IRS Loses: I.R.S. Defrauded Tax Court, a Judge Rules
by David Cay Johnston
The Internal Revenue Service committed fraud by brokering secret deals with two
airline pilots to let them escape taxes in return for testifying against 1,300 other
pilots who bought into the same tax shelters, a federal appeals court ruled Friday.
The Ninth Circuit Court of Appeals in San Francisco said that the remedy for this
"extreme misconduct" by the I.R.S. was to give all of the pilots the same
corrupt deal that one of the pilots got.
That pilot, John R. Thompson, settled his taxes from the shelter for a dime on the
dollar, but actually paid nothing, court papers show. Instead, Mr. Thompson received
a $60,000 refund through falsified tax returns prepared with the help of the I.R.S.
That money paid his legal fees. He also pocketed $20,000 in interest, court papers
The ruling will require the I.R.S. to pay tens of millions of dollars in tax refunds,
interest and legal fees, said Michael Louis Minns, a Houston tax lawyer who represented
some of the pilots. One pilot, who paid the disputed taxes more than two decades
ago and then took the I.R.S. to tax court, is due about $6 million, Mr. Minns said.
Some pilots, who did not pay the taxes, will receive nothing, but will have tax
liens removed from their homes, Mr. Minns said.
An I.R.S. spokesman, Terry L. Lemons, said yesterday that the agency had no comment.
The case involves tax shelters sold in the 1970s and early 1980's by Henry Kersting,
who was a German U-boat commander in World War II. He sold tax shelters from his
Honolulu office until he died three years ago.
The I.R.S. uncovered this Kersting scheme, which involved fabricating debt that
clients could deduct on their tax returns. In 1981 it disallowed the deductions
and sent bills to 1,300 pilots for additional taxes and penalties.
The appeals court said that rather than try the case honestly, two I.R.S. lawyers
made a secret deal with Mr. Thompson and a second pilot that let them escape taxes
in return for giving testimony favorable to the I.R.S. "The taxpayers have
clearly and convincingly demonstrated fraud on the court and are entitled to relief,"
the judges wrote, noting that the fraud continued through two separate trials in
tax court. "The I.R.S. had an opportunity to present its case fairly and properly."
Judge Michael Daly Hawkins criticized the I.R.S. for not taking serious action against
its lawyers, Kenneth W. McWade, who tried the case, and his supervisor, William
A. Sims. The court said the two lawyers "defiled the sanctity of the court
and the confidence of all future litigants."
The I.R.S. "has done little to punish the misconduct and even less to dissuade
future abuse," Judge Hawkins wrote. He noted that both lawyers received $1,000
bonuses from the I.R.S. for their work in the case. They also received two week
suspensions, after which Mr. McWade retired. Mr. Sims continues as an I.R.S. lawyer.
Mr. McWade and Mr. Sims, in testimony, insisted that they had behaved properly at
all times. Mr. Minns says that he wants both men disbarred, but cannot find a record
of their law licenses. He said he wrote to the I.R.S., which replied that it was
unaware of where they are licensed either, but noting that it only looked in a public
directory of lawyers and not in its own files.
The court said it would be unfair to let the pilots escape the taxes they owed just
because of the fraud by the I.R.S. So, instead, it directed the Tax Court to give
each pilot a settlement "on terms equivalent to those provided in the settlement
agreement" with Mr. Thompson.
Unrecorded deed beats IRS
A couple deeded real estate to their son shortly before the IRS tried to put a lien on the real estate to collect their past-due taxes. The IRS argued that the deed was invalid because it had not been recorded in the county courthouse as the law required.
A deed is recorded to give notice to third parties of a property's status. But because an IRS agent who had been dealing with the couple had been aware of the transaction, such notice was not required for the IRS. Thus, the deed was effective. Because it conveyed the property before the IRS issued the tax liens, the property escapes the liens.
Arthur D. Dalessandro, M.D. Pa., No. 3 :CV-93-00105
Fifth Amendment rights preserved
The IRS selected John Berry for a random audit, but he refused to comply, invoking his Fifth Amendment right against self-incrimination. The IRS then summoned all of Berry's tax records.
The summons against Berry was invalid because the IRS didn't know that the summoned records existed. Forcing Berry to produce records would in effect make him testify against himself by admitting that the records did exist.
Late amended claim is allowed
A refund claim was filed just before the filing deadline. After the deadline, the taxpayer discovered that the refund had been underestimated and filed an amended claim for a larger amount. But the IRS said it was too late.
The new claim was simply an adjustment of the original, timely claim, so it was allowed.
Can't collect interest after losing return for 11 years
In 1987, an individual filed an amended tax return claiming a loss carryback that he thought paid off a prior year's tax. In 1998, during a later tax dispute, he received an inexplicable tax bill and asked the IRS about the amended 1987 return. The IRS then realized it had lost the return, found it, processed it—and added 11 years of interest to the tax bill. The individual protested.
The individual's tax in fact had been underpaid, but this was entirely due to the IRS's error in losing the amended return and not telling him the status of his tax bill even when he had asked. So the IRS must abate the interest charge.
