Tax Court Sticks to Its Guns and Holds Fraud of Preparer Can Indefinitely Extend Taxpayer’s SOL on Assessment

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When a taxpayer commits fraud it is black letter law that the statute of limitations (SOL) on assessment remains open indefinitely. In the last decade or so IRS has taken the fraud issue one step further, essentially arguing that a third party’s fraudulent conduct that is connected to the taxpayer’s tax return can also indefinitely extend the taxpayer’s SOL. IRS has used this argument both in the context of sophisticated taxpayers engaging in advisor-created mind-numbingly complex tax shelters and in simple cases where preparers are goosing Schedule C deductions.

IRS has cracked down on crooked preparers, and in doing so it often pulls those preparers’ returns. Because fraud is difficult to both detect and prove (and at times the preparers do not sign the returns they prepare), it takes a long time for IRS to track down the crooked preparers’ tax returns. The upshot is that absent the indefinite SOL when IRS does track down the returns IRS is out of luck. On the other hand, as SOLs are meant to provide some finality an indefinite SOL can provide the tools for a crippling assessment with years of interest on top of civil penalties.

As we have previously discussed, the courts are split on whether a third party’s conduct can extend the taxpayer’s SOL. For example, in 2007 the Tax Court in Allen v Commissioner held that the third party’s fraud extends the taxpayer’s SOL; in 2015, a divided opinion the Court of Appeals for the Federal Circuit in BASR v Commissioner rejected the Tax Court’s Allen approach. Guest poster Robin Greenhouse discussed BASR in PT here; I discussed the lower court’s BASR opinion here.

This very issue presented itself in last week’s Tax Court case Finnegan v Commissioner. In this post I discuss that case and offer some observations.

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The Finnegan Facts

In Finnegan v Commissioner the taxpayers were a plumber and an employee of a community college who owned a rental property in Daytona, Florida they purchased in 1988 for $60,000. After their longtime preparer moved, they hired a new preparer, Duane Howell, who gave the following advice intending to allow the Finengans the opportunity to shelter the income from the rental property:

Mr. Howell advised petitioners that they should form a partnership to report their rental activity. Mr. Howell incorrectly explained that forming the partnership would allow petitioners to contribute moneys they received from the condo rentals to a Keogh/self-employment retirement plan account. With Mr. Howell’s help, petitioners formed a partnership named “Jomarjen”, which appears in every Schedule E, Supplemental Income and Loss, of petitioners’ Forms 1040, U.S. Individual Income Tax Return, for the years in issue.

Petitioners did not draft a partnership agreement for Jomarjen, and the filing address for the partnership return changed from year to year. Other than creating Jomarjen, petitioners did not change anything concerning the operation of their rental investment. Condo Rentals of Daytona continued to manage the renting of the condo and made payments of the rental revenues to petitioner Joan Finnegan, issuing her Forms 1099-MISC, Miscellaneous Income, rather than to Jomarjen. If, for any reason, petitioners communicated directly with their tenants, they did so individually, and not as Jomarjen. Petitioners never transferred title of the condo to Jomarjen. Petitioners never wrote checks to Jomarjen and Jomarjen never wrote checks to petitioners. Petitioners did not have a separate office for their condo rental activity.

The Tax Court described the scheme further:

[T]he Finnegan’s ] Forms 1040, Schedules E for tax years 1997, 1998, 1999, 2000, and 2001 show Gannan Co. in addition to Jomarjen. Gannan Co.’s partnership returns report petitioners as the sole partnership owners. At trial petitioners testified that they did not know what Gannan Co. was, that they learned the name only after the examination of their returns, and that it does not exist. Petitioners also testified that after following Mr. Howell’s advice, their tax returns became very thick and they received larger refunds than in years past.

While Howell did not testify in the Finnegan trial, there was testimony from one of Howell’s associates and an IRS Special agent. In addition, the IRS was also able to get into evidence an affidavit from Howell and Howell’s testimony in a prior criminal trial of another of Howell’s associates. The evidence showed that Howell was preparing 750 or so returns per year with a pattern of conduct that included false partnerships and falsified income to allow Keogh contributions. In addition, he did not sign the returns as preparer, instead using of fake entity names to mask his identity.

The Finnegans’ returns fit the pattern on Howell’s clients. IRS after extending significant resources on Howell’s prosecution examined the Finnegans’ 1994-2001 returns. IRS stipulated that but for Allen v Comm’r, the SOL on assessment had expired.

