A Round Trip Ticket to Unwanted IRS Attention: False Documents and Fraud

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As we approach year-end and clients push to get deals done, I am going to briefly discuss the cautionary tale of Brown v Commissioner from earlier this month. On paper, the issue in the case is dry: whether a taxpayer who took ownership of a plane on December 30, 2003 placed that plane “in service” in 2003 for the purpose of qualifying for bonus depreciation.

The case though makes for a fascinating read. It involves a $22 million dollar private plane, letters purportedly drafted by a CFO (also a CPA) whose responsibility included making up documents “to get the substantiation for deductions when the IRS requests them”, related audits that resulted in income adjustments of over $50 million, and over $20 million in civil fraud penalties.

In this post, I will highlight the procedural issue in Brown, namely the Court’s analysis of the civil fraud penalty. The case illustrates that while closing a deal before year’s end may make sense, sometimes the drive to secure tax benefits can lead to major tax problems.

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Depreciation: In Service

Some judges have a flair for making any issue interesting. Having spent some time recently with a Judge Holmes TEFRA opinion that I discussed here (involving affected items and notices of deficiency), and now with an opinion in case involving bonus depreciation, I appreciate his style. His opinions clearly discuss the applicable technical rules, directly address the authorities, and somehow manage to be funny even when discussing unfunny topics like TEFRA and depreciation.

In Brown v Commissioner, the issue revolved around whether Brown, a life insurance salesman to ultra high net worth clients, was able to take about $11 million in bonus depreciation deductions for a custom jet. The dispute was one of timing: Brown purchased the plane (a Challenger) on December 16, 2003 and took delivery on December 30, 2003. On December 30, he picked the plane up in Portland, and flew to a client in Seattle for a lunch meeting. After that meeting, he flew for about 3.5 hours to a colleague in Chicago, where he gave his colleague a 10 minute tour of the plane and met for under an hour at an airport pizza restaurant. After the meeting, Brown flew back to Portland, arriving back shortly after midnight on December 31.

After returning the plane (and flying his other plane to Mexico to celebrate New Year’s Eve), the new plane stayed back in Portland where customizers worked on making changes to the plane that Brown insisted on as necessary for his business. Those changes were  20 inch rather than 17 inch monitors he would use for Powerpoint presentations and a custom conference table for on-flight meetings. The customizer made the  changes in January 2004, and Brown picked up the plane for final delivery at the end of January, 2004.

Despite the changes Brown arranged for the plane, he wanted to claim 50% bonus depreciation in 2003.To get the depreciation deduction in 2003, Brown was aware of the need to treat the plane as in service before the end of 2003. As Judge Holmes describes:

Brown understood that taking delivery wasn’t enough to capture the bonus depreciation he was hunting. So his eventful day had only just begun. In what the Commissioner calls “tax flights,” Brown proceeded to take several trips in the Challenger.

For those who are interested in or who advise clients on whether property is placed in service for depreciation purposes, I recommend reading the opinion. For purposes of this post, I’ll summarize and state that the regs under Section 168 require that the otherwise depreciable object is in service when it is “first placed in a condition or state of readiness and availability” for the “specifically assigned function” for which a taxpayer purchased it. The main issue in the case was whether Brown’s returning the plane and adding the custom conference table and larger monitors meant that the plane was not ready and available for the assigned function until he took delivery in 2004. Because Brown testified that he “needed” the custom conference table and that the monitors and the table were “required” for his business, the court found that Brown did not place the plane in service until 2004, when the plane was specifically outfitted with the changes Brown insisted on:

 Cases [citations and names omitted] tell us to look at the taxpayer—he’s the one who gets to determine what an asset’s specifically assigned function is. And here that asset’s function wasn’t just to fly Brown around; it was to be configured in a particular way to meet his very particular business needs. Even though an asset like the Challenger may be operational, it’s not placed in service until it is operational for its intended use on a regular basis.

Penalties: Fraud and Substantial Understatement

In addition to IRS reversing the $11 million bonus depreciation, its notice of deficiency added a 75% civil fraud penalty.  Some context for the penalty is helpful.  Section 6663(a) adds a penalty equal to 75% of the portion of the underpayment attributable to the fraud. Generally, IRS has the burden of proving fraud, which requires clear and convincing evidence that a taxpayer underpaid tax and that the underpayment was due to the fraud. Under Section 6663(b) the burden shifts back to the taxpayer if the IRS proves that any part of the underpayment was due to fraud. Prior to trial the taxpayers agreed that $1.8 million of other adjustments to income from 2003 were subject to the fraud penalty—thus, the burden shifted back to Brown, who had to show that the bonus-depreciation was not attributable to fraud.

