On January 23, 2020, the Tax Court issued a Memorandum Opinion in the case of Isaacson v. Commissioner (T.C. Memo. 2020-17). The issues presented in Isaacson were whether the petitioner (1) failed to report taxable income for tax year 2007, and (2) if so, was the petitioner, therefore, liable for the civil fraud penalty under IRC § 6663.
The petitioner, a trial attorney, who specialized in (among other areas) tax fraud litigation, secured a $12.75m settlement for four victims of abuse by Catholic clergy when they were children. He “earned” a 60% contingency fee for his services in 2007. This, apparently, was legal in California. Notwithstanding this boon, the petitioner got greedy, invested the money (intended for his firm’s trust fund account) in risky securities at UBS (Switzerland), and cried foul when the market dropped out in 2008, and he lost much of his—rather, his client’s money. Much litigation, arbitration, settlements, ethics claims, and censure later, the client failed to report the legal fees as income, claiming instead that UBS stole the funds through the “unauthorized” investment in said securities.
To this end, the petitioner directed a legal assistant at his own law firm to draft a memorandum (which petitioner claimed was a “tax opinion letter”) advising the petitioner that the funds held in the UBS “trust” account would not represent income under the theory of constructive receipt due to the fact that UBS had invested the funds without authorization. The Tax Court takes 23 pages to unfold all of the petitioner’s machinations. The nail was firmly driven into the petitioner’s coffin when, on the 24th page, the Tax Court notes: “Although it has a tangled background, this is a simple case [of fraud].”
Tax Court Proceeding
After 23 pages of background, the Tax Court opinion summarizes the operative facts in a page and a half. The petitioner received the clergy lawsuit settlement funds into the UBS account—which he alone controlled—in December 2007. In doing so, he commingled his fee and his clients’ funds in that account. Also, in December 2007 petitioner exercised dominion and control over the funds, repeatedly using the funds and interest earned on the funds for his personal enjoyment.
Petitioner failed to account for these funds in his business ledgers, however, and chose not to report his claimed 60% fee as income for 2007. Petitioner also repeatedly claimed that UBS had invested the clergy lawsuit settlement funds in auction rate securities without his authorization. This was untrue when first asserted and remained untrue when petitioner asserted it again throughout the examination of his 2007 income tax return.
As a consequence, (1) petitioner had dominion and control over all of his claimed 60% fee in 2007; (2) he exercised dominion and control over the entire amount for his personal use in 2007; (3) he failed to report his asserted 60% fee as income for 2007; (4) he repeatedly claimed, succeeded in convincing prior tribunals to find as a fact, and personally benefited from prior tribunals’ finding that no fee dispute existed between him and his clients; and (5) he asserted untrue theories regarding the ownership and investment decisions relating to the clergy lawsuit settlement funds in various proceedings–including this one.
Burdens of Proof in Deficiency Proceeding
The petitioner bears the burden of proving that the deficiency determination in the notice of deficiency is incorrect. See Tax Court Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Conversely, the IRS bears the burden of proving new matters asserted in its answer and not determined in the notice of deficiency. See Tax Court Rule 142(a). Finally, the IRS bears the burden of proving, by clear and convincing evidence, that the petitioner is liable for the IRC § 6663 civil fraud penalty. Id. If the IRS meets that burden as to any item, the Tax Court presumes that the entire underpayment is attributable to fraud, unless the petitioner can show by a preponderance of the evidence that some portion is not attributable to fraud. See IRC § 6663(b).
Application of Doctrine of Constructive Receipt to Actual Trust Funds
A cash-method taxpayer must report income for the earliest year that he actually or constructively receives the income. Treas. Reg. § 1.451-1(a). If a taxpayer has money credited to his account, has money set aside for him, or otherwise has money made available so that the taxpayer may draw upon it at any time, the taxpayer has constructively received the income in that year. Treas. Reg. § 1.451-2(a). If, however, control of the receipt of this money is subject to a substantial limitation or restriction, the taxpayer is not in constructive receipt of the income. Id.
Under these principles, a taxpayer does not recognize as income funds the taxpayer holds in trust for the benefit of another. Ford Dealers Advert. Fund, Inc. v. Commissioner, 55 T.C. 761, 771 (1971), aff’d, 456 F.2d 255 (5th Cir. 1972). Accordingly, when a lawyer reporting on a cash basis holds funds for the benefit of his clients in a trust account and complies with the requirements placed on trust accounts by the relevant rules of professional conduct, the funds are not income to the lawyer. See Miele v. Commissioner, 72 T.C. 284, 290 (1979); Canatella v. Commissioner, T.C. Memo. 2017-124, *14-*15.
Once the lawyer has performed work for the client and billed for his services against amounts held in the client trust account, the lawyer has earned that amount without substantial limitation on his right to the funds, which is to say, the lawyer has “constructively received” the funds. See Miele, 72 T.C. 284 at 290. Upon constructive receipt, the funds represent income in that year. Id.; Canatella, T.C. Memo. 2017-124 at *14-*15.
California Rules of Professional Responsibility not Substantial Limitation, in Part, Because the Petitioner Violated Them Left and Right
The Tax Court makes *quick* work of the petitioner’s argument that a disputed fee held in a trust account is not “earned” under the California Rules of Professional Responsibility and is, therefore, subject to “substantial limitations and restrictions.” Not so, explains the Tax Court. Not only did the Tax Court not buy that the California Rules act as a substantial limitation, in and of themselves, because the petitioner completely disregarded nearly every single one of them regarding client trust accounts, they could not save him anyhow. Because the petitioner refused to conform his behavior to the limits of the California Rules while in practice; he cannot wield them as a shield to reporting income he in fact earned in tax year 2007.