Nicholas J. Paihnich, TC Memo 2003-297
Conviction overturned due to abusive search warrant
A tax professional was criminally convicted of advising clients to cheat on their taxes. The IRS used evidence it obtained by seizing his computers, client files, correspondence, seminar videos and many other business materials. But the adviser said the evidence had been obtained illegally and should be thrown out.
Court of Appeals:
The search warrant used by the IRS to seize the evidence was so expansive as to cover virtually anything in the adviser's office. Since it failed to be "reasonably specific" and state the activity being investigated, it was defective. So the adviser gets a new trial—without the ill gotten evidence.
Alfred G. Bridges. CA-9, No. 01-30316
Under-reporting income isn't fraud
John Maloney knowingly understated his income for a year. The IRS said this was fraud, so it could asses back taxes even though the status of limitations otherwise would have expired for the year.
While Maloney had under-reported his income for the year, he believed this merely offset the amount by which he had over-reported his income the prior year. He also kept good books and records, gave all necessary information to his accountant and cooperated with the IRS. None of this indicated and intent to evade tax—so there was no fraud and the limitations period did protect his return.
Occasional inventor doesn't owe self-employment tax
Melvin Levinson operated a retail store for more than 40 years and in his spare time created and patented various inventions. On his tax return, he reported royalty income from patents and settlement payments he received from a business that had infringed his patents. The IRS imposed self-employment tax on his invention related income.
Levinson did not design inventions regularly or continuously, but only sporadically. Thus, he was not engaged in the "trade or business" of inventing and does not owe self-employment tax on his invention-related income.
Lack of fraud saves businessman from paying tax
The IRS sent a tax deficiency notice to a businessman more than three years after he filled his tax return. It said the statute of limitations shouldn't apply because he had committed tax fraud. It claimed his tax underpayments were consistent with acknowledged skill in business—and pointed out he previously been convicted of filing a false return.
Tax fraud consists of activity hiding income from the IRS and the IRS had no evidence that the businessman had done that. Underpaying taxes is not fraud and neither is filing a false return. So the three-year limit applied and the businessman was safe from tax.
Must cooperate with request for information
Louis Peyton filed a Freedom of Information Act (FOIA) request with the IRS for documents indexed under his name regarding a criminal case being investigated by an IRS agent in Virginia. The IRS refused, saying the request wasn't specific enough and hadn't been filed in the Richmond, Virginia office.
The IRS, like other government agencies, is capable of finding documents indexed under an individual's name—so long as sufficient information has been provided to it. And the IRS is capable of forwarding the request to its Richmond Office itself. It was ordered to comply with the FOIA request.
Taxpayer keeps excess refund
The IRS mistakenly double-credited Raymond O'Bryant's account for a $28,000 tax payment he had made. They sent him a refund in the same amount, plus interest. Later the IRS realized its error, said the original tax bill remained unpaid and put a lien on O'Bryant's property.
The original tax debt was extinguished when O'Bryant made his payment. The problems that followed were the fault of the IRS. To recover the refund, it had to bring a separate action—and it had failed to do so before the statute of limitations ran out. So the lien was lifted and O'Bryant kept the refund.
Must release its own valuation expert's report
Richard Bennett claimed a $236,000 deduction for items he donated to a charity, but the IRS said the items had no value and disallowed the entire deduction. Later, Bennett learned that the IRS' initial appraisal of the items said they did have value—and that the IRS then obtained a second opinion from another appraiser who said they had no value. Bennett demanded that the IRS release its initial appraisal to him, but the IRS said that because it hadn't used the initial appraisal it was irrelevant to the case.
The appraisal was relevant to the issue of the items' value, so the IRS must produce it.
Transposed street number voids notice
The IRS mailed a deficiency notice to the wrong street number, 750 instead of 705, but told the Tax Court that this didn't matter because the local mail carrier knew the addressee and tried to deliver the notice to the correct address. However, the mail carrier did not testify.
The deficiency notice had been mailed to the wrong address, and the IRS had presented no evidence showing that it had actually delivered to the right address so the notice was invalid.
Deposit defeats levy
An attorney held funds for a client who was being sued by several creditors who wanted the money, including the IRS. The IRS levied on the funds, but instead of turning them over the attorney proposed to deposit them with the court and remove himself from the dispute. However, the IRS insisted on holding the attorney liable for the money.
For the attorney, it was reasonable for him to turn funds over to the court until the issue was decided. And because he never made any claim to the funds himself, it was reasonable to prevent creditors—including the IRS—from holding him accountable for them.
When the IRS brought a criminal charge against Bernhard Manko for tax fraud, he tried to get into evidence the fact that in an earlier civil tax proceeding the IRS had agreed to a compromise settlement of the same tax bill that it now said was fraudulent. Mr. Manko said that by agreeing to the compromise the IRS had admitted that his tax position was at least partly legitimate. But the court barred the compromise agreement as evidence and Mr. Manko was convicted. He appealed.
Court of Appeals:
For Mr. Manko. The agreement should have been admitted as evidence, so the conviction is vacated.
More IRS Loses to come, so check back often