Another tax season has passed and you’re relived that you have filed your taxes on time. But if you failed to report income, or exaggerated your deductions, you are probably a little paranoid about a tax audit. That is exacted what the IRS intends. The threat of back taxes, fines and criminal prosecution provides ample ammunition for the IRS to encourage your compliance with income tax laws. Congress has supplied the IRS with an arsenal of confusing and overlapping penalties to slap on an errant taxpayers.
THE BASICS
If you understate your income, you can be liable for interest and penalties under the income tax laws and general criminal statutes. Abatement of interest is rare since the government believes it is entitled to an interest charge for the taxpayer’s use of government funds. But penalties can be abated under a broader set of circumstances.
The most common penalties are the “accuracy-related” penalties of negligence, and substantial understatement of income. Less common is the substantial valuation misstatement. These penalties equal 20% of the portion of the tax underpayment cased by the taxpayer’s error. The penalty for civil fraud is more severe: it equals 75% of the tax underpayment.
More serious offenses, which are rarely used, include criminal penalties for tax evasion, failure to file returns or pay tax, and perjury and false statements. In addition, the IRS and Justice Department can charge errant taxpayers under the general criminal statutes of Title 18, such as the aider and abettor statute, the conspiracy statute, and the false statement statute. Charges of money laundering now accompany many criminal tax prosecutions as well.
CIVIL PENALTIES
Accuracy-related penalties
For a general overview on how these penalties may be applied, assume that taxpayers own a restaurant which had gross receipts of $500,000, but they only claimed $450,000 of income. What are the consequences? If the entire understatement was due to sloppy bookkeeping, the taxpayers could be subject to a penalty of 20 percent of the underpayment due to their negligence in failing to keep proper books and records. Only a single accuracy-related penalty would apply, even if the understatement is also substantial (exceeds both $5,000 and 10 percent of the tax required to be shown on the return) and flowed from a substantial valuation misstatement. Reg. 1.6662-2(c).
The Reasonable Cause Exception
No accuracy-related penalty applies if the taxpayer can show that there was reasonable cause for the underpayment and that the taxpayer acted in good faith with respect to the underpayment. IRC 6664(c)(1). Circumstances establishing reasonable cause and good faith include (1) “an honest misunderstanding of fact or law that is reasonable in light of the experience, knowledge and education of the taxpayer,” and (2) an “isolated computational or transcriptional error.” Reg. 1.6664-4(b)(1).
Note: Many computer generated IRS notices contain automatic penalties which may not necessarily apply to your situation. Always question penalties since they can be removed if you have acted in good faith and have reasonable cause. For instance, if you were emotionally or physically impaired (through drugs or alcohol), a doctor’s note verifying your condition could relieve you of negligence penalties.
CIVIL FRAUD
If the taxpayer’s actions involved destruction of records, concealment, or lies, civil or criminal fraud penalties (discussed below) may apply. The taxpayers will be liable for 75 percent of the portion of the underpayment that is attributable to civil fraud. The IRS must prove its case by clear and convincing evidence (a higher standard of proof than what is required for accuracy-related penalties) that the taxpayers were guilty of fraud with intent to evade tax. IRC 6663(a). The accuracy-related penalty does not apply to any portion of an underpayment on which the civil fraud penalty is imposed. IRC 6662(b); Reg. 1.6662-2(a).
With the objective of more consistent positions on civil penalties, the IRS issued a Consolidated Penalty Handbook as part of its Manual on July 27, 1992 (IRM, Part XX, MT(20)-1 et seq. (July 27, 1992), which includes penalty descriptions and methods of appealing penalties.
CRIMINAL PENALTIES
The ultimate missile in the IRS arsenal are the felony criminal statutes. In truth, however, criminal cases are rarely prosecuted. It has been suggested that a taxpayer has a greater chance of being murdered that to face criminal tax prosecution.
