Conduct During IRS Audit Evidence of Tax Return Fraud – Houston Tax Attorneys

The courts have taken an expansive view as to what counts as fraud for tax matters. Some courts have even said taxpayers can be held accountable for fraud committed by their tax return preparers.

When considering fraud, there is a question as to what activities are considered. Take for example the civil tax fraud penalty. This civil penalty applies to understatements of tax. This means that the relevant timeframe would seem to be the time leading up to and culminating with the filing of the tax return. Once the tax return is filed, the fraudulent has been completed.

What about additional actions by the taxpayer to further the fraud? For example, submitting false or altered documents to the IRS auditor who is examining the fraudulent tax return? Can those actions be considered evidence of fraud for the understatement of tax? The court recently answered this question Chopra v. Commissioner, T.C. Memo. 2025-2.

Facts & Procedural History

The taxpayer in this case is a healthcare consultant. She has several advanced college degrees.

The case involves her 2019 individual income tax return. The taxpayer filed her tax return and reported substantial business expense deductions and itemized deductions. This included more than $68,000 in medical expenses and nearly $90,000 in business expenses.

The IRS pulled her tax return for audit and requested documentation to substantiate the claimed deductions. The IRS auditor proposed adjustments for the larger items on the tax return and also proposed a civil fraud penalty.

The civil fraud penalty was due to the taxpayer’s failure to cooperate. This continued during the litigation in the tax court. The court described the conduct by the taxpayer as follows:

She provided only partial credit card statements to the IRS auditor (5 months out of 12)
She refused to produce partnership tax returns and agreements for the flow through income
She made false representations to the court about discussing matters with opposing counsel
She provided documents that appeared to be digitally altered
She offered implausible explanations when questioned about inconsistencies

The tax court ultimately upheld both the underlying tax deficiency and a civil fraud penalty. This article focuses on the fraud penalty.

Traditional Badges of Fraud vs. Procedural Conduct

The civil tax fraud penalty is found in Section 6663 of the tax code. It is a very short statute that just says that the taxpayer can be liable for a 75 percent penalty for any underpayment of tax that is attributable to fraud.

The IRS has the burden to prove that there was tax fraud. To do this, the IRS has to show that the taxpayer engaged in conduct with the intent to evade taxes that he knew or believed to be owing. The IRS also has to prove that the understatement of tax was due to the fraud.

There are several prerequisites implicit in these rules. For example, the taxpayer has to actually file a tax return. This provides one “out” for this penalty. For example, a document that is filed that does not qualify as a “tax return” cannot trigger this penalty. The tax return may not have to be signed for there to be fraud, but it does have to be intended to be a valid tax return and it has to be filed. Those who file a frivolous tax return or those do not file a tax return cannot be subject to this penalty.

As a separate note, it is often advisable to file a tax return, even if the tax return is being filed late, to get the statute of limitations for the IRS to audit and make an assessment. However, the tax return has to be an honest and truthful return to avoid for this to work and to avoid the fraud penalty. The taxpayer then has to contend with the late filing penalty.

Also, those who do not believe that intentionally file a false return under a genuine belief that they are complying with the law do not trigger this penalty. These concepts are not set out in the tax code. They are found in various court cases involving this penalty.

The Badges of Fraud

Section 6663 also does not provide a definition for the term “fraud.” The courts have developed factors that are used to establish fraud. These so-called “badges of fraud” typically focus on the taxpayer’s conduct at or before the time of filing of the tax return, such as:

Maintaining false books and records
Creating fictitious documents
Concealing income or assets
Making false statements to investigators
Dealing extensively in cash
Filing false documents

There are quite a few court cases that apply factors like these. The courts have largely said that no one factor is determinative, and then they essentially pick the set of factors that are relevant to the case. In many cases there is one fact triggers several of these factors, such as in cases where a fictitious business is reported on a tax return for a tax loss. The business is reported on the return, but the taxpayer may maintain false books and records or create false or fictitious documents to support it–as the court suggested that the taxpayer did in this case.

The tax court cases that address fraud penalties are largely sustained in the IRS’s favor. Even in those cases where the taxpayers prevail on the fraud penalty, the tax court still usually imposes the lesser 20 percent accuracy or negligence penalty.

