by David M. Fogel and Robert R. Rubin

For the first time following enactment of a 1998 provision shifting the burden of proof to the Internal Revenue Service, the United States Tax Court has ruled that the IRS had the burden of proof and failed to satisfy it (Forste v. Commissioner, T.C. Memo. 2003-103).

Since CPAs are usually their clients’ first line of defense in IRS audits, it is important for them to understand their role when it comes to the burden of proof, and how they can help a client perhaps prevail if the case ends up in litigation.

Prior to 1998, in a civil tax matter, the taxpayer generally had the burden of proving an error in the IRS’s audit findings. However, effective for audits that began after July 22, 1998, Congress enacted a law that, under limited circumstances, shifts the burden of proof to the IRS if the taxpayer introduces credible evidence with respect to any factual issue that is relevant to determining the taxpayer’s tax liability, and satisfies other requirements (Section 3001, IRS Restructuring and Reform Act of 1998, P.L. 105-206, adding Code Sec. 7491).

Since enactment of that law, dozens of taxpayers have attempted to shift the burden of proof to the IRS, but have failed because they didn’t satisfy one or more of the numerous requirements of the 1998 law. The Forste case is the first time that the Tax Court has shifted the burden of proof to the IRS and then decided in a reported case that the IRS failed to satisfy that burden with respect to a part of the case.

In this case, a dispute arose between the taxpayer and his employer and, ultimately, the taxpayer was forced out of employment.

The taxpayer’s lawyer made several tort and non-tort claims against the employer, including unlawful termination, which led to a 1985 settlement in which the employer agreed to pay the taxpayer monthly sums for the rest of his life.

The taxpayer presented several different drafts of the settlement agreement showing that a portion of the settlement was intended to compensate him for personal injuries he suffered as a result of the employer’s actions.

The Tax Court held that the taxpayer was entitled to exclude from income a portion of the settlement payments as damages paid for tort or tort-type personal injury claims. Tax Court Judge Robert Ruwe found that the taxpayer had presented credible evidence showing that $25,130 of the $45,615 received during 1996 was in settlement of the personal injury claims.

The court held that the burden of proof as to whether the $25,130 was received on account of the personal injury claims shifted to the IRS, and since the IRS presented no documents and only one witness who had almost no recollection of the settlement, the IRS failed to satisfy its burden of proof with respect to this amount.

Judge Ruwe also found that the taxpayer had not presented credible evidence showing that the remainder of the settlement payments (i.e. the amount in excess of $25,130) was received in settlement of the claims for personal injury.

To shift the burden of proof to the IRS in any court proceeding, Code Sec. 7491 requires the taxpayer to:

● Introduce credible evidence with respect to any factual issue relevant to determining the taxpayer’s tax liability;

● Comply with all requirements to substantiate any item;

● Maintain all records required under the code;

● Cooperate with the IRS’s reasonable requests for witnesses, information, documents, meetings and interviews; and,

● In the case of a partnership, corporation or trust, the net worth of such entity is $7 million or less.

In addition, the burden of proof for penalties is on the IRS.

CPAs are usually the first line of defense for a client who is audited. As a result, they are usually the client’s representatives in dealings with the IRS.

Two important requirements that must be satisfied in order to shift the burden of proof to the IRS are that the taxpayer must have maintained all records required under the code, and must have cooperated with the IRS’s reasonable requests for witnesses, information, documents, meetings and interviews.

Therefore, it is important for CPAs to inform their clients about the records that must be maintained under the tax laws, and cooperate with the IRS’s audit personnel by timely responding to their reasonable requests for documents and information.

CPAs may have gotten the impression that shifting the burden of proof to the IRS was an impossible task since, prior to the Forste case, no cases were decided in a taxpayer’s favor.

However, as a result of the Forste case, CPAs should now realize that shifting the burden of proof to the IRS is indeed possible, and they can contribute greatly toward helping a client prevail if the audit ultimately winds up in litigation.

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