Proving some kickbacks can support disallowance of related deductions

Plain-English summary

A taxpayer deducted meal, entertainment, and advertising payments that the IRS believed included illegal kickbacks. Sections 162(c)(1) and 162(c)(2) place the burden on the IRS to prove a payment is an illegal bribe or kickback to the same extent as in a fraud case. Chief Counsel advised that the IRS need not prove by clear and convincing evidence that every individual payment was a kickback. Once the IRS proves that some payments were covered kickbacks, it may determine the related tax deficiency, which is presumed correct. The taxpayer then bears the burden of showing that the deficiency determination is wrong unless another provision shifts that burden.

Ruling snapshot

• Question: Must the IRS prove by clear and convincing evidence that every disallowed payment was a kickback under section 162(c)(1) or (2)?
• Outcome: advice given, proof that some payments were kickbacks is sufficient before the IRS determines the related deficiency
• Key authorities: IRC §§ 162(c), 7454(a), and 7491(a); Tax Court Rules 142(a) and 142(b)

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum

Number: 202003004
Release Date: 1/17/2020
CC:ITA:B03:NMMulleneaux                            Third Party Communication: None
POSTU-110092-15                                    Date of Communication: Not Applicable

UILC:     162.21-05

date:     October 09, 2019

to:       Leon R. St. Laurent
          General Attorney
          (Large Business & International)

from:     Brinton T. Warren
          Branch Chief, Branch 3
          (Income Tax & Accounting)

subject:  Burden of Proof as to whether Individual Payments Constitute Kickbacks pursuant to
          162(c)(1) and (c)(2).

This Chief Counsel Advice responds to your request for assistance. This advice may
not be used or cited as precedent.

LEGEND

Taxpayer = -----------------------------------------------------------

Product = -----------------------

Individuals = ----------------------------------

Perform Action = --------------------------

Federal Law 1 = --------------------------

Federal Law 2 = ----------------------------------

Federal Law 3 = ------------------------------

State = ---------------------

A = ----------------

B = --------------
C = ------------------

D = ------------------

E = ----------

F = ------

Date 1 = -------------------

Date 2 = -------------------

Date 3 = -------

Industry = ---------------

Title = --------------

Name = ----------------------

ISSUE

Whether an income tax deficiency, arising from disallowed expenses that are
determined by the Commissioner to constitute kickbacks described in I.R.C. § 162(c)(1)
and (c)(2), requires the Commissioner to prove by clear and convincing evidence that
each payment is a kickback, or that only some of the payments are kickbacks, where
§ 162(c)(1) and (c)(2) place the burden of proof on the Commissioner to the same
extent as under § 7454 (concerning the burden of proof when the issue relates to fraud).

CONCLUSION

The Commissioner is not required to prove by clear and convincing evidence that each
payment is a kickback described in § 162(c)(1) and (c)(2). Proof by clear and
convincing evidence that only some of the kickbacks are described in § 162(c)(1) and
(c)(2) is sufficient for the Commissioner to meet the burden of proof imposed by these
subsections. The Commissioner may then make determinations as to the related
deficiencies, and these determinations are presumed to be correct; the taxpayer bears
the burden to prove that the determinations are in error.

FACTS

Taxpayer engaged in the manufacture, promotion, and sale of Product. Taxpayer’s
managers allegedly encouraged sales representatives to persuade Individuals to
Perform Action for Taxpayer’s Product by taking the Individuals out for repeated dinners
and paying the Individuals for speaker engagements. The sales representatives
allegedly warned the Individuals that these benefits would not continue if they failed to
Perform Action for Taxpayer’s Product. Taxpayer deducted the dinner expenses as
meals and entertainment expenses, while payments made to Individuals for speaker
engagements were deducted as advertising expenses (collectively, “Expenses”).

Taxpayer was criminally charged with Federal Law 1, and entered a guilty plea.
Taxpayer agreed to pay a criminal fine in excess of $A, forfeiture in the amount of $B,
and restitution to certain victims. Additionally, Taxpayer was sued civilly in a qui tam
action under the Federal Law 2. The United States did not intervene, but moved to stay
the civil proceedings in the District Court of State while a grand jury investigation was
undertaken by the State AUSA. Both matters were resolved in Date 1 and in the civil
settlement, Taxpayer agreed to pay the plaintiffs more than $C, but made no admission
of guilt. Taxpayer did not admit to the entirety of the facts as alleged by the
government, but did admit that from Date 2 through Date 3, sales representatives took
Individuals out for dinners that included little or no education and that certain speakers
were paid fees to provide promotional presentations even though, in certain instances,
they did not give a complete presentation or any presentation at all. In addition to the
federal suits, Taxpayer was sued by some states individually, a few of its district
managers pleaded guilty to Industry fraud, and the Title of the company, Name, was
unsuccessfully criminally prosecuted for conspiracy to violate the Federal Law 3.

