Tax Help: IRS determined that a horse-breeding activity is a business not a hobby in Michael J. Rozzano, Jr. and Rose Marie Rozzano v. Commissioner.Dkt. No. 12344-03 , TC Memo. 2007-177, July 3, 2007. Taxpayers conducted their horse-boarding activity as a bona fide business activity within the meaning of Code Sec. 183. Although the couple never reached a financial break-even point with respect to the activity, the manner in which the taxpayers conducted the activity indicated that it was engaged in for profit. The couple maintained accurate records, followed and modified business plans and, upon realizing that they could not earn a profit under the circumstances, minimized expenses until they were able to sell the business. The taxpayers had the expertise to run the business and expended effort to do so, and any pleasure the taxpayers may have experienced through their ownership and running of the business did not trump the finding the activity was operated for profit. Horse breeding cases are normally examined and the IRS is normally adverse on any business activity that does not make a profit.

Section 183(a) disallows deductions attributable to an activity not engaged in for profit. Section 183(b) provides two exceptions to this general rule. The first, provided by section 183(b)(1), permits deductions that otherwise would be allowable without regard to whether the activity is engaged in for profit; the second, provided by section 183(b)(2), permits deductions that would be allowable only if the activity were engaged in for profit to the extent that the gross income from the activity exceeds the deductions allowable pursuant to section 183(b)(1). Section 183(c) defines an "activity not engaged in for profit" as "any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212." In general, the Commissioner's determination set forth in the notice of deficiency is presumed correct. Rule 142(a)(1); Welch v. Helvering , 290 U.S. 111, 115 (1933). In certain circumstances the burden of proof shifts to respondent. Sec. 7491(a)(1); Rule 142(a). Because the issue in this case is a legal one, we reach our decision without regard to the burden of proof. However, petitioners contend that section 7491(a) and Rule 142(a) are applicable with respect to the increases in the deficiencies pleaded in respondent's answer. They are correct on this point.

In deciding whether petitioners' horse-boarding activity was engaged in for profit during the taxable years at issue, we must inquire whether petitioners had an actual and honest objective of making a profit from the activity. Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), affd. without opinion 702 F.2d 1205 (D.C. Cir. 1983). The taxpayers' expectation need not be a reasonable one. Id. at 644-645; Golanty v. Commissioner, 72 T.C. 411, 425 (1979), affd. without published opinion 647 F.2d 170 (9th Cir. 1981); sec. 1.183-2(a), Income Tax Regs. Whether there is present an actual and honest objective of making a profit is a question of fact that is to be resolved upon a consideration of all relevant circumstances, with the greatest weight being given to the objective factors rather than the taxpayers' expression of their intent. Dreicer v. Commissioner, supra at 645; Golanty v. Commissioner, supra at 426; sec. 1.183-2(a) and (b), Income Tax Regs.

Section 1.183-2(b), Income Tax Regs., lists these relevant factors that we now consider: (1) The manner in which the taxpayers carry on the activity; (2) the expertise of the taxpayers or their advisers; (3) the time and effort expended by the taxpayers in carrying on the activity; (4) the expectation that the assets used in the activity may appreciate in value; (5) the success of the taxpayers in carrying on similar or dissimilar activities; (6) the taxpayers' history of income or loss with respect to the activity; (7) the amount of occasional profits; (8) the financial status of the taxpayers; and (9) whether elements of pleasure or recreation are involved. Golanty v. Commissioner, supra at 426; sec. 1.183-2(b), Income Tax Regs.

Based on our consideration of these factors and in the light of the detailed record in this case, we conclude that petitioners' horse-boarding activity was carried on as a business within the meaning of sections 162 and 183 during the taxable years at issue. In reaching this conclusion, we view the following facts and circumstances as most persuasive:
Manner in Which Taxpayers Carried On the Activity

Respondent contends that the manner in which petitioners conducted their horse-boarding activity does not indicate that the activity was engaged in for profit during the years in issue. The relevant inquiries before us include whether petitioners conducted their business in a manner similar to other comparable businesses, whether petitioners maintained complete and accurate books and records, and whether changes were attempted to improve profitability. See Engdahl v. Commissioner, 72 T.C. 659, 667-668 (1979); sec. 1.183-2(b)(1), Income Tax Regs.

As to their manner of conduct, during the taxable years in issue, petitioners, for the most part, rented more than one-half of the available stalls in their barn. Petitioners provided detailed monthly boarding records for 1999 and 2000, which list each horse and the expenses incurred. From the inception of their activities in 1992, through the years in issue, petitioners also maintained extensive and separate accountings for all of their horse-boarding income and expenses using a software program tailored to small farm operators. Based on these facts, we are satisfied that petitioners' maintenance of complete and accurate records in this case supports a profit objective. See Elliott v. Commissioner, 90 T.C. 960, 971-972 (1988), affd. without published opinion 899 F.2d 18 (9th Cir. 1990); sec. 1.183-2(b), Income Tax Regs.