Criminal cases require extensive and investigations since the government must establish guilt beyond a reasonable doubt; consequently, the IRS and Justice Department will generally pursue more aggravated cases that involve deliberate omissions, false statements, destruction of records, and bribery.
Because of the government effort required, if the taxpayers were negligent and careless, or resolved doubts in their favor, they are more likely to avoid criminal prosecution. Bittker and Lokken, Federal Taxation of Income, Estates and Gifts, 2nd Ed. (Warren, Gorham & Lamont) 114-80.
Assume our hypothetical taxpayers had $500,000 in gross receipts, but they deliberately skimmed $200,000 out of the business and placed the cash in a safe deposit box. In addition to the civil sanctions discussed above, they could be convicted of tax evasion under IRC 7201, provided the government can prove, beyond a reasonable doubt: (1) willfulness on the part of the taxpayers, (2) the existence of a tax deficiency and (3) an affirmative act by the taxpayers constituting an evasion or attempted evasion of tax.
The tax evasion statute imposes the most severe sanctions of any tax offense described in the Code. Taxpayers convicted of tax evasion are subject to a fine and imprisonment for not more than 5 years, or both, plus the costs of prosecution. The maximum fine is $100,000 ($500,000 for a corporation), but 18 USC sec. 3571, a general statute on fines as punishment, raises the maximum for individuals to $250,000 and allows a fine exceeding this dollar ceiling up to twice the pecuniary gain from the offense.
If state law deems conviction of evasion a felony, the taxpayers may lose general civil liberties such as loss of the right to vote, hold public office, obtain many jobs, and retain professional licenses.
The evasion statute also subjects the taxpayer to other penalties provided by law, provided prosecution is not double jeopardy (conviction of the same crime twice). For example, false filing under IRC 7206(1) is a lesser included offense with respect to tax evasion; however, under IRC 7203, willful failure to pay tax or file a return has elements different from those of evasion under IRC 7201, so separate penalties under both statutes are not double jeopardy. The extent to which offenses and penalties can be cumulated when they overlap is a recurrent issue in criminal tax cases.
DEFENSES
Finally, assume our taxpayers attended a seminar and learned that payments to a foreign consultant are deductible. They decided to pay their mother in Bogata $100,000 as a consultant fee, and deducted this payment as a business expense. If the mother in Bogata fails to qualify as a foreign consultant to whom payments are deductible, the IRS could charge the taxpayers with violations of the various civil and criminal statutes. Taxpayers may assert the defenses of reasonable reliance on professional advice, or ignorance or mistake of law.
If the taxpayers followed the advice of an attorney or accountant to whom the taxpayers supplied all relevant facts (made full disclosure), they would probably avoid prosecution. See, e.g., Heasley v. CIR, 902 F2d 380, 383-84 (5th Cir. 1990). However, attendance at a seminar with speakers of unknown credentials, and where advice is not given directly and specifically to the taxpayers, would not shield the taxpayers from liability for an improper deduction.
Regardless of the presumption that the taxpayer knows the law, ignorance or mistake of law is a defense in tax crime cases. Taxpayers may produce evidence that they lacked the purpose, knowledge, belief, recklessness, or negligence required to establish a material offense of a tax crime. The United States Supreme Court has held that a good faith, but mistaken, belief about what the law requires need not be objectively reasonable. Cheek v. United States, 498 US 192 (1991). On remand, the Seventh Circuit distinguished cases where the taxpayer claims that the tax law is unconstitutional, which is not a defense, because such a claim demonstrates the taxpayer’s knowledge of the provisions of the law. On the other hand, a jury must be permitted to consider a taxpayer’s claim that the taxpayer believed in good faith that the tax laws do not apply to him, no matter how incredible or unreasonable those beliefs might be. United States v. Cheek, 931 F2d 1206 (7th Cir. 1991).
Likewise, reasonableness is not an issue when taxpayers defend against criminal liability on the basis that they had a mental disease or defect.
