Immediately after the lead juror announces a “not guilty” verdict in a criminal tax lawsuit, nearly everyone at the counsel table reacts like this. However, just like O.J. Simpson’s legal problems were far from over that day, a criminal tax trial is only round one. Before the ink is dry on the jury form, the IRS may already be planning its next move.

Yet our intrepid readers ask themselves “How can this be in the land of the free and the home of the brave? After all, a jury just looked at the evidence and absolved the taxpayer!” Well, not exactly. A not guilty verdict simply means prosecutors did not present enough evidence to convince the jurors beyond a reasonable doubt, and the outcome may be different in civil court, where the burden of proof is lower.

That burden is clear and convincing evidence, which is between the maybe-and-maybe-not scales of justice in everyday civil court and the near-overwhelming amount of evidence needed to convict a person in criminal court. What’s more, in most civil tax penalty proceedings, the taxpayer has the burden of persuasion (ultimate burden of proof) to establish that a penalty is not due. The Service, in contrast only has a minimal burden of production under Section 7491(c) to demonstrate that it had a rational basis for bringing the action in the first place.

Fraudulent Returns

6663(a) cases almost always follow unsuccessful criminal prosecutions, although they are not unheard of as stand-alone matters. Filing an utterly baseless return is perhaps the most serious allegation in the realm of civil tax penalties, which is probably why the Service bears both the burden of production and burden of persuasion in these cases. Under the innocent spouse doctrine, signing spouses are not liable unless they knowingly participated in the fraud.

If the IRS proves, by clear and convincing evidence, that at least part of the income understatement involved fraud, a 75 percent penalty presumptively applies to the entire understatement and not just the fraudulent portion; the taxpayer can rebut this presumption, and thus limit the penalty, by showing that the remainder of the understated income was not fraudulent.

The big question in this area is what’s the difference between fraudulent and mistaken? Most agents look for two or more badges of fraud before filing a 6663(a) matter:

• Failure to file return,
• “Willful” failure to pay taxes due (which usually means the taxpayer paid any vendors other than the taxman),
• “Intentional” failure to report all income (as a rule of thumb, the Service presumes that anything over about 25 percent was probably intentional),
• False or fraudulent income or deduction claims, and
• A false return.

Statistically, the IRS only brings an infinitesimal number of fraud cases as opposed to honest error cases, which is fairly small comfort if you are the listed defendant.

Fraudulent Failure to File Return

A 6651(f) penalty is based on the net tax due as opposed to the fraudulent portion of the return.

Assume Terry Taxpayer fraudulently did not file a return on April 15 of Year 1, and he would have owed $1,000. On July 15 of Year 2, his conscious gets the best of him (at least to a limited extent) and he files a Year 1 return showing $200 in liability. As for the remainder, half is attributable to honest error and half is outright fraud. By filing the fraudulent return, Terry now only owes $300 (75 percent of the $400 fraudulent amount) in 6663(a) penalties.

If the Service had not brought a previous action against Terry, he is probably looking at felony charges for the fraudulent return; however, a prior criminal matter may be collateral estoppel to a fraudulent failure to file action.

Nonfraudulent Failure to File

In contrast, 6651(a) cases are the most common civil tax penalty matters, because the IRS only has to show a mathematical error and the taxpayer has the nearly impossible burden of showing that the amounts were correct. The penalty is usually 5 percent a month up to a maximum 25 percent. Generally speaking, these are ad valorem penalties which only apply if tax is due. The major exception is filing an inaccurate Form 8300 (a cash transaction over $10,000), which carries a maximum penalty of $25,000 per violation.

The penalty for tax liability declared but not paid is 0.5 percent per month up to a maximum 25 percent. Financial hardship, though not a defense to nonfiling, is a defense to nonpayment. In the event that the failure to file and failure to pay penalties both apply, the failure to pay penalty serves as an offset, to a certain extent.

Finally, there’s the failure to pay estimated tax penalty. It kicks in if the estimated tax payment is both insufficient to cover current tax liability and less than 90 percent of the previous year’s prepayments. For individuals, the penalty is based on the interest rate of the unpaid portion; the calculation is a little different for corporations.

Simpson avoided criminal liability in his 1990s murder trial and then basically ignored a $25 million wrongful death verdict, but ignoring civil penalty proceedings is a big mistake, because things only get worse by sticking your head in the sand.