Conduct After the Tax Return is Filed

This brings us to the question posed by this article. Can conduct after the tax return is filed be considered as one of the “badges of fraud” for the understatement of tax on the tax return?

The understatement of tax happened at the time the tax return was filed. By the time the IRS audits the tax return, several years have usually passed. By the time the case gets to tax court, several more years have passed.

This Chopra case is a prime example. It is a tax court case with an opinion issued in 2025 for a 2019 income tax return. The court in Chopra did in fact find that the taxpayer’s post-tax return filing conduct supports a finding of fraud for the civil tax fraud penalty.

The tax court specifically identified several aspects of the taxpayer’s procedural conduct as badges of fraud:

Failure to cooperate with tax authorities
Providing implausible or inconsistent explanations
Offering testimony lacking credibility
Refusing to produce relevant documents
Making false representations to the court

The tax court even noted that the taxpayer’s “duplicitous and obstructive behavior throughout this [court] case is a badge of fraud” for the Section 6663 penalty.

The court made this ruling even though it has its own separate penalty for fraudulent conduct during tax litigation which is found in Section 6673. The Section 6673 penalty is limited to $25,000, which the Section 6663 fraud penalty is not. The opinion does not address the Section 6673 penalty so, presumably, the court did not impose this additional penalty.

The Takeaway

This case shows that conduct during tax audit and litigation matters as it can be additional evidence of fraudulent intent for any understatement on the tax return. Producing fraudulent documents to the IRS auditors and making false statements to the court can be evidence of fraudulent intent. While taxpayers retain their rights to challenge IRS positions and limit document production, they should exercise these rights in a way that doesn’t create additional evidence of fraud.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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When You Can’t Deduct Annual Business Expenses – Houston Tax Attorneys

Many businesses have significant recurring expenses that occur like clockwork each year. Think of annual maintenance shutdowns for manufacturing plants, seasonal refurbishments for hotels, or equipment rebuilds for industrial operations. While these expenses are predictable and virtually certain to occur, the timing of when they can be deducted for tax purposes isn’t always straightforward. The recent Morning Star Packing Co. v. Commissioner, No. 21-71191 (9th Cir. 2024), case provides an opportunity to consider when these expenses can be deducted.

Facts & Procedural History

The taxpayer in this case operates one of the largest tomato processing operations in the United States. During its 100-day processing season, the company runs its equipment at the maximum capacity, running 24-hours a day. This intensive operation requires extensive reconditioning of the equipment after each season. The historical cost has been between $16.7 and $21 million annually leading up to the year at issue in this case.

The taxpayer is an accrual method taxpayer. The taxpayer has always deducted these reconditioning costs on its income tax returns in the tax year when the wear and tear occurred–at the end of each processing season. Even though the costs were expected and known, the actual reconditioning work is performed just before the start of the next season.

The IRS had previously audited the taxpayer and accepted this method. Then, years later, the IRS conducted another audit and challenged the use of this method. The IRS argued that the expenses couldn’t be deducted until the work was actually performed. The U.S. Tax Court agreed with the IRS, which resulted in this appeal.

Why Does This Type of Timing Issue Matter?

Before getting into the rules, it is helpful to pause to consider why this type of timing issue matters.

At first glance, this might seem like something that is not all that important. After all, the taxpayer will eventually get to deduct these expenses–it’s just a question of which tax year. But timing can have significant financial implications.

Unlike government agencies like the IRS, businesses have to answer to a number of third parties. This includes investors, lenders, landlords, and others and for smaller businesses, the business’ owners. The timing of large deductions can impact the interaction with these third parties. There are two extremes here. There are instances where a business may want a level tax liability each year.

There are other instances where the business wants to time expenses so that the tax liability fluctuates. For the former, an unexpected cash-tax liability can impact operations given that taxes are often one of a business’ largest annual expenses. For the latter, the tax windfall in the low tax year may be cash that is needed to be used for capital improvements or expansion.

Underlying this is also the concept of time value of money. Taxpayers may simply prefer to get a deduction sooner rather than later. Getting a $21 million tax deduction a year earlier has real economic value due to the time value of money. Even at a modest 5% interest rate, the difference in present value is substantial.

There is also planning for tax rate changes

There is also planning for tax rate changes. Tax rates may vary between years, either due to legislative changes or a taxpayer’s changing circumstances. Deducting expenses in higher-rate years can be more valuable. The same goes for loss years. The timing of large deductions can affect whether a business shows a loss in particular years, which has implications for loss carrybacks and carryforwards that can free up cash.

