Tax Court Weighs Badges of Fraud in Ruling

The Tax Court, adding and subtracting “badges” of fraud, has found a California business owner and his companies not liable for a 75 percent civil fraud penalty.

In Carreon v. Commissioner, T.C. Memo 2014-6, the court found in a January ruling that even though some badges of fraud existed, there were more factors in the taxpayer’s favor, and consequently, the IRS failed to prove by clear and convincing evidence that some part of an underpayment was attributable to fraud.

David Carreon and his wife owned two credit card processing companies. Upon the advice of a friend, they became involved in asset-management protection and a financial strategy referred to as the “agent-principal” relationship. The strategy involved taking the net gross receipts from their credit card processing business and putting the funds into other entities including a business trust, a charitable trust, a management trust and a living trust.

To impose the fraud penalty for a particular year, the IRS must prove, for each year, by clear and convincing evidence, that the tax was underpaid for that year, and that some part of that underpayment for the year was due to fraud. The court found that three factors weighed in favor of civil fraud, one factor was neutral, and another six factors weighed against a finding of civil fraud: Carreon relied on a promoter, negating fraudulent intent; Carreon maintained adequate records; there was no evidence that Carreon engaged in illegal activities; Carreon didn’t make cash transfers; and he didn’t engage in false or incredible testimony.