The IRS argued that a pattern of fraud they claimed to see in a preparer’s clients returns indicated that the preparer should be subject to the fraud penalty for understatements on his own return in the case of Ericson v. Commissioner, TC Memo 2016-107. However, the Tax Court was not impressed with the IRS’s evidence in the case, though it did find the taxpayer liable for the general accuracy related penalty.

IRC §6663(a) outlines the fraud penalty:

(a) Imposition of penalty

If any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.

As the Tax Court notes in the opinion, generally the Court look for “badges of fraud” in deciding if the penalty imposed by IRC §6663(a) applies:

Courts usually rely on certain indicia (or badges) of fraud in deciding whether a taxpayer had the requisite fraudulent intent. The badges of fraud include: (1) understated income; (2) maintaining inadequate records; (3) failing to file tax returns; (4) implausible or inconsistent explanations of behavior; [*36] (5) concealing income or assets; (6) failing to cooperate with tax authorities; (7) engaging in illegal activities; (8) dealing in cash; (9) failing to make estimated tax payments; and (10) filing false documents. See Estate of Trompeter v. Commissioner, 279 F.3d at 773; Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Recklitis v. Commissioner, 91 T.C. 874, 910 (1988); see also Spies, 317 U.S. at 499-500. These badges of fraud are nonexclusive. See Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992). The taxpayer’s education and business background are also relevant to the determination of fraud. See id.

In this case, though, the IRS argued the individual’s actions in preparing tax returns for others was the most important indicator that the understatements of tax on his return arose from a fraudulent intent to evade the tax.

Mr. Ericson was a professional tax preparer. The IRS had received complaints from other preparers regarding the quality of Mr. Ericson’s returns. The agent, Mr. Van Zweden, who would eventually examine Mr. Ericson’s personal returns first investigated these complaints.

Mr. Van Zweden's examination of the client returns stemmed from complaints the IRS had received from local tax practitioners concerning returns they had become aware of that Mr. Ericson prepared. Mr. Van Zweden initially reviewed approximately 30 client returns and selected approximately 15 for examination. Mr. Van Zweden concluded after examining the 15 client returns that they tended to have at least one questionable Schedule C and oftentimes inflated employee business expenses and unallowable education credits.

In fact, the IRS had moved separately against this preparer to obtain an injunction to prevent him from preparing returns, an injunction the IRS received. As the Tax Court explained in a footnote:

The District Court granted summary judgment on most of the Government’s claims, and a permanent injunction, on the basis of considerably more extensive proof concerning Mr. Ericson’s return preparer activity.

At Mr. Ericson’s trial the IRS produced evidence related to two of these exams. The Tax Court, allowing the evidence over the taxpayer’s objection to its relevance to his case, noted the limited use that could be made of it:

Evidence of an individual’s crimes, wrongs, or other acts is generally not admissible to prove the character of the individual to show action in conformity therewith. See Fed. R. Evid. 404(b). Such evidence is generally admissible, however, to show motive, opportunity, intent, preparation, plan, knowledge, identity, or absence of mistake or accident. See id. The Court of Appeals for the Ninth Circuit views rule 404(b) of the Federal Rules of Evidence as a “rule of inclusion”, see United States v. Ayers, 924 F.2d 1468, 1472-1473 (9th Cir. 1991), and has held that evidence of other acts is admissible under that rule where the evidence (1) proves a material issue in the case, (2) if admitted to prove intent, is similar to the offense charged, (3) is based on sufficient evidence, and (4) is not too remote in time, see United States v. Ramirez-Robles, 386 F.3d 1234, [*39] 1242 (9th Cir. 2004); see also Sherrer v. Commissioner, T.C. Memo. 1999-122, 77 T.C.M. (CCH) 1795, 1804-1805 (1999), aff’d, 5 F. App’x 719 (9th Cir. 2001).

But the Tax Court was not impressed with the IRS’s evidence in this area. The Court pointed out that despite the agent’s assertion that the taxpayer was a “problem preparer” and that a standard type of fraud he committed, the IRS only produced evidence from two of the much larger number of returns the individual had prepared. As well, only one of the two returns presented the type of problems that the agent insisted were a “pattern” in his preparation.

It appears that the Court’s view as that if the IRS wanted to use his pattern of preparation misconduct as evidence of fraudulent actions it should have presented more returns to show that pattern—a “pattern” can’t be shown by a single example.

The Court went on to note that Mr. Ericson’s own return itself did not evidence that telltale pattern of errors that the IRS claimed existed. So even if such a pattern existed, it doesn’t explain the errors found on Mr. Ericson’s returns. In fact, the problems on his returns arose virtually entirely from a total lack of records, a situation that could just as easily be explained by incompetence or sloppiness as opposed to a fraudulent intent to evade tax.

The Court then took a look at the standard badges of fraud analysis, but found that the IRS simply had not met its burden to show the understatements were due to fraud. The Court also refused to hold Mr. Ericson to a higher standard as a “sophisticated preparer” noting that he didn’t really appear to be all that knowledgeable:

We disagree with respondent’s view that Mr. Ericson’s education, his work as an accountant, and his profession as a tax preparer lead to a finding of fraud. First, the record does not persuade us that Mr. Ericson is the sophisticated tax preparer that respondent makes him out to be. Mr. Ericson had minimal education on the preparation of income tax returns before he started his return preparation business, and we do not find that his preparation of tax returns for his clients strengthened his understanding of the tax law to any significant extent. In fact, the record establishes to the contrary that Mr. Ericson is misguided in his understanding of many areas of tax law, including, for example, the requirements that taxpayers maintain records for their businesses and maintain sufficient documents to support their claims to deductions. Second, even if Mr. Ericson was sufficiently knowledgeable with respect to tax law, we are not persuaded, as discussed above, that petitioners’ failure to maintain the requisite records was part of a plan to conceal, mislead, or otherwise prevent the collection of tax.

The Court came to that finding despite the fact that Mr. Ericson held a master’s degree, had worked initially under the supervision of a certified public accountant (though he was not a CPA) and had been preparing returns for 20 years. While that might have given Mr. Ericson the opportunity to have become expert in tax matters, the Court found he hadn’t actually gained that level of sophistication.

It is important to note that a major reason the IRS lost here is because of the higher burden the service bears in this area and, as is hinted in the footnote reference to the IRS’s action against the taxpayer as a preparer, the agency’s failure to actually bring sufficient evidence into this Court proceeding to carry that burden.

But the case also demonstrates that the IRS may target a preparer’s clients for special scrutiny if the agency receives complaints regarding the quality of work being performed by a preparer. That can be helpful to point out to clients who always have that “neighbor” whose tax preparer allows them to claim various problematical deductions.