The Eleventh Circuit Court of Appeals, which hears appeals from the federal district courts in Florida, Georgia, and Alabama, ruled earlier this month that in order to impose penalties under IRC § 6701, the government bears the burden of proving each element of the statute by clear and convincing evidence. In so doing, the Eleventh Circuit reversed the holding of the Middle District of Florida that a lower standard, preponderance of the evidence, applies to § 6701. Moreover, the Eleventh Circuit’s decision was contrary to the Second and Eighth Circuits, which have held that proof by a preponderance of the evidence is the proper standard. The Eleventh Circuit’s decision also created precedential case law that tax practitioners can potentially use to defend their clients from civil penalties beyond just § 6701.
The case before the Eleventh Circuit, Carlson v. United States, involved a tax return preparer, Frances Carlson, working for two companies doing business as Jackson Hewitt. Prior to starting this job, Carlson did not have any professional tax return experience. In this position, Carlson prepared both individual and corporate returns. In total, Carlson worked for Jackson Hewitt for five years and prepared between 1200 and 1500 tax returns.
In 2006, the owner of the two Jackson Hewitt franchises that employed Carlson was arrested for, among other crimes, money laundering. The arrest prompted an investigation of the businesses by the IRS. In its investigation, the IRS determined that approximately 40 of the returns prepared by Carlson during the course of her employment contained unsubstantiated deductions. The IRS thereafter assessed penalties against Carlson under IRC § 6701(a), which imposes a penalty against any person who:
(1) aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document,
(2) knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and
(3) knows that such portion (if so used) would result in an understatement of the liability for tax of another person.
Carlson paid 15 percent of the assessed penalty, filed a claim for refund, which was rejected, and then sued in the district court for a refund. Prior to trial, the IRS conceded 13 of the 40 penalties (one for each return bearing unsubstantiated deductions), leaving 27 penalties to determine. At trial, Carlson moved for judgment as a matter of law as to 5 of those penalties because the Government had failed to introduce any evidence that Carlson knew the returns she prepared were incorrect. The district court denied the motion and all 27 penalties went to the jury. Carlson then objected to the district court’s jury instruction that the Government’s burden of proof under IRC § 6701 was proof by a preponderance of the evidence rather than by clear and convincing evidence. The Court overruled the objection and the jury returned a verdict in favor of the government on all of the 27 penalties at issue, resulting in a judgment of $119,173.12 against Carlson.
The Eleventh Circuit’s Reasoning
On appeal, the Eleventh Circuit determined that the district court was incorrect in its jury instruction and in denying Carlson’s motion for judgment as a matter of law. In reversing the district court on the jury instruction issue, the Eleventh Circuit began by stating that under its longstanding precedent, the Government’s burden for proving fraud in a civil tax case was “clear and convincing evidence.” Based on this principle, the Eleventh Circuit stated that the pertinent question before it was whether § 6701 requires the Government to prove fraud. If so, then the proper burden of proof is “clear and convincing evidence.”
In holding that § 6701 does require the Government to prove fraud, the Eleventh Circuit analyzed the text of § 6701(a), particularly subsection (a)(3) which requires the defendant to “know[s] that such portion [of a return or other document] (if so used) would result in an understatement of the liability for tax of another person…”
Section 6701(a)(3) contains the statute’s scienter requirement–the state of mind the defendant must have had to be liable under the statute. The Eleventh Circuit read § 6701(a)(3) to require actual knowledge by the return preparer that the return the prepare had assisted in the preparation of would deprive the government of tax that is owed to it. To the Eleventh Circuit, § 6701’s requirement of actual knowledge of the understated tax is akin to “the preparer deceitfully prepar[ing] a return knowing it misrepresented or concealed something that understates the correct tax,” which amounts to “a classic case of fraudulent conduct.”
The Government attempted to argue that the statute could not require a finding of fraud, and therefore could not necessarily require clear proof of a violation by clear and convincing evidence, because the statute does not contain the word “fraud.” The Court summarily rejected that argument as elevating form over substance—“the lack of the word ‘fraud’ is immaterial if the conduct the government must prove meets the definition of fraud.”
