The US Income Tax Return form 1040 is probably one of the few annual forms that just about all Americans sign, either manually or electronically, under penalty of perjury. The exact phrase you certify in a quasi-oath like setting is: “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, are true, correct, and complete.” I don’t know about you all, but how many of us really understand everything on our tax return as we give the tax preparer the go ahead to file our returns each year.
So I would not be surprised if most of you did not welcome the thought of an IRS audit commencing up to three years from the date you filed your tax return as per IRS Code 6501. But did you know there are three “statute extenders” that the IRS has at its disposal to audit us even after 3 years? The first extender is the 25% or more understatement of income. The second extender is unreported foreign financial asset income of more than $5000 and the third extender is fraud or criminal attempt to evade tax. The 25% extender is straightforward: You report $100,000 of taxable income from earnings but omit another $30,000 of dividends and interest. Equally clear-cut is the $5000 extender; you report $100,000 of taxable income from earnings but omit $5000 of foreign dividends from that secret Swiss bank account. In each of these extenders your statute of limitations is 6 years. The Fraud or Criminal evasion extender, or what I call the “Ultimate Forever Extender, (UFE) has no statute of limitations, imposes very large penalties, and for about 2000 taxpayers a year, carries criminal prosecution and prison. Will any of these powerful extenders come into play with your tax returns? Will an audit of your tax return head south to fraud and criminal investigation? You say no way! I say perhaps someday if you don’t know the way. Keep reading to find out how to stay free of UFE.
Let’s take a look at what’s happening in US Tax Court. We start off with a Judge Halpern opinion Scott v IRS, US Tax Court decided in March of 2012. Scott was a dentist whose 1994 tax return was selected for audit by the IRS in 1996. For reasons that defy logic Scott did not cooperate with the examining agent Thomas Demeo. By 1997 Agent Demeo expanded the audit to 1995. Without the cooperation of Scott, Demeo was forced to go directly to the bank with official summons to review the original bank records. With the audit still going strong in 1998 the statute of limitations of 3 years was fast approaching. Most likely due to Scott’s lack of cooperation, the case was referred to Criminal Investigation Division (CID). But CID apparently did not find a criminal case so CID sent Scott back to civil examination sometime after 1999. By 2000 Scott had outlasted Demeo and a new agent was assigned to the case Agent Barbati. Eventually Barbati assessed a tax for 1994 95 and 96 many years after the statute had run and the notice of deficiency and 90 day letter was issued to Scott alleging he owed almost $300,000 in tax and $200,000 in penalties. Scott appealed to US Tax Court arguing the three year statute of limitations had run. The government claimed a UFE, the “Ultimate Forever Extender” and set about to prove that Scott was guilty of tax fraud thus unleashing the dreaded UFE.
The key question presented then for Judge Halpern was whether there was intentional wrongdoing of fraud with the specific purpose of avoiding a tax that Scott knew was owed to the government. If this question was answered affirmatively the IRS would be empowered to activate their UFE allowing the government an easy win. If not, the case would be dismissed due the 3 year statute of limiations having run out allowing the Scott to win. After a careful review of all the facts, Judge Halpern finds for the government, relying on his own 2011 Opinion Browning v IRS . Citing Browning, Judge Halpern applies the 11 factors or “badges of fraud” to the Scott case. The eleven badges of fraud are: 1, Understatement of income, 2, inadequate records, 3. Failing to file tax returns, 4. Implausible explanations of behavior, 5. Concealment of income 6. Failing to cooperate 7 engaging in illegal activity, 8 intent to mislead 9. Lack of credibility of testimony 10 filing false documents and 11 the last one, dealing in cash.
While the Court found many of the 11 badges of fraud in Browning applicable to Scott, in my view, the facts in Browning are very different than the facts in Scott. Browning owned a Vermont based manufacturing corporation. On advice of his tax advisor Browning allegedly illegally moved funds offshore. From these offshore accounts Browning used credit cards to purchase goods and services for personal use with funds that had not been taxed. In addition Browning allegedly tried to mislead the IRS during the audit about this scheme. As I see it Browning’s deception to the government was worse than the offshore scheme itself. The Court saw it that way too.. Judge Halpern handed over to the IRS the power of the UFE years after Browning’s three year statute had run its course.
While Scott did not mislead or deceive the IRS during the audit as Browning did, it was Scott's failure to cooperate with authorities, his lack of organized books and records, and his implausible testimony on the witness stand that eventually did him in with a Court approved UFE. Scott eventually paid all his tax he owed plus a 75% fraud penalty and surely massive amounts of interest. Just so you know, if Scott had cooperated with the IRS examination division in the first place, my guess is that he could have avoided the 75% fraud penalty and perhaps just got hit with a much lower substantial understatement penalty instead. However, on a positive note, Scott was fortunate (as was Browning) to avoid a criminal prosecution and possible jail time.
What does this mean for all of us? The IRS has three years to review your unique situation and decide whether or not to audit your tax return. Make sure you don’t empower the IRS with UFE. Fully disclose each year what is going to your tax professionals. Have your tax professionals insert into your tax returns anything unique in the tax strategy you are using each year. For example, if there is some question as to how much you received from a customer, or whether the amounts received were fully taxable, disclose in a footnote in the tax return before you file why you didn’t report all this income. Moreover, if you own a business as did Browning or Scott or have a somewhat complex financial situation you would be well advised to retain the appropriate tax counsel who could both prepare and file your returns and also be there for you years later to represent you in the event of an IRS audit, all a long maintaining that very important attorney-client privilege with you. If you are audited three, four or five years later, pull those books and records with confidence down from the Cloud to make sure your records are 100% complete. In conclusion, good records, open and honest disclosure in the actual tax return prior to filing, and cooperation with the IRS examination division will go a long way in avoiding the Ultimate Forever Extender. May you live long, prosper and avoid the UFE.
Thank you for joining Chris Moss CPA on TaxView.
See you next time,
Chris Moss CPA