As you can see, this is one of the tools the tax planner has to work with to help a business achieve its financial goals.

About the Accrual Method

The timing of expense deductions depends largely on whether a taxpayer uses the cash or accrual method of accounting. The accrual method is required for many larger businesses–businesses that are large or businesses that have inventory. The accural method aims to match income and expenses to the period when they are earned or incurred–regardless of when cash changes hands. It can also be used to defer paying taxes in some cases. This differs from the cash method, where expenses are simply deducted when paid.

While the cash method is simpler, it can distort the true financial picture when large expenses are paid in different periods than the related income is received. Cash-basis businesses know this well. Cash-basis business owners or managers may feel that they are doing well financially, only to realize that they failed to account for an accrued liability that they will have to pay all at once. During this window, the business owner or manager may spend money they have on hand under the mistaken belief that they have it available to spend. This can result in default on legal obligations and, often, the business going out of business.

The “All Events” Test

This brings us to the “all events” test. The “all events” test is the name of the game when it comes to the accrual method. This test has two main requirements for liabilities:

All events must have occurred that establish the fact of liability
The amount must be determinable with reasonable accuracy

The Morning Star case focused on the first requirement–whether the fact of liability was established when the processing season ended, even though the work hadn’t been performed yet.

The “Fact of Liability” Prong

So what is the “fact of liability?” A liability is considered “fixed” when it is legally established and unconditional. The courts have established that a liability must be ‘fixed, absolute, and unconditional’ to satisfy this requirement. The liability cannot be contingent on some future event.

For example, if a business agrees to pay a bonus if certain targets are met, the liability isn’t fixed until those targets are actually met. However, once a liability is legally binding, the fact that payment will be made in the future doesn’t prevent it from being “fixed” for tax purposes.

That brings us to this case. The taxpayer in this case argued that the final production run of the season created a fixed liability because:

The amount was known based on historical costs
The loan agreements required maintaining the equipment in good working order
The customer contracts required continued production capabilities
The equipment could not be used again without reconditioning

The taxpayer essentially argued that these combined obligations created a legal duty to recondition the equipment once the season ended.

The majority of the judges in this case held that the tax…

The majority of the judges in this case held that the taxpayer’s reconditioning expenses weren’t fixed at the end of the tomato season. This was largely because they did not accept the taxpayer’s arguments about its financing agreements. The court noted that because the financing agreements only required maintaining equipment in “good condition and repair, reasonable wear and tear excepted,” that is all these expenses were. The majority found these expenses to be repair costs for ordinary wear and tear that could be done at any time–not necessarily annually.

What is “Fixed” for an Annual Recurring Expense?

The dissent made several compelling arguments in this case for when an annual recurring expense like this is actually “fixed.”

The dissent argued that $21 million in damage could not possibly constitute “reasonable wear and tear.” As Judge Bumatay noted, “Ordinary wear and tear is when your bathroom’s tiles fade… It is not catastrophic damage that requires millions to repair.” The dissent also pointed out that the company’s lenders would hardly allow $21 million in unaddressed damage to their collateral. When combined with customer contracts requiring continued production, this created a fixed obligation to perform the reconditioning.

The dissent also noted that the court’s decision is at odds with other cases involving fixed liabilities. For example, the dissent cited United States v. Hughes Properties in which the Supreme Court allowed a casino to deduct guaranteed slot machine jackpots before they were won. The Court in that case focused on the fact that state law made the liability fixed and determinable.

Similarly, in Gold Coast Hotel, deductions were allowed for slot club points when members accumulated enough points to qualify for prizes, even though the prizes hadn’t been claimed yet. There are also court cases that reach the same result for gift cards. These cases suggest that a liability can be “fixed” even when payment or performance occurs later.

The Takeaway

This case highlights how difficult it is to determine when an expense is really fixed. This issue is ultimately a timing issue. A little tax planning can still achieve the desired timing. Businesses with large recurring expenses should review their contracts and consider whether modifications could help establish the “fact of liability” earlier in their business cycle. These taxpayers may need to restructure their contracts to explicitly create the liability, at least on paper, for the desired tax year. This case shows exactly how the taxpayer might do that.