When a Fictitious Business is Reported on Your Tax Return

So you reported a fictitious business on your income tax return. The fictitious business resulted in a tax loss and, maybe, you got a large tax refund from the IRS as a result of it. It’s a fraudulent tax return. The IRS sends you an IRS audit notice. What do you do?

The answer varies, but generally, your main concern is likely to avoid criminal and further civil liability. Criminal issues require an affirmative act and it is much less common for the IRS to pursue criminal liability. Even when it does, the IRS will usually start with civil tax liability. This includes imposing the civil tax fraud penalty.

The Kamal v. Commissioner, T.C. Memo. 2023-80, provides an example of this situation. It also helps explain how to avoid the penalty by not making matters worse than they already are.

Fact & Procedural History

The taxpayer filed his 2017 federal income tax return claiming that he was a self-employed consultant. He reported $100,000 in business income and $30,000 in business expenses.

The IRS audited the taxpayer’s return and determined that he had no real business activity. The IRS auditor disallowed the business expenses and closed the case. The IRS auditor did not propose a civil fraud penalty. As such, there was no civil fraud penalty included in the IRS’s statutory notice of deficiency.

During the litigation, the IRS attorney suspected that some of the documents the taxpayer provided were forged. The IRS attorney sought to obtain the records from the third party using a subpoena. The third-party confirmed that they were not able to locate records of transactions claimed by the taxpayer.

The IRS attorney told the taxpayer that he would likely assert a civil fraud penalty, but the IRS never amended its pleadings to assert a penalty. At the end of the tax court trial, the IRS attorney made an oral motion to conform the pleadings to the facts to assert a fraud penalty. The penalty was $100,000. The taxpayer did not object to the motion, apparently.

The U.S. Tax Court found that the taxpayer had willfully made a false or fraudulent statement on his tax return. The court found that the taxpayer had no real business activity and that he had made false statements to the IRS about his business activities. Given no objection or response from the taxpayer, the U.S. Tax Court considered the fraud penalty and ended up concluding that the taxpayer was liable for the penalty.

About IRS Penalties, Generally

The IRS is authorized to assert various penalties under the tax code, depending on the nature and severity of a taxpayer’s non-compliance or infractions. These penalties serve to encourage tax compliance and penalize any form of non-compliance or wrongdoing.

Some penalties can impose substantial financial burdens on taxpayers. For example, the Foreign Bank and Financial Accounts (“FBAR”) penalties can accrue to staggering amounts, often leading some to question whether the amount of the penalty is justified given the often innocent conduct for which they can be imposed. Similarly, penalties under Sec. 6700, related to promoting abusive tax shelters, and Sec. 6707A, associated with undisclosed reportable transactions, can be costly for taxpayers.

In terms of severity, penalties under Section 6707A are comparable to the seldom-levied penalties under Section 6663, related to civil tax fraud. We will address the civil fraud penalty more below. For now, know that the slightly less severe penalty that is lower in severity is the Sec. 6662 penalty, which applies to inaccuracies or negligence in tax reporting. Finally, the more common and less severe penalties include those for failure to file and failure to pay taxes on time.

These IRS penalties vary in severity, with the less severe ones being asserted more frequently by the IRS than the more severe ones. So there are more failure to file penalties asserted than there are tax shelter penalties.

The Fraud Penalty Under Sec. 6663

The Sec. 6663 civil tax fraud penalty is no joke. The fraud penalty can be significant.

The penalty is calculated as 75% of the additional tax liability that arises due to the fraudulent activity. This means that if, for instance, a taxpayer underreports their income leading to an additional tax liability of $10,000, the tax fraud penalty would amount to $7,500. The penalty is not a flat rate, but rather, it is proportional to the degree of the tax infraction, making it a significant financial deterrent against fraudulent tax activities.

The IRS has to prove fraud by clear and convincing evidence for the fraud penalty to apply.  The IRS must prove two elements of fraud by clear and convincing evidence: (1) an underpayment of tax and (2) fraudulent intent.

What is Fraudulent Intent?

Fraudulent intent is the willful and purposeful attempt to deceive the IRS, typically to evade tax obligations. Proving fraudulent intent requires more than just establishing that an error or irregularity occurred in a taxpayer’s filings. The IRS must demonstrate that the taxpayer intentionally engaged in fraudulent behavior.

