Tax Lawyer's Blog

Thomas J. Barrow v . Commissioner; Barrow, Aldridge & Co. v. Commissioner (BACO) – This case involved several issues. This update deals only with the IRS’s assessment of the civil fraud penalty (the penalty amount is equal to 75% of the understatement) and the Court’s use of the “badges of fraud” test to determine fraudulent conduct.

Thomas J. Barrow, a long-time Detroit CPA, businessman and politician, had been convicted at an earlier criminal trial of bank fraud, income tax evasion and filing false tax returns. 

Judge Holmes defined the issue before the Tax Court:

We must decide whether Barrow and his firm are liable for tax deficiencies and associated penalties for the years 1984-89.

For purposes of the imposition of the fraud penalty the government alleged that Barrow had intentionally diverted BACO funds to himself, had intentionally failed to pay personal income taxes on the diverted funds, and had intentionally caused BACO not to report those funds as taxable income on it’s corporate income tax returns.

The Commissioner argued that Barrow wore each of six “badges of fraud,” and, therefore, the assessment of the fraud penalty should be upheld. 

Judge Holmes analyzed the 6 badges and disagreed with the Commissioner’s conclusion.

Pattern of Underreporting

Even though the Petitioners’ underreported their income in 84 and 86, Judge Holmes said that it was unintentional and nominal and, therefore, did not rise to the level of a badge of fraud.

We do find that there was a pattern of under reporting because Barrow failed to report some taxable personal income to the IRS each year from 1984 until 1988. For the several reasons provided in this section, however, we do not find this pattern of under reporting to be a badge of fraud.

Books and Records

Judge Holmes also refused to consider the state of Barrows and BACO’s books and records a badge of fraud because the IRS auditor testified that the books were “easy to follow . . . they were in order.”

Diverting Assets to Personal Use

The Commissioner was estopped from arguing that Barrow had diverted funds from BACO to his personal use because the government had proffered a different theory in Barrow’s criminal trial. The Judge also found that Barrow’s use of the BACO stamp on checks he received from another company was for the purpose of deceiving his “journalistic inquisitors” and not the IRS. 

Education and Business Knowledge

Even though Barrow was one of the most respected and successful CPAs in the Detroit area and even though he had provided financial and accounting services to his myriad clients for more than 15 years, Judge Holmes found:

Barrow was an entrepreneur and budding politician, mainly focused on the non-tax activities of saving a struggling hospital and expanding his reputation as a civic leader in Detroit. And even in cases that involve attorneys or accountants with a proven knowledge of tax law, we have not found fraud where the specific intent to evade tax didn’t exist. See, e.g., Dajos v. Commissioner, T.C. Memo. 1986-330.

This finding is astonishing.

If Barrow’s extensive education and business knowledge is not considered a badge of fraud, it is hard to see how this “badge” could ever be applied to anyone other than an experienced tax CPA or tax lawyer.

Prior Tax Convictions

The Court found that Barrow’s prior criminal convictions for tax fraud (for other return years) were a factor that weighed against him.

Dishonest Dealings 

The Court found that even though Barrow had dealt dishonestly with others, those dishonest dealings were related to his political pursuits and not the filing of his tax returns.

Based on the above “badges of fraud” analysis, Judge Holmes found:

Despite Barrow’s many mistakes, we find that the Commissioner offers no clear and convincing proof that Barrow possessed the specific intent to evade a tax that he believed he owed for 1984 or 1986, or that BACO owed for 1988 or 1989. 

Practice Pointer: This Tax Court opinion is a great one for taxpayers who are assessed or about to be assessed a civil fraud penalty. When the government audits a highly educated and trained CPA and businessman who has already been convicted of tax evasion and still can’t get a civil fraud penalty to stick, you have to believe that you’ll have a damn good shot of avoiding the penalty for almost any taxpayer.

Show this T.C. Memo to  an auditor who is considering the imposition of the penalty. It should make him or her think twice. 

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