Lesson From The Tax Court: The Cheeky' Way To Avoid The Fraud Penalty

Courts and commentators often tout the voluntary nature of the United States tax system.  In one sense, the claim is true.  The tax determination process ultimately rests on taxpayers disclosing their financial affairs and paying what they owe---through withholding or otherwise---without overt government compulsion.  It is voluntary just like stopping one's car at a red light---at midnight with no traffic---is voluntary.  It takes each citizen's disciplined self-enforcement of the legal duty to keep both the tax and transportation systems running smoothly.

But saying the system is voluntary is also misleading.  The discipline of self-reporting and payment cannot be divorced from the constant coercive threat of discovery and the resulting civil or criminal sanctions.  It's Bentham’s Panopticon.  Congress weaves together civil and criminal penalties to enforce the legal duties to report and pay taxes.  It leaves the ever unpopular IRS to swing the net.  By my count, Chapter 68 of the Tax Code contains 48 separate civil penalty provisions to catch out taxpayers.

Today’s lesson concerns the §6663 fraud penalty.  On December 26, 2018, the Tax Court issued its opinion in Richard C. Mathews v. Commissioner, T.C. Memo 2018-212.  The decision was a holiday gift to a pro se taxpayer who was contesting deficiencies (and fraud penalties) assessed well after the normal three year limitation period had expired.  The IRS relied on the fraud exception in §6501(c)(1) but was unable to convince Judge Vasquez that the taxpayer had the necessary fraudulent intent.  This was likely a surprising result to the IRS because the taxpayer had: (1) lied to IRS agents; (2) massively unreported gross receipts for the two years at issue and many years before that; and (3) been convicted of the §7206 crime of subscribing to false tax returns for the years at issue.  To find out how the taxpayer dodged the fraud penalty bullet, read on.

The Law

The concept of fraud crops up in a number of tax procedure statutes.  Two are relevant today: §6501(c) and §6663(a). Normally, the IRS has three years to audit a filed return for accuracy. §6501(a). But §6501(c) provides that filing “a false or fraudulent return with the intent to evade tax,” removes the time limit, and gives the IRS unlimited time to audit. Similarly, §6663(a) says that if the taxpayer has underpaid a tax and any part of that underpayment is due to fraud, then the IRS can assess a penalty of 75% of the underpayment that was due to fraud.

Courts treat fraud for §6501(c) purposes the same as for §6663(a) purposes. See e.g. Schaffer v. Commissioner, 779 F.2d 849 (2d Cir.1985).  In both statutes, fraud means “actual, intentional wrongdoing, and the intent required is the specific purpose to evade a tax believed to be owing.” Porter v. Commissioner, T.C. Memo 2015-122 (a very nice opinion by Judge Marvel).

The IRS generally must prove fraud by clear and convincing evidence.  The IRS can avoid having to produce evidence in two situations. First, a taxpayer who has been previously convicted of a crime involving the same issue of fraud will be precluded from re-litigating that issue in the later Tax Court action.  For example, a conviction under §7201 (tax evasion) will preclude a taxpayer from contesting the issue of fraud in a later Tax Court case involving the §6663 fraud penalty.  Amos v. Commissioner, 360 F.2d 358 (4th Cir. 1965).  In contrast, a conviction under §7206 for signing a tax return which the taxpayer “does not believe to be true and correct as to every material matter,” does not estop the taxpayer from later contesting the issue of fraud. Wright v. Commissioner, 84 T.C. 636 (1985).  That is because a conviction under §7206 does not involve the same issue of intent as does the §6663(a) fraud penalty. It involves an intent to file a return containing false information, regardless of whether that information resulted in an evasion of tax.

Stipulations are the second way the IRS can avoid having to produce evidence.  The taxpayer might stipulate to the fraud.  More commonly, a taxpayer will fail to properly and timely respond to the IRS’s proposed stipulations.  In that case, Tax Court Rule 91(f)(3) provides that “the proposed stipulation or portion thereof...will be deemed stipulated for purposes of the pending case.” Rule 91(e) provides that any stipulation “shall be treated, to the extent of its terms, as a conclusive admission by the parties.... The Court will not permit a party to a stipulation to qualify, change, or contradict a stipulation in whole or in part, except that it may do so where justice requires.”

When the IRS does have to produce evidence, it rarely has direct evidence of the taxpayer’s subjective intent to avoid taxes. Courts generally allow the IRS to prove fraud by showing the court that the taxpayer’s objective actions were “badges” of fraud.  Judge Vasquez lists 11 of the badges in the Mathews opinion.  Two of the most common badges are underreporting or concealing income---especially when the behavior continues for a number of years---and attempts to mislead or lie to IRS agents.  When the IRS can accumulate enough badges, it can meet its burden of persuasion.   The Porter case gives a good example of how multiple badges of fraud might apply.

