The IRS suffered a major defeat last week in the Eleventh Circuit Court of Appeals, in Carlson v. United States, Case No. 12-13736 (June 13, 2014), as the appellate court reversed in part and vacated and remanded in part a decision from a Florida district court holding a tax preparer liable for penalties under Code Section 6701. The eleventh circuit held that the burden of proof was not the usual minimum of a “preponderance of the evidence” (sometimes described as “more likely than not”) but the higher “clear and convincing evidence” usually applied in civil fraud cases. (Note: the clear/convincing standard is lower than the “beyond a reasonable doubt” standard.) Appellant, Frances Carlson, was a return preparer for Jackson Hewitt tax services.
Section 6701(a) of the Internal Revenue Code, 26 U.S.C., provides for a penalty to be imposed on any person:
Her boss at JH was arrested in 2006 for drug and money laundering charges. (Wow!) The IRS later investigated the preparation business, at which time Carlson stopped working there, but had prepared more than a thousand returns during her tenure. The IRS penalized her for 40 of those returns, she paid 15% down and sued in district court for a refund (which is unique to certain penalties). The DOJ saw fit to defend only 27 of those 40 in a jury trial.
As you can see, Carlson is actually fairly sympathetic in this case. The government’s decision to litigate when there was a possible adverse decision on a purely legal issue was a hazardous one. There is a saying in litigation that “bad facts make bad law.” If the DOJ was trying to avoid making bad law, this may have been the wrong case to push.
Contrary to the government’s argument, Section 6701, even though it doesn’t use the word “fraud,”requires proof of fraud before penalties can be imposed. Essentially, knowledge that a false item would make a false refund is fraud.
The case was remanded for a whole new trial. The appeals court held the government was required to prove by clear and convincing evidence that the individual had actual knowledge that the returns she prepared for others contained an understatement of tax. Thus, the instruction to the jury on the lower standard of proof was improper. In a full sweep for the return preparer, the appeals court found the government’s case wanting under any standard. There was simply insufficient evidence to support the jury’s verdict that a tax preparer was liable for penalties under Section 6701.
Further, government presented no evidence that the preparer knew that twelve of the returns understated the correct tax. The government was required to show that the preparer knew that the returns were fraudulent; it was insufficient for the government to show only that the returns contained errors.
In contrast, the preparer presented substantial evidence that she did not know the returns she prepared understated the correct tax. Moreover, the simple fact that many of the preparer’s customers either failed to substantiate their deductions during the audit or were not cooperative during the IRS’s later audit was not evidence that those clients had not presented substantiation to the preparer (or misled the preparer) at the time the returns were prepared. A jury could not reasonably infer that the preparer knew the returns contained understatements based only on those clients’ conduct during audits.
This case represents a major “win” legal victory for this particular return preparer and a terrible defeat for the government. However, the “win” is not that great if you consider the public shame the IRS has brought on the return preparer and Jackson Hewitt and the likely loss of business it may have caused her practice. Hopefully, this case gives enough guidance to prevent similar cases from being pushed forward by the DOJ and IRS unnecessarily.
The Wilson Tax Law Group has extensive experience in return preparer penalties and criminal defense of tax return preparers. Please feel free to contact our firm with any inquiries on similar issues or any other tax problems.