The notion that a taxpayer could be penalized for filing a false tax return is obvious. However, it is not so obvious as to which penalties will be applied or when they will be imposed.
Depending upon the relevant facts and circumstances , including most importantly whether criminal and/or civil tax fraud is involved, a taxpayer could be facing imprisonment and/or monetary fines in the case of a criminal matter, for example, as provided in Internal Revenue Code (IRC) section 7201, and/or monetary fines and an unlimited statutory period for assessment of tax in the case of a civil matter, as provided in IRC sections 6663(a) and 6501(a), respectively.
Ultimately, whether criminal charges are warranted or whether the matter will be resolved civilly will generally be determined by the IRS’ Criminal Investigation Division and/or the Department of Justice’s Tax Division. See https://www.irs.gov/compliance/criminal-investigation/how-criminal-investigations-are-initiated. This article considers some of the civil aspects of the penalties faced by taxpayers.
Reasonable Care Admonition
Taxpayers are well advised to exercise reasonable care when preparing and filing their tax returns. To do otherwise is likely negligence. If a taxpayer retains a third-party to prepare the tax return, the taxpayer should exercise reasonable care when hiring such person as well as when providing the tax related information to the preparer and when reviewing, signing and filing the return.
See, e.g., IRC section 6662 which imposes the 20% accuracy-related penalty on the underpayment of tax due to a taxpayer’s negligence or disregard of rules or regulations, in the circumstances where fraud is not involved.
Civil Tax Aspects of Intent to Evade Tax
IRC section 6663(a) imposes a penalty of 75% of the underpayment of tax attributable to the fraud aspect of a false or fraudulent tax return. However, before the penalty can be imposed on the taxpayer, the taxpayer must be shown to have had the intent to evade tax.
Compare IRC section 6501(c)(1), which although not a penalty provision as such also penalizes the taxpayer in the case of a false of fraudulent return, through its elimination of any time restriction on the assessment of the tax resulting from the filing of any such return.
Although not totally free from doubt, this provision is broader in application than the 75% underpayment penalty, since so long as somebody involved in the process of preparing, filing and/or signing the fraudulent return had the intent to evade tax, i.e., generally either the taxpayer or the tax preparer, the statute of limitations on assessing the taxpayer becomes unrestricted.
Let’s review the bidding!
Penalties, Omissions and Overstatements
Omitting income and overstating deductions led to the imposition of substantial penalties on the taxpayers in Sehati, et.al. v. Commissioner, T.C. Memo 2025-3 (Sehati).
Taxpayers were penalized with the 75% fraud penalty, as provided in IRC section 6663(a), for that part of the underpayment of tax due to fraud, and the 20% accuracy-related penalty for that part of the underpayment that was not related to the fraud, but due to negligence or disregard of rules and regulations as provided in IRC section 6662.
A messy case factually with numerous issues, there were at least two that deserve some discussion. One issue concerned the omission of income that should have been reported based upon the partnership guaranteed payment provision of IRC section 707(c).
Briefly, the taxpayers owned an interest in a limited liability company, referred to as SJS, which owned and managed various real estate properties including a residential property in which the taxpayers apparently resided, notably without the burden of having to pay rent. SJS was treated as a partnership for federal income tax purposes.
The Tax Court’s Judge Marvel upheld the IRS’ position that the taxpayers use of the residential property resulted in the receipt of a “guaranteed payment” being made by SJS in the amount of the fair market value of the use of the property. As a result, the taxpayers had imputed income to the extent of the fair rental value of the residential property without any offsetting deduction, since apparently no deduction was ever claimed by SJS.
According to Judge Marvel, “…. [A] partner may receive guaranteed payments for services or use of capital.” Guaranteed payments are payments that are determined without regard to the partnership’s income and are treated as if made to a person who is not a partner. See IRC section 707(c) and Treasury Regulation 1.707-1(c).
A guaranteed payment is includible in the taxpayer’s income in accordance with IRC section 61 (gross income defined) and may or may not be deductible as provided by sections 162 (trade or business expenses) or 263 (capital expenditures). See Treasury Regulation 1-707(c).
In hindsight and with proper planning, perhaps SJS would have been allowed a deduction to be passed through to the LLC members based upon the value of either the services provided to SJS by the taxpayers, or the capital invested in SJS by them. In any event, the court applied the 75% fraud penalty to the omitted items of income including the guaranteed payment, i.e., the fair rental value of the residential property.
When May a Tax be Assessed?
The other issue of note came up in Judge Marvel’s discussion of the fraud penalty provisions, and specifically his mention of Murrin v. Commissioner (Murrin), T.C. Memo 2024-10, appeal docketed, (3d Cir. June 12, 2024).
