A Terrible (But Apparently Effective) Way to Thwart the IRS’ Civil Fraud Penalty

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This post originally appeared on Forbes on December 17, 2014, and can be found here.

Frivolous arguments are not ‘How to STOP the IRS,’ but saying them loudly enough and often enough might prevent the fraud penalty.  The Tax Court in Kernan v. Commissioner recently had the opportunity to review the case of Eugene Kernan.  Mr. Kernan seems to have a lot of interesting ideas, which you can find at this webpage, www.theamericanrepublic.com (absolutely not an endorsement).   Some of Mr. Kernan’s ideas pertain to his not having to file tax returns or pay taxes.  You too can learn how to stop paying taxes for the low price of $1,295.00 by purchasing “How to STOP the IRS” on CD-Rom…

I know that seems like an exciting offer, but, as most readers have probably surmised, Mr. Kernan eventually drew the IRS’ ire, and was assessed taxes, penalties and interest for many of the past years where he was implementing his “How to STOP the IRS” strategies.  Many of the readers–and the author of this post—are probably happy to see Mr. Kernan forced to fulfil one of his civic duties, and there is some entertainment value in person who is smug but incorrect being publicly reprimanded, but we focus on tax procedure and not humiliation.  Thankfully, this backdrop provides an interesting tax procedure issue—whether or not Mr. Kernan’s proselytizing about his improper tax scheme to everyone who would listen, including on TV and to the IRS, was sufficient to insulate him from the civil fraud penalty.

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The Facts

Around 1993, Mr. Kernan ceased filing returns, and years 2001 through 2006 were at issue in the Tax Court case.  Mr. Kernan’s interpretation of the Code was that Section 6001 required the Commissioner of the IRS to personally invite him to file a return before he was required to file or pay any tax.  Contrary to Mr. Kernan’s tax philosophy, the Service issued notices of deficiency for each year for the tax due.  The noticed included the failure to pay estimated taxes penalty, the failure to file penalty, the failure to pay penalty, and the applicable interest.  The Service also imposed the fraudulent failure to file penalty under Section 6651(f).

Before issuing the notice, the IRS had recreated Mr. Kernan’s income by reviewing deposits made into his bank account.  Kernan refused to provide records (apparently, that request too should have come from the Commish), so the IRS summonsed the information from his banks.   The IRS found he had two sources of income, from which he seemed to earn a fairly nice living.  First, he sold various tax avoidance products (a fool and his money are soon parted).  Second, he acted as a paralegal, advising folks in IRS matters, and apparently setting up companies, trusts, doing estate planning, and other legal work.

As stated above, Mr. Kernan did not report any of this income, did not file returns, and did not pay tax.  Mr. Kernan did however share this thought on Section 6001 with the Social Security Administration and the IRS by letter – perhaps multiple times.  He also went on TV and discussed his strategy, and plastered his scheme all over his web page.

Before the Court, Mr. Kernan advanced his argument that he was not required to file a return until the Commissioner personally notified him that the IRS would like to review his tax information.  The Tax Court tossed Mr. Kernan’s briefs and refused to review them; generally, not a strong start to a case.  As a side note, the holding has an interesting discussion about the Court’s ability to do this when a party ignores the specific filing requirements.  Here, the Court noted Kernan greatly exceeded the “generous page limits” for briefs that the Court had allowed in this case.  The Court also stated that striking the brief didn’t matter much, because all 88 pages of initial brief and 88 pages of reply brief were garbage.

The tax, interest, and all penalties, except for the fraud penalty, were upheld.  Although Mr. Kernan’s briefs were tossed, the Court did still address whether or not tax and each of the penalties should have been imposed.

The Law

As stated above, the fraud penalty was imposed but not upheld by the Court.  The penalty under Section 6651(f) increases the failure to file penalty from 25% to 75% of the unpaid tax when the failure is fraudulent.  The government must show by clear and convincing evidence that the “taxpayer deliberately failed to file, and…that…the taxpayer intended to evade tax that he knew was owed.”