As to petitioners' other business practices, although petitioners made no great effort to advertise their boarding service to the general public, we do not find their lack of advertising indicative of an absence of profit motive, as their word-of-mouth approach in attracting clientele was clearly successful, as they had, at one point during the years in issue, 80 percent of their stalls rented.

Notably, however, despite the significant stall rental statistics and petitioners' thorough accounting methods, we cannot overlook Mr. Rozzano's refreshingly candid testimony at trial that he came to realize sometime in 1999 that petitioners would neither earn a profit nor reach a break-even point if they held to their existing boarding fees, nor could they raise boarding fees or hire additional help in order to become profitable. Mr. Rozzano reached this conclusion after he analyzed all factors necessary to attempt to make the business more profitable.

In fact, after his analysis, he calculated that these measures (i.e., raising boarding fees and hiring additional help) would likely increase his operating costs taking into account the scope of the services provided to the boarders. Moreover, it was likely that the terms of the contracts then existing with the boarders meant that any modification to the monthly rental agreements would have placed petitioners in breach of contract. Mr. Rozzzano then did what any prudent business person would do, attempt to lessen expenses until the business including the property could be sold.

Petitioners' rental fees remained unchanged after Mr. Rozzano decided to sell Sugar Tree (a decision made sometime in 2000). Notably, petitioners still kept meticulous business records and used word-of-mouth to advertise their boarding services during the years in which they were continuing the boarding activities while, at the same time, preparing the property for sale.

Mr. Rozzano also testified that it was primarily the cost associated with hay feed that caused their business to experience ongoing losses. We note that for 1999 and 2000, hay and feed expenses accounted for 34 percent and 32 percent, respectively, of all cash expenses before depreciation. To this end, petitioners devised a strategy to ensure that their hay supply costs could be mitigated so as to reduce losses and accord with their budget projections. Petitioners took steps to ensure that the hay would remain dry and free from infestation and that their helper would not waste it unnecessarily. Petitioners also took steps in 1999 and 2000 to reduce other operating expenses, such as travel, meals, and utilities. These costs did, in fact, decrease from 1999 to 2000. Although petitioners did make efforts to reduce their hay expenses by protecting their supply, an increase in the number of boarders in 2000, coupled with an increase in the wholesale price of the feed, resulted in an increase in hay costs. While we recognize that efforts to improve profitability can be indicative of whether petitioners intended to realize a profit, we do not find their refusal to raise stall rental prices or hire additional help, especially in the light of their existing contracts, of their decision to sell Sugar Tree, and of their efforts to reduce hay and other costs, dispositive on the issue of their profit motive. It is beyond this Court's purview to second-guess petitioners' business judgment or the manner of operations of their business. We decline to do so.

In this case, we are presented with taxpayers who admit that during 1999, they became aware that they could not make a profit but yet still continued business operations while taking steps to mitigate their expenses until the business and property could be sold. Accordingly, we now address whether petitioners' admission at trial should trump the other facts and circumstances of this case.

While we cannot disregard Mr. Rozzano's admission that at some point in 1999 he realized that his hopes of turning the boarding activities into a profitable business were unattainable we do not find that as of that moment, petitioners' activities ceased to be a bona fide business within the meaning of section 183. Moreover, our decision comports with this Court's holding in Dreicer , where greater weight must be afforded to the consideration of all of the facts and circumstances. In this case, the facts and circumstances surrounding petitioners' actions between the time of their realization with respect to profitability in 1999 and the ultimate disposal of the property in 2003 show that they continued to conduct their horse-boarding activities in a businesslike manner.

Even after petitioners' realization with respect to the profitability of their horse-boarding activities, their actions illustrate steps taken to mitigate costs and to try to achieve at least a break-even point until the business could be sold. First, petitioners held contracts for stall rentals which they did not change, nor could they change, for fear of being in breach. Second, petitioners made active attempts to reduce hay and feed costs. Third, petitioners continued to rent stalls, maintain their ongoing operations, and even moved back to the property on a full-time basis in 2000. Finally, and perhaps most significantly, the amount of operating costs borne by petitioners comprised a large share of their wage income in the years at issue. Petitioners had wages of $221,968 in 1999, and $159,018 in 2000, and reported net out-of-pocket expenses in those years from Sugar Tree of $76,687 and $73,722,4 respectfully. These net out-of-pocket expenditures were 34 percent and 46 percent of petitioners' wages in 1999 and 2000, respectfully. We cannot conclude, based on the entirety of the foregoing, that their activities turned from business into hobby overnight in 1999 based upon Mr. Rozzano's admission at trial.