Murrin concerned the issue whether the statute of limitations on assessment pursuant to IRC section 6501(c)(1) was extended indefinitely when a false or fraudulent return was filed where the fraud was committed not by the taxpayer but by the third-party tax return preparer. More on this follows shortly.
Assessment Overview
First, a brief review of the rules governing assessments. For example, U.S taxpayers are responsible for filing annually income tax returns and paying the resulting tax liabilities under the voluntary compliance and self-assessment system that underlies the Internal Revenue Code.
Such taxpayers include individuals, trusts, decedents and bankrupts’ estates, and various entities such as corporations, partnerships and limited liability companies. In addition to income taxes, U.S. taxpayers are subject to other taxes such as estate and gift taxes as well as various excise taxes.
Depending upon the applicable state law, taxpayers may also have responsibility to file state tax returns and to pay the resulting tax liabilities.
Generally, income, estate and gift taxes may be assessed by the IRS against the taxpayer within the 3 year-period after the tax return is filed. See IRC section 6501(a).
The 3-year period is expanded to 6 years in the case of income taxes if more than 25% of the taxpayer’s reported gross income was omitted from the tax return, and in case of estate and gift taxes, if the taxpayer omits either more than 25% of the reported gross estate in the case of estate tax, or more than 25% of the reported total gifts, in the case of gift tax. See IRC section 6501(e).
Noteworthy, however, there is no limitation on the IRS’ ability to assess the applicable tax in any case where the taxpayer either fails to file a tax return or files a false or fraudulent return with the intent of evading the tax. See IRC section 6501(c).
Whose Intent to Evade?
The issue in Murrin was whether IRC 6501(c) requires the taxpayer to have the intent to evade the tax in the case where the fraudulent return was prepared by another person, and such other person admittedly had the fraudulent intent. In Murrin, the Tax Court found that the taxpayers “did not put any false or fraudulent information on their returns, nor did they intend to evade the tax.”
Apparently, the false or fraudulent entries on their joint income tax returns and the tax returns for the partnerships in which Mrs. Murrin was a general partner, were made by a Mr. Howell, the third-party tax return preparer, without the knowledge or participation of the taxpayers.
Following its existing precedent in Allen v. Commissioner, 128 T.C. 37 (2007), the Tax Court held that there is no time limitation on assessment pursuant to IRC section 6501(c) in the case of a false or fraudulent return even though the taxpayer did not have the intent to evade tax, so long as the tax preparer had such intent.
In other words, the IRS may assess the tax at any time if the taxpayer’s return is false or fraudulent, irrespective of the fact that the taxpayer lacked any fraudulent intent so long as the third-party tax preparer had the fraudulent intent.
The Tax Court did consider but ultimately rejected the Murrins’ argument to override its decision in Allen, notwithstanding the intervening decision of the Federal Circuit in BASR P’ship v. United States, 795 F3d 1338 (Fed. Cir. 2015) (BASR), affirming BASR P’ship v. United States, 113 Fed. Cl. 181 (2013).
BASR disagreed with Allen and held that it was the taxpayer, and not any third party or agent, who must have fraudulent intent before the statute of limitations under IRC section 6501 becomes unlimited.
Perhaps of importance in BASR was the fact that a more remote actor was found to have had fraudulent intent and to have actually committed the fraud. That is, the fraud was not caused by either the taxpayer or its tax return preparer, rather it was caused by an attorney who was promoting the fraudulent tax shelter investment that was at the root of the taxpayer’s problems in the first place.
Murrin is appealable to, and has actually been appealed to, the Third Circuit Court of Appeals. Thus, the Tax Court is not bound to follow the Federal Circuit’s BASR decision insofar as the Murrins are concerned. The Tax Court also questioned the holding in BASR due to its lack of clarity as demonstrated by the conflicting concurring and dissenting opinions rendered by the Federal Circuit judges.
Verdict
Although there is no grand conclusion here, it is important to reiterate the advice that taxpayers should exercise reasonable care when preparing and filing their tax returns. Furthermore, currently when utilizing the services of a third-party tax preparer is commonplace, taxpayers are cautioned to exercise reasonable care when hiring the tax return preparer.
The lesson here is that even if the taxpayer is innocent, the statute of limitations on assessment on the taxpayer’s return will forever remain open if the preparer commits fraud.
Jeffrey A. Galant is counsel to Meltzer, Lippe, Goldstein & Breitstone’s business & real estate taxation, trusts and estates, tax exempt organizations and private wealth and taxation practice groups.
Read the article here: https://www.law.com/newyorklawjournal/2025/03/19/musings-on-taxpayer-responsibility/?slreturn=20250325103558