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

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.