Expertise of and Effort Expended by the Taxpayers

Respondent does not challenge either petitioners' expertise or the time and effort expended on the activity at issue. We believe that petitioners have established, through credible testimony, that they not only were well possessed of the knowledge necessary to operate a horse-boarding business, but that Mr. Rozzano contributed vast amounts of time to the operations at Sugar Tree. First, petitioners were well aware from their experience as horse owners of the requirements for boarding horses before they commenced activity at Sugar Tree. Second, horse-boarding, unlike other horse-related endeavors, such as breeding and training, while it entails risk, to be sure, is rather simple in its day-to-day execution; horses are taken out to pasture ("turned out"), fed, returned to stables to rest, taken out again, fed again, and retired to their stables. There is nothing in the record that suggests that petitioners were not well versed and extremely competent in these practices.

Finally, although we suspect that Mr. Rozzano's testimony that he spent every weekend and holiday for 10 years performing upkeep at Sugar Tree may be an overstatement, we find him a credible and forthright witness overall and moreover, we believe that he performed most, if not all, of the major upkeep projects on Sugar Tree himself. Therefore, we believe that the expertise of and time and effort expended by petitioners support a finding that the activity was engaged in for profit.

Expectation That Assets Would Appreciate

Petitioners argue that the increase in the value of Sugar Tree and the efforts they expended and expenses they incurred in upkeep of the property support a conclusion that the horse-boarding activity was engaged in for profit. We disagree. On the issue of whether appreciation of land supports petitioners' profit intent, the relevant inquiry is whether the holding of the land for appreciation and the conducting of the horse-boarding constitute a single activity or separate activities. Sec. 1.183-1(d)(1), Income Tax Regs. Determining whether the two undertakings are a single activity requires the examination of all of the facts of the case; the most significant facts being those that show the degree of organizational and economic interrelationship of the undertakings. Id.

In this case, petitioners primarily purchased the land for personal enjoyment and not to engage in a business. Therefore, they had no bona fide intention, at the time of purchase, to realize a profit that could offset later operating losses as they had not yet contemplated any business using the property. Only subsequent to the purchase did petitioners use the property in their horse-boarding activities.

Moreover, we note that the variable costs of petitioners' horse-boarding activities, including fees, veterinarian care, etc., exceeded the gross income produced by the activities, with the result that the horse-boarding activities do not meet the test imposed under the regulation pertaining whether such activities will be integrated. See sec. 1.183-1(d)(1), Income Tax Regs. Accordingly, we believe, in this case, that their holding the property for appreciation and horse-boarding are separate activities. See sec. 1.183-2(b)(4), Income Tax Regs.; Engdahl v. Commissioner, 72 T.C. 659 (1979); Allen v. Commissioner, 72 T.C. 28 (1979). Irrespective of this conclusion, however, we do not believe that petitioners' inability to argue the appreciation of their land is ultimately determinate on the issue of whether the horse-boarding activity was engaged in for profit.

Financial Status of the Taxpayers

The fact that petitioners have substantial income from sources other than the activity at issue may indicate that the activity was not engaged in for profit. Cf. Engdahl v. Commissioner, 659, 670. Respondent argues that Mr. Rozzano's income from his job in executive management was sufficient to absorb the expenses in operating Sugar Tree, indicating that it was not operated for profit. We disagree. As previously stated, these out-of-pocket expenditures were 34 percent and 46 percent of petitioners' wages in 1999 and 2000, respectively. We are not persuaded that petitioners were able to absorb easily the losses attributable to the activity at Sugar Tree during these years. As previously stated, the income reported by petitioners on their tax returns for the years in controversy does not, in our opinion, demonstrate that the losses incurred by petitioners were offset either by petitioners' income in those years or excessive depreciation deductions claimed by them.

Moreover, whatever income petitioners may have had during the years in issue is secondary to the primary inquiry as to whether or not petitioners engaged in the activity with a genuine intent to profit from it. We note that petitioners had no other income in the years at issue apart from Mr. Rozzano's work and a 3-week, holiday job taken by Mrs. Rozzano at The Gap, Inc. By 1999, both of petitioners' adult children had left the familial home, and so, the physical work and personal efforts expended by petitioners were not being done for the immediate benefit of their children. We believe it unlikely, given the distance petitioners regularly traveled to and from Sugar Tree, the liability risk inherent to their activity, and the nature and extent of the physical labor which they performed while at Sugar Tree, that petitioners would maintain a hobby costing thousands of dollars and entailing much physical labor.

Elements of Pleasure/Recreation

Respondent argues that not only are Mr. Rozzano's claims regarding his involvement with the work done at Sugar Tree improbable, but that regardless of the amount of effort petitioners put into the activity, elements of pleasure should trump any consideration that the activity was a business. We disagree. Until sometime in 2000, petitioners resided at least 5 hours away from Sugar Tree. This distance required petitioners to travel between their home and Sugar Tree on weekends and holidays. We believe, based on their credible testimony at trial, that once at Sugar Tree, petitioners did perform a significant amount, if not all, of the major upkeep on the property. Furthermore, petitioners did not ride either of their horses for pleasure after 1990. We do not find that the pleasure that petitioners may have experienced through their ownership of Sugar Tree should trump a finding that the horse-boarding activity was operated for profit. See Jackson v. Commissioner, 59 T.C. 312, 317 (1972).

