On July 26, 2021, the Tax Court issued a Memorandum Opinion in the case of Harrington v. Commissioner (T.C. Memo. 2021-95). The primary issue presented in Harrington was whether the IRS’s assessment was assessment is barred by the three-year period of limitations in IRC § 6501(a), or whether the statute of limitations remained open due to fraud under IRC § 6501(c)(1).
Summary1
“Sarah, I feel like I don’t even know you.”
“It’s Vivian. Would you say that you’re completely full of shit, or just 50 percent.”
“I hope just 50, but who knows?”
Spoiler alert: The petitioner, Mr. Harrington, was, unquestionably, unabashedly, and completely full of shit, and Judge Lauber had a field day sticking it to the petitioner.
Background and Bad Judgment in Harrington v. Commissioner
The petitioner was a glorified lumberjack. A U.S. citizen, the petitioner worked in the “forest product industry.” He started his career in Newfoundland and Labrador, where he became involved with Eastern Wood Harvesters (EWH), which exported lumber to Europe. As a contractor for EWH, the petitioner procured lumber and delivered it to an EWH warehouse. EWH “seems to have been structured to enable its European owners to minimize taxes imposed by Canada and their home countries.” This was effectuated by EWH’s Canadian attorney, John Glube.
Glube had formed Malta, Ltd., a Cayman Islands entity, to serve as EWH’s “operating and financial company.” Under Malta’s name he opened a bank account (Malta Account) with the Cayman Islands branch of the Royal Bank of Canada (RBC). Mr. Glube explained all of this to the petitioner, who testified that he was impressed by Mr. Glube, who seemed “on the ball.”
And this is where Judge Lauber takes a page out of Judge Holmes playbook.
The petitioner described Mr. Glube and his associates as “the most honorable people I have ever dealt with.”
Mr. Glube was later imprisoned for embezzlement.
Now that’s just funny.
The Foreign Dealings
Initially, the petitioner had a personal Swiss bank account and a business Cayman Islands account, which were closed in 2007. According to the petitioner, UBS bankers advised him that, for “estate planning” purposes, the funds in his “conduit account” would be safer in a “stiftung,” a European trustlike vehicle. Petitioner told the bankers he “thought that was a good idea * * * because it solved [his] estate planning dilemma.” The funds were accordingly transferred to a UBS stiftung, newly formed in Liechtenstein. The funds left the stiftung in 2009, when UBS entered into a deferred prosecution agreement with the United States. The petitioner then purchased two Liechtenstein life insurance policies to the tune of $3 million. In 2013, the petitioner cancelled the policies, and moved the assets to a Liechtenstein bank account under his wife’s name because, “the bank wasn’t accepting U.S. clients.”
The Returns
For tax years 2005 through 2010, the petitioner, himself, prepared and filed with his wife a joint Federal income tax return. On these returns he reported no income attributable to the offshore investment vehicles discussed above.
The Examination
In 2012 the IRS selected the couple’s 2005-2010 returns for examination. The IRS initiated the examination on the basis of information and documents obtained from UBS pursuant to the deferred prosecution agreement. The IRS received 844 pages of information concerning UBS accounts held by or associated with petitioner. This material included bank records, investment account statements, letters, emails between petitioner and UBS bankers, summaries of telephone calls, and documentation concerning the entities through which the offshore assets were held.
This cannot turn out well for the petitioner…
The RA assigned to conduct the examination first interviewed petitioner in January 2013. Knowing that the IRS had likely received UBS bank records by that time, petitioner acknowledged the existence of the offshore bank accounts and life insurance policies. However, he asserted that he had no control over any account and had never received financial statements for any account. He asserted that he had lent $350,000 to EWH and that, while he did not know where the loan proceeds were, the money was “supposed” to have been placed in a Liechtenstein bank under his wife’s name.
The same month, the petitioner contacted his Swiss financial “advisor” based in Liechtenstein. He asked the shyster to structure a transaction that “would show a greater degree of continuity between 2012 and 2013 in disposition of funds, making the diversion to [the stiftung] more explainable, and perhaps less embarrassing.” The life insurance policies were then canceled, and the funds were moved to the Liechtenstein bank under his wife’s name.
But wait…there’s more…
The RA interviewed the petitioner a second time in April 2013. During that interview petitioner retracted his prior statement that the proceeds of the purported $350,000 loan had been placed in a Liechtenstein bank; he said that he “must have misspoken.” He instead asserted (for the first time) that his former business associates had run off with his money and that he had asked the U.S. Embassy in Switzerland for assistance in getting it back. He again represented that he had no control over any account and had received no financial statements for any account.
