The Transupport, Inc. v. Commissioner, No. 17-1265 (1st Cir. 2018) case involved evidence that was not sufficient to support imposing a penalty, but the same evidence was sufficient to hold the taxpayer liable for the tax. The case provides an opportunity to consider how courts evaluate evidence in tax cases.
The Facts & Procedural History
The taxpayer was in the business of selling engines and engine parts used in military vehicles. It purchases parts in bulk lots from the U.S. Government and resells them.
One of the taxpayer’s largest deductible expenses was its costs of goods sold (“COGS”). The taxpayer computed its COGS using the gross profit method. This method used estimates for the inventory on hand at the beginning of the year and the end of the year and applied a profit percentage to the difference between the beginning and ending estimates. The profit percentages determined by the taxpayer were in the 30 percent range.
On audit, the IRS estimated the percentage to be 75 percent. The IRS made an adjustment for disallowed COGS deductions based on this percentage and asserted a fraud penalty.
The U.S. Tax Court first considered the fraud penalty, concluding that the IRS’s 75 percent figure was “improbable” given the evidence presented in the case. In a later option, the U.S. Tax Court concluded that the IRS’s evidence was sufficient to support the disallowance of the COGS deduction.
The taxpayer filed an appeal, noting the U.S. Tax Court had taken an inconsistent position with respect to the fraud penalty and the tax deficiency.
The Burden of Proof
The appeals court held that there was no inconsistent position. This was based on the differences between the burden of proof in fraud penalty and tax deficiency proceedings. The difference comes down to the party who bears the burden and the degree of the burden.
With the fraud penalty, the IRS is required to prove by clear and convincing evidence that the taxpayer committed fraud. More specifically, the burden of proof falls on the IRS to prove by clear and convincing evidence that (1) an underpayment of tax exists and (2) some portion of the underpayment is attributable to fraud.
The term “clear and convincing evidence” is said to be that measure or degree of proof which will produce in the mind of the trier of facts a firm belief or conviction as to the allegations sought to be established. It is intermediate, being more than a mere preponderance, but not to the extent of such certainty as is required beyond a reasonable double as in criminal cases.
With deficiency tax cases, the taxpayer has to prove the notice of deficiency was incorrect by a preponderance of the evidence. This is less than the clear and convincing standard for fraud penalties.
Given these rules, the trial court in Transupport concluded that the evidence satisfied the preponderance standard, but not the clear and convincing standard:
The mere fact that the 75% figure could not survive the clear and convincing evidence standard does not mean that Transupport had shown the figure was incorrect. The Tax Court’s determination in the first proceeding therefore does not support an inference that the court’s determination in the second proceeding was erroneous.
This is one of the difficult determinations courts are tasked with making. It comes down to an assessment of the evidence that is presented. In this case, the appeals court even noted that the evidence presented by both parties was not ideal.
Considering the Positions
These rules also present a difficult decision for the tax litigator, one that often has to be considered in deciding how to proceed with the case.
Had the taxpayer lost on the fraud penalty, it would also have lost on the tax deficiency given that the standard was higher for the fraud penalty than it was for the tax deficiency litigation. But if the taxpayer prevailed on the fraud penalty, as it did here, it could leave the IRS wondering whether its evidence is sufficient. This could put pressure on the IRS to settle the tax deficiency case.
Despite having lost the initial case, the IRS didn’t settle this particular case. This is likely due to there being a second significant tax position in dispute in the case.