INNOCENT SPOUSE DEFENSE
If the taxpayers are married, one spouse can attempt to avoid liability as an innocent spouse under IRC 6013(e). One spouse can avoid liability if the spouse did not know and had no reason to know that there was a substantial understatement of tax on the joint return signed by both spouses, and taking into account all of the facts and circumstances, in would be inequitable to hold the spouse liable for the additional tax attributable to the substantial understatement of the guilty spouse.
STATUTE OF LIMITATIONS
What if the taxpayers took the improper deduction four years ago? The assessment of any internal revenue tax must generally be made within a three-year period beginning with the date a return is filed, or the tax is uncollectible by a proceeding in court or administrative levy. IRC 6501(a). However, the tax may be assessed at any time (there is no statute of limitations) where a taxpayer (1) fails to file a return; or (2) files a false or fraudulent return with the intent to evade tax (the burden of proof in this instance is on the IRS). IRC 6501(c)(1), (3). Finally, f there is more than a 25 percent omission of income which has not been disclosed on the tax return, the statute of limitations is six years. IRC 6501(e)(1)(A).
An indictment or information for a tax crime must be brought within three years after the offense is committed. A six-year statute of limitations period is substituted for many of the major tax crimes such as willfully attempting to evade tax, false statement, and assisting in the preparation of a false or fraudulent return. IRC 6531. The general statute of limitations for Title 18 offenses is five years (18 USC 3282), but IRC 6531(8) provides for a six-year period where the conspiracy is one to attempt to evade or defeat any tax or its payment.
CORRECTED RETURNS
Assuming these unfortunate restaurant owners have read this graphic depiction of their worst nightmare, should they attempt to come clean and confess their sins to the IRS? Unfortunately, the IRS has long abandoned a brief policy of not recommending prosecution of taxpayers who attempt to file correct amended returns where the taxpayer attempted to defraud the IRS. Taxpayers have no guarantee that the IRS will not use their corrected returns against them as admissions against interest. Bittker and Lokken, supra at 114-87.
There is limited relief available for those filing an amended return: under IRC 6721(C)(2), where taxpayers filed the original information return and failed to include all the information required, or incorrect information has been included in the return, and the return is corrected on or before August 1, then the original return is treated as having been filed with all the correct required information.
Once the IRS is on the taxpayer’s trail, the taxpayer cannot recharacterize a transaction to avoid liability. “Queen” Leona Helmsley (Helmsley Hotels, Empire State Building – estimated net worth: over one billion) and her money-is-no-object legal team tried this tactic without success. They claimed that by failing to comply with the “accelerated cost recovery system,” the Helmsleys deducted too little of the cost basis of partnership buildings, resulting in the overpayment of their personal income taxes in specified years in amounts sufficient to offset the alleged deficiencies. The Second Circuit rejected this reasoning and stated that “[h]aving selected a particular depreciation method – whether or not it was a method authorized under the law – Mrs. Helmsley was not free to recalculate her taxes by resorting to one of the four depreciation methods in ACRS solely to defend an evasion charge.” United States v. Helmsley, 941 F2d 71 (2nd Cir. 1991), cert. denied, 112 S. Ct. 1162 (1992).
SUMMARY
Although tax law offenders might decide to play “audit roulette,” betting they will not be the 1% of the taxpayers snagged by and IRS audit, a multitude of sanctions are available to punish them if they lose. The statute of limitations period is tolled in some situations, including the failure to file or fraudulent returns. While several defenses are available, the best advice is to comply with the laws in the first place and consult with professionals when in doubt. If you receive advice from a tax attorney or accountant, make sure the opinion is in writing and addresses your specific situation. Save yourself a lot of sleepless nights, not to mention the exorbitant expenses that make noncompliance never worthwhile. Engage in proper tax planning early in the year.
Rather than wasting your ingenuity scheming to beat the system illegally, try finding legal means, such as political involvement, to influence changes in the tax system that you believe will be more equitable. Changes obviously won’t happen overnight, but your efforts could help make a difference for others in your situation over the long run.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**