In Chief Counsel Advice 202003004[1] the IRS Chief Counsel’s office looked at the impact of the burden of proof imposed on the agency when it asserts that payments are to disallowed under IRC §165(c) as illegal kickbacks, bribes, and the like.

IRC §162(c)(1)-(2) read as follow:

(c) Illegal bribes, kickbacks, and other payments

(1) Illegal payments to government officials or employees

No deduction shall be allowed under subsection (a) for any payment made, directly or indirectly, to an official or employee of any government, or of any agency or instrumentality of any government, if the payment constitutes an illegal bribe or kickback or, if the payment is to an official or employee of a foreign government, the payment is unlawful under the Foreign Corrupt Practices Act of 1977. The burden of proof in respect of the issue, for the purposes of this paragraph, as to whether a payment constitutes an illegal bribe or kickback (or is unlawful under the Foreign Corrupt Practices Act of 1977) shall be upon the Secretary to the same extent as he bears the burden of proof under section 7454 (concerning the burden of proof when the issue relates to fraud).

(2) Other illegal payments

No deduction shall be allowed under subsection (a) for any payment (other than a payment described in paragraph (1)) made, directly or indirectly, to any person, if the payment constitutes an illegal bribe, illegal kickback, or other illegal payment under any law of the United States, or under any law of a State (but only if such State law is generally enforced), which subjects the payor to a criminal penalty or the loss of license or privilege to engage in a trade or business. For purposes of this paragraph, a kickback includes a payment in consideration of the referral of a client, patient, or customer. The burden of proof in respect of the issue, for purposes of this paragraph, as to whether a payment constitutes an illegal bribe, illegal kickback, or other illegal payment shall be upon the Secretary to the same extent as he bears the burden of proof under section 7454 (concerning the burden of proof when the issue relates to fraud).

IRC §7454(a) provides that “[i]n any proceeding involving the issue whether the petitioner has been guilty of fraud with intent to evade tax, the burden of proof in respect of such issue shall be upon the Secretary.”  As the Tax Court held in the recent case of Purvis, et ux v. Commissioner, TC Memo 2020-13, that burden is to prove the matter by clear and convincing evidence.

What if the taxpayer in question engaged in a large number of transactions that the IRS suspects are covered by these provisions?  May the agency use a sample, presumably statistically significant, in which such bad conduct is shown by clear and convincing evidence to then propose an assessment covering the entire population based on the results of the sample?  Or is the IRS required to obtain evidence on each specific transaction in question?  This memorandum considers that issue.

The memorandum summarizes the issue as follows:

Taxpayer engaged in the manufacture, promotion, and sale of Product. Taxpayer’s managers allegedly encouraged sales representatives to persuade Individuals to Perform Action for Taxpayer’s Product by taking the Individuals out for repeated dinners and paying the Individuals for speaker engagements. The sales representatives allegedly warned the Individuals that these benefits would not continue if they failed to Perform Action for Taxpayer’s Product. Taxpayer deducted the dinner expenses as meals and entertainment expenses, while payments made to Individuals for speaker engagements were deducted as advertising expenses (collectively, “Expenses”). [2]

The taxpayer entered a guilty plea on a criminal charge related to the events.  The taxpayer also was subject of a related civil suit.  The taxpayer settled the suit, but did not admit guilt in the settlement.  However, the memorandum notes:

…[I]n the civil settlement, Taxpayer agreed to pay the plaintiffs more than $C, but made no admission of guilt. Taxpayer did not admit to the entirety of the facts as alleged by the government, but did admit that from Date 2 through Date 3, sales representatives took Individuals out for dinners that included little or no education and that certain speakers were paid fees to provide promotional presentations even though, in certain instances, they did not give a complete presentation or any presentation at all. [3]

The IRS then took the following actions:

When the Commissioner analyzed Taxpayer’s books and records, it was determined that the amount of Expenses was approximately $D. Based on a sample of E line-items of Expenses, the Commissioner found that only F% of the meals and entertainment expenses paid to Individuals were acceptable as legitimate expenses, and none of the advertising expenses paid to Individuals were acceptable as legitimate expenses. The Commissioner issued notices of proposed adjustments, proposing to disallow the Expenses that were not considered legitimate expenses. [4]

The memorandum concludes that the IRS is not required to demonstrate by clear and convincing evidence that the requirements of IRC §§162(c)(1) and/or (c)(2) were met for each individual transaction.  The memorandum holds:

Section 162(c)(1) and (2) disallow deductions for certain payments that would otherwise be deductible under § 162(a), and place the burden of proving that a payment is one described in § 162(c)(1) or (2) on the Commissioner to the same extent as he or she bears the burden of proof under § 7454 (concerning the burden of proof when the issue relates to fraud). Section 7454(a) provides that for proceedings involving fraud with the intent to evade tax, the burden of proof with respect to that specific issue is on the Commissioner. This burden is to be carried by clear and convincing evidence. Rule 142(b), Tax Court Rules of Practice. The Commissioner may meet his burden by presenting several badges of fraud throughout the entire record. Hicks Co. v. Comm’r, 56 T.C. 982, 1019 (1971).

Although the burden of proving fraud falls upon the Commissioner, the burden of proving entitlement to deductions is with the taxpayer. Id. at 1031. Once the Commissioner proves fraud with clear and convincing evidence, the burden shifts to the taxpayer to rebut the Commissioner’s deficiency determination on any items falling within the logical ambit of that fraud, and, further, such rebuttal must take the form of something more than bank statements, receipts, and cancelled checks, or cursory, unsubstantiated assertions of business need. See Neaderland at 538-541. [5]

The analysis continues:

Thus, in the present case, similar to fraud cases, once the Commissioner proves that some of the Expenses are kickbacks described in § 162(c)(1) or (c)(2), he or she then separately determines the total deficiency in the income tax. This means that while the burden of proof falls to the Commissioner with respect to the issue of whether some of the Expenses are described in § 162(c)(1) or (c)(2), the Commissioner retains the presumption of correctness in regard to the determination of any deficiencies. The burden of proof regarding Taxpayer’s deficiency does not shift to the Commissioner unless a separate provision shifts that burden. For example, § 7491(a) shifts the burden of proof as to all issues relevant to the amount of the taxpayer’s liability if the taxpayer introduces credible evidence, substantiates items, maintains required records, and fully cooperates with the Commissioner’s requests.

Here, the Commissioner is required to prove by clear and convincing evidence, by considering the entire record, that Taxpayer made some payments that are kickbacks described in § 162(c)(1) or (c)(2). Once the Commissioner has met this burden of proof, he or she may disallow Taxpayer’s deductions for Expenses by making a determination of deficiency. This determination has a presumption of correctness. The Commissioner does not bear the burden of proving by clear and convincing evidence that each individual payment is a kickback described in § 162(c)(1) or (c)(2).[6]

[1] Chief Counsel Advice 202003004, January 17, 2020, https://www.irs.gov/pub/irs-wd/202003004.pdf https://www.irs.gov/pub/irs-wd/202003004.pdf (retrieved January 17, 2020)

[2] Chief Counsel Advice 202003004, p. 3

[3] Chief Counsel Advice 202003004, p. 3

[4] Chief Counsel Advice 202003004, p. 3

[5] Chief Counsel Advice 202003004, p. 4

[6] Chief Counsel Advice 202003004, p. 5