After completing her interviews with the petitioner, the RA compiled her interview notes into an April 2015 memorandum, which the petitioner read and signed a few months later. According to this memorandum petitioner averred that he had no control over the Swiss accounts, that he had received no account statements from UBS, and that he had no meaningful contact with UBS bankers. He averred that, after the Swiss account was closed, assets in the account were moved to a Swiss conduit account without his knowledge. He suggested that UBS directed him to move assets from the conduit account into a newly formed stiftung but said he “did not recall” being a beneficiary of the stiftung. He told the RA that he had no control over the stiftung and that UBS unilaterally closed its bank account in 2009 because “they didn’t want American investors anymore.”
According to the RA’s memorandum, the petitioner admitted that, on advice from UBS, he had contacted his Liechtenstein “advisor” to discuss moving the offshore assets into Liechtenstein life insurance policies, allegedly for “estate planning” purposes. Petitioner averred that he had no control over these policies and that they were canceled in 2013 because “the Swiss agency that sold the policies did not want Americans as customers.”
The RA compiled all of this information and determined that petitioner had received, but failed to report, $791,661 in offshore investment income. The RA identified numerous disbursements from and transfers among the offshore accounts. Although petitioner did not withdraw any money personally, the RA concluded that he controlled the accounts, that all transactions were made for his benefit, and that he was currently taxable on the dividends, interest, and capital gains realized within the accounts.
Approval and Assertion of Civil Fraud Penalties
In March 2016, the RA prepared a Civil Penalty Approval Form. On that form she recommended that the IRS impose fraud penalties under IRC § 6663 for 2005-2010. She forwarded the case file, including the Civil Penalty Approval Form, to her supervisor.
On March 17, 2016, the RA’s manager (in her capacity as “Group Manager”) signed the Civil Penalty Approval Form, approving assertion of fraud penalties. On March 22, 2016, a Fraud Technical Advisor approved those penalties. At trial respondent introduced into evidence the RA’s case activity record and internal IRS emails to verify the date on which the manager approved the penalties. On April 20, 2016, the RA sent a closing letter to the petitioner. The RA attached to her letter a Form 4549, Income Tax Discrepancy Adjustments, dated April 14, 2016. These documents formally communicated to petitioner the Examination Division’s decision to assert fraud penalties. On April 11, 2018, the IRS issued the petitioner a notice of deficiency for 2005-2010 determining deficiencies of $118,000 and fraud penalties of $94,000.
Unreported Income
The petitioner did not dispute that the offshore accounts earned large amounts of investment income. Rather, he contended that he is not subject to tax because he had no control over the accounts. Judge Lauber called bullshit. The UBS records showed that the petitioner not only owned the accounts, but also he exercised significant control over them.
Judge Lauber also found it “inconsequential” that the petitioner did not personally “make withdrawals” or “receive disbursements” from the accounts. A taxpayer need not actually withdraw cash for an investment gain to be taxable. See Treas. Reg. § 1.451-2(a) (stating that “income, although not actually reduced to a taxpayer’s possession, is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time” except when receipt is “subject to substantial limitations or restrictions”). The petitioner supplied no documentary evidence to show that his ability to draw on any of the accounts was “subject to substantial limitations or restrictions.” Id.
In any event, to the extent that there were restrictions on the petitioner’s ability to make routine withdrawals, Judge Lauber found that the petitioner had willingly divested himself of that power in order to conceal his offshore assets. See Murphy v. United States, 992 F.2d 929, 931 (9th Cir. 1993) (holding that a taxpayer constructively received income where “his failure to receive cash was entirely due to his own volition”). Accordingly, the Tax Court sustained the deficiencies to the extent that assessment was not barred by the period of limitations (i.e., if the Tax Court did not find fraud).
Fraud and Limitations on Assessment
Generally, IRC § 6501(a) requires the IRS to assess a tax within three years after the return was filed. The period of limitations is extended to six years where the taxpayer omits from gross income an amount “in excess of 25% of the amount of gross income stated in the return.” IRC § 6501(e)(1)(A)(i). The notice of deficiency in this case was issued on April 11, 2018, more than six years after the period of limitations began to run for 2010, the last year at issue—the original return for 2010 having been filed on in May of 2011.
However, IRC § 6501(c)(1) provides that, where a taxpayer has filed “a false or fraudulent return with the intent to evade tax,” there is no period of limitations and the tax “may be assessed at any time.” The determination of fraud for purposes of the period of limitations on assessment under IRC § 6501(c)(1) is the same as the determination of fraud for purposes of the penalty under IRC § 6663. See Neely v. Commissioner, 116 T.C. 79, 85 (2001). Thus, whether the underpayments at issue were due to fraud thus determines both whether petitioner is liable for the civil fraud penalties and whether respondent can assess the deficiencies.
