Badges of Fraud Defeat Summary Judgment on Penalty

NORTH DONALD LA PROPERTY, LLC, NORTH DONALD LA INVESTORS, LLC, TAX MATTERS PARTNER,
Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent

United States Tax Court

ORDER

This case is calendared for trial at an initial special session of the Court beginning September 9, 2024, and a second special session beginning October 7, 2024, both in New Orleans, Louisiana. The case involves a charitable contribution deduction claimed by North Donald LA Property, LLC (NDLA), for the donation of a conservation easement. The Internal Revenue Service (IRS or respondent) issued NDLA a notice of final partnership administrative adjustment (FPAA), disallowing this and other deductions and determining penalties, including the civil fraud penalty imposed by section 6663(a).¹

On February 16, 2024, petitioner filed a Motion for Partial Summary Judgment seeking a ruling that the civil fraud penalty, as a matter of law, does not apply because respondent has not alleged facts showing that NDLA “intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes.” Memorandum in Support of Motion for Partial Summary Judgment at 7 (quoting Parks v. Commissioner, 94 T.C. 654, 661 (1990)). In essence, petitioner contends that respondent cannot carry his burden of proving fraud by clear and convincing evidence because NDLA disclosed on its tax return the facts relating to the conservation easement transaction. Finding that there exist genuine disputes of material fact regarding the possible application of the fraud penalty, we will deny the Motion.

Background

The following facts are derived from the parties' pleadings, Motion papers, Declarations, and attached Exhibits. They are stated solely for the purpose of deciding the Motion and not as findings of fact in this case. See Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 (7th Cir. 1994). For purposes of deciding the Motion, we view the facts in the light most favorable to respondent, the non-moving party.

NDLA is a Missouri limited liability company (LLC) classified as a TEFRA partnership for the taxable year ending December 31, 2017.² Petitioner North Donald LA Investors, LLC (NDLA Investors or petitioner), is its tax matters partner. NDLA represented in its Petition that its principal place of business was in Missouri when the Petition was filed. Absent stipulation to the contrary, appeal of this case would apparently lie to the U.S. Court of Appeals for the Eighth Circuit. See §7482(b)(1)(A), and (2).

Sixty West, LLC (Sixty West), was a promoter of syndicated conservation easement transactions.³ In March 2016 Reserve at Welsh, LLC (Welsh), an entity controlled by Sixty West, purchased 3,324 acres of land in Jefferson Davis Parish, Louisiana (Parent Tract). Sixty West allegedly purchased the Parent Tract for use in multiple syndicated transactions that would generate large charitable contribution tax deductions for investors. The total purchase price for the Parent Tract was $9,888,008, or $2,975 per acre.

In October 2017 Welsh transferred to NDLA, by contribution to its capital, a 260.5-acre parcel (Subject Property) carved from the Parent Tract. On December 28, 2017, NDLA conveyed to the Atlantic Coast Conservancy, a “qualified organization” for purposes of section 170(h)(3), a conservation easement that covered 244.7 acres of the Subject Property, or roughly 7% of the original Parent Tract. NDLA timely filed a Form 1065, U.S. Return of Partnership Income, for 2017. On that return it claimed a charitable contribution deduction of $115,391,000 for its donation of the easement.

NDLA included with its 2017 return an appraisal executed by Claud Clark III. The appraisal asserted that clay mining was the “highest and best use” of the Subject Property before the easement was granted. The appraisal asserted that the “before value” of the property was $116,303,000, or $471,4561 per acre. Subtracting from the sum an “after value” of $912,000, Mr. Clark asserted that the easement was worth $115,391,000.

Petitioner included with its return a Form 8283, Non-Cash Charitable Contributions. This form listed the “donor's cost or adjusted basis” as $804,232 and the “appraised fair market value” of the easement as $115,391,000. An attachment to the Form 8283 explained that the Subject Property had been acquired on March 23, 2016, by Welsh, which contributed it to NDLA on October 6, 2017.

