14 - IRS Didn't Prove That Taxpayer Convicted of Filing False Returns Intended to Evade Tax

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1 14 - IRS Didn't Prove That Taxpayer Convicted of Filing False Returns Intended to Evade Tax Mathews, TC Memo The Tax Court has held that, although the taxpayer was convicted of filing false income tax returns for the tax year in question, significantly understated his taxable income, and lied to IRS agents during the audit, he was genuinely confused about his tax liability and thus didn't have the intent to evade tax. As a result, the general statute of limitations on assessment applied. Background statute of limitations on assessment. Code Sec. 6501(a) requires that, except as otherwise provided, the amount of tax imposed by the Code must be be assessed within three years after the return was filed. Code Sec. 6501(c)(1) provides that [i]n the case of a false or fraudulent return with the intent to evade tax, tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time. IRS has the burden of proving exceptions to the general limitation period. To establish fraud, IRS must show by clear and convincing evidence that: (1) an underpayment exists for each year and (2) the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. (Parks, (1990) 94 TC 654) Over the years, courts have developed a nonexclusive list of factors that demonstrate fraudulent intent. These badges of fraud include: (1) understating income, (2) maintaining inadequate records, (3) implausible or inconsistent explanations of behavior, (4) concealment of income or assets, (5) failing to cooperate with tax authorities, (6) engaging in illegal activities, (7) an intent to mislead which may be inferred from a pattern of conduct, (8) lack of credibility of the taxpayer's testimony, (9) filing false documents, (10) failing to make estimated tax payments, and (11) dealing in cash. (Niedringhaus, (1992) 99 TC 202) Background willful filing of false tax return. Code Sec. 7206(1) imposes a criminal penalty if a taxpayer willfully makes and subscribes to Federal income tax returns, verified by his or her written declaration made under penalties of perjury, which the taxpayer did not believe to be true and correct as to every material matter. Facts. The taxpayer, Mr. Mathews, dropped out of high school after completing the 10th grade. In the late '90s, he began participating in multilevel marketing, a sales strategy in which distributors recruit secondary distributors to sell products. 44

2 Sometime thereafter, he created Mathews Multi-Service, a sole proprietorship that operated several internet-based multilevel marketing programs. Under most of the Multi-Service programs, people would join with the intention of recruiting new members. If they were successful, they would receive a percentage of the membership fees paid by their recruits and the recruits of their recruits (and so on). For example, one of the programs had a membership fee of $99. Of that $99, Mathews was required to pay out $90 to the member-recruiters. Mathews wanted to establish an international business presence for the Multi- Service programs. Unsure how to operate internationally, Mathews turned to the internet. His online research eventually led him to a Panamanian entity whose representatives advised him to establish a trust in Belize. He established a trust. Mathews believed that 90% of the funds he received through the Multi-Service programs belonged to the other member-recruiters. Mathews also believed that he had deductible expenses with respect to the Multi-Service programs. On the basis of these beliefs, Mathews did not report any income from the Multi-Service programs on his 2004, 2005, and 2006 returns. IRS Revenue Agent (RA) Crawford then audited Mathews' 2005 return. Mathews described Mathews Multi-Service as an online network-marketing business for which he wrote marketing material. Mathews stated that he received no income from Mathews Multi-Service, that it was a beneficiary of a Belize Trust, and that "all taxes were handled in Belize." RA Crawford believed that there were two bank accounts in Mathews' name that had suspicious deposits. Mathews initially told RA Crawford that there was only one account and that the bank at which he first opened that account had been purchased by another bank, which may have caused RA Crawford to believe there were two accounts. Thereafter, Mathews changed his story and admitted that there were two such accounts. RA Crawford believed that Mathews had deliberately concealed the one account and expanded his examination to tax year Mathews then prepared his 2007 return on which he reported gross receipts from Mathews Multi-Service of $5,323 and a net profit of $3712. Thereafter, RA Crawford referred the case to the IRS Criminal Investigation Division (CID) and special agent (SA) Williams. On July 21, 2009, CID executed a search warrant of Mathews' home. In response to a question about his cash on hand, Mathews stated that he had $20 in his pocket but no other cash in his home. Later that morning, special agents uncovered two safes. One safe had $3,000 in cash, and the other had $10,000. Mathews stated that he had forgotten about the first safe and that he had never seen the second safe. When SA Williams threatened to question Mathews' wife 45