An Aside: Government Forgery and Shenanigans
The petitioner did not argue that there was formal communication before the date on the Civil Penalty Approval Form. No, that would be too easy. He argued instead that the RA’s manager fraudulently backdated the Form. In support of that position petitioner points to a typed date of June 14, 2016, which appears in the upper right-hand corner of the Form. Once again, Judge Lauber calls bullshit.
He observed that there was not even a scintilla of evidence to suggest that the RA and her supervisor engaged in a concerted effort to falsify documents. “The presumption of regularity supports the official acts of public officers and, in the absence of clear evidence to the contrary, courts presume that they have properly discharged their official duties.” Pietanza v. Commissioner, 92 T.C. 729, 739 (1989), aff’d without published opinion, 935 F.2d 1282 (3d Cir. 1991). The petitioner has offered no “clear evidence to the contrary.”
Meanwhile, Back to the Actual Fraudster
If any part of any underpayment of tax required to be shown on a return is due to fraud, IRC § 6663(a) imposes a penalty of 75% of the portion of the underpayment attributable to fraud. The IRS has the burden of proving fraud, and it must prove fraud by clear and convincing evidence. IRC § 7454(a); Rule 142(b). To sustain its burden, the IRS must establish two elements: (1) that there was an underpayment of tax for each year at issue and (2) that at least some portion of the underpayment for each year was due to fraud. Hebrank v. Commissioner, 81 T.C. 640, 642 (1983).
Where the Commissioner determines fraud penalties for multiple tax years, his burden of proving fraud “applies separately for each of the years.” Vanover v. Commissioner, T.C. Memo. 2012-79 (quoting Temple v. Commissioner, T.C. Memo. 2000-337, aff’d, 62 F. App’x 605 (6th Cir. 2003)). If the IRS proves that some portion of an underpayment for a particular year was attributable to fraud, then “the entire underpayment shall be treated as attributable to fraud” unless the taxpayer shows, by a preponderance of the evidence, that the balance was not so attributable. IRC § 6663(b).
A Note on Amended Returns
As we mentioned in this wonderful article, The Truth about Amending Tax Returns, amending a return that shows an underpayment is an admission of the deficiency. See Badaracco v. Commissioner, 464 U.S. 386, 399 (1984) (holding that an amended return, of course, may constitute an admission of substantial underpayment). Although the IRS in the notice of deficiency determined underpayments in slightly different amounts, it need not “establish the precise amount of the deficiency” to satisfy the first prong. See DiLeo v. Commissioner, 96 T.C. 858, 873 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
The petitioner in Harrington v. Commissioner argued that his “amended returns should be disregarded because he would not have filed them had they not been requested by the revenue agent.” Although the law is clear that statements made in a tax return may be treated as admissions, Lare v. Commissioner, 62 T.C. 739, 750 (1974), aff’d, 521 F.2d 1399 (3d Cir. 1975), the petitioner politely asked the Tax Court to create an exception to this rule where the taxpayer has been cooperative during an examination. Judge Lauber, as politely, “decline[d] the petitioner’s invitation,” insofar as there was no legal support or justification for an “exception of this kind.”
Badges of Fraud
Fraud is “intentional wrongdoing designed to evade tax believed to be owing.” Neely, 116 T.C. at 86. The existence of fraud is a question of fact to be resolved upon consideration of the entire record. Estate of Pittard v. Commissioner, 69 T.C. 391, 400 (1977). Fraud is not to be presumed or based upon mere suspicion. Petzoldt, 92 T.C. at 699-700. However, because direct proof of a taxpayer’s intent is rarely available, fraudulent intent may be established by circumstantial evidence. Id. at 699. The IRS satisfies its burden of proof by showing that “the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes.” Parks v. Commissioner, 94 T.C. 654, 661 (1990). The taxpayer’s entire course of conduct may be examined to establish the requisite intent, and an intent to mislead may be inferred from a pattern of conduct. Webb v. Commissioner, 394 F.2d 366, 379 (5th Cir. 1968), aff’g T.C. Memo. 1966-81; Stone v. Commissioner, 56 T.C. 213, 224 (1971).
Circumstances that may indicate fraudulent intent, often called “badges of fraud,” include but are not limited to:[2]
- understating income;
- keeping inadequate records;
- giving implausible or inconsistent explanations of behavior;
- concealing income or assets
- failing to cooperate with tax authorities
- engaging in illegal activities
- supplying incomplete or misleading information to a tax return preparer
- providing testimony that lacks credibility
- filing false documents (including false tax returns);
- failing to file tax returns, and
- dealing in cash.