NDLA included with its return a Form 8886, Reportable Transaction Disclosure Statement, for the tax year ending December 31, 2017. NDLA filed this Form pursuant to IRS Notice 2017-10, 2017-4 I.R.B. 544, which required that reportable or “listed” transactions — including specified conservation easement transactions — be timely disclosed to the IRS. See id. at 545 (stating that the IRS “intends to challenge the purported tax benefits from [such transactions] based on the overvaluation of the conservation easement”). The Form 8886 informed the IRS of facts relating to NDLA's reporting of the conservation easement transaction.

The law firm of Morris, Manning & Martin (Morris firm) served as a “material advisor” to NDLA with respect to the conservation easement transaction. The Morris firm timely filed Form 8918, Material Advisor Disclosure Statement, with the Office of Tax Shelter Analysis. This Form provided to the IRS essentially the same information as the Form 8886 filed by NDLA.

Discussion

A. Summary Judgment Standard

The purpose of summary judgment is to expedite litigation and avoid costly, unnecessary, and time-consuming trials. See Fla. Peach Corp. v. Commissioner, 90 T.C. 678, 681 (1988). We may grant a motion for partial summary judgment when there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law. Rule 121(a)(2); Sundstrand Corp., 98 T.C. at 520. In deciding whether to grant summary judgment, we construe factual materials and inferences drawn from them in the light most favorable to the nonmoving party (here respondent). Sundstrand Corp., 98 T.C. at 520.

B. Fraud Penalty

“If any part of any underpayment of tax required to be shown on a return is due to fraud,” section 6663(a) imposes a penalty of 75% of the portion of the underpayment due to fraud. Respondent has the burden of proving fraud, and he must prove it by clear and convincing evidence. §7454(a); Rule 142(b); Richardson v. Commissioner, 509 F.3d 736, 743 (6th Cir. 2007), aff'g T.C. Memo. 2006-69. “To satisfy his burden of proof, respondent must show . . . that the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes.” Parks, 94 T.C. at 660-61.

Fraud is defined as intentional wrongdoing designed to evade tax believed to be owed. Neely v. Commissioner, 116 T.C. 79, 86 (2001). The existence of fraud is a question of fact to be resolved upon consideration of the entire record. Estate of Pittard v. Commissioner, 69 T.C. 391, 400 (1977). The taxpayer's entire course of conduct may be examined to establish the requisite intent, and an intent to mislead may be inferred from a pattern of conduct. Webb v. Commissioner, 394 F.2d 366, 379 (5th Cir. 1968), aff'g T.C. Memo. 1966-81; Stone v. Commissioner, 56 T.C. 213, 224 (1971).

Because direct proof of a taxpayer's intent is rarely available, fraudulent intent is usually established by circumstantial evidence. See Grossman v. Commissioner, 182 F.3d 275, 277-78 (4th Cir. 1999), aff'g T.C. Memo. 1996-452. Circumstances that may indicate fraudulent intent, commonly called the “badges of fraud,” include but are not limited to: (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) supplying incomplete or misleading information to a tax return preparer, (8) providing testimony that lacks credibility, (9) filing false documents, (10) failing to file tax returns, and (11) dealing extensively in cash. See Spies v. United States, 317 U.S. 492, 499 (1943); Podlucky v. Commissioner, T.C. Memo. 2022-45. 123 T.C.M. (CCH) 1229, 1237; Morse v. Commissioner, T.C. Memo. 2003-332, 86 T.C.M. (CCH) 673, 675, aff'd, 419 F.3d 829 (8th Cir. 2005). No single factor is dispositive; however, the existence of several factors is “persuasive circumstantial evidence of fraud.” Vanover v. Commissioner, T.C. Memo. 2012-79, 1203 T.C.M. (CCH) 1418, 1420-21.

