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Tax Court Corner: The Important Concept of Collateral Estoppel

Feb 1st 2017
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In the perplexing case of Isidro Garza Jr., et al. v. Commissioner, TC Memo 2017-7, we run into something called collateral estoppel.

It is an important concept that can basically be explained like this: Under the doctrine of collateral estoppel (also known as “issue of preclusion”), an issue that is actually litigated in a prior action between two or more parties is conclusive of the same issue raised in a later action between the same parties or those in privy of interest with them.

For collateral estoppel to be invoked, four factors need to be present:

  1. The issue must be identical in the pending case to that decided in the prior proceeding.
  2. The issue must necessarily have been decided in the prior proceeding.
  3. The party to be estopped must have been a party or have been adequately represented by a party in the first proceeding.
  4. The precluded issue must actually have been litigated in the first proceeding.

It should be common knowledge that if you commit a crime, then after your prison sentence there are other repercussions. For example, in the past, drug dealers would be sentenced to prison for dealing drugs, and after their sentence was served, the IRS would examine the tax returns in question and hit the drug dealers with an additional tax liability. That is pretty much no different from what has happened in this case.

The facts of this case are that Isidro Garza Jr. and his wife, Martha, organized an S corporation in 1995 for the purposes of Isidro’s engineering business, Bay Area Consultants (BAC) Inc. Martha worked as the bookkeeper and office manager in the business. She hired a CPA firm to file the couple’s 1995 Form 1120S. No other S corporation return was filed after 1995.

For the years at issue – 1998, 2000, 2001, and 2002 – Isidro managed an Indian tribe’s casino. His wife acted as the casino’s bookkeeper. Isidro’s compensation from the casino was 10 percent of the casino’s net income. He instructed the tribe to pay his management fees to BAC, and the tribe did so. Martha was aware of the management fees paid to her husband and deposited into BAC’s bank account – the amounts of these fees were several hundred thousand dollars per year.

Isidro also withdrew approximately $35,000 to $50,000 in cash for each of the years at issue from the casino’s vault. None of the other individual cash withdrawals from the casino’s vault equaled or exceeded $10,000.

After 1998, BAC did not exist as a legal corporate entity, but it continued to maintain a bank account, which received Isidro’s management fees from the tribe.

On their 1998 and 2002 joint returns, the only amounts of income that the Garzas reported from the casino were the amounts that they withdrew from the BAC account, which was only approximately $20,000 per year. The Garzas hired an accounting firm to prepare their 2000 and 2001 tax returns, but they never filed for those years.

In 2007, Isidro was convicted of conspiracy to commit theft from an Indian tribe, and both he and his wife were found guilty of tax evasion under Code Section 7201 for tax years 1998 through 2002. They both served prison time.

In 2010, they appealed their verdicts, had the verdicts vacated, and had their cases remanded for new trials. In 2012, Isidro pled guilty to the theft charge, and Martha pled guilty to one count of tax evasion. Their pleas were accepted.

In 2008, they had filed an amended 1998 return on which the Form 1040 Schedule C showed all of the casino’s income, as well as a large amount of business expenses.

The only issues before the US Tax Court were whether the spouses were liable for the Section 6663 civil fraud penalties for tax years 1998 and 2002. The court found both spouses liable.

The Tax Court concluded that, as a result of her tax evasion guilty plea, Martha was collaterally estopped from asserting a defense to a civil fraud penalty for tax year 2002.

The court said that whether the application of collateral estoppel is appropriate necessitates four inquiries:

  1. Whether the party to be estopped was a party to or assumed control of the prior litigation.
  2. Whether the issues presented are, in substance, the same as those resolved in the earlier litigation.
  3. Whether the controlling facts or legal principles have changed significantly since the earlier judgment.
  4. Whether other special circumstances warrant an exception to the normal rules of preclusion.

Martha conceded that her plea agreement met the first three of the above elements of collateral estoppel. However, she argued that her guilty plea should not preclude her from contesting the Section 6663 fraud penalty for tax year 2002 because “other special circumstances warrant an exception to the normal rules of preclusion.”

She argued:

  • Her guilty plea agreement was binding only between her and the US Attorney’s Office, and could not be relied upon by the IRS.
  • Her motivation for entering the guilty plea was that she had already served nearly three years in prison before her initial conviction was reversed, and the plea agreement would be enforced only if the US District Court sentenced her to time served.

But the Tax Court said it has held repeatedly that a taxpayer is collaterally estopped from denying civil tax fraud under Section 6663 when convicted for criminal tax evasion under Section 7201 for the same tax year. Martha’s guilty plea conclusively established the elements necessary for finding fraud under Section 6663 because the elements of criminal tax evasion and civil tax fraud are identical.

And, the court said, the fact that Martha’s plea agreement did not mention the IRS was irrelevant because the IRS is in privity with the US Attorney’s Office – the plaintiff in her criminal proceedings. Her motivation for entering into the plea agreement was irrelevant and did not undermine the reliability of the admissions she had made. Therefore, the court held that Martha was collaterally estopped from denying the existence of fraud for tax year 2002.

The Tax Court also found that the Garzas exhibited many of the “badges of fraud” for both 1998 and 2002. First, they consistently understated their income. They had conceded that they severely understated their income for not only 1998 and 2002, but also for 2000 and 2001. They failed to even file a return for 2000 and 2001.

The Garzas contended that their understatements did not constitute evidence of fraudulent intent because Martha lacked the expertise to calculate the couple’s income properly and prepare their returns.

But the court said the Garzas knew their income was substantially greater than what they reported on their returns. It was their choices, not their limited bookkeeping experience, that had them prepare and file false tax returns for 1998 and 2002.

The question is, should we agree with the Tax Court? Stop and think about this for a second: Both husband and wife served a prison sentence, and that sentence was then set aside. When there was a plea bargain that each took, where the penalty for the crime just happened to be the time served, the couple cried “Uncle” and gave up. So, what does the tenacious IRS do? It goes after them for stupid civil penalties. The couple even goes so far as to admit that they copped a plea to just end the nightmare that they have endured.

Legally, I believe that the Tax Court is doing what it is designed to do. However, is this just a step for the taxpayer to get the ruling and appeals to US District Court, with the hope that it will be thrown out? Is estoppel really the issue here? I think this whole thing just needs to go away.

What do you think?