Possibly the only elements of pleasure taken by petitioners were either when watching their own horses frolic in the pasture or in the mere fact that they could attest to "owning a horse farm near Lexington, Kentucky."

Therefore, on the basis of all of the evidence in the record of this case, the circumstances of which are unique, we conclude and hold that petitioners conducted their horse-boarding activity in the years in issue as a bona fide business within the meaning of section 183.

Tax Attorney: Taxpayers contended that the IRS abused its discretion in sustaining the second notice of Federal tax lien because they were negotiating an offer-in-compromise when the lien was filed. The notice was filed after the IRS assessed the taxpayers' liabilities, gave notice and made demand for payment, and after it returned their proposed offer because they failed to provide supporting documentation. Oliver W. and Harriet S. Williams v. Commissioner. Dkt. No. 3000-06L , TC Memo. 2007-162, June 21, 2007. This case is interesting because it implies that the IRS cannot file a notice of lien when an offer in compromise is being actively considered by the IRS. The Tax Court noted:

The Federal Government obtains a lien against "all property and rights to property, whether real or personal" of any person liable for Federal taxes upon demand for payment and failure to pay. Sec. 6321; Iannone v. Commissioner, 122 T.C. 287, 293 (2004). The lien arises automatically on the date of assessment and continues until the tax liability is satisfied or the statute of limitations bars enforcement. Sec. 6322; Iannone v. Commissioner, supra at 293. The notice of Federal tax lien is filed with the appropriate State office or other government office in order to validate the lien against any purchaser, holder of a security interest, mechanic's lienor, or judgment lien creditor. See sec. 6323(a); Lindsay v. Commissioner, T.C. Memo. 2001-285, affd. [2003-1 USTC ¶50,307] 56 Fed. Appx. 800 (9th Cir. 2003).

The Commissioner "may" withdraw a Federal tax lien pursuant to section 6323(j)(1), but respondent's failure to do so in this case is not an abuse of discretion. See Crisan v. Commissioner, T.C. Memo. 2007-67; Ramirez v. Commissioner [Dec. 56,102(M)], T.C. Memo. 2005-179; Stein v. Commissioner , T.C. Memo. 2004-124.

Back Taxes: The Tax Court determined that the IRS made excessive interrogatories and motions in Richard L. Clark v. Commissioner, TC Memo. 2007-172, July 2, 2007.

IRS interrogatories contained eight pages of "definitions" and "instructions" and were, in effect, directions to require petitioner to lay out his case in writing rather than simple questions such as those anticipated by Rule 71. See Pleier v. Commissioner, 92 T.C. 499 (1989). Such interrogatories are particularly inappropriate against a pro se petitioner and were unnecessary in this case because petitioner's compliance with other Rules and the standing pretrial order would have supplied the information that respondent needed. Moreover, the interrogatories apparently motivated petitioner to give evasive answers to respondent's poorly phrased requests for admissions and to refuse to admit to the items of income identified in the statutory notice and in the requests for admissions. Thus, respondent's motions to compel answers to interrogatories and to review the sufficiency of the responses to the requests for admissions were denied.

Tax Help: The Tax Court considered “substance over form” standards in determining whether a tax shelter was “tax motivated” in River City Ranches , Jeffry Bergamyer, Tax Matters Partner, et al., v. Commissioner, TC Memo. 2007-171, July 2, 2007. The Tax Court also determined that there was fraud for purposes of applying the 6-year statute of limitations

The Tax Court noted:

Section 6621(c) provides for an increased rate of interest with respect to any substantial underpayment of tax in any taxable year attributable to a tax-motivated transaction. Section 6621(c)(3)(A) generally lists the types of transactions which are considered "tax-motivated transactions". A tax-motivated transaction includes any valuation overstatement within the meaning of section 6659(c), and such a valuation overstatement exists, among other situations, if the adjusted basis of property claimed on any return exceeds 150 percent of the correct amount of basis. Secs. 6621(c)(3)(A)(i), 6659(c). A tax-motivated transaction further includes "any sham or fraudulent transaction." Sec. 6621(c)(3)(A)(v).

It is well established that the tax consequences of transactions are governed by substance rather than form. Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978). When taxpayers resort to the expedient of drafting documents to characterize transactions in a manner which is contrary to objective economic realities and which has no significance beyond expected tax benefits, the particular forms they employ are disregarded for tax purposes. Id. at 572-573; Helvering v. F. & R. Lazarus & Co., 308 U.S. 252, 255 (1939). If a transaction is devoid of economic substance, it is not recognized for Federal taxation purposes. Gregory v. Helvering, 293 U.S. 465 (1935).

