The Burden of Proof in Tax Controversies

By George S. Jackson

In Brief

It All Makes Sense

The word was out that the tax restructuring act of 1998 turned completely upside down the issue of who has to prove what in court proceedings involving the IRS. The burden of proof was said to have shifted to the IRS---apparently good news for the taxpayer, but perhaps not such good news for the tax preparer who deals with the IRS and its now apparent need to build a stronger case.

But the tax act did not throw out all the rules regarding what each party has to prove.

A complete understanding requires a look at the issues of burden of proof and standard of proof both before and after the IRS Restructuring and Reform Act of 1998. It is an oversimplification to say that the new law merely shifts the burden of proof in tax liability cases. It does not apply to taxpayer entities above a certain size, and those that do qualify must still meet the "credible evidence" test.

Two tables and two exhibits clarify these somewhat complex issues.

The IRS Restructuring and Reform Act of 1998 (RRA '98), reflects the legislative branch's willingness to address several long-simmering issues pertaining to administration of the tax laws. With bipartisan support of the kind not seen since, Congress enacted provisions that, among other things, reallocate the burden of proof in civil tax litigation.

Ironically, the new burden of proof rules have aroused considerable constituent controversy since first being proposed in the House of Representatives. Most taxpayers seem to favor the revisions, while many tax professionals are wary of them. Practitioners worry that IRS agents, knowing they may have to prove their case if litigation occurs, will become more intrusive during routine taxpayer examinations. Additionally, the complexity of the new burden of proof statutes might result in a surge of malpractice actions directed at tax advisors, who, because they are not trained in legal proceedings, might give faulty advice.

Practitioners and taxpayers will benefit from an overview of the fundamental rules regarding both the burden of proof and the standard of proof in tax adjudications. Pre-RRA '98 rules still come into play because many still apply. The two accompanying "penalty continuum" tables provide convenient pictorial summaries of the applicable provisions. Familiarity with the rules regarding burden of proof lessens the likelihood that an advisor will suggest actions not in a client's best interests.

The Genesis of Litigation: Tax Assessments

The Secretary of Treasury is charged with examining taxpayer returns and, if necessary, making an additional assessment for taxes due. When the IRS, acting in the Secretary's stead, determines that an additional amount is due, it issues a Notice of Deficiency. The notice advises the taxpayer that an additional tax will be assessed in 90 days unless the taxpayer files a petition in the Tax Court.

Civil tax litigation begins in one of two ways: Either the taxpayer files a Tax Court petition before the assessment is rendered, challenging the IRS's determination; or the taxpayer pays the tax, then challenges the assessment by suing for a refund. A refund suit is brought in a U.S. district court or in the U.S. Court of Federal Claims.

Criminal tax litigation works differently. The IRS must determine that a "willful" violation has occurred. Then, the Government brings a judicial action. Criminal prosecution can occur without regard to whether a tax has been assessed. "Intent to evade" is not a required element for the crime of tax evasion. In particularly egregious situations, "reckless disregard" of tax rules, typically a basis for civil fraud, will satisfy the willfulness prerequisite for criminal charges.

Burden of Proof and Standard of Proof

Regardless of how the litigation begins, courts generally follow a long-standing common law tradition. The party bringing the lawsuit must introduce evidence to prove its case. There are two exceptions to this rule: 1) When it is patently unfair to follow the general rule, the courts can relieve the plaintiff of the burden of proving the case; or 2) When statutory provisions set out a different rule, the courts must abide by it. The common law tradition and its two exceptions are often referred to as the "burden of proof" rules.

A Tax Court petition or refund suit is brought by the taxpayer, so under the common law, absent one of the exceptions, the taxpayer has the burden of proving the case. Since the government brings charges in a criminal case, it bears the burden of proof.

Courts sometimes bifurcate the burden of proof into a burden of going forward (introducing evidence) and a burden of persuasion (convincing the court that you are correct). Once a litigant introduces a sufficient amount of competent evidence, she is said to have made a prima facie case. Then, the burden of going forward with additional evidence shifts to the other party. The ultimate burden of persuasion, however, remains with the party that was initially assigned it.

The burden of proof relates only to facts. It is inapplicable to legal arguments. Questions of law are decided without regard to any presumption. Thus, when all facts are stipulated, as they often are in Tax Court cases, the burden issue does not arise.

Standard of proof is a common law term that refers to how convincing the burdened party's case must be. We live with uncertainty, and litigation is no exception. Indeed, the presence of uncertainty is one reason the burden of proof allocation is so important. Often, when both sides have presented their versions of the facts, the judge and jurors aren't sure whom to believe. In this instance, the party with the burden of proof loses because he hasn't met the required standard of proof.

In civil cases, the general standard of proof rule requires the burdened party to persuade the court by a "preponderance of the evidence." The burdened party prevails if the court concludes his or her position is "more likely than not" true. The corollary is that a tie goes to the nonburdened party. In criminal cases, the standard of proof imposed on the burdened party is "beyond a reasonable doubt," which is much more difficult to achieve. Still another standard of proof applies to civil fraud tax cases: "clear and convincing" evidence, a term subject to debate. Clearly, it is more stringent than the preponderance of the evidence and less stringent than beyond a reasonable doubt. RRA '98 does not affect the common law standards of proof.

Pre-RRA '98 Burden of Proof Rules

Prior to RRA '98, the common law rules for burden of proof governed most civil tax litigation. The Tax Court adopted these rules in its early decisions, and the Supreme Court long ago acknowledged their appropriateness.