No single factor is dispositive, but the existence of several factors “is persuasive circumstantial evidence of fraud.” Vanover, T.C. Memo. 2012-79. Several of these factors are neutral or inapposite in the present case. The petitioner did not engage in illegal activities. Since he prepared his own tax returns, he had no occasion to supply information to a return preparer. He did not deal extensively in cash—given the character of the income, that would have been impossible—and he did not altogether fail to file tax returns. But after thorough review of the record, the Tax Court concluded that seven of the badges demonstrate that the petitioner acted with fraudulent intent.
Understated Income
A pattern of substantially understating income for multiple years is strong evidence of fraud, particularly if the understatements are not satisfactorily explained. See Vanover, T.C. Memo. 2012-79. The petitioner failed to report five years’ worth of income earned on investments in the Cayman Islands and Switzerland. This income, nearly $800,000, took the form of interest, dividends, and capital gains. The volume of this income was extremely large relative to the income that petitioner actually reported on his original returns for 2005-2009, which totaled roughly $170,000. The petitioner knew that he had earned income on these investments. Indeed, during the examination he filed amended returns admitting that he underpaid his tax by $103,756 for the years at issue. These facts provide strong evidence of fraudulent intent.
Keeping Inadequate Records
The petitioner failed to maintain and supply to the IRS adequate records of his offshore assets and income. He repeatedly told the RA that he had never received statements for those investment accounts. That assertion was false: The evidence established that he received statements from UBS at least intermittently, on an “as needed” basis, when certain decisions had to be made. To the extent that he did not receive regular monthly statements, we find that this was part of the tax-avoidance strategy that he implemented with UBS, hoping that the absence of records, coupled with Swiss bank secrecy laws, would prevent discovery of the offshore accounts. See Meier v. Commissioner, 91 T.C. 273, 302 (1988) (holding that a taxpayer’s inadequate recordkeeping evidences an intent “to conceal information” from the IRS).
Giving Implausible or Inconsistent Explanations
The petitioner is a sophisticated businessman and investor, but he offered to the IRS and the Court a variety of implausible and inconsistent explanations about his income and assets. The petitioner also provided inconsistent explanations about the whereabouts of the funds he had purportedly lent. During one interview he told the RA that he had no idea where his money was. During another interview he asserted that his former business associates had taken his money and that he was trying to track them down.
Nor did the petitioner provide consistent explanations of his connections with the various bank accounts. While he acknowledged the existence of the accounts, he told the RA that he did not remember being a beneficial owner or having control over any account. When asked about his trip to the Cayman Islands in 2003, he admitted that he met with UBS bankers, but he represented that he did not know why he had been summoned there. He admitted that he had signed some documents on that trip, but he stated that he did not remember what he had signed. When the RA refreshed his memory, the petitioner said that he “should have read the documents more carefully.”
At trial petitioner changed his story, explaining that, while he may have had beneficial ownership, he never agreed to be a UBS client. That explanation was likewise implausible, on account of the fact that the banking records show that he received account statements from UBS and that he communicated with UBS bankers—in person, over the phone, and by email—to discuss investment options. When confronted with this “evidence,” the petitioner again tweaked his story, conceding that he was a “de facto” client but asserting that UBS had complete autonomy over the accounts. :cough: Bullshit :cough:
In the light of these repeated inconsistencies, the Tax Court had no trouble finding that this badge supplies strong evidence of fraudulent intent.
Concealment of Assets
A willful attempt to evade tax may be inferred from a taxpayer’s concealment of income or assets. Spies v. United States, 317 U.S. 492, 499 (1943). It is at this point that Judge Lauber cooked the petitioner’s proverbial goose when he stated:
This case presents a paradigm of asset concealment.
During 2002-2007, the years for which UBS admitted that it facilitated U.S. tax evasion, petitioner held millions of dollars in offshore UBS accounts. These accounts were held in the names of shell companies and fictitious entities, as well as a German family name used by his wife. It is obvious that petitioner desired to conceal his ownership of these assets.
Failure To Cooperate With Tax Authorities
The petitioner contends that he cooperated with the IRS by acknowledging his offshore accounts in his first meeting with the RA. But that meeting occurred four years after UBS had entered into a deferred prosecution agreement and supplied its customers’ bank records to U.S. authorities. Those facts were widely publicized, and petitioner knew that his ownership of UBS accounts almost certainly triggered the IRS audit. Under these circumstances, his acknowledgment that the offshore accounts existed is most plausibly regarded, not as a sincere act of cooperation, but as a strategic gambit.
