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No Fraud Found Where IRS and Taxpayer's CPA Turned Their Heads on Improper Inventory Reporting.

(Parker Tax Publishing September 30, 2015)

The IRS did not prove fraud by clear and convincing evidence for purposes of extending the statute of limitations. As a result, a company that had improperly reported its inventory escaped liability for over $13 million in taxes and penalties. Transupport, Inc. v. Comm'r, T.C. Memo. 2015-179.

Background

Harold Foote founded Transupport, Inc. in 1972. During the years in issue, Foote and his four sons were the company's only full-time employees and officers. Transupport is a supplier and surplus dealer of aircraft engines and engine parts for use in military vehicles. It primarily purchased surplus parts from the government in bulk lots that contained parts having little value as well as parts that Transupport wanted for its business. The company bought the lots to acquire items that it expected to sell but ended up with items that would not be sold. The costs of particular items were not specified as part of the purchase transactions.

The company was also a distributor of parts. Distributorship purchases were of specific parts, and the individual item costs were traceable. The purchased distributorship items were susceptible to accurate inventory accounting, and some computer records were kept in later years, but an accurate inventory was never made part of Transupport, Inc.'s financial and tax reporting.

In the 1970s, Transupport hired Elaine Thompson as its accountant and she served as the company's accountant until she died in 2010. She was a CPA and a name partner in her firm. Transupport provided to Thompson handwritten summaries, usually prepared by one of Foote's sons. Thompson, through her accounting firm, prepared compiled financial statements for Transupport for 1990 through 2008. The compiled financial statements were based upon the summaries and upon financial information maintained by Transupport. The financial statements were not audited by Thompson or her firm, and the information on the summaries was never verified by Thompson or her firm.

Thompson prepared Transupport's Forms 1120 using the same financial information provided by Transupport in connection with the preparation of the company's compiled financial statements. Costs of goods sold reported as percentages of purchases ranged from 91 percent for 2008 to over 100 percent for 1999, 2002, 2004, and 2005.

IRS Audits

The IRS audited Transupport's Forms 1120 for 1982, 1983, 1988, 1989, and 1990. The IRS was aware that Transupport did not maintain a physical inventory of the unsold parts in its warehouse and backed into the closing inventory, reported in its returns, by using a percentage of sales as costs of goods sold. The examining agent accepted Transupport's representation that, on the basis of Foote's experience in selling the surplus items, Transupport had averaged approximately a 30 percent gross profit margin. Although the examining agents in each audit informed Foote or Thompson that Transupport should maintain a physical inventory, the costs of goods sold were adjusted only to reflect a minor change in the purchases that Transupport made in 1983.

In connection with a potential sale of Transupport in 2007, Foote hired Richard Lodigiani and provided him with estimates of inventory and profit margins on surplus parts. Based on conversations with Foote, Lodigiani prepared a confidential offering memorandum. Included in the memorandum was a document entitled "Recast Financial Summary," in which the profits of Transupport's operations as reported on its financial statement and tax returns were substantially improved.

Foote also provided prospective purchasers with information about engines in inventory in 2007. By any measure, Transupport's inventory at cost or market value in 2007 far exceeded the inventory values reported on its correlating financial statements and tax return. Copies of the documents prepared by Lodigiani were provided to prospective purchasers, including Peter LaHaise. During his conversations with prospective purchasers, Foote never disavowed the information set forth in the Lodigiani documents.

In 2009, the IRS audited Transupport's returns for 2006 and 2007. The audit was conducted by Revenue Agent Robert Canale. By early October 2009, the audit was expanded to include 1999 through 2005. The IRS subsequently issued notices of deficiency in which Transupport's costs of goods sold were adjusted to reflect a 25 percent cost and a 75 percent profit on its sales of surplus parts. Compensation to Transupport's officers other than Foote were reduced to reflect a reasonable allowance for their compensation. The notices also determined that all or part of the underpayments of tax were due to fraud or, to the extent that the fraud penalty did not apply, that an accuracy-related penalty under Code Sec. 6662(a) applied. Additional tax and penalties assessed for 1999 through 2008 totaled over $20 million. The determinations were made on the basis of the admissions in the documents prepared by Lodigiani and statements made to Canale by Foote. Of the 10 years at issue, the statute of limitations barred assessments for seven of those years, absent proof of fraud. Taxes and penalties assessed for those seven years totaled more than $13 million.

Analysis

The Tax Court held that the IRS did not prove fraud by clear and convincing evidence for purposes of extending the statute of limitations and, thus, the IRS assessments for years 1999 through 2005 were barred.

The admissions made in Transupport's promotional materials established, the court said, that the company's officers and shareholders knew that the ending inventory was substantially undervalued. Those materials, the court noted, openly asserted that the accounting method used allowed current write-offs of purchases during the year, and they boasted of a gross profit percentage far in excess of that reported on Transupport's tax returns. However, the court noted, those claims were not concealed. Transupport's methodology had been used for years notwithstanding two prior audits and Transupport's use of a well-qualified accountant who knew or should have known that Transupport did not keep physical inventories. The court was not persuaded, however, that the clear and convincing evidence of underpayments also established fraudulent intent.

The court noted that the actions or inactions of Transupport's accountants and the IRS auditors included no clear warnings to Transupport that its conduct was illegal or fraudulent. According to the court, to the extent that none of these professionals undertook the task of determining Transupport's correct income, they were complicit in the duration of the improper reporting. As a result, the court concluded that fraud had not been established and assessments for 1999 through 2005 were barred.

OBSERVATION: The case ended up before the court only because the IRS's acquiescence in Transupport's methodology ended when a whistleblower saw an opportunity for an informant's reward.

For a discussion of situations in which there is no statute of limitations, see Parker Tax ¶260,130. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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