Judicial Estoppel – Another Nail in the Petitioner’s Coffin
In his Tax Court petition, the petitioner argues that he could not recognize income from the clergy lawsuit settlement because clients disputed his fees, and he was barred under the California Rules from disbursing his fee until the dispute was resolved. In prior (non-Tax Court proceedings), however, the petitioner repeatedly represented, and earlier tribunals accepted as true, that no fee dispute existed between the petitioner and his clients. The Tax Court felt that the petitioner could not have his cake and eat it too, and so they pulled out an argument that is all but futile if the petitioner argues it—judicial estoppel.
Judicial estoppel is an equitable doctrine that the Tax Court may invoke in its sole discretion to protect the integrity of the judicial process and to prevent the improper use of the courts. New Hampshire v. Maine, 532 U.S. 742, 749-750 (2001); Edwards v. Aetna Life Ins. Co., 690 F.2d 595, 598 (6th Cir. 1982); Konstantinidis v. Chen, 626 F.2d 933, 938 (D.C. Cir. 1980)). Under the doctrine, where a party has assumed a certain position in a legal proceeding, and succeeded in maintaining that position, he may not thereafter, simply because his interests have changed, assume a contrary position. New Hampshire, 532 U.S. at 749; Davis v. Wakelee, 156 U.S. 680, 689 (1895).
Courts may examine three factors in assessing whether to apply judicial estoppel. Milton H. Greene Archives, Inc. v. Marilyn Monroe LLC, 692 F.3d 983, 994 (9th Cir. 2012); New Hampshire, 532 U.S. at 750-751; Fazi v. Commissioner, 105 T.C. 436, 444-445 (1995); Huddleston v. Commissioner, 100 T.C. 17, 26 (1993). First, is the party’s later position clearly inconsistent with its earlier position? Second, did the party succeed in persuading the prior tribunal to accept the earlier position? Third, would the party seeking to assert the inconsistent position derive an unfair advantage if permitted to do so?
To these three questions, the Tax Court responds with a resounding hell, yes. The Tax Court notes, for posterity, that it must protect the integrity of the courts from a ne’er-do-well party “playing fast and loose with the courts.” Milton H. Greene Archives, Inc., 692 F.3d at 993; Hamilton v. State Farm Fire & Cas. Co., 270 F.3d 778, 782 (9th Cir. 2001); Huddleston, 100 T.C. at 26. When asked to reward the petitioner’s “cynical gamesmanship,” Judge Marvel politely notes that the Tax Court “decline[s] the invitation” to reward further “manipulation of the judicial process.”
The Civil Fraud Penalty of IRC § 6663, a Tax Court Love Letter
The Code imposes a 75% penalty on any underpayment of tax if the underpayment is due to fraud. IRC § 6663(a). The IRS bears the burden of proving fraud by clear and convincing evidence. See IRC § 7454(a). Clear and convincing evidence is a degree of proof that will “produce in the mind of the trier of facts a firm belief or conviction” regarding the allegations sought to be established. Ohio v. Akron Ctr. for Reprod. Health, 497 U.S. 502, 516 (1990).
It’s higher than a preponderance of the evidence, but not to the extent of “beyond a reasonable doubt.” Id. To meet its burden of proof, the IRS must show that (1) an underpayment exists and (2) the taxpayer intended to evade taxes known to be owing through conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. Sadler v. Commissioner, 113 T.C. 99, 102 (1999).
The IRS must present evidence beyond the taxpayer’s failure to prove error in the deficiency determination but need not establish the precise amount of the deficiency. See DiLeo v. Commissioner, 96 T.C. 858, 886 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992). To prove that the taxpayer intended to evade taxes, the IRS may rely on circumstantial evidence because fraud is rarely provable by direct evidence alone. See Estate of Trompeter v. Commissioner, 279 F.3d 767, 773 (9th Cir. 2002).
The existence of certain badges of fraud allows a court to infer fraudulent intent. Maciel v. Commissioner, 489 F.3d 1018, 1028 (9th Cir. 2007), aff’g in part, rev’g in part T.C. Memo. 2004-28. Such badges include (1) consistently understating income; (2) failing to maintain adequate records; (3) offering implausible or inconsistent explanations; (4) concealing income or assets; (5) failing to cooperate with authorities; (6) filing false documents; and (7) providing false testimony. See Parks v. Commissioner, 94 T.C. 654, 664-665 (1990).
Importantly, the Tax Court considers these badges in the light of the taxpayer’s sophistication, education, and experience. Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992). Because the petitioner was a long-time tax fraud defense attorney (with over 30 years specializing in–among other areas—tax fraud and controversy cases), the badges shone pretty brightly in this case.
Not unsurprisingly, the Tax Court has often held that a taxpayer’s experience with Federal tax matters is relevant to the analysis of the presence or absence of fraudulent intent. See, to name but a few, Cryer v. Commissioner, T.C. Memo. 2013-69; Fiore v. Commissioner, T.C. Memo. 2013-21; Cooley v. Commissioner, T.C. Memo. 2004-49; McGee v. Commissioner, T.C. Memo. 2000-308; Beretta v. Commissioner, T.C. Memo. 1997-570; Scallen v. Commissioner, T.C. Memo. 1987-412, aff’d, 877 F.2d 1364 (8th Cir. 1989). Simply put, the Tax Court could not (and sure as hell would not) ignore the fact that the petitioner ran a law firm specializing in tax fraud defense. Hatling v. Commissioner, T.C. Memo. 2012-293.
Original opinion: (T.C. Memo. 2020-17) Isaacson v. CommissionerAdd to favorites