Determining the economic substance of a transaction requires an analysis of several objective factors: (1) Whether the stated price for the property was within reasonable range of its value; (2) whether there was any intent that the purchase price would be paid; (3) the extent of the taxpayer's control over the property; (4) whether the taxpayer would receive any benefit from the disposition of the property; (5) whether the benefits and burdens of ownership passed; (6) the presence or absence of arm's-length negotiations; (7) the structure of the financing; (8) the degree of adherence to contractual terms; and (9) the reasonableness of the income and residual value projections. Levy v. Commissioner, 91 T.C. 838, 854 (1988); Rose v. Commissioner, 88 T.C. 386, 410 (1987), affd. 868 F.2d 851 (6th Cir. 1989).

Our findings reflect the consideration of these objective factors. The partnerships had no business purpose beyond generating tax benefits. The facts show that the partnerships themselves were shams and lacked economic substance. They were merely a facade used by Hoyt to provide the tax benefits he promised in his promotional materials. They had no independent economic substance beyond the purported sheep breeding transactions which were also illusory and had no economic effect.


It is also significant in these cases that for section 6621(c) penalty-interest purposes the partnerships overvalued their assets and overstated their bases therein. The parties have stipulated facts that support findings of partnership asset overvaluations and basis overstatements. For example, they stipulated that: (1) The purchase prices exceeded the value of each partnership's flock because many of the sheep purportedly sold did not exist; (2) sheep sold to the partnerships for average prices ranging from $1,135 to $2,126 were nowhere near the quality of breeding sheep Barnes Ranches sold for $400 or more; (3) the partnerships never acquired the benefits and burdens of ownership; and (4) the promissory notes used to purchase the sheep did not represent valid indebtedness. Because we have determined that the partnership transactions lacked economic substance and are shams and that the partnerships never acquired the benefits and burdens of ownership, it follows that the adjusted bases in the sheep are zero. Clayden v. Commissioner, 90 T.C. 656, 677-678 (1988); Rose v. Commissioner, supra at 426; Zirker v. Commissioner, 87 T.C. 970, 978-979 (1986).

We conclude that the partnerships' activities are tax-motivated transactions within the meaning of section 6621(c).

Issue 2. Whether the Period of Limitations on Assessment Had Expired When the FPAAs Were Issued

The period for making assessments of tax attributable to a partnership item or affected item is set forth in section 6229. Section 6229 provides in pertinent part:

SEC. 6229. PERIOD OF LIMITATIONS FOR MAKING ASSESSMENTS.

(a) General Rule. --Except as otherwise provided in this section, the period for assessing any tax imposed by subtitle A with respect to any person which is attributable to any partnership item (or affected item) for a partnership taxable year shall not expire before the date which is 3 years after the later of --

(1) the date on which the partnership return for such taxable year was filed, or

(2) the last day for filing such return for such year (determined without regard to extensions).

(b) Extension by Agreement. --

(1) In general. --The period described in subsection (a) (including an extension period under this subsection) may be extended --

*******

(B) with respect to all partners, by an agreement entered into by the Secretary and the tax matters partner (or any other person authorized by the partnership in writing to enter into such an agreement),

before the expiration of such period.

*******

(c) Special Rule in Case of Fraud, Etc. --

(1) False return. --If any partner has, with the intent to evade tax, signed or participated directly or indirectly in the preparation of a partnership return which includes a false or fraudulent item --

(A) in the case of partners so signing or participating in the preparation of the return, any tax imposed by subtitle A which is attributable to any partnership item (or affected item) for the partnership taxable year to which the return relates may be assessed at any time, and

(B) in the case of all other partners, subsection (a) shall be applied with respect to such return by substituting "6 years" for "3 years."

Respondent issued the FPAAs at issue after the normal 3-year periods for assessment had expired. With regard to these FPAAs, however, Hoyt, as TMP, had executed consents extending the limitations periods. The partnerships argue that the extensions are invalid because Hoyt executed them while disabled by conflicts between his own interests and those of his partners. Respondent argues that the consents were valid and, alternatively, if the waivers are invalid, the 6-year limitations period under section 6229(c)(1) applies.

The 6-year limitations period applies if four requirements are met: (1) The entity is a partnership; (2) the partnership return includes a false or fraudulent item; (3) a partner signed or participated directly or indirectly in the preparation of the return; and (4) the partner signed or participated with the intent to evade tax. Sec. 6229(c)(1); Transpac Drilling Venture, 1983-2 v. United States, 83 F.3d 1410, 1414 (Fed. Cir. 1996), affg. 32 Fed. Cl. 810 (1995); cf. Allen v. Commissioner, 128 T.C. 37 (2007). There is no requirement that the signer of the partnership return intend to evade his own taxes. The 6-year statute is applicable to each partner if, in signing a false or fraudulent partnership return, the signer intended to evade the taxes of the other partners. Transpac Drilling Venture, 1983-2 v. United States, supra at 1414-1415. There is also no requirement that the other partners have knowledge of the false or fraudulent deductions claimed on a partnership return. The intent of the signer of the partnership return to evade the taxes of the other partners satisfies the intent element of the 6-year statute of limitations for making additional assessments under section 6229(c)(1), which applies when the partnership return containing false or fraudulent items is signed with intent to evade tax.Id. It is the fraudulent nature of the return that extends the limitations period. Allen v. Commissioner, supra at 42.

