Penalties for tax fraud against a corporation.

• Author: Pollack, Sheldon D.

Civil and criminal penalties for tax fraud are an imposing weapon that can be used against taxpayers. At a minimum, the taxpayer against whom civil tax fraud is asserted by the IRS will confront a liability for penalties that may turn out to be nearly as great as the tax claimed to be owed. If criminal charges are asserted, the taxpayer will face the possibility of imprisonment and fines on top of all the other penalties otherwise provided for under the Code.

This article will discuss the daunting tax fraud situation commonly confronted by corporate taxpayers.

The Corporate Entity

A corporation is a legal and taxable entity separate and distinct from the individuals who own or manage it. Because a corporation can act only through its agents, when a "responsible person" of a corporate taxpayer (e.g., a key employee, controlling shareholder, officer or director) causes the corporation to commit a fraud, the IRS will often assert tax fraud against the corporation. (Of course, any such claims against the corporation will be in addition to those that may be brought against the individual.) However, in many cases the individual's motivation in causing the corporation to commit an illegal act is to hide his own fraudulent acts, such as the misappropriation of corporate funds (for instance, through embezzlement or the use of corporate funds for the individual's own personal benefit). The perpetrator may falsify the corporation's books and records to disguise fraudulent payments to himself or enter false payments for nonexistent purchases, etc., thereby causing the corporation to file a false tax return by understating income or overstating expenses. In such circumstances, assertions of tax fraud against the corporation may appear as if the IRS is vindictively pouring salt on a wound already inflicted on the corporation by its own fiduciary.

While the IRS will routinely assert tax fraud against a corporation based on such acts committed by a responsible person, the likelihood of the Service actually prevailing in litigating this position in court is less certain. Indeed, in some jurisdictions, there is case law suggesting that the corporate taxpayer may be able to successfully defend itself against such claims.

Civil Tax Fraud

The Omnibus Budget Reconciliation Act of 1989 (OBRA) substantially modified the statutory scheme for the civil fraud penalty, providing a somewhat less complex structure that is better integrated with the other civil penalties. Under pre-OBRA law, the fraud penalty was embodied in former Sec. 6653(b), applicable to returns due before Jan. 1, 1990. For 1990 and later years, the fraud penalty is imposed under Sec. 6663. Under Sec. 6663(a1, the fraud penalty is imposed at the rate of 75% of that portion of the underpayment attributable to fraud.(1)

* Establishing fraud

Neither old Sec. 6653 nor new Sec. 6663 defines "fraud" for purposes of the civil fraud penalty. Instead, the definition is found only in case law. Under that case law, to prevail in establishing fraud, the IRS must show by clear and convincing evidence that the taxpayer "intended to evade taxes which it knew or believed it owed, by conduct intended to conceal, mislead, or otherwise prevent the collection of such taxes."(2) To establish a penalty for fraud, the Service must show that the taxpayer intended to evade taxes that it knew or believed to be owed.(3) One commentator has summarized the factors necessary to support a charge of tax fraud.

* The end to be achieved--the payment of less tax than that known by the taxpayer to be legally due.

* An accompanying state of mind that is variously described as being "evil," "in bad faith," "deliberate and not accidental" or "willful."

* An overt act aimed to achieve the nonpayment of taxes known to be due.(4)

The courts have continually reiterated that fraud will not be "imputed or presumed."(5) Mere suspicion of fraud is insufficient, nor can a finding of fraud be based on a taxpayer's failure to carry its burden of proof as to the underlying deficiency. Instead, the IRS must prove fraud by clear and convincing proof, and a preponderance of the evidence is not enough to sustain that burden of proof.(6) The courts find fraudulent intent by reviewing "the taxpayer's entire course of conduct and draw[ing] reasonable and appropriate inferences therefrom."(7) The indicia on which a court can draw reasonable inferences of fraud may be compiled from the case law.

* A substantial understatement of income and a pattern of such understatement over several years.

* Failure to keep adequate (or any)books and records, particularly when the taxpayer is an intelligent and experienced business person.

* Extensive dealings in cash.

* Destruction or alteration of financial records.

* Failure to turn over to an accountant all information necessary to prepare accurate income tax returns.

* A guilty plea.(8) The mere presence of indicia of fraud is not enough to sustain the IRS's burden of proof, although the Service can satisfy its burden by circumstantial evidence.(9)

The OBRA further clarified prior law by providing that the taxpayer must establish the items not attributable to fraud by a preponderance of the evidence. (10)

* Fraud by a corporation Fraud can be established against an individual based only on his own actions. However, because a corporation is a separate "artificial" legal entity, "special rules" apply in determining liability for tax fraud. (11) Under special facts and circumstances, fraud can be asserted against a corporation based on the actions of a responsible person. Obviously, the IRS must first prove that the actions and intentions of the employee, officer, shareholder or director were willful and motivated by the requisite "evil" intent. Assuming that this can be established, the question becomes under what circumstances can the actions and intentions of the individual be imputed to the corporation itself.

In the case of tax fraud, the wrongful acts and intentions of a responsible person will be imputed to the corporation itself only under limited circumstances.(12) According to the Tax Court, "corporate fraud exists if either: (1) the corporate agent so controls the corporation that the corporation becomes the agent's alter ego, or (2)the agent is acting in behalf of the corporation with the result that the corporation actually benefits from the agent's fraudulent acts."(13) The courts have uniformly applied the Tax Court's two-part test, one part of which must be satisfied before the fraudulent actions of an officer, shareholder or director will be attributed to the corporation. Alter ego: Under the first part of the test, to satisfy its burden, the IRS must prove that the corporation was the "alter ego" of the individual whose actions are at issue.

Tax Court case law suggests...