11th Circuit Holds Clear and Convincing Evidence Required for Section 6701 Penalty; Can Reasoning be Extended to FBAR Willful Penalty? (6/14/14)

In United States v. Carlson, ___ F.3d  ___, 2014 U.S. App. LEXIS 11001 (11th Cir. 6/13/14), here, the issue was the plaintiff's liability for " aiding and abetting understatement of tax liability in violation of I.R.C. § 6701."  Section 6701 is here.  In relevant part, Section 6701 imposes the penalty upon a person:

(1) who aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document,
(2) who knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and
(3) who knows that such portion (if so used) would result in an understatement of the liability for tax of another person.

Section 6701 may be viewed as the civil penalty analog to the tax crime of aiding and assisting, Section 7206(2), here.

One issue on the appeal was the appropriate burden of  proof the Government must bear.  Carlson argued that it was by clear and convincing evidence; the Government argued that it was by a preponderance.  The Court held that the standard of proof is by clear and  convincing evidence.  Here is the Court's discussion:

I. The Government must prove violations of I.R.C. § 6701 by clear and convincing evidence. 

At trial, the parties disputed the correct standard of proof. Carlson contends the correct standard should be clear and convincing evidence while the Government contends the correct standard is a preponderance of the evidence. The district court agreed with the Government and instructed the jury that the Government must prove its case by a preponderance of the evidence. We conclude that this instruction misstated the law. 

Under the Eleventh Circuit's longstanding precedent, the Government must prove fraud in civil tax cases by clear and convincing evidence. See, e.g., Ballard v. Comm'r of Internal Revenue, 522 F.3d 1229, 1234 (11th Cir. 2008) ("The Commissioner has the burden of proving allegations of fraud by clear and convincing evidence."); Korecky v. Comm'r of Internal Revenue, 781 F.3d 1566, 1568 (11th Cir. 1986) ("The IRS bears the burden of proving fraud, which must be established by clear and convincing evidence."); Marsellus v. Comm'r of Internal Revenue, 544 F.2d 883, 885 (5th Cir. 1977) (holding fraud must be proved by clear and convincing evidence); Webb v. Comm'r of Internal Revenue, 394 F.2d 366, 378 (5th Cir. 1968) (same); Goldberg v. Comm'r of Internal Revenue, 239 F.3d 316, 320 (5th Cir. 1956) ("The Commissioner has the burden of proving fraud by clear and convincing evidence."); Jemison v. Comm'r of Internal Revenue, 45 F.2d 4, 5-6 (5th Cir. 1930) ("Fraud is not to be presumed, but must be determined from clear and convincing evidence, considering all the facts and circumstances of the case."). Our sister courts of appeals follow the same rule. See, e.g., Grossman v. Comm'r of Internal Revenue, 182 F.3d 275, 277 (4th Cir. 1999) (holding that a finding of fraud must be supported by clear and convincing evidence); Lessmann v. Comm'r of Internal Revenue, 327 F.2d 990, 993 (8th Cir. 1964) (same); Davis v. Comm'r of Internal Revenue, 184 F.2d 86, 86 (10th Cir. 1950) (same);Rogers v. Comm'r of Internal Revenue, 111 F.2d 987, 989 (6th Cir. 1940) ("Fraud cannot be lightly inferred, but must be established by clear and convincing proof."); Duffin v. Lucas, 55 F.2d 786, 798 (6th Cir. 1932) (same); Griffiths v. Comm'r of Internal Revenue, 50 F.2d 782, 786 (7th Cir. 1931) ("Fraud is never presumed but must be determined from clear and convincing evidence, considering all the facts and circumstances of the case.").

Thus, the inquiry is whether I.R.C. § 6701 requires the Government to prove fraud. If I.R.C. § 6701 requires the Government to prove fraud, then under our precedent the Government must prove its case by clear and convincing evidence. I.R.C. § 6701 penalizes an individual
(1) who aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document, (2) who knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and (3) who knows that such portion (if so used) would result in an understatement of the liability for tax of another person . . . . 

The third element embodies a scienter requirement. As other courts have recognized, the third element of I.R.C. § 6701 requires the Government to prove that the preparer acted with actual knowledge that the document would deprive the Government of tax it is owed. See Mattingly v. United States, 924 F.2d 785, 791 (8th Cir. 1991); Sansom v. United States, 703 F. Supp. 1505, 1511 (N.D. Fla. 1988); Warner v. United States, 698 F. Supp. 877, 882 (S.D. Fla. 1988). 