Moreover, the Government itself had previously argued that because § 6701 is an anti-fraud provision, no statute of limitation applied to deficiencies resulting from actions prohibited under § 6701. Thus, the government was seeking to cabin the characteristics of fraud contained in § 6701 to situations in which only it benefitted.
Creation of a Circuit Split
In holding that § 6701 requires proof by “clear and convincing evidence,” the Eleventh Circuit contradicted the Second Circuit and the Eighth Circuit Courts of Appeal. In Mattingly v. United States, 924 F.3d 785 (8th Cir. 1991), the Eighth Circuit determined that § 6701 requires proof by a preponderance of the evidence for two reasons (which the Second Circuit followed without much elaboration in Barr v. United States, 67 F.3d 469 (2d Cir. 1995)): first, the Eighth Circuit reasoned that § 6701 does not require proof of fraud (and thus does not require a heightened standard of proof) because it does not refer to the “evasion of tax.” The Eleventh Circuit in Carlson rejected this notion because it could not discern a reason why a reference to evasion of tax in § 6701 was relevant to its analysis of the burden of proof imposed by § 6701. Moreover, the Eleventh Circuit reasoned, even if it were necessary for the statute to reference tax evasion to implicate a higher standard of proof, § 6701 does reference tax evasion (without explicitly using that phrase) due to its requirement that the return preparer’s knowing violation “result in an understatement of the liability for tax of another person.”
Second, in Mattingly, the Eighth Circuit reasoned that the structure of sections 6700, 6701, 6702, and 6703 suggests the application of a uniform standard of proof. The Eleventh Circuit dismissed this reasoning on the basis that applying standards of proof based on a statute’s relationship to other statutes could lead to perverse results. Additionally, even if sections 6700-6703 suggest the need to apply a uniform standard of proof, there is no specified standard of proof for those sections. Thus, there is nothing specifically requiring a court to impose a preponderance of the evidence standard over a clear and convincing evidence standard in any of those statutes.
Finally, the Eighth Circuit, in justifying the application of a lower standard of proof to § 6701, reasoned that § 6701 was enacted as “another piece in the expansive non-fraud penalty scheme” applicable to taxpayers and tax preparers. In refusing to follow this rationale, the Eleventh Circuit, drawing on the case of Sansom v. United States, 703 F.Supp. 1505 (N.D. Fla. 1988), identified three penalties applicable to tax preparers, IRC §§ 6694(a), 6694(b), and 6701. Of those, only § 6701 requires the return preparer to actually know that that the return understates the proper amount of tax, thus suggesting that § 6701 was unique among those three statutes and worthy of a higher standard of proof.
After rejecting the approach taken by the Second and Eighth Circuits and holding that the imposition of penalties under § 6701 required proof by clear and convincing evidence, the Eleventh Circuit further determined that the district court’s application of the incorrect standard of proof was not harmless and required a new trial.
Additionally, the Eleventh Circuit reversed the district court’s decision to deny Carlson’s motion for judgment as a matter of law as to the penalties imposed on five specific returns. With regard to each of these five penalties, the Government only presented evidence that the taxpayer assisted by Carlson did not substantiate the claimed deductions. The Government did not present evidence that Carlson actually knew the returns understated the correct tax.
A verdict based on evidence that merely demonstrates that the taxpayers could not substantiate their deductions would have the effect of improperly transferring the burden to Carlson to prove that she did not actually know of the error, as opposed to the Government proving she did know of the error. Additionally, it would be an impermissible inference by a jury to conclude that Carlson actually knew of the error based solely on the fact that the taxpayer could not substantiate his deduction—the presence of an incorrect deduction does not prove that the return prepare knew the return was inaccurate.
Because the government failed to present any evidence as to Carlson’s knowledge of the inaccurate returns on these five penalties, the Eleventh Circuit held that Carlson’s motion for judgment as a matter of law should have been granted. The Eleventh Circuit went out of its way to state that it was not deciding what standard of proof should be used to review a district court’s denial of a motion for judgment as a matter of law on § 6701 penalties (as opposed to the context of jury instructions, which it did decide). Under either the preponderance of the evidence or clear and convincing evidence standards, the government’s failure to introduce any evidence of Carlson’s knowledge required judgment as a matter of law in Carlson’s favor.
