Can a Taxpayer Avoid a Civil Fraud Penalty by Filing an Amended Tax Return?

In a prior blog post, we discussed amending a tax return to avoid the accuracy-related penalties. This blog post will discuss whether the same strategy can be used to avoid the civil fraud penalty under IRC Section 6663.

IRC Section 6663 states that “if any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.” For the civil fraud penalty to apply the IRS must prove by clear and convincing evidence that an underpayment of tax exists and some portion of the underpayment is attributable to fraud. In addition, there is no statute of limitations on assessment of additional tax where some portion of a tax underpayment is attributable to fraud.

In Gaskin v. Commissioner, T.C. Memo 2018-89, the taxpayer admitted he originally filed fraudulent tax returns, but argued that the fraud penalty should not apply because he filed amended tax returns reporting additional income after he was under criminal investigation. The IRS issued a notice of deficiency that included the additional tax on the amended tax returns and a civil fraud penalty. In his petition to the Tax Court, Mr. Gaskin only challenged the fraud penalty arguing that the fraud penalty can only be applied to the difference between the tax shown on the amended tax returns and the notice of deficiency, i.e., zero. In holding for the IRS, the Tax Court cited Income Tax Regulation 1.6664-2(c)(2) which states that the amount shown on an amended return is not included in the “amount shown as the tax by the taxpayer on his return” for establishing the amount of the underpayment in determining the fraud penalty under Section 6663.

In further support of its holding in Gaskin, the Tax Court cited Badaracco v. Commissioner 464 U.S. 386 (1984). In Badaracco, the taxpayers conceded that they had filed fraudulent partnership and individual income tax returns. However, before the taxpayers were contacted by the IRS they filed non-fraudulent amended returns and paid the additional taxes shown on the amended tax returns. More than 3 years later, the IRS issued notices of deficiency, asserting liability for the fraud penalty. The taxpayers argued that the notices of deficiency were barred by the statute of limitations because they were issued more than 3 years after the non-fraudulent amended returns had been filed. In a decision in favor of the IRS , the U.S. Supreme Court held that “a taxpayer who submits a fraudulent return does not purge the fraud by subsequent voluntary disclosure; the fraud was committed, the offense completed, when the original return was prepared and filed.”

Unlike the taxpayers in Gaskin and Badaracco, most taxpayers do not admit that their tax returns were fraudulent. Therefore, the courts and IRS have developed a list of “badges of fraud” from which fraudulent intent might be inferred. Some common indicators of fraud include the following:

• Understatement of income (e.g., by omissions of specific items or entire sources of income, failure to report substantial amounts of income received)
• Fictitious or improper deductions (e.g., overstatement of deductions, personal items deducted as business expenses)
• Accounting irregularities (e.g., two sets of books, false entries on documents)
• Acts of the taxpayer evidencing an intention to evade tax (e.g., false statements, destruction of records, transfer of assets)
• A consistent pattern over several years of underreporting taxable income
• Implausible or inconsistent explanations of behavior
• Failure to cooperate with the examining agent
• Concealment of assets
• Engaging in illegal activities or attempting to conceal illegal activities
• Inadequate records
• Dealing in cash

The IRS Fraud Handbook includes a more extensive list of fraud indicators.

For any questions on this or any other tax-related matter, please feel free to contact me at (214) 749-2456 or jcrouch@meadowscollier.com.