Circumstantial Evidence

Circumstantial evidence can be used to infer fraudulent intent. This evidence can come in various forms and the weight assigned to such evidence may depend on the taxpayer’s sophistication. For example, in Clark v. Commissioner, T.C. Memo. 2021-114, the taxpayer was deemed a sophisticated businessman due to his experiences in running businesses, selling houses, managing a mortgage-lending business, selling mortgage-backed securities, and dealing with numerous entities like banks, title companies, homebuyers, and the federal government. His sophisticated business dealings suggested a higher expectation of compliance with tax laws.

Badges of Fraud

The term “badges of fraud” is used to refer to indicators that may suggest fraudulent intent. These indicators, while not definitive proof of fraud on their own, can collectively provide strong circumstantial evidence of fraudulent intent when present in multiple forms. As per Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992) and Clark v. Commissioner, T.C. Memo. 2021-114, these badges of fraud include:

1. Failure to file tax returns
2. Underreporting of income
3. Keeping inadequate records
4. Providing implausible or inconsistent explanations of behavior
5. Failure to cooperate with tax authorities
6. Concealing income or assets
7. Engaging in illegal activities
8. Demonstrating a lack of credibility
9. Filing false documents, including false tax returns
10. Dealing in cash excessively

Each of these badges, especially when present in combination, can be seen as flags for fraudulent activity. The more sophisticated a taxpayer is perceived to be, the less likely these actions can be attributed to innocent mistakes or oversights, and the more they may point to a deliberate attempt to evade tax obligations.

As Applied in This Case

In the present case, the U.S. Tax Court held that the taxpayer was liable for the fraud penalty. The taxpayer had claimed that he was a self-employed consultant, but the court found that he had no real business activity and the taxpayer had made false statements to the IRS about his business activities:

Several badges of fraud are evident in this case: Mr. Kamal understated income, failed to maintain adequate records, offered implausible and inconsistent explanations, failed to cooperate with the IRS or respondent’s counsel, and offered vague, conflicting, defensive, and unbelievable testimony. Mr. Kamal failed to report a substantial amount of long-term capital gain income and deducted fictitious business expenses for a phantom business. To support his implausible story, Mr. Kamal submitted numerous documents that bear hallmarks of fabrication, he could not explain who drafted those documents, and he became increasingly uncomfortable and defensive every time he was asked direct questions related to their drafting or signing. His theories were inconsistent and illogical, designed to offset the income he received from Cisco.

Thus, the court imposed the civil tax fraud penalty.

How to Avoid the Fraud Penalty

There are a number of things that taxpayers can do to avoid the fraud penalty under Sec. 6663. These include:

• Being truthful and accurate in all dealings with the IRS. This includes providing accurate information on tax returns, responding to IRS inquiries, and appearing for audits. Taxpayers should do this even when the IRS behaves poorly and the IRS employees take actions that are against good conscious and in bad faith, which is unfortunately, more common than one would expect (and give the IRS and the much larger number of honest, dedicated, and hardworking IRS employees a bad reputation…).
• Keeping accurate records of all financial transactions. This will help to substantiate the taxpayer’s claims and to defend against any allegations of fraud. This includes keeping notes of conversations. These records serve as a robust defense against potential fraud allegations and validate the taxpayer’s claims, as there can be instances of incorrect note-taking on their part, leading to wrongful attributions of statements or facts to taxpayers.
• Seeking professional advice if there is any question about a tax issue. A tax attorney can help the taxpayer to understand their obligations and to avoid making any mistakes. Tax attorneys who have prior experience working with the IRS can provide insight into how some IRS employees might cut corners or misrepresent cases to expedite their work, often to the taxpayer’s disadvantage.

The answer above is the textbook answer. The answer can be more nuanced than this in some cases. Consider, for instance, the situation where an unsophisticated taxpayer engages an unscrupulous tax return preparer to prepare their tax return. The preparer might include a fictitious business, such as a Schedule C business, on the return that generates a tax loss or an unjustifiable earned income tax credit. In such instances, the taxpayer might inadvertently benefit from the falsely reported business without even being aware of its inclusion on their return. In these specific cases, a non-response to the IRS auditor and acceptance of the tax adjustment might be the most suitable course of action. This may avoid the Sec. 6663 fraud penalty and even the Sec. 6662 penalty in some cases.

Conclusion

The fraud penalty under Sec. 6663 is a serious penalty that can be very costly for taxpayers. Taxpayers can avoid the fraud penalty by being truthful and accurate in all dealings with the IRS, keeping accurate records of all financial transactions, and seeking professional advice if there is any question about a tax issue. There are nuances, however. For example, in the case of a fictitious business reported on a tax return by an unsophisticated taxpayer, the best answer is often not responding to an IRS audit and simply paying the tax adjustment.