C. Analysis

In urging that the fraud penalty does not apply here, petitioner relies chiefly on Mill Road 36 Henry, LLC v. Commissioner, T.C. Memo. 2023-19 (2023). That case likewise involved a charitable contribution deduction claimed for a conservation easement. Following a one-week trial, the Court sustained (in large part) the disallowance of the charitable contribution deduction and the imposition of a 40% penalty for a “gross valuation misstatement.” See id. at *68. But the Court held the fraud penalty inapplicable, finding that “[t]he evidence [did] not establish an attempt by [the taxpayer] to conceal or deceive in the Commissioner's administration of tax collection.” Id. at *64.

“Important to our determination that the fraud penalty [was] not applicable” in Mill Road 36 was the taxpayer's “express disclosure on its tax return of the principal facts about the easement contribution.” Id. at *59. We found that the taxpayer “had strictly complied with the [statutory] substantiation and reporting requirements . . . by attaching to its return a Form 8283 that confessed the disparity between its very low basis [in the subject property] and the very high claimed value of the easement.” Ibid. The value claimed for the easement was “20 times the reported basis.” Ibid. We noted that Form 8886 had been properly filed, disclosing the transaction to the IRS, and reporting that the value claimed for the easement exceeded the taxpayer's basis by $8,518,437. Ibid. We likewise concluded that the taxpayer had attached to its return a “qualified appraisal” by a “qualified appraiser.” Id. at *42-45. We found no evidence that the donor “had knowledge of facts that would cause a reasonable person to expect the appraiser falsely to overstate the value of the donated property,” which would have stripped the appraiser of his “qualified” status. See Treas. Reg. §1.170A-13(c)(5)(ii).

While finding the taxpayer's “compliant reporting [to be] starkly at odds with an intention to conceal,” see Mill Road 36, at *59, we did not hold that disclosure is sufficient, as a matter of law, to preclude a finding of fraud. Rather, we considered the evidence upon which the Commissioner relied to “show fraud notwithstanding disclosure.” Id. at *60. The Commissioner in Mill Road 36 did not cite any of the traditional “badges of fraud” listed above; indeed, we found those 11 badges “not perceptible” in that case. Ibid. Rather, the IRS relied chiefly on certain questionable features of the transaction, including the wildly inflated value placed on the easement, the errors contained in the appraisal, the lack of a bona fide business purpose, and the replication of the transaction “in ten other equivalent syndications.” Id. at *60-64. While sustaining a 40% penalty for “gross valuation misstatement,” we concluded that these facts were not indicia of fraud because they did not reveal “an intent to conceal or mislead.” Id. at *60.

In its current posture, this case differs from Mill Road 36 in several important respects. First, in Mill Road 36, we decided the applicability of the fraud penalty after a one-week trial, “upon consideration of the entire record.” Estate of Pittard, 69 T.C. at 400. Here, petitioner asks that we rule the fraud penalty inapplicable as a matter of law, at a point in this case where discovery is still ongoing. Second, the Commissioner in Mill Road 36 eschewed reliance on the traditional 11 “badges of fraud,” which we found to be not “perceptible” in any event. Here, respondent devotes considerable attention to the customary badges of fraud and urges that some of them are displayed by the factual record he has compiled thus far. Third, respondent contends that NDLA's managers, in effect, dictated several critical inputs to Mr. Clark's appraisal and the mining report on which he based his valuation. Respondent recently filed a Second Request for Admissions directed to this and related allegations. If respondent can establish these facts at trial, he may be able to show that in this case (unlike in Mill Road 36) the taxpayer and its managers “had knowledge of facts that would cause a reasonable person to expect the appraiser falsely to overstate the value of the donated property.” See Treas. Reg. §1.170A-13(c)(5)(ii).

