Convincing the IRS to Concede on a Civil Fraud Penalty

This case was originally started in November 2011, and involved the 2009 and 2010 tax years. The Member lived in Texas, and the examiner was in Washington, DC. The Revenue Agent (RA) was conducting the audit by correspondence, which was unusual, but he was doing it that way because it had originated from a related corporate examination.

The main issue was a Schedule C loss (self-employment) in both years. The Schedule C showed no gross receipts and the losses were over $130,000 in each year, mostly from a Section 179 deduction. The Schedule D also reflected over $1 million in capital loss carryovers.

A quick review of the two returns revealed that the Member had made a number of unintentional errors on his tax returns for the two years in question. His carryover loss appeared to be a duplication of another figure, and his rental depreciation looked like it had been doubled. His return also showed high medical expenses, which seemed unlikely since his position as a CEO would presumably include medical insurance benefits.

The document request from IRS asked for the original returns from which the capital losses had originated, and the Member explained those had originated in 2003 and 2004. When we received the returns for those years, as well as the intervening tax years between 2005 and 2008, it became increasingly clear that those returns were problematic as well.

I warned the Member about the additional items I had identified on his return as being incorrect, and we went over them in detail. In the course of the conversation he told me that his Schedule C business had been inactive since 2004, and that he had overridden a number of entries in the tax program. I explained that he should expect a large tax bill resulting from the audit and estimated he would owe about $30,000 for each of the two years, before penalties and interest were calculated.

In the meantime, the IRS agent informed me that he was transferring the case to Pittsburgh, as the agents at that location were the ones actually doing the corporate examination. I was contacted by the new Revenue Agent in February 2012, and we briefly discussed the issues the IRS had identified. The RA said he would like to complete the audit as soon as possible, but warned it was not likely to happen that quickly because of his workload and the related corporate audit.

After going back and forth with the Agent regarding document requests and getting those documents from the Member, the RA informed me in September 2012 that he had been promoted to management and the case would be reassigned to a new agent. This meant another delay while the IRS transferred the case to the new agent and she became familiar with the issues.

The Member was becoming increasingly impatient at the pace of the examination and said he wanted us to hurry up and settle the case. I explained to him that we could not settle anything until the IRS decided what adjustments were warranted. In the meantime, the new Revenue Agent expanded the examination to the itemized deductions and a bank deposit analysis. While the Member’s documents for those items were sketchy, it was at least better than his Schedule C documentation, which was nonexistent.

The RA contacted me in June 2013 with the proposed adjustment, disallowing the Schedule C losses in full – as expected – but making no adjustments to the itemized deductions. This had a cascading effect on the rental losses, which were now limited to $0, as well as impacting the Member’s medical deductions. However, she was also proposing to assess the Civil Fraud penalty (which is 75% of the tax) due to the large amount of the disputed deductions. She explained that the IRS felt that the Member’s preparation of his return was so egregious that it rose above mere negligence, and instead was deliberately deceptive.

IRS sent us a three page explanation stating why they felt the civil fraud penalty was appropriate, and gave us time to compose a rebuttal. IRS’s main argument was that a CEO in the Member’s position should have known better than to override the software, and by doing so he had deliberately attempted to deceive the government. The Member was unhappy about the large amount of the adjustment but I was able to point out to him that these were exactly what I had predicted at the beginning of the audit and that this was the amount he rightfully owed. Since he agreed the Schedule C loss was not correct, and the other adjustments were based on the resulting increase to his AGI, I explained that none of this could be negotiated downward any further.

I spent a week composing the rebuttal. I pointed out that the Member had cooperated fully with all requests from the IRS, and that the bank deposit analysis had shown that he and his wife routinely deposited all monies they received, including small gift checks for their children. I also showed that, despite the large refunds he had received every year, he had never reduced his withholding (nearly $50,000 in each year), which was not typical of someone out to defraud the government. Had he prepared the returns correctly, I noted, he still would have received refunds of nearly $10,000 in both years. I agreed that the Member may have seemed negligent in failing to consult with a professional tax advisor, but he was not required to do so, and his misunderstanding of the applicable laws regarding his loss carryovers had tripped up many taxpayers before him.

IRS responded two weeks later stating they would not assess the fraud penalty, but would assess the 20% substantial understatement penalty. They also agreed to abate the interest charges for nearly a year due to the delay incurred by the transferring of the case between agents. While the Member still ended up with a tax bill of nearly $82,000 for the two years, we managed to save him over $45,000 in additional penalties by getting the IRS to concede the fraud penalty.