Fraud, as Brown discussed, is the “intentional wrongdoing with the specific purpose of avoiding a tax believed to be owed.” Because it is unusual to have direct proof of the fraud, courts and IRS look to a grab bag of factors (often called badges). The opinion lists a number of the factors that courts and IRS alike have identified.

One of the factors the courts look to as a sign of fraud is the use of false documents. Here, to support its finding of fraud, the IRS principally relied on that factor (as well as the taxpayer’s sophistication and multi-year and multi-million dollar patter of overstating deductions). Let’s consider the false documents, and consider why in some cases there are really bad false documents and only somewhat bad false documents.

False Documents and Fraud

To justify his position that he placed the plane in service in 2003, Brown introduced letters from two people he supposedly flew to and visited on December 30, a client in Seattle and a business associate in Chicago.

First, the opinion discussed the client letter.  Brown testified that he flew to Seattle on December 30 and had lunch at a restaurant for 1.5 to 2 hours, where the client introduced Brown to two potential clients. The opinion included the letter. The client did not testify at Brown’s tax trial—he was a fugitive facing money laundering and fraud charges. Following is an excerpt from the letter:

Because of your extraordinary knowledge of insurance and related matters, I was happy to introduce you to a business associate of mine and his wife. I enjoyed watching their eyes light up as you discussed how you could help them take advantage of various estate planning alternatives. I trust you will be able to turn this introduction into a win-win situation for both parties. Again, thanks for all you have done for me and my family in the past and I look forward to working with you in the future.

Best regards, /s/ Michael Mastro

Judge Holmes  was skeptical: “[n]ot only do our eyes not light up, but we sense something doesn’t smell quite right with the whole Seattle visit.” The flight logs suggested that Brown was in Seattle for only 66 minutes, but Brown said his lunch meeting in Seattle lasted between 90 minutes and two hours. At trial, Brown admitted that the letter was

neither contemporaneous nor even prepared by Mastro. He admitted his CFO/CPA, Gary Fitzgerald, drafted the letter sometime much later and had Mastro sign it. Although at one point Brown said he thought he had told Fitzgerald to write the letter “several months” after year end, we find more credible his later testimony that one of Fitzgerald’s jobs is to write letters on behalf of Brown’s business associates “to get the substantiation for deductions when the IRS requests them.”  We therefore find that Fitzgerald didn’t write this letter until at least 2006 when the IRS began auditing Brown’s return for the 2003 tax year. We do not take it seriously as proof of anything but a reason to question Brown’s credibility.

A similar finding was made with respect to a letter from a business colleague, who Brown claimed he had visited in Chicago for about an hour. Here’s the letter Brown introduced from his colleague:

 Thanks for coming through for me when I told you how vital it was for us to meet before the books are closed on 2003.

As we discussed yesterday in Chicago, due to my efforts, we were able to share insurance commissions on well over a million dollars of policies in 2003. The list we reviewed, of prospective clients in the greater Chicago area, should generate even greater commissions in 2004.

Our relationship has always been mutually rewarding in the past, and based on yesterday’s meeting, looks like it will continue so well into the future. Thanks again. Sincerely, OAK VENTURE ADVISORS, LLC /s/ Marc A. Pasquale Marc A. Pasquale

Again, Judge Holmes found problems with the letter:

This is just not believable. Brown admitted that Fitzgerald [Brown’s CFO/CPA] had written the letter at his direction–like the Mastro letter–and sent it to Pasquale to sign. (Pasquale confirmed he signed a letter that had been written for him.) Pasquale “couldn’t recall” exactly when he received it, saying he thought it was at some point in 2004 but also that it was possible that it was given to him as late as 2006. In light of that testimony, and Brown’s testimony that one of Fitzgerald’s jobs was to get documentation for these events only “when the IRS requests [it],” we find–as we did with the Mastro letter–that Fitzgerald didn’t send this letter to Pasquale until after the IRS began auditing Brown’s return in 2006.

Despite the problems with the letters, they did not support a finding of fraud. In addition to pointing out that it “was not clear the contents of the letter were patently false,” even if they were false, they did not support a finding of the required fraudulent intent, which must exist at the time the taxpayer files the return.

