The IRS has released a new internal guidance legal memorandum, ILM 201238026, here. In that memorandum, one of the owners of an S Corporation had caused income to be falsely underreported and hence, when the underreported income was passed through to the two shareholders, their returns underreported the income. With respect to the underreported income, the culpable partner had been convicted of "one count of 18 U.S.C. § 371, Conspiracy to Commit Mail Fraud and Tax Fraud, one count of 26 U.S.C. § 7201, Tax Evasion, one count of 26 U.S.C. § 7206(1), Filing a False Individual Tax Return, and one count of 26 U.S.C. § 7206(1), Filing a False Corporate Tax Return for the year 2001." The issue addressed in the memorandum was whether the nonculpable owner who reported the fraudulently understated net income on his return (1040) was subject to the unlimited states of limitations under Section 6501(c)(1).
Facially, at this point, there is little to distinguish the key facts in the memorandum from the Allen facts and holding. In Allen, the fraudulent position on the return was attributable to a preparer; in the memorandum, the fraudulent position on the return was attributable to the other S corporation owner. There is nothing to distinguish the fraudulent position on the return other than its source -- the preparer or the other shareholder. Nevertheless, the memorandum concludes that the unlimited statute of limitations does not apply.
Here is how the author of the memorandum distinguishes Allen:
Finally, in the recent case of Allen v. Commissioner, 128 T.C. 37 (2007), the Tax Court held that a return preparer's fraud can result in an unlimited period of limitations on assessment under I.R.C. § 6501(c)(1). In Allen, the Tax Court agreed with the Service's position that the fraud in question does not have to be committed by the taxpayer who filed the return. This was because 'the special disadvantage to the Commissioner in investigating fraudulent returns is present if the income tax return preparer committed the fraud that caused the taxes on the returns to be understated." Allen, 128 T.C. at 40. In addition, allowing the fraud of a third person to hold the limitations period open is consistent with the general principal that statutes of limitation should be strictly construed in favor of the government. Id. at (citing Bufferd v. Commissioner, 503 U.S. at 526-27 n.6). When examining the fraud of a third party, the Tax Court has recently focused on whether that third party intended to evade tax, or whether such evasion was merely 'an incidental consequence or secondary effect" of the third party's conduct. See Citywide Transit v. Commissioner, T.C. Memo. 2011-279 (appeal docketed).
In this case, B's fraud with respect to the corporate return may have 'caused" tax to be understated on A's return. It is questionable, however, whether there is evidence of intent to evade tax directly associated with A's return. There is no evidence that B prepared A's individual tax return for 2001. Neither is there evidence that B intended to evade A's tax when he fraudulently filed Corporation's corporate return. It may be that he intended to evade only his own tax, and A's deficiency was merely a by-product of that intent. * * * Ultimately, it is doubtful that Allen can be extended to allow for an unlimited assessment statute of limitations in this case. Such an extension would require the Tax Court to focus on the fraud of a third party who did not prepare or file the return at issue, which seems an unlikely legal and factual stretch.I am unpersuaded by this distinction. I do agree that a court would balk at this extension of the Allen holding. But the better inference from the balk would be that the premise is incorrect. Allen was not properly decided.
If fraud on the return justifies an unlimited statute of limitations, then how does it matter whose fraud it was? The same amount of time and audit resources is needed by either type of third party fraud. And, if fraud on the return justifies an unlimited statute of limitations, why would it make any difference whether the fraud is a direct object of the culpable party's intentions or an indirect, necessarily foreseeable object of his intentions. It seems to me plain that the IRS just cooked up the distinction in order to preserve something from the ill-guided Allen holding that the IRS foisted off on the Tax Court.
Moreover, earlier in the memorandum the author discusses the TEFRA rules which technically did not apply because the year involved was after C Corporations were removed from the TEFRA rules. The TEFRA rules provide that the innocent partner's statute of limitations for the partnership return fraud is six years. 6229(c)(1)(B); Transpac Drilling Venture 1983-2, 83 F.3d at 1414-15. Yet, a fraudulent position on a partnership return will flow through to and cause the reporting of the fraudulent position on the taxpayer's return to itself be fraudulent. Obviously, this position of the TEFRA rules assumed that the mere reporting of a fraudulent position on an innocent partner's return would not be subject to the unlimited statute of limitations. Otherwise Congress had performed meaningless act. Congress imposed that statutory rule because it assumed that there was no unlimited statute of limitations, because anyone asked the question at the time would have given the answer that Section 6501(c)(1) requires the taxpayer's fraud.
And, indeed, as I noted in my earlier blogs, the IRS itself had interpreted Section 6501(c)(1) to require the taxpayer's fraud until it had some type of Eureka moment in the Allen case.
Finally, of course, as I noted, in terms of the statutory text (i.e., silence as to whose fraud is required), Section 6501(c)(1) cannot be differentiated in any way from Section 6663, here. Yet, we know that Section 6663 requires the taxpayer's fraud. The IRS strategically did not attempt to assert the fraud penalty in Allen, but it would seem to apply just from the text. Of course, the need for additional time to discover the fraud is not directly relevant, but that is an extra-textual notion imported into the Section 6501(c)(1) text. Textualists like Justice Scalia and others might well be inclined to impose a fraud penalty on the extrapolation that, if Section 6501(c)(1) is basically the same text and if we don't dig for some hidden reasons to interpret text differently, then the fraud penalty applies. But, I think, even Justice Scalia would balk at the application of the fraud penalty. Which, is precisely why we should balk at the application of the unlimited statute of limitations because there is not enough in the extra-textual sources that would indicate a clear congressional intent that it apply when the taxpayer is innocent. Congress has provided ample penalties for preparers and others fraud (including tax evasion and aiding and assisting of which preparers and promoters can be found guilty).
I submit that Section 6501(c)(1) is more properly read to require the taxpayer's fraud. As I have noted, in Allen, the IRS took a poorly formulated position, picked the best case it could (including one that it knew would likely not be well litigated or briefed), and smoked it past the Tax Court in a division opinion (T.C.), so that now, until reversed, it is precedent in the Tax Court. I hope that cases in the pipeline will not accept that misguided opinion and will shoot for full court review in the Tax Court.
For more detailed refutation of the Allen holding, see Professor Bryan Camp's articles: Bryan T. Camp, Presumptions and Tax Return Preparer Fraud, 120 Tax Notes 167 (2008);, here and Bryan T. Camp, Tax Return Preparer Fraud and the Assessment Limitation Period, 116 Tax Notes 687 (Aug. 20, 2007). here.
My prior blogs are:
Does the Preparer's Fraud Invoke the Unlimited Statute of Limitations? (Federal Tax Crimes Blog 8/5/12), here.
Civil Statutes of Limitation for Abusive Tax Shelters (Federal Tax Crimes Blog 5/10/10), here.
Civil Tax Statute of Limitations for Fraudulent Tax Shelters (Federal Tax Crimes Blog 12/19/09), here.