3 about the second safe, Mathews admitted that the $10,000 in the second safe was his. At another point in the interview with SA Williams, Mathews stated he did not know how to report income from the Multi-Service programs. Mathews stated that RA Crawford had determined that his unreported income for all of the years under examination totaled $9,000. Mathews also stated that RA Crawford had not yet taken deductions into consideration. In late 2009, Mathews filed his 2008 return. The 2008 Mathews Multi-Service Schedule C reported gross receipts of $10,000 and no expenses, but Mathews did not report any income from Multi-Service on his 2008 return. He attached a typed statement to the return in which he indicated that CID had taken all his paperwork, that he knew he had deductions, but he didn't have access to his records and that he reserved the right to amend his return whenever CID returned his items to him. SA Crawford then did a bank deposit analysis and determined that for the years , Mathews had underreported his gross receipts from Mathews Multi- Service by over $200,000. SA Williams also obtained a car loan application, dated May 23, 2008, signed by Mathews. There Mathews stated that he was employed by Mathews Multi- Service as a "network consultant" and that his "Gross Monthly Salary" was $3,600. At the conclusion of her investigation, SA Crawford referred Mathews' case to the Justice Department. In 2014, Mathews was convicted under Code Sec. 7206(1) for subscribing to false income tax returns for 2004 through Thereafter, RA Crawford was assigned to examine Mathews' 2007 and 2008 returns. Using the bank deposit method, RA Crawford determined that Mathews had understated his gross receipts by $62,000 in 2007 and $93,000 in After the general statute of limitations under Code Sec. 6501(a) had expired, IRS issued Mathews notices of deficiency for 2007 and 2008 reflecting RA Crawford's adjustments. Mathews timely brought suit in the Tax Court; he argued that the periods of limitation for the years in issue had expired. IRS didn't prove intent to evade tax. In what it characterized as a "close case," the Tax Court held that IRS failed to prove by clear and convincing evidence that Mathews had the specific intent to evade tax believed to be owing when he filed his 2007 and 2008 returns. As a result, it held that the statute of limitations barred IRS from assessing additional tax and penalties for those years. 46

4 The Court noted that second prong of the fraud test requires IRS to prove that, for each year in issue, at least some portion of the taxpayer's underpayment of tax is due to fraud. Fraud for this purpose is defined as intentional wrongdoing, with the specific purpose of avoiding a tax believed to be owing. IRS must therefore prove that the taxpayer intended to evade tax believed to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of tax. The existence of fraud is a question of fact to be resolved from the entire record. Because direct proof of a taxpayer's intent is rarely available, fraud may be proven by circumstantial evidence, and reasonable inferences may be drawn from the relevant facts. The sophistication, education, and intelligence of the taxpayer are relevant to determining fraudulent intent. Conduct of the taxpayer, even though reprehensible, will not justify a finding of fraud unless the fraudulent intent is shown to have existed when the return was made. The Court first noted that it found both Mathews and the IRS witnesses to be credible. Mathews lied on numerous occasions to RA Crawford and SA Williams during IRS's civil examination and criminal investigation. However, the Court said that it did not believe he did so at the trial. Before trial, Mathews had served a substantial prison sentence stemming in large part from his behavior during the audit and criminal investigation. The Court said that it believed that this experience impressed upon Mathews the importance of telling the truth. The Court then noted that Mathews was not a sophisticated taxpayer or financially astute. He dropped out of high school after the 10th grade and had no training or experience in bookkeeping, taxation, or accounting. At trial he appeared confused about the nature of his tax liabilities and, at one point, credibly testified: "[I]t's over my head." Given Mathews's lack of sophistication, the Court said that it questioned whether he knew there was a tax owing from the Multi-Service programs when he prepared his 2007 and 2008 returns. Mathews consistently maintained throughout trial that he "didn't know" how to report income from the Multi-Service programs. That testimony was consistent with his statements to SA Williams during the July 2009 interview. Mathews's testimony also accorded with the general confusion Mathews expressed in the typed statement he attached to his 2008 return. From the record, the Court said, it appeared that the source of Mathews's confusion was his belief that 90% of the funds he received through the Multi- Service programs belonged to the member-recruiters. Mathews testified to this belief at trial, and SA Williams confirmed that the Multi-Service programs required payouts to its members. The record also reflected that Mathews believed he had deductible expenses with respect to the Multi-Service programs. 47

5 Notes taken by RA Crawford and SA Williams during their respective investigations corroborated Mathews's confusion about the taxability of the Multi- Service program income. While Mathews behaved reprehensibly during IRS's civil examination and criminal investigation (which, for the most part, pertained to tax years not in issue), the Court said that it believed that he was genuinely confused about the taxability of the Multi-Service program income when he filed his 2007 and 2008 returns. Accordingly, his misconduct during IRS's civil examination and criminal investigation did not establish that his 2007 and 2008 returns were fraudulent. IRS argued that the car loan application was evidence that Mathews knew his income from Mathews Multi-Service was taxable. However, the Court said, it was unclear from the record what "Gross Salary" meant in this context, as neither party contended that Mathews was a salaried employee of Mathews Multi- Service. The Court said that, given this gap in the record, it declined to draw any inferences from this document. Furthermore, the Court said, if "Gross Salary" means "gross receipts," this document did not establish that Mathews knew he had positive net income from the Multi-Service programs. With respect to Mathews's criminal case, a Code Sec. 7206(1) conviction does not collaterally estop a taxpayer from denying that his returns were fraudulent. Under Code Sec. 7206(1) it is a crime to willfully make and submit any return verified by a written declaration that is made under penalties of perjury which the taxpayer does not believe to be true and correct as to every material matter. The intent to evade taxes is not an element of the crime charged under Code Sec. 7206(1). Thus, although Mathews's conviction under Code Sec. 7206(1) may have been evidence of fraudulent intent, it did not establish as a matter of law that he intended to evade taxes. 48