Through participation in the Hoyt partnerships, the partners received the benefits of the false and fraudulent partnership deductions. A partnership is required to file an annual information tax return even though it is not a taxable entity for Federal income tax purposes. Secs. 701, 6031; sec. 1.701-1, Income Tax Regs. Each partner is liable for income tax in his or her individual capacity with respect to his or her share of partnership items of income, loss, deduction, and credit. Sec. 701; sec. 1.702-1, Income Tax Regs. Thus, through such participation in the Hoyt partnerships, each partner received flowthrough partnership deductions that were false and fraudulent and which reduced or eliminated the partner's tax liability.

Tax Attorney: Fraudulent intent may be inferred from various kinds of circumstantial evidence, or "badges of fraud", including the consistent understatement of income, inadequate records, implausible or inconsistent explanations of behavior, concealing assets, and failure to cooperate with tax authorities. Dealing in cash is also considered a "badge of fraud" by the courts because it is indicative of a taxpayer's attempt to avoid scrutiny of his finances. Whether a taxpayer has consistently underreported income over an extended period of time is also a relevant factor in analyzing whether the taxpayer had a fraudulent intent in understating his tax liability. Kosinski v. Commissioner, TC Memo. 2007-173, July 2, 2007. The Tax Court noted:

Fraud Penalty

The penalty in the case of fraud is a civil sanction provided primarily as a safeguard for the protection of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer's fraud. Helvering v. Mitchell, 303 U.S. 391, 401 (1938); Sadler v. Commissioner, 113 T.C. 99, 102 (1999). Respondent has the burden of proving, by clear and convincing evidence, an underpayment for the year in issue and that some part of the underpayment for that year is due to fraud. Sec. 7454(a); Rule 142(b). If respondent establishes that any portion of the underpayment is attributable to fraud, the entire underpayment is treated as attributable to fraud and subjected to a 75-percent penalty, unless the taxpayer establishes that some part of the underpayment is not attributable to fraud. Sec. 6663(b). Respondent must show that the taxpayer intended to conceal, mislead, or otherwise prevent the collection of taxes. Katz v. Commissioner, 90 T.C. 1130, 1143 (1988).

The existence of fraud is a question of fact to be resolved upon consideration of the entire record. King's Court Mobile Home Park, Inc. v. Commissioner, 98 T.C. 511, 516 (1992). Fraud will never be presumed. Id.; Beaver v. Commissioner, 55 T.C. 85, 92 (1970). Fraud may, however, be proved by circumstantial evidence and inferences drawn from the facts because direct proof of a taxpayer's intent is rarely available. Niedringhaus v. Commissioner, 99 T.C. 202, 210 (1992). The taxpayer's entire course of conduct may establish the requisite fraudulent intent. Stone v. Commissioner, 56 T.C. 213, 223-224 (1971). Fraudulent intent may be inferred from various kinds of circumstantial evidence, or "badges of fraud", including the consistent understatement of income, inadequate records, implausible or inconsistent explanations of behavior, concealing assets, and failure to cooperate with tax authorities. Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo. 1984-601. Dealing in cash is also considered a "badge of fraud" by the courts because it is indicative of a taxpayer's attempt to avoid scrutiny of his finances. See id. at 308. Whether a taxpayer has consistently underreported income over an extended period of time is also a relevant factor in analyzing whether the taxpayer had a fraudulent intent in understating his tax liability. Solomon v. Commissioner, 732 F.2d 1459, 1461 (6th Cir. 1984), affg. T.C. Memo. 1982-603.
Although petitioner's conviction for subscribing false Federal tax returns does not collaterally estop him from denying that he fraudulently understated petitioners' income tax liability, his conviction is evidence of fraudulent intent. See Wright v. Commissioner, 84 T.C. 636, 643-644 (1985).
A taxpayer is not entitled to shift responsibility for inaccurate returns onto his return preparer where the preparer is not provided with complete and accurate information regarding the taxpayer's income and expenses. See Korecky v. Commissioner, 781 F.2d 1566, 1569 (11th Cir. 1986), affg. per curiam T.C. Memo. 1985-63; Merritt v. Commissioner, 301 F.2d 484, 487 (5th Cir. 1962), affg. T.C. Memo. 1959-172. The responsibility of filing accurate returns remains principally with the taxpayer, especially where the taxpayer has taken an active and controlling role regarding the information that is used for the preparation of the returns. See Medlin v. Commissioner, T.C. Memo. 2003-224, affd. 138 Fed. Appx. 298 (11th Cir. 2005). Petitioners cannot blame their return preparers for the substantial errors in reporting their tax liability for 1997 when petitioner, who alone possessed the information that would have indicated potential discrepancies between petitioners' actual tax liabilities and the amounts reported on their returns, provided the accountants with misleading information and documentation regarding the nature of disbursements out of T.J. Construction. See Bacon v. Commissioner, T.C. Memo. 2000-257, affd. without published opinion 275 F.3d 33 (3d Cir. 2001). Furthermore, petitioner's failure to inform the accountants, despite regular meetings with them, of the existence of the cash advances from petitioner to Phillips or that Phillips was endorsing checks received from T.J. Construction back to petitioner, who was then depositing those funds in petitioners' personal bank account, is indicative of fraud. See Medlin v. Commissioner, supra; Ishler v. Commissioner, T.C. Memo. 2002-79.
Petitioners cite McGowan v. Commissioner, T.C. Memo. 2004-146, affd. 187 Fed. Appx. 915 (11th Cir. 2006), in support of their contention that the errors on petitioner's tax returns are due to confusion between petitioner and his accountants, and not fraudulent intent. We have found, for the reasons stated above, that the errors were deliberately designed by petitioner and were coupled with several other indications of fraudulent intent.
As outlined above, the evidence indicates the fraudulent intent of both petitioner and Mrs. Kosinski with regard to the overstatement of cost of goods sold and understatement of their taxable income for 1997. Petitioners have not proven that any part of the underpayments was not attributable to fraud. See sec. 6663(b). On consideration of the entire record, we conclude that petitioners are liable for the fraud penalty determined under section 6663(a).
.