A taxpayer can negate the objective badges of fraud by proving that the taxpayer had a subjective, good-faith misunderstanding of the law.  Judge Marvel calls this the Cheek defense in reference to the classic Supreme Court case Cheek v. United States, 498 U.S. 192 (1991). In Cheek, the taxpayer was tried for criminal tax evasion under §7201.  Part of Mr. Cheek’s defense was that he honestly did not believe wages were income within the meaning of §61 and he honestly believed he was not a taxpayer within the meaning of the Code.  Both beliefs were highly unreasonable.  The trial court told the jury that Mr. Cheek’s honest but unreasonable beliefs were not a defense.  The jury convicted under that instruction.  The Court of Appeals affirmed the conviction but the Supreme Court reversed, holding that a taxpayer who operates on a good-faith misunderstanding of the law cannot commit fraud, even if the taxpayer’s understanding is objectively unreasonable.

The Cheek case was about criminal fraud.  The Tax Court, however, has allowed taxpayers to use the Cheek defense against civil fraud penalties as well.  Niedringhaus v. Commissioner, 99 T.C. 202 (1992).  But the Cheek defense is limited.  As Judge Marvel explained in Porter:

“Only a good-faith misunderstanding of the law, where a taxpayer misconstrues the tax laws and honestly but incorrectly believes that a particular law is not applicable to his situation, may negate fraudulent intent. See . Conversely, a good-faith disagreement with the law shows that the taxpayer was “fully aware of his legal obligations and simply * * * [disagrees] with his known legal duty”. Id. This type of disagreement does not negate fraudulent intent. Similarly, a taxpayer who contends that the law is unconstitutional cannot rely on Cheek as a defense to the fraudulent failure to file addition to tax.”

The Facts

Mr. Mathews was heavily involved in multi-level marketing (MLM) during the years in question.  Participants in MLM activities make money two ways: (1) directly, from selling products; (2) indirectly, by recruiting downstream distributors to sell the same products and taking a cut of the downstream distributor’s gross receipts.  MLM activities are like pyramid schemes in that the folks who get in early get to draw a bigger indirect revenue stream and folks who get in later have a harder time developing new downstream distributors.  Well established MLM activities like Amway or Herbalife, are the basis for what I call the blue collar tax shelter because the folks who get in are generally too late to make any money from further downstream distributors and tend to join in order to buy personal products at a discount and then claim a “business” loss when those “business” expenses exceed their meager receipts. See e.g. Theisen v. Commissioner, T.C. Memo 1997-539, where Mr. Theisen testified:

“The way the plan is written is, you're taught to purchase things from yourself for yourself, and you get other people -- say, Look. Just change your buying habits. Don't go to HEB. Don't go to Eckerd's. Don't go to Sam's. You get access to all these products. Change your buying habits. Buy things for yourself.”

For those who start an MLM, however, there is money to be made by being at the top of a pyramid.  That is apparently what Mr. Mathews did.  He started a variety of MLM schemes in the late 1980's or early 1990's and then moved to the internet in the early 2000's.  In 2007 his MLM activities collectively brought him gross receipts of $67,000.  In 2008 they dropped some $103,000 in his bank accounts.  In 2007, however, Mr. Mathews reported gross receipts of only $5,000 (and net profit of $3,700) and in 2008 he reported no income from his MLM activities and only a $10,000 payment from an unrelated entity that had sent him a 1099.  It also appears in the opinion that he had not reported any income from his MLM activities for the prior 17 years.

Repeated and serious underreporting of gross income is one badge of fraud.

In October 2007 Mr. Mathews’ 2005 return was selected for audit.  Mr. Mathews’ evasive behavior with the Revenue Agent caused the RA to first expand the audit to 2004 and 2003, and then, eventually, to refer the matter to Criminal Investigation. Mr. Mathews was also evasive with the Special Agent.  For example, he denied having any cash in the house other than what was in his pocket.  When, within hours, a search of the house turned up two fire safes, one with $3,000 cash and one with $10,000 cash, Mr. Mathews denied he had ever seen the second safe and had just forgotten about the first.  He later admitted that both were his.

Repeated and serious evasiveness with an RA or SA is another badge of fraud.

Eventually, Mr. Mathews’ behavior resulting in the SA and RA having to perform complex detective work to uncover his web of activities, bank accounts, and offshore trusts. Mr. Mathews kept poor records and had created multiple websites, payment platforms, and bank accounts.  The IRS agents had to obtain information from third parties that Mr. Mathews could not provide. 

A failure to keep adequate books and records is another badge of fraud.

The SA concluded that Mr. Mathews should be criminally prosecuted for his behavior.  Mr. Mathews was indicted in 2001 for tax evasion under §7201 for tax years 2004 through 2008 and for subscribing to a false return under §7206 for the same years.  In a superseding indictment, however, the §7201 charge was dropped.  Mr. Mathews went to trial on the §7206 charge and a jury convicted him.  The conviction was upheld by the Eight Circuit.  United States v. Mathews, 761 F.3d 891 (8th Cir. 2014).  He was sentenced to 27 months in prison and ordered to pay the government some $57,000 in restitution.  Judge Vasquez’s opinion is silent on how much time Mr. Mathews served.

