Civil fraud penalty under IRC 6663 and the IRS's burden of proof

The penalty and its elements

IRC 6663(a) imposes a penalty equal to 75 percent of the portion of an underpayment due to fraud. The Code does not define fraud; the IRM says “Courts have long recognized the essence of the fraud penalty is the state of mind” and that “Intent is distinguished from inadvertence, reliance on incorrect professional advice, honest difference of opinion, negligence, or carelessness” (IRM 20.1.5.19.1). Two elements must be shown: an underpayment, and that some part of it was due to a knowingly false representation made with intent to evade tax the taxpayer believed was owing (IRM 20.1.5.19.2).

IRM 25.1.6.2 adds that tax due is never enough by itself: “the fact that a taxpayer has tax due is not sufficient to assert the civil fraud penalty. An affirmative act of fraud” must also be present.

Burden of proof

IRC 7454(a) puts the burden of proving fraud with intent to evade on the IRS, and IRM 20.1.5.19.2 says “The IRS bears the burden of proving civil fraud by clear and convincing evidence”, citing Tax Court Rule 142(b). IRM 25.1.6.1.7 defines that standard as evidence showing the assertion “is highly probable or reasonably certain”: more than a preponderance, less than beyond a reasonable doubt.

The burden shifts once some fraud is proven. Under IRC 6663(b), if any portion of the underpayment is due to fraud, the entire underpayment is treated as fraud except any portion the taxpayer establishes, by a preponderance of the evidence, is not. The IRM tells examiners to make a good faith effort to remove items that are inaccurate but not fraudulent from the computation (IRM 20.1.5.19.6). For a defense, that means working item by item: even when fraud on one item is hard to contest, the remaining adjustments may be shown to be errors.

Badges of fraud

Because direct proof of intent is rare, fraud is proven by circumstantial evidence. IRM 20.1.5.19.1 and IRM 25.1.6.4 list the common indicators:

• Understatement of income, including omitted sources or substantial amounts.
• Fictitious or improper deductions, such as personal items deducted as business expenses.
• Accounting irregularities: two sets of books, false entries.
• Acts showing intent to evade: false statements, destroying records, transferring or concealing assets.
• A consistent pattern over several years of underreporting.
• Implausible or inconsistent explanations.
• Failure to cooperate with the examiner.
• Illegal income or concealment of illegal activity.
• Inadequate records and dealing in cash.
• Failure to file returns.

IRM 25.1.6.4 says the determination rests on the taxpayer's entire course of conduct and the weight of the evidence “rather than the quantity of the factors.”

How the IRS develops a fraud case

1. The examiner spots first indicators and discusses them with the group manager. If the manager agrees, the examiner consults a fraud enforcement advisor (FEA) through the Specialist Referral System (IRM 25.1.6.3).
2. With manager and FEA agreement, the case moves to fraud development status on Form 11661, Fraud Development Recommendation, with an FEA plan of action. The examiner develops the affirmative acts.
3. If firm indications of fraud exist and criminal criteria are met, the case may be referred to Criminal Investigation; if only the civil penalty applies, no referral is needed (IRM 20.1.5.19.3).
4. The civil fraud determination is shared by the examiner, group manager and FEA; for LB&I cases FEA concurrence is mandatory (IRM 25.1.6.3).
5. The initial determination needs timely written supervisory approval under IRC 6751(b) (IRM 20.1.5.19.2).
6. “All statutory notices of deficiency asserting the civil fraud penalty must be reviewed by area counsel” (IRM 20.1.5.19.1). Unagreed reports must include alternative penalty positions, usually the accuracy-related penalty.

Civil and criminal fraud

The difference is the standard of proof: criminal fraud requires proof beyond a reasonable doubt, civil fraud clear and convincing evidence. A taxpayer not convicted of evasion can still owe the civil penalty (IRM 20.1.5.19.4). Collateral estoppel runs the other way: a conviction for evasion under IRC 7201 bars the taxpayer from contesting fraud for the years of conviction, though not the amount of the underpayment. A conviction under IRC 7206(1) (false return) does not, because it does not require proof of intent to evade (IRM 25.1.6.5). IRM 25.1.6.3 says the civil fraud or fraudulent failure to file penalty must be asserted after a successful Title 26 prosecution that involved additional tax, unless Area Counsel approves an exception.

Coordination with other penalties

• Accuracy-related penalty. Cannot apply to the same portion of an underpayment as fraud, except as an alternative position; both can apply on one return to different portions (IRM 20.1.5.3.2). Adjustments are ordered: no-penalty items first, then 20 percent, then 40 percent, then 75 percent items (IRM 20.1.5.3.3).
• Fraudulent failure to file (IRC 6651(f)). Same intent element; 15 percent per month up to 75 percent. Generally, if a fraudulent return is filed late, 6651(f) is the appropriate penalty, and counsel should be consulted before asserting both (IRM 20.1.5.19.2; IRM 20.1.2.3.7.5). See the failure-to-file penalty.
• Amended returns. An amended return “does not cure the defects on the previously filed fraudulent return”; under Treas. Reg. 1.6664-2(c)(2), tax shown on it is not counted as tax shown on the return when fraud is involved (IRM 20.1.5.19.2).

Computation, interest and special cases

The penalty is 75 percent times the underpayment attributable to fraud (IRM 20.1.5.19.6). Interest on civil fraud and accuracy-related penalties runs from the return due date, including extensions, until paid; it stops on amounts paid within 21 calendar days of notice and demand (10 business days if the amount is $100,000 or more) under IRC 6601(e)(3) (IRM 20.1.5.3.2). The penalty is assessed with the tax on the examination or Appeals closing record (IRM 20.1.5.19.7).

Joint returns filed after separate returns follow IRC 6013(b)(5): if the sum of tax shown on the two separate returns is less than the tax shown on the joint return, the sum is treated as the tax shown for computing the fraud penalty, and fraud on a separate return is deemed fraud on the joint return (IRM 20.1.5.19.2). In restitution-based assessment cases, the civil fraud penalty must be addressed, and counsel approval is needed if it will not be asserted (IRM 20.1.5.19.4). Employees in non-examination functions are generally not authorized to assess the penalty; they discuss suspected fraud with their manager and the FEA for referral (IRM 20.1.5.19.2).

The limitations period

IRC 6501(c)(1): “In the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time.” See the assessment statute of limitations.

Defending a fraud penalty

Make the IRS carry its burden. Identify each affirmative act the report relies on and test whether it shows intent or only error. The IRM's own list of what intent is not (inadvertence, reliance on incorrect professional advice, honest difference of opinion, negligence, carelessness) frames the argument.

Narrow the portion. Under IRC 6663(b), show by a preponderance which items were not fraudulent; they drop to the accuracy-related penalty or none.

Joint returns. “On a joint return, the civil fraud penalty does not apply to a spouse unless some part of the underpayment is due to civil fraud on the part of that spouse” (IRM 20.1.5.19.2; IRC 6663(c)). IRM 25.1.6.2 says intent must be established separately for each spouse. Consider also innocent spouse relief.

Reasonable cause. IRC 6664(c)(1) applies to 6663 as well as 6662: no penalty applies to a portion of an underpayment with reasonable cause and good faith.

Procedure. Check the supervisory approval record and its timing; see IRC 6751(b). In a Tax Court case the IRS carries the burden under IRC 7454(a) and Rule 142(b), and Appeals can settle penalties on hazards of litigation (IRM 20.1.1.4.1) (see hazards settlements).

Questions practitioners ask