The Court first reviewed Mr. Kernan’s disclosure as a potential mitigating factor for fraud.  The Third Circuit, which is where I am located but not where Kernan’s case would be appealed, has held that disclosure can be a mitigating factor for fraud in tax protestor failure to file cases.  See Raley v. Comm’r, 676 F2d 980 (3d Cir. 1982).  In the Third Circuit case, the taxpayer sent multiple letters to the IRS, to the Secretary of Treasury, and various other federal officials, in which he claimed taxes were unconstitutional.  The taxpayer later filed returns, but failed to sign the returns and did not include any income.  After the taxpayer pled (or pleaded) guilty to criminal failure to file, he challenged the imposition of the civil fraud penalty.  The Third Circuit held:

[he] went out of his way to inform every person involved in the collection process that he was not going to pay any federal income taxes.  The letters do not support a claim of fraud; to the contrary, they make it clear that [the (non)-taxpayer] intended to call attention to his failure to pay taxes.  It would be anomalous to suggest that [his] numerous attempts to notify the Government are supportive, let alone suggestive, of an intent to defraud.

Although not discussed in detail in the Kernan case, other courts have come to this same conclusion regarding protestors failing to file, requiring an affirmative act of misrepresentation.  See Zell v. Comm’r, 763 F2d 1139 (10th 1985).

Other courts, including the Ninth Circuit, the Seventh Circuit, and the Tax Court when not appealable to the Third or Tenth, have found that disclosure was not sufficient in these cases to prevent the imposition of the fraud penalty.  The Ninth Circuit stated, “disclosed defiance, standing alone, would not bar a finding of fraud.”  Further, fraudulent intent “does not require the taxpayer hide his defiance from the IRS.”  Edelson v. Comm’r, 829 F2d 828 (9th Cir. 1987).

It does not appear that the Ninth, Seventh or Tax Court holdings create a bright line that disclosure will never prohibit the imposition of the fraud penalty.  Likewise,  I would not be confident that the Third Circuit or Tenth Circuit opinions require the penalty to be waived in all protestor disclosures.  For instance, the Third Circuit relied heavily upon the non-taxpayer’s various (and entertaining) letters, indicating those were sufficient to “dilute” the government’s case to the point where it had not proven fraud by clear and convincing evidence.  Where there was less disclosure, the disclosure was less clear, there was stronger evidence of fraudulent intent, or the disclosure was simply an effort to reduce penalties, I would not be surprised if the Third and Tenth held the opposite.

It should also be noted that disclosure does not fix all fraud.  For instance, if a fraudulent return is filed, and then the taxpayer attempts to disclose and fix the fraud, the Service may still be able to impose the fraud penalty, and the statute of limitations will almost certainly still be extended because of the initial fraud.  This holding, and the cases discussed above, pertain to a more narrow fact pattern.

The Court in Kenan held the disclosure did not automatically mitigate the fraud, and went on to determine if the taxpayer had the customary badges of fraud required for the imposition of the penalty.  The Court determined, probably correctly, that Mr. Kenan in good faith believed his interpretation was correct, which was sufficient to erode the government’s attempt to show the intent to defraud by clear and convincing evidence.

A few parting thoughts.  Depending on where you reside, if you espouse your cockamamie tax ideas loud enough and often enough (and actually believe them), the fraud penalty may not be upheld; however, that is not a sure thing in any jurisdiction in my mind.  In addition, unless you have a new tax protestor idea, the Service can use your statements against you, as the rehashed failed protestor arguments can be an evidence of an intent to defraud on the part of the taxpayer – this does still generally require an affirmative action indicting something false to the IRS though.

Congress has also enacted a specific Code Section for protestors.  Section 6702 allows for an additional $5,000 penalty for frivolous returns or other submissions if they are based on positions identified as being frivolous in a published list, or reflect a desire to delay or impede tax administration.  Again, being creative and original in your balderdash should help.