Some cases have looked to postfiling events as suggestive of finding intent that formed earlier. Despite those cases, Brown “credibly” testified that he only had his employee write the letters for others to sign when the IRS requested them at audit. Thus, according to Judge Holmes, they were not supportive of an intent to mislead at the time of filing, the crucial time when the intent must exist to justify a fraud penalty.

What also helped the court decide that Brown should not be subject to the fraud penalty was that the IRS conceded that the bonus depreciation expense was legitimate—albeit for 2004, not 2003, and that he actually took ownership of the plane in 2003. The court also concluded that Brown indeed did fly to Chicago to meet with his business associate Pasquale.  To the court, Brown did try to meet the “placed in service” requirement and he “actually believed he completed all the steps necessary to use the plane in 2003” to justify taking the expense. In light of the above, even with the burden on Brown, the court concluded that the fraud penalty should not apply.

Substantial Understatement

Despite the finding that there was no fraud, it was not a complete wipeout for the IRS on penalties. While the IRS cannot stack the fraud and 20% accuracy-related penalties, it can, and often does, argue them in the alternative. The Court sustained the 20% accuracy related penalty attributable to a substantial understatement of income taxes. That issue turned on determining whether the claimed depreciation was justified based upon substantial authority.

Finding that the penalty applied, the court rightly identified that the substantial authority standard is objective, but also seemed to fault the taxpayer for barely mentioning favorable case law in its briefs that arguably justified its position that the plane was placed in service in 2003 (“we previously noted that the discussion in their opening brief of that term was limited to one footnote that didn’t even discuss the regulation or any pertinent caselaw interpreting it”). Nonetheless, given the weight of the case law that suggested that the plane was not placed in service in 2003, the court found that there was not substantial authority. Substantial authority exists only “if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.” Sec. 1.6662-4(d)(3).

Some Parting Thoughts

Year-end tax planning is part of tax practice. Sometimes, the desire to get something done before the end of the year can invite unwelcome IRS attention and put taxpayers in the uncomfortable position of staring down a major penalty bill. The hubris that clients sometimes feel when it comes to serving up documents justifying an expense can lead clients (and advisors) to do foolish and aggressive things that can lead to major problems.

 

 

 

Leslie Book About Leslie Book

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

Comments

  1. Virginia La Torre Jeker J.D. says

    Thank you for writing this. It was a well written piece that was both informative and very interesting to read. Fine job! If you make your law lectures as clear as your writing, you have very lucky students.

  2. Arnold Handler says

    Fascinating account of a fascinating case! Perhaps also worth mention is Judge Holmes’ cogent discussion of the weight of precedent in evaluating subsequent cases, in the context of Hellings v. Comm’r, T.C. Memo. 1994-24.

    In Hellings, the Tax Court had held a charter sailboat to have been placed in service by year-end, even though it had no sails (but which could be easily borrowed). The taxpayer argued that if a sailboat without sails could qualify, so could an airplane lacking only a conference table and larger video screens. Judge Holmes, however, limited Hellings to its “peculiar facts” because it did “not mention, much less distinguish” earlier Tax Court opinions unfavorable to the taxpayer:
    “Truly, if Hellings were the only case on point, we’d have to agree with Brown. But where we have gaps in the Code and regs that need to be welded or riveted together to keep like cases decided alike, any one case’s persuasiveness often depends on how it treats earlier ones. In Hellings, we did not mention, much less distinguish, Noell, Consumers Power, or Valley Natural Fuels in concluding that the taxpayers placed the boat in service in 1983. . . . [W]e think it best to confine Hellings to its peculiar facts. Consumers Power is a T.C. Opinion, so we must follow it—which means that we should follow its reasoning as elaborated and illuminated by the facts of later cases that discuss it, and not a possible outlier that doesn’t.”
    T. C. Memo. 2013-275 at 40-41

    • Great point Arnold. In fact I co-teach a class for all incoming CPA students in our graduate tax program here at Villanova–we are one of the few grad tax programs that serves both accountants and lawyers. When I read the case originally, I thought about adding this case discussion for the very point you make. It illustrates quite nicely the relationship between the statute, regs, and the different types of Tax Court opinions, and how some opinions are more persuasive than others.
      Your comment reminds me to add the case to the syllabus.

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