Shifting the Burden-of-Proof Rules in Federal Tax Cases

By Tanya M. Marcum

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Prior to the changes, a taxpayer contesting an IRS audit had the burden of proof to show in court that the tax deficiency was in error or that a tax refund was due. Essentially, taxpayers had to show that they were entitled to deductions and tax credits or that they had reported the correct income on the form filed with the IRS. Under the new law, Congress intended for taxpayers to cooperate with the audit, and upon its completion, if there was still a dispute and a court proceeding commenced, the IRS would have the burden of proof in the case. Taxpayers must first prove that they have complied with the requirements of the law before the burden of proof is shifted.

The Tax Court Process

A taxpayer who contests the findings of an audit by the IRS and has not paid the contested deficiency in tax can file a petition in the U.S. Tax Court. This petition is usually a result of the receipt by the taxpayer of a notice of deficiency. A statutory notice of deficiency prepared by the IRS indicates that an audit has been completed, that a deficiency in tax has been determined, and that this deficiency can be contested by the taxpayer. The deadline for filing a petition with the U.S. Tax Court is 90 days from receipt of the notice; 150 days if the taxpayer is outside of the U.S. A taxpayer who contests a deficiency but pays it can also contest the IRS’s position and file a claim for refund with the U.S. District Court in the appropriate jurisdiction.

Prior to the IRS Restructuring and Reform Act, there was a long-established principle of tax law that the IRS’s determinations in the statutory notice of deficiency were presumptively correct (Welch v. Helvering [290 U.S. 111 (1933)] and Rule 142(a), Tax Court Rules of Practice and Procedure). The taxpayer also bore the burden of proving that the IRS’s determinations were incorrect. A taxpayer would not prevail by merely asserting that the return was correct as filed. Other evidence was necessary to substantiate the deductions that the taxpayer claimed [Wilkinson v. Comm’r, 71 TC 633 (1979)]. The IRS ordinarily requested from the taxpayer the information that was needed to substantiate an issue during the audit. If providing the information made the issue no longer contested, it would then be considered resolved between the parties.

The IRS Restructuring and Reform Act introduced IRC section 7491(a)(1), which states that if a taxpayer introduces credible evidence about any factual issue relevant to ascertaining the liability for any tax imposed by subtitle A or B, the IRS will have the burden of proof with respect to such issue. In a bankruptcy court action, the court determined that this new section did not apply to an audit that began before the enactment of the law [Berardi v. U.S., 2002-2 USTC P 50736, 90 AFTR ed 7554 (ED Pa 2002); aff’d 70 Fed Appx 660, 92 AFTR 2d 5669 (CA3 2003)]. The examination must begin after July 22, 1998, for the burden of proof to be shifted to the IRS.

The burden of proof in any case means that the party must prove the allegations brought forth by them in the complaint. More specifically, this burden of proof means the burden of production and the burden of persuasion. The burden of production means that the party must present prima facie evidence to have an issue decided by the trier of fact. The burden of persuasion requires the party to establish the merits of the claim by a preponderance of the evidence.

Implementation of the Changes by the Tax Court

Most Tax Court opinions refer to the party with the burden of proof. A footnote usually references the Internal Revenue Code section and the date of the commencement of the examination by the IRS. Such a footnote would indicate that the Tax Court has given a summary review of the issue. If the burden of proof were a contested issue, then the court would discuss the resolution of the issue in the body of the opinion itself.

In some cases, the IRS and the taxpayer have filed a stipulation of facts with the court as to the actions of the taxpayer during the audit. These facts are agreed upon by both parties and will not need to be proved during the trial. If the court finds that the taxpayer has complied with the law regarding substantiation and cooperation, the burden of proof falls on the IRS. If it finds that the taxpayer has not complied, the burden of proof would then remain with the taxpayer for the duration of the trial. In some cases, pretrial motions will require the court to determine which party bears the burden of proof.

Requirements and Contingencies

For the IRS to have the burden of proof in a tax case, certain conditions or contingencies must first be met by the taxpayer. IRC section 7491(a)(2) indicates that the taxpayer must do three things for the burden of proof to shift to the IRS: substantiation of all claimed items; long-term maintenance of records; and cooperation at all stages with the IRS.

The taxpayer must comply with the substantiation and record-keeping requirements of the IRC. The substantiation requirements include any requirement under the IRC or Treasury Regulations for the taxpayer to establish an item to the IRS’s satisfaction, generally proof of a deduction or expense. This may include receipts, journals, statements, logs, accounting records, or other such proof. The taxpayer must also maintain these records over time. These records must also be made contemporaneously with the event that generates the deduction or expense.

