Small Business Taxes & Management

Special Report

IRS Traps Taxpayer Who Filed Fraudulent Returns


Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.


You can't have it both ways. More than one small business owner has either underreported his income or overstated his business expenses in order to save on income taxes. But that can come back to haunt them when they go to sell the business. While not universally true, most buyers base their offer on the cash flow from the business. Low income means a low selling price. That was the situation in this case. The big difference was the buyers were undercover IRS agents.

In John M. Potter (T.C. Memo. 2014-18) the taxpayer owned and operated a "gentlemen's club," Potter's Pub, Inc. Potter's Pub was a cash-based business that derived receipts from food and drink charges run through the cash register, door cover charges, juke box moneys, pool table receipts, and moneys paid to the pub by the dancers for the privilege of "dancing." The taxpayer was the president and sole owner. For each year at issue he filed, and signed as president, a Form 1120, U.S. Corporation Income Tax Return, for Potter's Pub. Those returns reported losses for 2002 and 2003 and zero taxable income for 2004 and 2005. The taxpayer filed individual income tax returns for the years at issue, but the returns for 2002 and 2003 were very late. The taxpayer reported no wages, dividends, or other income from Potter's Pub on the returns.

In December 2006 IRS special agents engaged in an undercover investigation of Potter's Pub, posing as buyers interested in acquiring the business. The taxpayer assured the agents that Potter's Pub was much more profitable than it appeared. He explained that he deposited in the corporate account only enough of the business revenues to cover its expenses and that he wired the balance of its revenues to his personal bank account in Florida. These wire transfers were structured in amounts less than $10,000 to avoid reporting obligations by the bank to the IRS. In reality, the taxpayer told the agents, Potter's Pub grossed more than $1 million annually and he took home between $400,000 and $520,000 each year. He showed the agents clandestine sales ledgers for 2003 and 2004 that supported the gross receipts he claimed, acknowledging that it might have been unwise to maintain documentary evidence of his skimming.

During a subsequent search of Potter's Pub, IRS agents seized upwards of $200,000 in cash and obtained the set of clandestine sales ledgers that tracked its daily receipts. These ledgers confirmed that Potter's Pub's annual receipts for 2002-05 were vastly in excess of the amounts that the taxpayer had reported to the IRS. The difference between its actual gross receipts and the gross receipts reported on the company's Forms 1120 for those years exceeded $2 million.

After the search of Potter's Pub, when he knew he was under criminal investigation, the taxpayer provided his accountant additional bank account information for the 2003-05 tax years. The accountant used this information to file amended Federal income tax returns for those years, both for Potter's Pub and for the taxpayer individually. The IRS assessed additional income tax and additions to tax on the basis of the amounts shown on the amended returns for 2003-05.

In January 2009 the taxpayer was criminally charged with eight counts under Section 7206(1) and (2) for making and subscribing false tax returns, and for assisting in the preparation of false tax returns, for himself and Potter's Pub. In May 2009 he pleaded guilty to one count of making and subscribing a false Form 1120 on behalf of Potter's Pub for 2002. Pursuant to his plea, he was sentenced to 18 months' prison time and supervised release for one year. He was also ordered to pay restitution of $400,000.

In the factual basis for his guilty plea, the taxpayer admitted under penalties of perjury that he willfully submitted false tax returns for Potter's Pub for the 2002-05 tax years; that he did not believe those returns to be true and correct as to every material matter; and that he had falsely subscribed those returns with the specific intent to violate the law.

In April 2009 the taxpayer signed, in his capacity as president and sole owner of Potter's Pub, a Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment. He thereby agreed that, for tax years 2002-05, Potter's Pub was liable for tax deficiencies (in addition to those previously collected) in excess of $340,000 and for fraud penalties under Section 6663 in excess of $250,000.

The Court had to decide if the taxpayer was liable for the fraud penalty. The Court noted the taxpayer conceded the first element of the fraud penalty, namely, that he underpaid his tax liability for each year at issue. The Court looked to the other "badges of fraud" usually examined including:

The Court noted that some factors had no application, but after a thorough review of the record, the Court concluded the "badges of fraud" overwhelmingly demonstrated the taxpayer acted with fraudulent intent for each year at issue.

Rather than review all the factors discussed, we'll just look at some of the ones particularly noted by the Court.

Understating Income A pattern of substantially underreporting income for multiple years is strong evidence of fraud, particularly if the understatements are not satisfactorily explained. The fact that the taxpayer acknowledged that he intentionally underreported his income weighed heavily in favor of finding fraudulent intent.

Maintaining Inadequate Records The taxpayer's records were both inadequate and fraudulent. The second set of books provides clear circumstantial evidence of fraudulent intent.

Concealing Income or Assets The two sets of books has relevance here as well. The taxpayer also wired the cash to his personal bank account. The amounts transferred were kept below $10,000 to avoid reporting of the transactions by the banks. The pattern of structuring bank deposits (keeping them under $10,000) is a sign of intent to conceal income.

Providing Incomplete or Misleading Information Evidence that a taxpayer provided incomplete or misleading information to his return preparer is circumstantial evidence of fraud. Here the taxpayer provided his accountant with the false information. The Court also noted the once a fraudulent return has been submitted, filing an amended return does not undo the original fraudulent conduct.

Extensive Dealings in Cash Extensive dealings in cash are a badge of fraud because they are indicative of a taxpayer's attempt to conceal income and avoid scrutiny of his finances. Fraudulent intent may be inferred when a taxpayer handles his affairs in a manner designed to avoid making the records usual in transactions of the kind. Here, the business was of necessity a cash-based operation. Although conducting a cash business does not necessarily prove fraud, when coupled with attempts to conceal transactions or avoid the requirement of reporting cash transactions, it becomes more probative.

The taxpayer argued that he lacked fraudulent intent because was uneducated and unsophisticated and had to hire tax professionals. The Court said the taxpayer's lack of education and sophistication was irrelevant. The tax laws involved were not esoteric. He knowingly concealed more than $2 million in gross receipts from the business. Additionally, he was sophisticated enough to structure his wire transfers in amounts under $10,000 and failed to provide his tax professional with the clandestine sales ledgers he personally prepared.

The taxpayer asserted he went to extraordinary lengths to cooperated with the IRS. But the Court noted he began to cooperate only after he knew the jig was up.

The Court concluded that the IRS established by clear and convincing evidence that the taxpayer's underpayments were attributable to fraud for the years 2002 through 2005. The Court held the taxpayer liable for civil fraud penalties of some $239,900. That's in addition to late filing/paying penalties and the actual tax deficiencies to which the taxpayer admitted.

Don't think the case above could happen to you? In a case some years ago a taxpayer was selling his business and divulged the second set of books to the buyer. At some point the buyer had a falling out with the seller and reported him to the IRS.

One of the dangers of filing false returns, other than the obvious one of problems with the IRS (and the applicable state), is that how you deal with other parties who are interested in your financial position. For example, you're going for a bank loan for your business, or a home mortgage, a car loan, or, as in this case, you're trying to sell your business. If you present financials that conflict with your tax return you run the risk being accused of defrauding the lender or buyer. Worse, the financials presented to the bank can be used as evidence of fraudulent intent with respect to the tax returns.

Already filed returns which can be considered fraudulent? Consult a tax attorney.


Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 02/17/14