Respondent contends that the evidence at trial will establish the existence of several traditional badges of fraud, as well as other indicia of intent to conceal or mislead the IRS. Respondent agrees that petitioner's disclosures relating to the easement transaction are relevant in deciding whether the fraud penalty applies. But he urges that disclosure weighs most heavily in the taxpayer's favor when the disclosure is “complete, clear, correct, and forthcoming.” In contrast, some of the disclosures here were allegedly “incomplete, opaque, and misleading.”

The traditional “badges of fraud” were developed by the courts chiefly in cases involving unreported income. During 2017, the tax year at issue, NDLA engaged in little or no business activity and had no income; the dispute between the parties focuses on an allegedly overstated deduction. In a case such as this, several traditional badges of fraud — e.g., understating gross income, concealing income or assets, failing to file tax returns, and dealing extensively in cash — may have little salience because they will be absent almost by definition. Other badges of fraud — e.g., providing testimony that lacks credibility, giving implausible or inconsistent explanations of behavior, and failing to cooperate with tax authorities — are incapable of complete evaluation at the current stage of this litigation, with a trial scheduled six months down the road and discovery still ongoing.

In prior opinions addressing the fraud penalty, we have repeatedly noted that circumstantial evidence of fraud “may include but is not limited to” the 11 factors listed above. See Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), aff'g T.C. Memo. 1984-601; Recklitis v. Commissioner, 91 T.C. 874, 910 (1988); Minemyer v. Commissioner, T.C. Memo. 2023-149. On the basis of facts compiled so far, respondent contends that the trial of this case will establish the existence of one or more traditional badges of fraud, as well as other evidence of an intent to conceal or mislead the IRS:

• Respondent alleges that the entities to which NDLA allocated 94% of the charitable contribution deduction — NDLA Investors and Welsh Land Investors — were not, in fact, members of NDLA during 2017, the year in which the easement was granted and for which the deduction was claimed. According to respondent, the relevant operating agreements and membership purchase agreements were not actually executed until January 4, 2018, and were backdated to hide this fact. If established at trial, these facts could constitute evidence of an intent to conceal or mislead the IRS as to the investors' entitlement to claim passthrough charitable contribution deductions for 2017.⁴

• The Form 8886 that NDLA filed with its return regularly refers to the “effective dates” for various documents and transactions. Respondent contends that these references to “effective dates” were intended to conceal the fact that numerous documents were backdated. In addition to the backdating described in the previous paragraph, respondent alleges that six other transactional documents were backdated, as well as “dozens of subscription documents” allegedly backdated by NDLA's managers or “by investors at the instructions of the managers.” If established at trial, these facts could constitute evidence of an intent to mislead the IRS.

• All investors in NDLA were promised a charitable contribution tax deduction that was a substantial multiple of their cash investment. According to respondent, investors who purchased interests in NDLA Investors received a contribution-to-investment ratio of 4.67 to 1, and investors who purchased interests in Welsh Land Investors received a contribution-to-investment ratio of 15 to 1. When drafting the Form 8886, NDLA's managers allegedly rejected the advice of counsel that these ratios should be disclosed. Instead, they insisted on language stating only that the “transaction created a deduction greater than a 2.5 to 1 ratio.” If established at trial, these facts may constitute evidence that NDLA's disclosures were incomplete or misleading.

• One traditional badge of fraud is “maintaining inadequate records.” See Lollis v. Commissioner, 595 F.2d 1189, 1192 (9th Cir. 1979), aff'g T.C. Memo. 1976-15 (“Inadequate or non-existent records are also a badge of fraud.”). Respondent contends that the transactions at issue were structured by Sixty West so that neither NDLA nor petitioner had possession of their own business records, allegedly with a view to making it more difficult for the IRS to obtain access to these documents. To facilitate the backdating of documents, various participants were allegedly instructed to stop using DocuSign to avoid the automatic dating of the documents. According to respondent, Sixty West and NDLA's managers also “tried, where possible, to have substantive discussions orally rather than in writing,” e.g., by providing instructions to appraisers during an airplane ride and switching from email to the telephone when discussing sensitive topics. If established at trial, these facts may constitute evidence that NDLA's managers intentionally maintained incomplete records.