Finally, cooperation with the IRS at all times during the audit is paramount in order for the burden of proof to lie with the IRS. If the IRS requests a document, the taxpayer must produce it. If the IRS requests a meeting or conference, the taxpayer must cooperate. In Redman v. Commissioner [T.C. Summary Opinion 2003-42 (April 22, 2003)], the court looked at the new law to determine if the burden of proof shifted from the taxpayer to the IRS. The case revolved around whether the head-of-household filing status was applicable for the taxable year involved. The court ruled that section 7491 was not applicable because the taxpayer could not establish cooperation, substantiation, or the maintenance of applicable records.

What Is Credible Evidence?

Although the new law states that the evidence must be credible, it does not define the term “credible evidence.” The Conference Report preceding the enactment of the IRS Restructuring and Reform Act states the following:

Credible evidence is the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of the IRS correctness). A taxpayer has not produced credible evidence for these purposes if the taxpayer merely makes implausible factual assertions, frivolous claims, or tax protestor-type arguments. The introduction of evidence will not meet this standard if the court is not convinced that it is worthy of belief. If after evidence from both sides the court believes that the evidence is equally balanced, the court shall find that the Secretary has not sustained his burden of proof.

The Tax Court has applied the language from the Conference Report in cases where the burden of proof has become an issue.

In Mentzel v. Comm’r (TC Summary Opinion 2003-38, which cannot be treated as precedent for any other case), the issue was whether the taxpayer was entitled to a dependency exemption. The court ruled that the taxpayer had failed to provide credible evidence, leaving him with the burden of proof for that issue. An item of proof or substantiation that was not provided to the court was proof that he was the custodial parent during the year at issue. He did not attach to his tax return a written declaration by his ex-spouse indicating that he was the custodial parent of the minor child for the year. The taxpayer could not prove that he provided more than one-half of the support for his child.

In Griffin v. Commissioner [TC Memo 2004-64 (March 11, 2004); 315 F.3d 1017 (8th Cir. 2002), rev’g and remanding 83 T.C.M. (CCH) 1058, 2002 T.C.M. (RIA) P2002-006], the Tax Court examined the issue of credible evidence. Robert and Julia Griffin owned all of the stock of Griffin California Enterprises, Inc. Robert paid substantial delinquent real property taxes on partnership property for 1995 and 1996 and claimed the tax payments as deductible expenses on Schedule E, Supplemental Income and Loss. The IRS disallowed the deduction during an audit because it was not their expense, but the expense of another taxpayer.

The Tax Court determined that the burden of proving that the expenses were deductible was on the Griffins because they failed to introduce credible evidence that they were engaged in a trade or business for which the tax payments would have been ordinary and necessary business expenses. The 8th Circuit Court of Appeals overruled the Tax Court’s decision, finding that the Griffins’ testimony in the Tax Court constituted credible evidence. The case was remanded back to the Tax Court, and the burden of proof was on the IRS. The IRS could not provide evidence to overcome the testimony, and the Tax Court allowed the tax payments as deductions for ordinary and necessary business expenses.

In Gale v. Comm’r [83 TCM 1270 (2002)], the court ruled that an admission by the taxpayer that income was received was sufficient evidence to shift the burden of proof to the IRS. In Tanner v. Comm’r [91 AFTR 2d 1842 (5th Cir. 2003)], the court ruled that an undisputed Form 1099 was credible evidence to shift the burden of proof to the IRS. The burden only shifted because the taxpayer introduced evidence with respect to a factual issue relevant to the determination of the tax liability.

In another case, a small claims court petition that sought to recover a loss due to home damage was not considered credible evidence of a casualty loss. The taxpayer’s receipts were also not credible evidence without independent evidence of its donated value for a claimed charitable contributions deduction [Higbee v. Commissioner, 116 TC 438 (2001)].

Practical Advice

Credible evidence for travel, entertainment, business gift, or local transportation expenses can be proven by some simple acts by the taxpayer. If a taxpayer keeps timely and accurate records that substantiate these expenses, there should be enough credible evidence to satisfy the court. These records must be contemporaneous with the occurrence of the expense, not reproduced for an audit or the court. Written records are given greater weight than oral testimony. Cancelled checks and credit card receipts should be kept in a journal indicating the date, destination, and business purpose for each expense. For entertainment expenses, the taxpayer should note the business benefit gained or expected to be gained, and the recipients of the entertainment expenses.

These items taken together are proof of actually incurring these expenses by the taxpayers and their purpose toward a business or individual tax deduction.

Good record-keeping is essential in protecting deductions during an IRS audit. The IRS operates during an audit under the basic premise of “no substantiation, no deduction.” The best records indicate whom one has paid, when one has paid them, how much one has paid them, and what type of expense was incurred. If the audit remains contested, good record-keeping should cause the Tax Court to find that the IRS should bear the burden of proving that the deductions are not legitimate.