The Carlson decision is an important victory for tax return preparers operating in the Eleventh Circuit. Under a fair reading of the decision, tax return preparers are entitled to rely upon the information supplied to them by the taxpayer, without the fear of being accused they were “willfully blind” to the errors contained in the taxpayer’s claimed deductions. Additionally, by deciding the question in contravention of the Eighth and Second Circuits, the Eleventh Circuit has created a circuit split, heightening the chances the Supreme Court may ultimately decide the question.
Potential Relevance in Other Contexts
i. Willful FBAR Violations
It remains to be seen if the Eleventh Circuit’s articulation of the burden of proof under IRC § 6701 will translate to or be adopted in other areas where the correct burden of proof is less than clear. A very active area where the burden of proof is less than clear is the imposition of willfulness penalties for failing to file a Report of Foreign Bank Account (“FBAR”). A non-willful failure to file an FBAR may lead to a penalty of $10,000 per violation, but a willful failure to file an FBAR can lead to a penalty of the greater of $100,000 or 50 percent of the highest balance in the undisclosed account during the given year, so the determination of willfulness or non-willfulness is an important one.
There is a dearth of judicial precedent regarding the proper burden of proof in determining willfulness in the FBAR context. In a recent high profile case, United States v. Zwerner, the Southern District of Florida submitted the willfulness question to the jury with the instruction to apply the preponderance of the evidence standard, and the jury found that the taxpayer had willfully failed to meet his FBAR obligations.
While the amount of the penalty to be imposed in the Zwerner case settled before the jury’s verdict could be appealed, some have speculated that had the Eleventh Circuit’s decision in Carlson been released earlier, the taxpayer in Zwerner would have had leverage to seek a more favorable settlement. This is because under Carlson, the imposition of civil penalties based on fraudulent conduct requires the Government to prove its case by clear and convincing evidence, even where the subject statute does not explicitly reference fraud. Rather, under Carlson, the key determination was whether the return preparer knew that her actions would result in the understatement of liability for the taxpayer, which the Eleventh Circuit held to be synonymous with fraud.
Willfulness is generally defined as an intentional violation of a known legal duty. It can be effectively argued that knowingly taking action that would result in an understatement of liability (which the Eleventh Circuit held in Carlson to require proof by clear and convincing evidence) is analogous to an intentional (i.e. knowing) violation of the FBAR requirement. Hence, establishing willfulness for purposes of applying the higher civil FBAR penalty should require proof by clear and convincing evidence just as proving the elements of a § 6701 violation now (in the Eleventh Circuit at least) requires proof by clear and convincing evidence.
While there are certainly counterarguments as to why the Carlson should not extend to the context of FBARs, the Carlson decision certainly provides a weapon for clever and resourceful tax attorneys to use in defense against civil penalties imposed beyond the scope of IRC § 6701.
ii. The Offshore Voluntary Disclosure Program
In a related issue, the IRS recently modified the rules applicable to its Offshore Voluntary Disclosure Program (OVDP). As we wrote about more extensively here, a key determination regarding what type of voluntary disclosure a taxpayer may make is whether that taxpayer’s past non-compliance (such as failure to file FBARs) was willful or non-willful. In general, far more lenient treatment is provided to those OVDP filers who successfully establish that their past non-compliance was not willful.
The problem, as more thoroughly explained in our previous blog entry, is that defining “non-willfulness” in the context of the OVDP is extremely difficult. Under the new OVDP rules, the ultimate arbiter of whether an OVDP filer’s past non-compliance was or was not willful is the IRS—its determinations are final and the methodology it will employ in evaluating willfulness is unknown to both taxpayers and to IRS personnel.
To compound the uncertainty, as the Carlson case demonstrates, not even the Circuit Courts of Appeal are in agreement as to what proof is required to establish certain penalties, such as those imposed under § 6701, that are based on the violator’s knowledge and willfulness, and there appears to be no circuit-level authority regarding the standard of proof for imposing civil, willful FBAR penalties. The disagreement and lack of guidance from the courts on these points simply exacerbates the uncertainty surrounding how the IRS will evaluate willfulness in the OVDP and leaves potential OVDP filers searching for answers.