In reality the petitioner attempted to obfuscate facts and mislead the RA during the examination. At one point he told her that he did not know where his money was, speculating that Mr. Glube (remember the honorable Mr. Glube?) or his former business associates stole it. This was clearly false. The bank records show that his money was at UBS and that he was in active contact with UBS bankers regarding its management, informing them at one point that he was “very pleased with their performance.” The petitioner told the RA that he had never been issued bank statements for any offshore account. That averment was plainly false, as the bank records show that UBS had been sending him statements at least since 2003. Emails confirm that UBS sent him more statements in 2005. Finally, the petitioner repeatedly told the RA that he had no control over any account. Those statements were clearly false.
Lack of Credibility of Taxpayer’s Testimony
The Tax Court did not find the petitioner to be a credible witness.
Well, no shit…
He was often evasive or dismissive of questions that respondent’s counsel and the Court asked of him. We have noted above numerous points on which we found his testimony to lack credibility. The petitioner “acknowledged inconsistencies” in his testimony. Nonetheless, he urged that these lapses were attributable to the fact that he “was 88 years old at the time of trial” and that “many of the events at issue occurred 10 to 35 years before the trial began.” Judge Lauber was not persuaded, because the petitioner testified intelligently at trial; he did not simply misremember a few trivial facts, but he mischaracterized facts and events of critical importance. He may have conceivably forgotten that he signed a particular document in 2003, but he cannot have “forgotten” that he had control over offshore investments worth $3 million.
Filing False Documents
Petitioner has admitted that the returns he originally filed for 2005-2009 omitted almost $800,000 of income. These omissions were large, both in absolute terms and relative to the income he did report (roughly $170,000 in the aggregate). The FBARs he originally filed for each year were incomplete (and thus substantially false), reporting trivial assets in New Zealand and omitting massive assets in the Cayman Islands, Switzerland, and Liechtenstein. The false documents supply further evidence of fraudulent intent.
The Petitioner’s “Arguments”
The petitioner contends that his underpayments were attributable to “good faith misunderstanding of the tax laws.” He argues that he did not believe he had gross income because he could not (and did not) withdraw funds from his offshore investment accounts or otherwise exercise control over them. But as explained above, the petitioner plainly had (and knew that he had) control over the accounts because he repeatedly authorized moving assets among them. Further, it is common knowledge that individuals are taxable on income earned in an investment account—e.g., dividends and capital gains reinvested in a mutual fund—regardless of whether that income is withdrawn or currently distributed to them in cash.
Petitioner contends that respondent’s failure to produce the original tax returns filed by petitioner and his wife “is fatal to the IRS’s fraud case.” Again, the Tax Court disagreed. In Estate of Clarke v. Commissioner, 54 T.C. 1149, 1163 (1970), the IRS did not produce the taxpayer’s original returns, but the Tax Court nevertheless sustained the fraud penalty because “there was sufficient [secondary] evidence as to what the returns contained.” Included among this secondary evidence was a “Certificate of Assessment and Payments showing the amount of tax due.” Id. In the present case, the IRS also produced Certificates of Assessment and Payment for 2005-2009. It also produced the petitioner’s amended returns, which show the amounts reported on the original returns. This evidence is more than sufficient to sustain the fraud penalty.
Entire Underpayment not Due to Fraud
The petitioner, in a last ditch Hail Mary toss, argued that, “even if the Court finds fraud, the entire underpayment is not due to fraud.” IRC § 6663(b) provides that if the IRS establishes that any portion of an underpayment is attributable to fraud, the entire underpayment shall be treated as attributable to fraud, except with respect to any portion of the underpayment which the taxpayer establishes (by a preponderance of the evidence) is not attributable to fraud.
About $11,500 of unreported income in 2007 consisted of interest and dividends received by the petitioner’s wife from Merrill Lynch and Fidelity. At trial the RA admitted that she did not believe that the petitioner or his wife had intentionally failed to report these payments. As such, the Tax Court found that the petitioner carried his burden to establish that this portion of the underpayment was “not attributable to fraud.” See IRC § 6663(b).
(T.C. Memo. 2021-95) Harrington v. Commissioner
Footnotes:
[1] Wedding Crashers (2005).
[2] See Schiff v. United States, 919 F.2d 830, 833 (2d Cir. 1990); Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Parks, 94 T.C. at 664-665; Recklitis v. Commissioner, 91 T.C. 874, 910 (1988); Morse v. Commissioner, T.C. Memo. 2003-332, aff’d, 419 F.3d 829 (8th Cir. 2005).
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