The Beard Test and Differences Between Civil Penalties Fraudulent Failure to File and Civil Fraud (12/9/16)

I again want to plug the Procedurally Taxing Blog which has this new entry:  Stephen Olsen, Procedure Grab Bag: CCAs - Suspended/Extended SOLs and Fraud Penalty (Procedurally Taxing Blog 12/9/16), here.  The issue addressed in the CCA is whether the manner in which fraudulent OID was claimed on the filed "returns" met or did not meet the Beard test (summarized in the CCA and below) of what is a return for tax purposes (at least some tax purposes addressed in the CCA).  If the "returns" are returns, then the penalty for fraud on the documents is the civil fraud penalty, § 6663; if the "returns" are not returns, then the penalty for fraud would be the fraudulent failure to file penalty, § 6651(f).

As paraphrased in the CCA, the Beard test requires (citing Beard v. Commissioner, 82 T.C. 766, 777 (1984)):

(1) it must contain sufficient data to calculate tax liability; (2) it must purport to be a return; (3) it must be an honest and reasonable attempt to satisfy the requirements of the tax law; and (4) it must be executed by the taxpayer under penalties of perjury.

The CCA recommends taking protective positions -- assertion of the civil fraud penalty and the fraudulent failure to file penalty.

Based on the CCA, I just added to my draft for the next Federal Tax Procedure edition (usually published in August of each year) the following paragraph to the discussion of the fraudulent failure to file penalty (footnotes omitted):

Finally, by definition, the fraudulent failure to file penalty applies only if no return is filed.  It is not uncommon for a taxpayer to file a document on the reporting form (in the case of income tax, the Form 1040) that appears at least superficially to be a return.  As noted earlier in discussing the requirements for a return, a standard test – referred to as the Beard test (Beard v. Commissioner, 82 T.C. 766, 777 (1984) – is often applied in determining whether the document is a return.  If it is a return that is fraudulent, the civil fraud penalty, § 6663, can apply and the fraudulent failure to file penalty cannot apply; if it is not a return, the fraudulent failure to file penalty, § 6651(f), can apply but the civil fraud penalty cannot.  It is not always clear whether a document having some resemblance to a return is a return under the Beard test.  Where that is the case, the IRS may assert protectively both the civil fraud penalty applicable if it is a return and a fraudulent failure to file penalty if it is not a return.  And, in those cases where the IRS does not assert alternative positions protectively, an unlimited statute of limitations would probably apply to fraudulent positions (e.g., if the document is a return, the unlimited statute of limitations for fraud would apply and, if the document is not a return, the unlimited statute of limitations would apply).

And, I previously had (and am carrying forward), the following paragraphs on the relationship of the two penalties (footnotes omitted):

The critical differences that distinguish the civil fraudulent failure to file penalty from the civil fraud penalty are: (1) the fraudulent failure to file penalty is based upon the net tax due on the due date of the return (i.e., appropriate credits are given for tax payments on or before the date of the return), whereas the civil fraud penalty is based on the portion of amount shown on the return attributable to fraud, which excludes the tax payments and any portion of the tax underpaid not attributable to fraud; and (2) the fraudulent failure to file penalty is a time based penalty that permits mitigation where the taxpayer acts promptly after the event giving rise to the penalty. The latter is illustrated where a taxpayer fails to file a Year 01 return on April 15 of Year 02 with the intent to commit fraud by the failure to file and then, in 4 months or less (before August 15 of Year 02), files a nonfraudulent delinquent return for Year 01. The taxpayer will thus not be subject to the entire 75 percent penalty, but will be subject to some lesser percentage depending upon when in that 4 month period the taxpayer files the delinquent return.  This pristine illustration is not a real world example because, barring absolutely bizarre facts, the filing of the delinquent return so quickly will cure any practical fraud risk, civil or criminal.  The IRS will never look for fraud because, by the time the IRS would look for a reason for the original failure to file timely, a delinquent return will have been filed and the IRS will not expend resources to inquire as to the reason for the original delinquency.  The only fraud the IRS will concern itself with is fraud with respect to the delinquent return, but the example posits the filing of a nonfraudulent delinquent return.  Hence, as a practical matter, if you have a client subject to this penalty, it will be the maximum 75 percent which, except for the potential difference in the amount to which the percentage applies, will be the same as civil fraud penalty.

The difference in the amount of the base may be illustrated by a variation of the same example.  Let’s say that the tax due on a correct return would be $100, and there is no advance payment of tax.  The taxpayer fraudulently fails to file the Year 01 return on April 15 of Year 02, the due date for the Year 01 return.  On October 1 of Year 02, the taxpayer files a return reporting $20 of tax.  Assume that, of the underreported tax of $50 on the delinquent return, $50 is attributable to fraud and $50 is attributable to erroneous but nonfraudulent positions.  The civil fraudulent failure to file penalty would be $75.  By filing the delinquent but fraudulent return, the taxpayer would have practically avoided the IRS investigating fraud with respect to his original delinquency, and will have reduced his civil penalty exposure to 75 percent of $50, or $37.50.  But, by filing a fraudulent delinquent return, the taxpayer will also have raised the potential stakes of criminal prosecution from what would likely be a failure to file misdemeanor prosecution under § 7203 to a felony evasion prosecution under § 7201. 

The latter point further illustrates that one of the easiest tricks in the lawyer’s arsenal for a client who is in the situation of having failed to file a return is to advise the client to promptly file a return.  The filing of a delinquent return before a criminal investigation starts will usually forestall the institution of a criminal investigation in the first instance and the IRS is not likely to expend resources to determine whether the original failure to file was fraudulent so as to assert the fraudulent failure to file penalty.  The IRS will usually automatically assert the general failure to file penalty (5 percent per month up to 25 percent) when it receives the delinquent return, but the risk of the IRS’s investigation and assertion of the fraudulent failure to file penalty will be practically cured.  (See the discussion elsewhere in the text on Voluntary Disclosure.) 

One of the things I do speculate about the book footnotes -- where I am free to speculate -- is whether both penalties might apply to the same income tax year. Example: T fraudulent fails to file on the Year 01 due date of 4/15/02, but later files a fraudulent delinquent return on, say, 1/1/03. If anyone knows the answer to that, let me know. As I noted above, the issue may not be a practical one because, assuming the return is a return, the IRS would likely pursue only the civil fraud penalty for the amended return. And, in terms of criminal prosecution, I am certain that the IRS would pursue evasion for the return filing rather than evasion for the failure to file subsequently corrected late or even failure to file.