Back Taxes: The Internal Revenue Service is always looking for ways to improve taxpayer compliance with current tax laws. Two ways the IRS enforces compliance include examinations and collections. Here is some helpful information for you about IRS examination and collection activities:

When selecting taxpayer returns for examination, the IRS pays special attention to taxpayer categories that have, in the past, demonstrated a high degree of noncompliance. This means that small businesses like yours, as well as self-employed individuals, are always under scrutiny. Make sure you report your income and expenses correctly and file all of your returns on time to help stay in compliance with current tax laws.

In matters of examination and collection, the earlier you address ant tax issue, the better. The only thing waiting will accomplish is to increase any interest and penalties that you may owe.

If you have not filed federal tax returns for up to six years, and if you have not received any notices from the IRS, then you can opt to use the voluntary disclosure program. You will still owe taxes – and possibly interest and penalties, as well – but voluntary disclosure will allow you to avoid criminal prosecution.

set up an online payment agreement with the IRS if you owe $25,000, or less, and if all of your returns have been filed. You can check out the rest of the terms for an online payment agreement on the IRS Web site: www.irs.gov.
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Tax Help: IRS guidance has been announced for the return preparer penalty provisions of Code Sec. 6694, as amended by the Small Business and Work Opportunity Act of 2007 (P.L. 110-28) (the Small Business Tax Act). The Small Business Tax Act expanded the income tax return preparer penalties to apply to all tax return preparers, including preparers of estate, gift, and generation-skipping transfer (GST) tax returns. The amendments also altered the standards of conduct that a return preparer must meet to avoid imposition of the penalty. The "realistic possibility" standard for undisclosed positions was replaced by an "unreasonable position" standard.

In addition, the Small Business Tax Act of 2007 increased the amount of the return preparer penalty for the understatement of a tax liability from $250 to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the preparer with respect to the return or refund claim. The return preparer penalty for an understatement of tax liability due to willful or reckless conduct was increased under the new law from $1,000 to the greater of $5,000 or 50 percent of the income derived (or to be derived) by the preparer with respect to the return or refund claim. The IRS is considering the type of guidance necessary to address the changes made by the Small Business Tax Act. In the interim, for estate, gift, and GST tax returns, the reasonable basis standard provided in the regulations issued under Code Sec. 6662, without regard to the disclosure requirements contained therein, will be applied in determining whether the IRS will impose a penalty under Code Sec. 6694(a). The transitional relief is effective as of May 25, 2007. See IRS Notice 2007-54, to be published in I.R.B. 2007-27, July 2, 2007. Notice 2007-54 states:


This notice provides guidance and transitional relief for the return preparer penalty provisions under section 6694 of the Internal Revenue Code, as amended by the Small Business and Work Opportunity Act of 2007.



SCOPE

The transitional relief provided by this notice will apply to all returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing); to 2007 estimated tax returns due on or before January 15, 2008; and to 2007 employment and excise tax returns due on or before January 31, 2008.



BACKGROUND

The Small Business and Work Opportunity Act of 2007, Pub. L. No. 110-28, 121 Stat. ___, (the Act) was enacted into law on May 25, 2007. Section 8246 of the Act amends several provisions of the Code to extend the application of the income tax return preparer penalties to all tax return preparers, alter the standards of conduct that must be met to avoid imposition of the penalties for preparing a return which reflects an understatement of liability, and increase applicable penalties. The amendments are effective for tax returns prepared after the date of the enactment, May 25, 2007.

