COLE v. COMMISSIONER OF INTERNAL REVENUE (March 28, 2011)

Scott Cole is a licensed attorney in Indiana, specializing in business law and tax consulting. Beginning in the 1990s, Scott and his brother, also an attorney, created what the court referred to as a "web of corporate and partnership entities serving dubious purposes." In 2001, Scott's law practice had a banner year. He received $1.2 million that year from one client alone. But when Scott and his wife Jennifer filed their joint tax return for 2001, they reported only about $100,000 total income. The IRS conducted an audit. The Coles kept very few records, requiring the IRS to reconstruct their earnings indirectly. They used both the "specific items" and "bank deposits" methods. The former looks for specific amounts of unreported income and the latter assumes that money in a taxpayer's account is income. The IRS ultimately concluded that the Coles underreported their income by over $2.5 million. They assessed a deficiency of over $500,000 and imposed a fraud penalty of over $400,000. The Coles petitioned the Tax Court for relief. The Tax Court found against the Coles and assessed the same deficiency and fraud penalty calculated by the IRS. The court found that: a) the IRS was justified in its indirect income reconstruction because of the Coles’ failure to maintain adequate records, b) the indirect reconstruction was reasonable, and c) there was "clear and convincing" evidence of fraud. The Coles appeal.

In their opinion, Judges Kanne, Tinder, and Hamilton affirmed. The Court first noted that the Coles waived most of the issues they raised in their 71-page brief because they failed to adequately develop the arguments. The Court identified two issues (of 15 total) that the Coles adequately developed -- whether the Tax Court was wrong in a finding that they omitted income and whether the Tax Court was wrong in finding fraud. On the first issue, the Coles have a heavy burden. An IRS deficiency assessment is entitled to a presumption of correctness and the Court's review of the Tax Court's findings of fact is under a clearly erroneous standard. The Court concluded that the Coles failed to overcome the presumption and failed to show any clear error. On the fraud issue, the Coles have a somewhat lighter burden. Although the clearly erroneous standard still governs the Court's review, there is no presumption of fraud. Instead, the IRS must prove fraud by "clear and convincing evidence." In order to meet that burden, the IRS must show that the taxpayer had specific intent to evade the tax. The IRS can show that intent with circumstantial evidence. The Supreme Court and other courts have identified certain "badges of fraud" that can be used in making a circumstantial case: a double set of books, false entries, destruction of records, covering up income, understatement, failure to file, filing late, co-mingling assets, and failing to keep adequate records. Courts also are allowed to consider a taxpayer's education and intelligence. Here, the Tax Court relied on the Coles’ education and intelligence (Scott is a lawyer, Jennifer is an accountant), their income understatement, their elaborate corporate structures, their failure to maintain adequate records, the co-mingling of business and personal assets, and their concealing of assets. The Court found no clear error in the Tax Court's fraud finding.