A fraudulent tax return is bad news for a taxpayer. Normally, the IRS has a limited period of time (3 years) to audit a taxpayer’s return. The existence (or allegation) of fraud, however, gives the IRS an unlimited amount of time to make an assessment of tax liability. But more importantly, taxpayers may be surprised to learn that the IRS considers fraud by someone other than the taxpayer to also trigger the open-ended statute of limitations. So if a return preparer or someone else affecting the reporting of your taxes engages in fraud, the taxpayer could be the one left on the hook to make the IRS whole (including the possibility of a 75% fraud penalty to boot). The Tax Court has given the IRS latitude in using this tool against taxpayers in these situations, but an appellate court recently limited the IRS’s reach on the issue.
Sometimes tax return preparers act fraudulently on their own initiative without the taxpayer’s knowledge and without the taxpayer’s own fraudulent intent to evade tax. It seems appropriate and just in these circumstances for the IRS and Justice Department to pursue the unscrupulous return preparer. And the government frequently does so. But, in seeking to recover any tax loss, the IRS may decide that the unwitting taxpayer who submitted the fraudulent return is liable to make the government whole. The IRS approach is founded in the idea that the taxpayer signing and submitting the return is obligated to review it and is deemed to know its contents. If the return is fraudulent, the unwitting taxpayer should have found the errors and had them corrected. The argument that the taxpayer relied on the accountant and just signed the return without reviewing it generally does not stand up.
The framework for the IRS’s actions stems from an exception to the general three-year statute of limitations. Under IRC Section 6501(c)(1) and (2), fraudulent conduct can suspend the running of the limitations period indefinitely. The key statutory phrase is “intent to evade tax.” But the statute does not clearly state whose fraudulent intent triggers the open-ended assessment period by the IRS. It should be noted, however, that the IRS will bear the burden of proving that the return was fraudulent by clear and convincing evidence. It cannot merely make the assertion without something to back it up.
In the past decade, the Tax Court has considered this issue and decided several cases favorable to the IRS. For example, in Allen v. Commissioner, 128 T.C. 37 (2007), a tax return preparer put false itemized deductions on a taxpayer’s return without the taxpayer having indicated to the preparer that he was entitled to those deductions. The return preparer was eventually convicted of preparing false and fraudulent tax returns under IRC Section 7206(2). The IRS then sent deficiency notices to the taxpayer after the general three-year assessment period had passed, claiming that IRC Section 6501(c)(1) applied because fraud was present, even if it wasn’t the taxpayer’s own conduct that caused it.
The Tax Court upheld the IRS’s deficiency notice based on the preparer’s fraudulent conduct even though the taxpayer was not to blame for the fraud. In its analysis of the issue, the Tax Court concluded that the statute’s fraud exception contained no “express requirement that the fraud be the taxpayer’s” in order to extend the statute of limitations. The court stated that “the statute keys the assessment extension to the fraudulent nature of the return, not to the identity of the perpetrator of the fraud,” [emphasis added] and so chose to strictly construe the limitations periods in the government’s favor. An additional reason for letting the IRS go after the taxpayer is Congress’s intent to ensure that the IRS is not at a disadvantage in recovering unpaid taxes resulting from fraudulent tax returns, the court said. The court seemed concerned that an outcome against the government could allow a taxpayer to “hide behind an agent’s fraudulent preparation.”
However, an appeals court recently held for a taxpayer in dismissing the government’s argument that third-party fraud is relevant in applying the unlimited statute of limitations. In BASR Partnership v. United States, No. 2014-5037 (Fed. Cir., 7/29/15) the taxpayer relied on a law firm’s tax opinion in deciding how to report large capital gains arising from the sale of a business. When the lawyer was later convicted for fraud, he acknowledged that he acted with intent to evade the tax that the taxpayer would have otherwise owed on the transaction. This allowed the government to claim the fraud exception in assessing tax against the partnership a decade after the returns had been filed.
The Federal Circuit, in an opinion issued in July 2015, held that IRC Section 6501(c) requires that the taxpayer be the one who has the intent to evade tax in order for the limitations period to stay open indefinitely. This means that in situations where the taxpayer has clean hands (i.e., no fraudulent intent), fraud by a third-party that causes a taxpayer’s return to be false will generally not allow the IRS to go after the taxpayer for the unpaid taxes if the three-year assessment period has passed. The circuit court maintained that the Tax Court had conducted only a limited analysis of IRC Section 6501’s text in Allen that was not necessarily congruent with Supreme Court precedents, and that even if the reasoning in Allen was persuasive, the particular facts of BASR further distinguished the case from Allen.
With different outcomes among federal courts, taxpayers facing this issue should be aware of the jurisdictional benefits and disadvantages of pursuing litigation in Tax Court versus the U.S. Court of Federal Claims.