In his criminal trial Mr. Mathews raised the Cheek defense.  The jury did not accept it.

After the criminal trial, the civil audits resumed and the IRS sent Mr. Mathews Notices of Deficiency for the 2007 and 2008 tax years, apparently sometime in 2014 and 2015 (the opinion does not say but the docket numbers are for 2014 and 2015).  This was too late unless the IRS could prove fraud and claim the fraud exception in §6501(c).

The Opinion

Judge Vasquez found the IRS failed to show fraud by clear and convincing evidence.  He wrote: “we believe [Mr. Mathews] was genuinely confused about the taxability of the Multi-Service program income when he filed his 2007 and 2008 returns.” Judge Vasquez then cites to Cheek.

In other words, the Cheek defense that did not work in the criminal trial worked in Tax Court.  Let’s look at why.

Judge Vasquez writes a very detailed and thorough opinion that appears to rely heavily on his central finding that Mr. Mathews was an unsophisticated taxpayer. For example, he writes:

“Petitioner is not a sophisticated taxpayer or financially astute. He dropped out of high school after the 10th grade and has no training or experience in bookkeeping, taxation, or accounting. At trial he appeared confused about the nature of this tax liabilities and, at one point, credibly testified: “[I]t’s over my head.” Given petitioner’s lack of sophistication, we question whether he knew there was a “tax owing” from the Multi-Service programs when he prepared his 2007 and 2008 returns. Petitioner consistently maintained throughout trial that he “didn’t know” how to report income..."

In other parts of the opinion Judge Vasquez emphasizes how Mr. Mathews appeared in 2007 and 2008 to have also been "genuinely confused" about how to report his MLM activities for those years.  If that were the basis of Judge Vasquez's opinion, one may rightfully think it reflects a misunderstanding of the Cheek defense.  Honest confusion is not the same as honest belief.  If a taxpayer is honestly confused, the taxpayer needs to consult with someone who can help.  Otherwise, the confusion slides into a willful ignorance and that is not good faith.  The First Circuit Court of Appeals explained in United States v. Anthony, 545 F.3d 60, 65 (1st Cir.2008):

“the defense that the accused did not know of his duty fails if he came by his ignorance through deliberate avoidance of materials that would have apprised him of his duty, as such avoidance undermines the claim of good faith. Other circuits share our conclusion that Cheek does not foreclose the use of a willful blindness instruction in tax-avoidance cases in general.”

Judge Vasquez, however, linked the confusion to an affirmative belief, writing: “from the record, it appears that the source of petitioner’s confusion was his belief that 90% of the funds he received through the Multi-Service programs belonged to the member recruiters.”

Several facts laid out in the opinion might lead a reader to question the good faith of Mr. Mathew's claimed belief.

First, if he really believed that 90% of the fund he received were not his, then why did he not even report the remaining 10% of the gross receipts on his returns?  For example, of the total gross receipts in 2008 of $103,000 that Mr. Mathews received, Mr. Mathews reported none of them.

Second, the opinion describes Mr. Mathews reporting behavior for the 2003-2008 years as only reporting income when he received a 1099 or W-2.  For example, although he reported none of his MLM activity receipts in 2008, he did report a $10,000 payment for which he had received a 1099.

Third, Mr. Mathews ran these activities for some 17 years.  You would think that if his belief that 90% of the payments made were supposed to be returned (at some point) to the subscribers, he would be able to show that he actually did that.  Judge Vasquez's opinion silent on that point.  But the Eighth Circuit Court of Appeals opinion affirming the criminal conviction is not.  It says: “Mathews claimed the gross receipts were not income to him, but were paid out to members of one of his businesses. However, Mathews was unable to identify any payments to members from his accounts in those years.”

Despite these points, Judge Vasquez believed enough of Mr. Mathews testimony to find that Mr. Mathews successfully raised the Cheek defense.  Accordingly, Judge Vasquez also relieved Mr. Mathews from the onerous Rule 91 consequence of having failed to respond to the IRS proposed stipulations of fact.

Lesson

To win a Cheek defense, one must convince the finder of fact.   The lesson here is that a good live witness can overcome any number of otherwise highly suspicious facts in a case.  In this case, Judge Vasquez was persuaded by the credible testimony of Mr. Mathews.  Even so, Judge Vasquez acknowledges "this is a close case.”  And perhaps a different fact-finder would have come to a different conclusion.  But neither you nor I, dear reader, are the fact-finders.  We weren’t there to see and hear the witness.  Judge Vasquez was.  It was his job to sort through the facts presented, including the live testimony.  That's why we call him "Judge."  

Coda: Mr. Mathews is apparently still in the MLM business.  Here are two of his websites: Wealth Team International Association 2.0 and Glad Club 2.0.  Notice the "2.0" designation.  One hopes that in this second iteration he pay his taxes.