• An essential input to Mr. Clark's “highest and best use” analysis was the economic feasibility of the hypothetical clay mining operation. And an essential input to his discounted cash flow (DCF) analysis was the royalty rate that would supposedly be paid for the clay thus produced. Respondent alleges that NDLA's managers procured false documentation in the form of letters from two trucking companies to create the appearance of the requisite market demand for clay. According to respondent, Sixty West drafted these letters and procured signatures from individuals associated with the trucking companies who allegedly signed only because they had been paid to sign. If established at trial, these facts could constitute evidence of an intent to mislead the IRS as to the economic feasibility of the hypothetical mining operation.

Another traditional badge of fraud is “filing false documents,” including filing a return that omits income or contains false information. See Harrington v. Commissioner, T.C. Memo. 2021-95, 122 T.C.M. (CCH) 116, 121, aff'd, No. 22-9000, 2022 U.S. App. LEXIS 33006, 2022 WL 17333080 (10th Cir. Nov. 30, 2022). We have viewed the filing of false documents with the IRS as “an 'affirmative act' of misrepresentation sufficient to justify the fraud penalty.” Zell v. Commissioner, 763 F.2d 1139, 1146 (10th Cir. 1985), aff'g T.C. Memo. 1984-152.

Respondent contends that NDLA's 2017 return and the attached appraisal were “false documents.” Sixty West purchased the Parent Tract, including the Subject Property, in March 2016 for $2,975 an acre. Subsequent arm's-length appraisals prepared on behalf of financial institutions valued the property at between $2,800 and $3,097 per acre, and respondent alleges that NDLA's managers were aware of these appraisals. According to respondent, a knowledgeable outsider had advised that any valuation of the Subject Property based on a clay mine would be insupportable because “all of Louisiana is essentially clay.”

According to respondent, Sixty West and NDLA's managers nevertheless colluded with Mr. Clark to produce an appraisal that valued the Subject Property at more than $400,000 per acre. They allegedly did so by dictating to Mr. Clark key elements of the methodology he was to employ. According to respondent, Mr. Clark had agreed to value the Subject Property as a clay mine, using a “royalty rate” method of valuation, even before he was formally engaged by Sixty West. He allegedly agreed from the outset to base his appraisal on a mining report prepared by Edmundo Laporte. And he allegedly agreed to employ in his DCF analysis the discount rate preferred by Sixty West.

According to respondent, Mr. Laporte was brought on board “when the initial value estimates were not high enough.” Sixty West and/or NDLA's managers allegedly gave him “a target value to hit,” and they allegedly ensured that he would hit the desired target “by feeding facts and assumptions” to him. Some of these assumptions were supported by false documentation allegedly procured from trucking companies, who signed the letters only because Sixty West paid them to sign. Respondent anticipates that the evidence produced at trial will show that Sixty West and/or NDLA's managers dictated other instructions to Mr. Laporte and Mr. Clark. These facts, if established at trial, could constitute evidence that Mr. Clark's appraisal was a false document and that Sixty West and NDLA's managers knew that the appraisal was false.

On the basis of documents he has obtained thus far, respondent contends that the evidence at trial will support the existence of other badges of fraud, including “giving implausible or inconsistent explanations of behavior” and “failing to cooperate with tax authorities.” See Bradford, 796 F.2d at 307-08. At this juncture, we need not discuss all of the evidence on which respondent expects to rely. In view of the allegations discussed above, we conclude that there exist numerous genuine disputes of material fact that bear upon a determination of fraud and that these disputes preclude the grant of partial summary judgment for petitioner.

It is accordingly,

ORDERED that petitioner's Motion for Partial Summary Judgment, filed February 16, 2024, is denied.

Albert G. Lauber
Judge