The SOL Remains Open

In Finnegan, the Tax Court reaffirmed its commitment to Allen, stating  the following at note 6:

We see no reason to revisit Allen v. Commissioner, 128 T.C. 37 (2007), on account of BASR P’ship v. United States, 113 Fed. Cl. 181 (2013), aff’d, 795 F.3d 1338 (Fed. Cir. 2015). In the Court of Appeals for the Federal Circuit’s opinion, a persuasive dissent was filed, as well as a concurring opinion that relied on sec. 6229, a provision inapplicable in the instant case. Accordingly, even in cases appealable in the Federal Circuit, it is unclear whether, in the absence of the application of sec. 6229, which interpretation of sec. 6501(c)(1) would prevail. Moreover, there is no jurisdiction for appeal of any decision of the Tax Court to the Court of Appeals for the Federal Circuit. Sec. 7482(a)(1). Additionally, the parties have not cited BASR P’ship and do not contend we should revisit Allen. Thus, Allen is controlling precedent in the instant case, and we do not revisit the analysis and conclusion in that Opinion.

Jack Townsend in his Federal Tax Crimes blog discusses the Finnegan case here and observes that the case highlights the importance of forum choices, with the Court of Federal Claims offering the best option for taxpayers (though Flora requires full payment for that forum). As an aside, Jack has been all over this issue, and in my view has persuasively made the case why the Tax Court approach in Allen is wrong (see here), as has Bryan Camp, in a 2008 Tax Notes article here.

Some Observations

I find it interesting that Finnegan did not cite to City Wide in its note 6 discussion of why it was not revisiting Allen. It suggests perhaps that the Tax Court took a cautious view of the Second Circuit’s opinion’s reach. In City Wide Transit, the Second Circuit seemed to bless the view that a third party’s fraud can extend the sol, though as Jack Townsend has discussed, the precedential effect of City Wide is suspect due to taxpayer concessions on the issue.

Given Finnegan’s  concession on Allen as discussed in note 6 above, it is not clear to me that this case will be the vehicle for situating a more defined circuit split on the issue. In Finnegan, as note 6 states, the taxpayers did not argue that the Tax Court was wrong in Allen (analogous perhaps to the taxpayer concession in City Wide) but focused its SOL argument on the issue as to whether the IRS was able to sufficiently connect the preparer’s fraud to the taxpayer’s return in question.

The focus in Finnegan thus was on a secondary though important issue: just because a third party engages in some fraudulent activity does not lead to an automatic poisoning of the return. A case in point in Eriksen v Commissioner, which I discussed in my BASR post a couple of years ago:

An example of a different this issue coming up in less sophisticated matters is  Eriksen v Commissioner, a memorandum Tax Court decision from 2012, which involved low dollar phony Schedule C expenses claimed by employees of the Oakland County Sheriff Department. The taxpayers in Eriksen used preparers who plead guilty to aiding and assisting in the preparation of a false federal income tax returns in violation of Section 7206(2). In Eriksen, the Tax Court applied Allen to find that a preparer’s fraud could extend the statute, but held the IRS had not met its burden to show that that the preparer’s actions in the particular returns at issue amounted to fraud rather than negligence. In other words, a preparer’s fraud on some returns was insufficient to taint other returns, even if those other returns had errors of the type that were implicated in the criminal case against the preparers.

In distinguishing Eriksen the Tax Court in Finnegan dug a bit deeper. In fact, Eriksen involved six taxpayers whose returns were prepared by convicted preparer and the Tax Court found for the taxpayer in five of the six taxpayers. The IRS was successful, however, in arguing that the statute was extended for one of the taxpayers in that case in part because the IRS was able to prove at trial that the errors on the sixth return were of the type that were of the type that were the subject of the crime and the sixth taxpayer herself testified that she did not incur the expenses on the return.

The taxpayer in Finnegan hung his hat on Eriksen, but the last week’s opinion finds that the facts in Finnegan were more like the unlucky sixth Eriksen taxpayer than the first five:

Petitioners contend that Eriksen stands for the proposition that, to establish fraud, the Commissioner must prove a “direct link” between the commission of fraud and a taxpayer’s return. Petitioners strongly imply that the only way to establish such a direct link is through the preparer’s testimony. In Eriksen, the Commissioner established the existence of fraud by matching the incorrect information on the taxpayer’s return to the preparer’s modus operandi. In other words, even taking petitioners’ contention into account, there are ways of providing an evidentiary link that do not involve a preparer’s specific testimony as to a particular taxpayer.

Petitioners also contend that their circumstances are similar to those of the first five Eriksen taxpayers because, without a connection or direct link between Mr. Howell’s wrongdoing and petitioners or their partnerships, respondent’s evidence rises only to the level of “a suspicion of fraud”. We do not agree. Respondent has already shown that petitioners’ returns include significant errors, namely, Jomarjen’s gross income above and beyond the revenues collected by Condo Rentals of Daytona and the Gannan Co. partnership’s entries on petitioners’ returns. Respondent provided additional testimony that identified specific figures in petitioners’ returns, e.g., $4,896, which were frequent fabrications of Howell’s. Additionally, the preparer in Eriksen testified in his plea allocution that not all returns he prepared were fraudulent. Id. at *4. Mr. Howell testified that every return he prepared included at least some fraudulent entries, and because of these false entries, was “dirty”.

