Gentleman’s Club Owner Hit With Fraud Penalty

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A new Tax Court decision just came out – Potter v. Commissioner, TC Memo 2014-18.  The case involved a “gentleman’s club” owner in Michigan.

In December 2006 IRS special agents engaged in an undercover investigation of Potter’s Pub, posing as buyers interested in acquiring the business. John Potter assured the agents that Potter’s Pub was much more profitable than it appeared (note – great admission of fraud).

Mr. Potter explained that he deposited in the corporate account only enough of the business revenues to cover its expenses and that he wired the balance of its revenues to his personal bank account in Florida.  The wire transfers were structured in amounts less than $10,000 to avoid reporting obligations by the bank to the IRS.

In reality, Mr. Potter told the agents that Potter’s Pub grossed more than $1 million annually and he took home between $400,000 and $520,000 each year.  Mr. Potter showed the agents clandestine sales ledgers for 2003 and 2004 that supported the gross receipts he claimed.

Not surprisingly, Mr. Potter is now a convicted felon a was sentenced to 18 months in prison.  His crime was filing false tax returns. 

As is the normal course of business for the IRS – after it got its “pound of flesh” – the IRS now wants to hit him with the fraud penalty. 

Section 6663(a) of the Internal Revenue Code imposes a 75% penalty on any underpayment of tax that is due to fraud.  Ouch!

In order to establish fraud, courts look at circumstances that may indicate fraud which are known in the tax world as “badges of fraud”:

  1.  understating income
  2.  maintaining inadequate records
  3.  giving implausible or inconsistent explanations of behavior
  4.  concealing income or assets
  5. failing to cooperate with tax authorities
  6.  engaging in illegal activities
  7.  providing incomplete or misleading information to one’s tax preparer
  8.  lack of credibility of the taxpayer’s testimony
  9.  filing false documents, including false income tax returns
  10. failing to file tax returns; and
  11.  dealing in cash

Unfortunately for Mr. Potter he had little defense to the penalty.  His behavior will likely haunt him for many years to come.