The amendments made by the Act raise questions regarding activities representing preparation of a tax return, who is a return preparer within the meaning of section 7701(a)(36) (as amended), and how the statute applies to signing and non-signing preparers. In order to address these questions, the Internal Revenue Service and the Treasury Department are considering whether regulations or other published guidance are needed, including but not limited to, amendments to Treas. Reg. sections 301.7701-15 and 1.6694-0 through 1.6694-4. Because the Act extends the types of returns subject to the new provisions, changes are also required to the relevant forms and publications. The Service must also alter existing procedures in order to process disclosures with certain forms and in electronic formats. Because the amendments to section 6694 are effective immediately for returns prepared after May 25, 2007, the Service and the Treasury Department believe that effective tax administration requires transitional relief with respect to the new standards of conduct under section 6694(a).



PENALTY UNDER SECTION 6694

Prior to amendment by the Act, the penalty under section 6694(a) applied if:

(1) any part of an understatement of liability with respect to any return or claim for refund is due to a position for which there was not a realistic possibility of being sustained on its merits,

(2) any person who is an the income tax return preparer with respect to such return or claim knew (or reasonably should have known) of such position, and,

(3) such position was not disclosed as provided in section 6662(d)(2)(B)(ii) or was frivolous.

Prior to amendment by the Act, the penalty under section 6694(b) applied if any part of an understatement was due to:
(1) a willful attempt in any manner by an income tax return preparer to understate the liability for tax; or

(2) to any reckless or intentional disregard of rules or regulations by an income tax return preparer.

Section 8246 of the Act amended several provisions of the Code to extend the scope of the income tax return preparer penalties to preparers of all tax returns, amended returns and claims for refund, including estate and gift tax returns, generation-skipping transfer tax returns, employment tax returns, and excise tax returns. The Act amended section 6694(a) to provide that the penalty would apply if:

(A) the tax return preparer knew (or reasonably should have known) of the position,

(B) there was not a reasonable belief that the position would more likely than not be sustained on its merits, and

(C)(i) the position was not disclosed as provided in section 6662(d)(2)(B)(ii), or

(ii) there was no reasonable basis for the position.

Although the Act did not alter the standard of conduct under section 6694(b), it increased the amount of the penalty and made the penalty applicable to all tax return preparers.

Section 8246 of the Act amends the standards of conduct under section 6694(a) in two ways. First, for undisclosed positions, the Act replaces the realistic possibility standard with a requirement that there be a reasonable belief that the tax treatment of the position would more likely than not be sustained on its merits. Second, for disclosed positions, the Act replaces the not-frivolous standard with the requirement that there be a reasonable basis for the tax treatment of the position.

The Act also increased the first-tier section 6694(a) penalty for understatements from $250 to the greater of $1000 or 50% of the income derived (or to be derived) by the tax return preparer from the preparation of a return or claim with respect to which the penalty was imposed. The Act increased the second-tier section 6694(b) penalty for willful or reckless conduct from $1000 to the greater of $5,000 or 50% of the income derived (or to be derived) by the tax return preparer.

Under both the prior and current law, disclosure under section 6694(a) is adequate if made on a Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, attached to the return, amended return, or refund claim, or pursuant to the annual revenue procedure authorized in Treasury Regulation sections 1.6694-2(c)(3) and 1.6662-4(f)(2). In addition, under both the prior and current law, the penalty under section 6694(a) would not be imposed if it is shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith.



TRANSITIONAL RELIEF

In order to provide sufficient time to address issues pertaining to the implementation of the Act, the Service is providing the following transitional relief: For income tax returns, amended returns, and refund claims, the standards set forth under the previous law and current regulations under section 6694 will be applied in determining whether the Service will impose a penalty under section 6694(a). Generally, in applying transitional relief for income tax returns, amended returns or refund claims, disclosure would be adequate if made on a Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, attached to the return, amended return, or refund claim, or pursuant to the annual revenue procedure authorized in Treasury Regulation sections 1.6694-2(c)(3) and 1.6662-4(f)(2).

For all other returns, amended returns, and claims for refund, including estate, gift, and generation-skipping transfer tax returns, employment tax returns, and excise tax returns, the reasonable basis standard set forth in the regulations issued under section 6662, without regard to the disclosure requirements contained therein, will be applied in determining whether the Service will impose a penalty under section 6694(a).

This transitional relief will apply to all returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing); to 2007 estimated tax returns due on or before January 15, 2008; and to 2007 employment and excise tax returns due on or before January 31, 2008.

No transitional relief is available under section 6694(b) as transitional relief is not appropriate for return preparers who exhibit willful or reckless conduct, regardless of the type of return prepared.



EFFECTIVE DATE

This Notice is effective as of May 25, 2007.