The pre-RRA '98 statutory exceptions to the common law are set out in the IRC. These statutory provisions are unaffected by the new legislation. For example, IRC section 7454 shifts the burden of proof to the IRS in civil fraud cases. Similarly, IRC section 534 assigns to the commissioner the burden of proof in unreasonable accumulation of earnings and profits cases. Table 1 lists the primary pre-RRA '98 statutory provisions that create exceptions to the general rule.

Occasionally, the courts fashion additional exceptions. When the IRS raises new matters at trial, the courts routinely require it to bear the burden of proof. Similarly, when the government's assessment relies solely upon reconstructed income, most courts will shift the burden of proof to the IRS.

Unfortunately, not all courts agree on the judicially derived exceptions. Different circuits apply different rules, and they sometimes apply accepted rules in different ways. For example, controversy continues to surround which party bears the burden of proof when the IRS loses taxpayer records. Table 2 lists the most widely recognized judicially derived burden of proof provisions. Exhibit 1 utilizes a "penalty continuum" to pictorially depict the pre-RRA '98 burden of proof landscape, absent some of the narrow exceptions.

IRS Restructuring and Reform Act of 1998

RRA '98 includes numerous provisions pertaining to taxpayer rights and protections. Title III of the act addresses the burden of proof issue. IRC section 7491 has been added and reads as follows:

If, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer ... the Secretary shall have the burden of proof.

It is an oversimplification to say that the new law merely shifts the burden of proof in tax liability cases. First, the taxpayer must meet the "credible evidence" test. Then, for individual taxpayers only, the burden shifts if--

* the taxpayer has complied with the requirements (of the IRC) to substantiate any item;

* the taxpayer has maintained all records required [by the IRC] and has cooperated with reasonable requests by the [IRS] for witnesses, information, documents, meetings, and interviews.

Business entities have an additional restriction: owners' equity cannot exceed a certain size. Corporations, partnerships, and trusts with a net worth exceeding $7 million are excluded from the burden-shifting provision of IRC section 7491(a).

Thus, there are four tests that must be met before a taxpayer is relieved of the burden of proof: 1) She must be a qualifying taxpayer; 2) she must present credible evidence; 3) she must satisfy all IRC substantiation requirements; and 4) she must cooperate with the IRS. When this occurs, the standard of proof becomes the critical variable. Exhibit 2 utilizes a penalty continuum to depict the situation.

Even when the tests are satisfied, the RRA '98 rules relieve the taxpayer of the ultimate burden of persuasion only. Still, the taxpayer has the burden of going forward with evidence either at trial or in pre-trial hearings. How else will the court know whether credible evidence has been presented?

The statute itself is silent on the definition of credible evidence. The Senate Finance Committee Report regarding RRA '98 provides limited interpretive guidance: "Credible evidence is the quality of evidence which, after critical analysis, a court would find sufficient ... if no contrary evidence were submitted (without regard to the judicial presumption of IRS correctness)." "Implausible factual assertions, frivolous claims, or tax protestor-type arguments" do not pass the "credible" test. The evidence must be "worthy of belief." Put another way, the taxpayer must make a prima facie case for the burden of proof to shift to the IRS.

The statute's substantiation requirements apply when the legitimacy of a deduction is at issue. The various IRC sections set forth whether the taxpayer has maintained the required records. For example, IRC section 274(d) mandates certain record-keeping requirements for entertainment and gifts.

Determining whether the taxpayer is cooperating with reasonable IRS requests is less certain. The Finance Committee report indicates that this encompasses providing assistance in securing documents not within the control of the taxpayer and exhausting all available administrative remedies before bringing a legal action.

Fortunately, the two other burden shifting provisions in RRA '98 are less tentative:

IRC section 7491(b): In the case of an individual taxpayer, the Secretary shall have the burden of proof in any court proceeding with respect to any item of income which was reconstructed by the Secretary solely through the use of statistical information on unrelated taxpayers.

IRC section 7491(c): Notwithstanding any other provision of this title, the Secretary shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.

The reconstruction of income provision eliminates the uncertainty regarding one of the judicially derived "net worth" exceptions (See Table 2). However, the provision is limited to cases built upon unrelated statistical information. It remains to be seen what impact the new law will have on other new worth methods, such as the receipts and disbursements approach.

The across-the-board shifting of the burden of proof to the IRS in regards to penalties could be the most significant tax litigation provision of the new law. It brings tax litigation in line with the common law rule that the burden of proof rests with the government whenever it attempts to impose fines or penalties. In order to apply the 20% substantial understatement penalty, for example, the IRS will be required to prove the taxpayer's proper tax liability. Note that the new law does not relieve the taxpayer of the burden to prove any affirmative defenses to the penalty, such as substantial authority or reasonable cause.

Creating Better Balance

The explanation contained in the Finance Committee Report best summarizes the purpose of the burden-of-proof provisions of RRA '98:

[A]ll other things being equal, facts asserted by individual and small business taxpayers who cooperate with the IRS and satisfy relevant recordkeeping and substantiation requirements should be accepted. ... The Committee believes that shifting the burden of proof to the
Secretary in such circumstances will create a better balance between the IRS and such taxpayers, without encouraging tax avoidance.

If the taxpayer maintains credible records and exercises reasonable attempts to resolve controversies with the IRS, she should expect that the courts will adjudicate the issues with an unbiased view. The era of arbitrary assumptions on behalf of the government is past. Additionally, if the IRS contends that the taxpayer's conduct deserves a penalty, it should be prepared to prove its case. *

George S. Jackson, JD, LLM, CPA, is a professor and chair of the Walter R. Davis Department of Business & Economics, Elizabeth City State University, N.C. He also serves as a legal and tax advisor to several small businesses and local government agencies.

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