Were the level of scienter required by I.R.C. § 6701 not so high, we might face a difficult task in deciding whether I.R.C. § 6701 requires proof of fraud.  However, under this standard the IRS must prove that the preparer actually knew the return understated tax. In other words, the IRS must prove that the preparer deceitfully prepared a return knowing it misrepresented or concealed something that understates the correct tax. This is a classic case of fraudulent conduct. The standard could be accurately paraphrased as requiring the IRS to prove that the preparer actually knew that the return defrauded the Government of tax it is owed. As one of our district courts noted, "[i]f the preparer knows that use of the tax document as prepared will result in an understatement of tax liability, must not the document necessarily be false or fraudulent?" Warner, 698 F. Supp. at 882. 

The Government contends that I.R.C. § 6701 cannot be a fraud statute because the statute never uses the word "fraud." However, the lack of the word "fraud" is immaterial if the conduct the government must prove meets the definition of fraud. And based on the foregoing analysis, it does. As a master of the English language noted, "What's in a name? That which we call a rose by any other name would smell as sweet . . ." n3 And, in other cases considering whether I.R.C. § 6701 requires proof of  [*11] fraud for determining the statute of limitations, the Government contends-and courts agree-that I.R.C. § 6701 does require proof of fraud. See, e.g., Mullikin v. United States, 952 F.2d 920, 929 (6th Cir. 1991) (holding no limitation applied "since Section 6701 is an anti-fraud provision of the Code."); Lamb v. United States, 977 F.3d 1296, 1297 (8th Cir. 1992) (holding Section 6701 is an anti-fraud provision).
   n3 William Shakespeare, Romeo and Juliet, Act II, Scene 2. 

We recognize that our decision places us at odds with two other courts of appeals that have considered the correct standard of proof under I.R.C. § 6701. Both the Second and the Eighth Circuits have held that the correct standard of proof is by a preponderance of the evidence. See Barr v. United States, 67 F.3d 469, 469 (2d Cir. 1995); Mattingly v. United States, 924 F.2d 785 (8th Cir. 1991). The Second Circuit followed the Eighth Circuit, and gave little rationale for its decision. The Eighth Circuit acknowledged that the Government must prove civil tax fraud by clear and convincing evidence, but held that this rule did not apply to I.R.C. § 6701 for three reasons. 

First, the Eighth Circuit concluded that I.R.C. § 6701 does not require proof of fraud because it "does not refer to the evasion of tax." Mattingly, 924 F.2d at 788. At the outset, it is unclear why reference to the evasion of tax is relevant. The Eighth Circuit's prior precedent that fraud must be proven by clear and convincing evidence does not include this limitation. Neither does the Eleventh Circuit's precedent require reference to the evasion of tax. But, even if we were to assume that it is correct to require a statute to reference tax evasion, I.R.C. § 6701 does reference tax evasion. IRC § 6701 requires actual knowledge that a return "would result in an understatement of the liability for tax of another person." (emphasis added). Contrary to Mattingly's conclusion, this penalty exists to penalize tax preparers who design returns to evade tax. 

Second, the Eighth Circuit concluded that "the integrated enactment of §§ 6700-03 suggests application of a uniform standard of proof." Id. But, we know of no reason why statutes enacted at the same time must all use the same standard of proof. If anything, such a rule would likely lead to perverse results based on happenstance instead of reason and precedent. We decline to allow such an assumption to overrule our clear precedent that the Government must prove civil tax fraud by clear and convincing evidence. n4
   n4 Even assuming laws enacted simultaneously must share the same standard of proof, the Eighth Circuit provides no reason why the correct standard is by a preponderance of the evidence and not by clear and convincing evidence. The act does not specify a standard of proof for I.R.C. § 6700-03. Thus, the Eighth Circuit's analysis does not help us determine which standard of proof is correct; it merely states that all three penalties must use the same standard. 