Finnegan now sits in the pantheon of cases that should give taxpayers caution when hiring a return preparer. When something is too good to be true, the preparer’s shenanigans can come back to haunt a taxpayer years after the fact. With the passage of time small tax savings can multiply to sizeable deficiencies due to interest and penalties. No doubt other courts will be weighing in on the IRS’s attempts to reach taxpayers who benefitted from preparer misconduct, and I would not be surprised if this issue eventually is before the Supreme Court.

Update: An earlier version of this post indicated that this case was appealable to the Second Circuit. While the taxpayers lived in NY at the time the returns at issue were filed, in 2003 they moved to Florida, where they resided at the time they filed the petition in this case. Absent stipulation, this case is appealable to the 11th Circuit. 

 

Leslie Book About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

Comments

  1. Bob Kamman says:

    “Because fraud is difficult to both detect and prove (and at times the preparers do not sign the returns they prepare), it takes a long time for IRS to track down the crooked preparers’ tax returns.”

    Or try, “because IRS is an inefficient bureaucracy, it is unable to spot fraudulent preparers and their clients in less than three years, or roughly twice the gestation period of a rhinoceros.”

    What does proving fraud on one return have to do with examining other returns before the SOL expires – and before the preparer commits the same offenses, often with the same taxpayers, for another three or four years?

    Except for poverty-level filers claiming refundable credits, IRS generally chooses not to look at any of the returns until all of the returns are filed. IRS apologists notwithstanding, the message here should be “don’t tell me why you can’t do it; tell me how you are going to get it done.”

    • One of the reasons why Congress changed the PTIN rules a decade or so ago was that IRS was unable to track preparers even if they actually signed returns that they prepared.The upshot was that in the 2000’s IRS had a difficult time tying returns to preparers even when preparers did in fact sign returns in their correct names. When you have preparers such as Howell in this case who masked his identity using bogus preparer names it I think is not so easy to correlate the preparer and the taxpayer. Having said that as I have written before TIGTA has criticized IRS for the way it uses the powers and info it has to chase down bad preparers and connect the dots.

      • Bob Kamman says:

        That’s funny. I remember asking Commissioner Richardson, at a seminar about 20 years ago, when IRS would live up to its promise to replace the requirement that the preparer enter his/her SSN on a return, with a less-intrusive PTIN. It didn’t take Congressional action to do that. I’m looking at a 1986 Form 1040 that requires the preparer SSN. How did the PTIN make it any easier for IRS to tie preparers to returns, compared to using the SSN?

        (I still have clients who have kept copies of old tax returns that, if they fall into the wrong hands, expose me to identity theft.)

        • from GAO in 2008:
          Fiscal Year 2009 Budget Request and Interim Performance Results of IRS’s 2008 Tax Filing Season

          IRS faces limitations in identifying individual paid preparers and monitoring their performance. Because they now prepare over 60 percent of all individual income tax returns, paid preparers are a key part of tax administration. IRS requires that paid preparers identify themselves on all income tax returns they prepare by entering their Social Security Number (SSN) or Preparer Tax Identification Number (PTIN). If the preparer has a partnership or an employer, then the preparer must also include the Employer Identification Number (EIN) of the partnership or employer on the return, in conjunction with an SSN or PTIN. However, according to IRS officials, many preparers do not sign tax returns with the required identifying number or numbers. Because processing returns is a priority for IRS, it accepts returns even if preparers’ information is not provided on returns. Because preparers have the choice between two numbers and may be required to use a third as well, IRS officials said that confusion is created for preparers and IRS faces challenges in enforcing the signing requirement. The limitations in identifying preparers complicate enforcement because IRS cannot systemically match tax returns with preparers in order to detect patterns of noncompliance. Furthermore, IRS officials said this is an impediment to research on preparer compliance, its causes, and possible solutions. Several IRS officials with responsibility for preparer compliance said that requiring a single identifying number could improve preparer compliance with signing requirements, but that IRS has not evaluated the usefulness or costs of implementing such a requirement.

          https://www.gpo.gov/fdsys/pkg/GAOREPORTS-GAO-08-567/pdf/GAOREPORTS-GAO-08-567.pdf

  2. A. J. Decaria, EA says:

    Tell me if I am wrong, but previous to Allen and Finnegan, IRS had to prove civil fraud on the taxpayer in order to have the SOL open indefinitely, and otherwise were limited to 3 years or possibly the 6 year statute. Now, because of Allen and Finnegan, the 3rd party fraud is enough to hold the SOL open, even if the civil fraud penalty is not imposed on the taxpayer. I recently spoke to a fraud group revenue agent, and the IRS has not made her aware of this option. It will be interesting to see if they do. The clients of a fraudulent preparer become low hanging fruit for the IRS if they can now audit some tax returns without respect to the SOL.

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