret the statutes the agency administers. In what is commonly referred to as the two-step "Chevron analysis", the Supreme Court stated:
“When a court reviews an agency's construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute.” 467 @ 842-843.
As applied here, the question is what the term "underpayment" means in the context of a fraud statute. The examination requires us to analyze the definitions of a "deficiency" and of an "underpayment" and their interrelationship, if any, in §§6663 and 6664. The question to consider was whether an underpayment can exist without a deficiency.
In determining a deficiency under §6211(a), which has been unchanged since 1954, the term means the correct amount of tax reduced the tax reported by the taxpayer. The excess is a deficiency. Estimated tax payments and withholding credits are ignored. §6211(b)(1).
The definition of an underpayment for purposes of the civil fraud penalty remained unchanged from 1954 until 1989 when existing provisions I the Code were replaced with the accuracy-related penalties set forth in §§6662-6665. See Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, sec. 7721(a), 103 Stat. 2395. The legislative history was cited by the Tax Court in recognizing that Congress' primary focus in enacting a new penalty regime was to alleviate taxpayer confusion and the difficulties of administration of several different penalties relating to the accuracy of a tax return. H. Rept. 101-247, supra at 1388. The House report also stated that the definition of "underpayment" in section 6664(a) was not "intended to be substantively different from * * * [previous] law."
Repealed §6653(b)(1) provided that if any part of any underpayment (as defined in subsection (c)) of tax required to be shown on a return was due to fraud, certain penalties applied. Former § 6653(c) tied the definition of an underpayment to the definition of a deficiency. Again, this tied into the definition of a deficiency in §6211(b)(1) where estimated payments and withholding credits did not enter into the calculation.
Sections 6663 and 6664 replaced repealed §6653. The 75% civil fraud penalty under §6663 applies “if any part of any underpayment of tax required to be shown on a return is due to fraud…” The term "underpayment" is defined in §6664(a) as the amount by which the tax imposed exceeds the excess of the amount reported on the return which is essentially the same definition as used previously.
Judge Haines opined that where a case involves a deficiency and fraud in which no excess withholding credits are claimed, the calculation of an underpayment is unchanged. In such case, “deficiency” and “underpayment” mean the same thing. However, in a fraud case where there is no deficiency but excess withholding credits have been claimed, as was present in this case, or where there is a fraud case where there is a deficiency and such credits have been claimed, the effect of the statutory changes, in relation to the amount of any underpayment, is unclear from looking at §§6663 and 6664(a) on their face. In other words, the statutory definition of an underpayment is no longer connected or directly linked to the definition of a deficiency under §6211, as it had been in former §6653(c), and the restrictions in §6211(b)(1), excluding estimated tax and withholding credits from the calculation of a deficiency, no longer apply to an underpayment by explicit cross-reference.
Therefore, under Chevron’s first step, for the determination of an underpayment, Congress apparently wanted to retain the basic formula (correct tax - reported tax = underpayment) in §6664 but deleted the express cross-reference to the definition of a deficiency in §6211. Section 6664 is silent and therefore ambiguous with respect to the issue before the Court, i.e., Congress has not directly addressed the meaning of the term "underpayment" when a taxpayer has overstated withholding credits.
Thus, based on this open question, the Chevron doctrine requires whether the regulation that “filled in the gap” so to speak, Treas. Regs. §§ Treas. Regs. §§ 1.6664-2(c)(1) and (g), Ex.(3), is based upon a permissible construction of the statute. Judge Haines stated that it doesn’t have to be the only permissible construction. The Court should not disturb the agency's action unless it appears from the statute or its legislative history that it is one that Congress would not have sanctioned.
On March 4, 1991, the Federal Register published a notice of proposed rulemaking regarding the accuracy-related penalty under §6662, the fraud penalty under §6663, and the definitions and rules for purposes of both penalties under §6664. See Notice of Proposed Rulemaking, 56 Fed. Reg. 8943 (Mar. 4, 1991). The preamble to the proposed regulations stated, inter alia: (i) overstated prepayment credits increase the amount of an underpayment but have no effect on the calculation of a deficiency; (ii) whether a position with respect to an item has substantial authority or is disclosed on a return is relevant to the determination of the amount of a deficiency, but not to the determination of the amount of an underpayment; and (iii) the amount of an underpayment is reduced by amounts not shown on the return that have been previously assessed (or collected without assessment), but the amount of a deficiency is not. The proposed regulations were adopted and published as final regulations on December 31, 1991. T.D. 8381, 1992-1 C.B. 374.
Treas. Reg. §1.6664-2(c)(1), interprets the definition of "underpayment" in §6664 by stating that the tax shown on the return is reduced by the excess of: (i) the amounts shown by the taxpayer on his return as credits for tax withheld under section 31 (relating to tax withheld on wages) * * * over (ii) the amounts actually withheld, * * * with respect to a taxable year before the return is filed for such taxable year. This resulted in “underpayment” status for the year in issue for civil fraud penalty purposes.
Feller, the petitioner, argued that the regulation was inconsistent with Congress’ intent that the House Report to the 1989 legislation stated that the definition of "underpayment" in §6664(a) was not "intended to be substantively different from * * * [previous] law." H. Rept. 101-247, supra at 1394. On the basis of that statement, petitioner argues that the definition of an underpayment, as contemplated by §6664, should not be different from what it was under §6653(c) and thus withholding credits should be excluded from the computation of an underpayment.
The Court rejected the taxpayer’s argument finding that neither §6664(a) nor the regulation in issue differs substantively from prior law. The basic formula (correct tax - reported tax = underpayment) is retained, and in cases involving a deficiency in which no excess withholding credits are claimed, the calculation of an underpayment, for purposes of §6664 and its regulations, is no different from what it would have been under former §6653(c)(1). Indeed, Congress has amended §6664 on three occasions but has not altered the definition of the term "underpayment" in response to the regulation. (citations omitted).
The Court found the regulation was entitled to Chevron deference and upheld the validity of the regulation and civil fraud penalty in this case. As to the particular regulation in issue, Judge Haines wrote “By fleshing out the mechanics of what factors into the section 6664 underpayment calculation when a deficiency is not present, it promotes fairness in the administration of the penalties. It also facilitates the standardization of the reasonable cause/good faith exception criteria for the application of all accuracy-related penalties.”
Where the Service proves any portion of an underpayment is due to fraud, the entire underpayment will be treated as attributable to fraud for purposes of the penalty under §6663(b), except any portion of the underpayment that the taxpayer establishes by a preponderance of the evidence is not attributable to fraud. Knauss v. Comm’r, T.C. Memo. 2005-6. Here, the government proved that the taxpayer committed fraud in filing his returns for the years at issue and the taxpayer has not shown that any portion of the underpayment in any year at issue is not attributable to fraud. Therefore, the underpayments for the years at issue are subject in their entirety to fraud penalties. §6663(b). Ten other judges agreed with the majority opinion, one concurred and there were two dissents.