Interestingly, had Mr. Kernan argued he was doing this as a “test case” for his position, which was also his livelihood, the Tax Court may have also considered that as a mitigating factor for fraud.  This would have shown a different intent.  The Tax Court has stated that full truthful disclosure of an intention to present a test case could be a mitigating factor in a fraud penalty case.  See Habersham-Bey v. Comm’r, 78 TC 304 (1982).  I’m not aware of any actual holdings in favor of taxpayers on that argument, but it is possible.

And to conclude, the IRS and the Tax Court do not believe “How to STOP the IRS” is an accurate title, but Mr. Kernan was successful in thwarting the fraud penalty—there was, however, a substantial cost in other penalties, interest, time and perhaps some embarrassment in obtaining that Pyrrhic victory.

Stephen Olsen About Stephen Olsen

Stephen J. Olsen’s practice includes tax planning and controversy matters for individuals, businesses and exempt entities for the law firm Gawthrop Greenwood, PC.

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Comments

  1. In a case such as Kernan, the imposition of the 6651(f) fraudulent failure to file a return tax addition is absurd. How does one commit “fraud” by omission? To ask that question is to show its absurdity.

    Let’s imagine a taxpayer who deliberately fails to file a required return. But this one, unlike Kernan, doesn’t say a word to anyone about his failure. In that case, how is the government defrauded? I say if Kernan did not commit fraud, then the silent non-filer did not commit fraud.

    Here is a case where the fraudulent failure to file tax addition could apply:

    A taxpayer believes he must file an income tax return and believes, if he does so, he will be liable for a substantial tax. Instead of doing and saying nothing about it, however, he submits an application for an extension of time to file a return. On his extension application, in answer to the question of his anticipated tax liability, he writes in “$0.00.” The IRS grants the extension. The taxpayer never files any return.

    After an investigation, the IRS determines the taxpayer’s tax liability is really $20,000. On top of the tax deficiency, it asserts against the taxpayer the 6651(f) tax addition for fraudulent failure to file a timely return.

    Under those circumstances, the 6651(f) tax addition makes sense because the taxpayer committed an affirmative act of fraud. He submitted an application for a return filing extension in which he misrepresented his tax liability as $0.00. He thereby concealed his tax liability from the IRS and misled it into believing that he qualified for a return filing extension.

    How on Earth, though, can a taxpayer commit fraud by saying and doing nothing? I’d argue that the logical reverse side of Kernan says he cannot do so.

  2. But see Bennett v. Comm’r, T.C. Memo. 2014-256 (released 12/22/14). Why do you think Judge Cohen rejected Bennett’s “sincere belief” and “good faith” arguments against imposition of 6651(f)? Bennett’s argument seems analogous to Kernan’s. Soley because Bennett had affirmatively acted (i.e., filed returns in earlier years)? Or do you think there may be (an)other reason(s)?

  3. I think Bennett met a different fate on the 6651(f) “fraudulent failure to file” issue than did Kernan because of the former’s prior criminal convictions for tax evasion. I also suggest that you may have misread Bennett.

    Except in Kernan, in tax defier cases involving 6651(f), the Tax Court employs a “heads, the Commissioner wins” or “tails, the taxpayer loses” trap.

    If the taxpayer filed returns in the immediate prior years, the Tax Court will use that fact to find fraud (e.g., “Petitioner knew he was violating the law because he had dutifully filed returns in each of the prior 10 years.”). If, as in most other cases, the taxpayer did not file returns in the immediate prior years, then the Tax Court will use THAT fact to find fraud (e.g. “Petitioner has an extensive history of failing to file returns”; see following paragraph for the most recent example).

    In Bennett, the Tax Court called tails, i.e., “…fraud includes ‘badges of fraud’ such as THOSE PRESENT HERE: a longtime pattern of failure to file returns….” Bennett at
    *11. The Tax Court did note that Bennett filed returns prior to his criminal conviction years. But it did so only to reject Bennett’s lack of fraudulent intent argument. The Tax Court did not rely on Bennett’s filed returns as evidence of fraud…but it will in the next 6651(f) case.

    Charitably, a “fraudulent failure to file a return” is a misnomer.

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