Finally, the Eighth Circuit concluded that the "the overall civil penalty structure applicable to taxpayers and tax preparers suggests that § 6701 is just another piece in the expansive non-fraud penalty scheme." Id. at 789. While we agree with the Eighth Circuit's recognition that the penalty structure is relevant, we think it suggests the opposite conclusion: that I.R.C. § 6701 does require proof of fraud. The first district court in our circuit to analyze the scienter requirement in I.R.C. § 6701 artfully identified three penalties in the Internal Revenue Code that pertain to tax preparers: I.R.C. §§ 6694(a); 6694(b); and 6701. Sansom, 703 F. Supp. at 1510. First, I.R.C. § 6694(a) penalizes tax preparers who take unreasonable positions. Second, I.R.C. § 6694(b) penalizes tax preparers who understate the correct tax willfully or recklessly, even if the preparer does not actually know the return understates the correct tax. Third, and in contrast, I.R.C. § 6701 requires  [*14] actual knowledge that the document understates tax. "[A]ctual knowledge is a higher standard than the 'willfulness' standard utilized in other statutes. Simply put, 'know' requires knowledge-awareness of the facts and the ultimate result of the conduct." Id. Whereas both § 6694(a) and § 6694(b) penalties can apply when a tax preparer is negligent or reckless, § 6701 requires proof that the tax preparer knew his or her conduct would defraud the Government. This penalty structure indicates that I.R.C. § 6701 is designed to require the highest level of culpability among the civil penalties for tax preparers. 

For these reasons, we are not persuaded by the Eighth Circuit's reasoning.  We hold that the Government must prove fraud in I.R.C. § 6701 penalties by clear and convincing evidence. In this case, many of the penalties were supported only by weak evidence. Under these circumstances, we cannot assume that the district court's error was harmless because the jury instruction reduced the level of proof required.

This is, of course, an  important decision in its  own right.  Every tax litigator knows -- as the Court held -- that the difference between the two standards is significant.

RELATIONSHIP TO FBAR WILLFUL PENALTY

Readers of this blog will recall that I have discussed this burden of proof issue in the context of the FBAR willful penalty.  We now have three court cases that have addressed the issue:  United States v. Williams, 2010 U.S. Dist. LEXIS 90794 (E.D. Va. 2010) (arguably dicta in the case), reversed on other grounds without reaching the standard of proof issue, 2012 U.S. App. LEXIS 15017 (4th Cir. 2012); United States v. McBride, 908 F. Supp. 2d 1186 (D. UT 2012); and United States v. Zwerner (SD Fl. - No. 13-22082) (no opinion, but submitted to the jury on a preponderance standard; would likely have been raised on appeal, but case settled after jury verdict).  I have urged that the burden of proof for FBAR willfulness should be clear and convincing for the same reasons as for civil fraud.  This new Carlson case, I think, holds some possibility that at least the Eleventh Circuit might be open to this analysis.  I note in this regard that Zwerner would have been appealable to the 11th Circuit, the Court deciding Carlson.  The Zwerner case settled last week, but I wonder whether, had the Carlson decision been rendered earlier, the case might not have been settled or, possibly, the Government might have accepted a better settlement.  (I suspect that the Government does not perceive much risk in its position on preponderance, but Carlson may call that assessment into question.)

The argument on the FBAR willful penalty would be like this:  (i) willfulness is required for the FBAR willful penalty; all authorities on the issue (including the IRM) interpret willfulness in the FBAR statute to be the same as the Cheek standard - intentional violation of a known legal duty (see e.g., Ratzlaf); this is the mens rea element for tax crimes (e.g., Cheek), the civil analogs of which (Section 6663) require proof by clear and convincing evidence; therefore, by the type of extension in Carlson, the FBAR willful civil penalty requires proof by clear and convincing evidence.  (There are some fine connections in this sparse argument, but most readers can supply them.)

I suppose that the Government might make the argument that the FBAR civil penalty does not involve fraud.  Historically, fraud has involved the taking of something of value.  The failure to file the FBAR does not involve the taking of something of value.  However, since the penalty regime for the form plays out in the context of other potential crimes, including tax crimes, involving the taking of something of value (e.g., tax evasion in a tax setting), then I would argue that fraud is inextricably linked to the penalty.  Stated otherwise, it is hard for me to imagine the Government asserting the willful penalty if there is not some other misconduct going on.  (To illustrate, where the only potential related crime is a tax crime (either 26 or 18 USC), if there is not tax involved, the IRS does not assert the penalty, at least so I understand).  Moreover, as we all know, the definition of defraud in terms of the defraud / Klein conspiracy does not even require the taking of money but can involve simply the interference of the lawful functioning of a government agency / IRS.  Certainly, the failure to file the FBAR fits easily within that expanded notion of fraud.