When the Commissioner analyzed Taxpayer’s books and records, it was determined
that the amount of Expenses was approximately $D. Based on a sample of E line-items
of Expenses, the Commissioner found that only F% of the meals and entertainment
expenses paid to Individuals were acceptable as legitimate expenses, and none of the
advertising expenses paid to Individuals were acceptable as legitimate expenses. The
Commissioner issued notices of proposed adjustments, proposing to disallow the
Expenses that were not considered legitimate expenses.

LAW AND ANALYSIS

Section 162(a) allows as a deduction all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or business.

Section 162(c)(1) disallows any deduction for any payment made to an official or
employee of any government if the payment constitutes an illegal bribe or kickback or, if
the payment is to an official or employee of a foreign government, the payment is
unlawful under the Foreign Corrupt Practices Act of 1977. The burden of proof as to
whether a payment constitutes an illegal bribe or kickback (or is unlawful under the
Foreign Corrupt Practices Act of 1977) shall be upon the Secretary to the same extent
as he bears the burden of proof under § 7454 (concerning the burden of proof when the
issue relates to fraud).

Section 162(c)(2) disallows any deduction for any payment made to any person if the
payment constitutes an illegal bribe, illegal kickback, or other illegal payment under any
law of the United States or any law of a State (but only if such state law is generally
enforced). The burden of proof as to whether a payment constitutes an illegal bribe,
illegal kickback, or other illegal payment shall be upon the Secretary to the same extent
as he bears the burden of proof under § 7454 (concerning the burden of proof when the
issue relates to fraud).

Section 7454(a) provides that in any proceeding involving the issue whether the
petitioner has been guilty of fraud with intent to evade tax, the burden of proof in respect
of such issue shall be upon the Secretary.

There is a presumption of correctness attached to any determination of deficiency made
by the Commissioner. Rule 142(a), Tax Court Rules of Practice; Welch v. Helvering,
290 U.S. 111, 115 (1933); Neaderland v. Comm’r, 52 T.C. 532, 538 (1969). When the
Commissioner disallows a deduction, the burden is generally on the taxpayer to prove
to the Tax Court the merits of the deduction. Rule 142(a), Tax Court Rules of Practice;
INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); Nor-Cal Adjusters v. Comm’r, 503
F.2d 359, 361 (9th Cir. 1974). Deductions may be disallowed if they would frustrate
sharply defined national or state policies proscribing particular types of conduct, such as
where a taxpayer has violated a federal or state statute. Comm’r v. Heininger, 320 U.S.
467, 473 (1943). Some of these disallowances are codified in the Internal Revenue
Code.

Section 162(c)(1) and (2) disallow deductions for certain payments that would otherwise
be deductible under § 162(a), and place the burden of proving that a payment is one
described in § 162(c)(1) or (2) on the Commissioner to the same extent as he or she
bears the burden of proof under § 7454 (concerning the burden of proof when the issue
relates to fraud). Section 7454(a) provides that for proceedings involving fraud with the
intent to evade tax, the burden of proof with respect to that specific issue is on the
Commissioner. This burden is to be carried by clear and convincing evidence. Rule
142(b), Tax Court Rules of Practice. The Commissioner may meet his burden by
presenting several badges of fraud throughout the entire record. Hicks Co. v. Comm’r,
56 T.C. 982, 1019 (1971).

Although the burden of proving fraud falls upon the Commissioner, the burden of
proving entitlement to deductions is with the taxpayer. Id. at 1031. Once the
Commissioner proves fraud with clear and convincing evidence, the burden shifts to the
taxpayer to rebut the Commissioner’s deficiency determination on any items falling
within the logical ambit of that fraud, and, further, such rebuttal must take the form of
something more than bank statements, receipts, and cancelled checks, or cursory,
unsubstantiated assertions of business need. See Neaderland at 538-541.

Courts generally presume that Congress is aware of the law pertinent to the legislation it
enacts, particularly when the new legislation invokes and builds off of an existing
framework. Internal Revenue Service v. Murphy, 892 F.3d 29, 35 (1st Cir. 2018)
(quoting Goodyear Atomic Corp. v. Miller, 486 U.S. 174, 184-85 (1988)). When
Congress obviously borrows words from another legal source, the words “bring[] the old
soil with it.” Sekhar v. U.S., 570 U.S. 729, 733 (2013) (quoting Justice Frankfurter in
Some Reflections on the Reading of Statutes, 47 Colum. L. Rev. 527, 537 (1947)).
Here, in § 162(c)(1) and (c)(2), Congress directly references the fraud statute, so we
must assume that Congress was aware of the law pertinent to the legislation—namely,
that once the Commissioner meets his burden of proving the presence of fraud, he may
make a determination regarding deficiencies coming within the logical ambit of that
fraud, and those determinations are presumed to be correct This is a straightforward
result, and, absent the presence of any congressional intent to the contrary, we must
generally apply these established principles regarding fraud and deficiency
determinations to § 162(c)(1) and (2).

Thus, in the present case, similar to fraud cases, once the Commissioner proves that
some of the Expenses are kickbacks described in § 162(c)(1) or (c)(2), he or she then
separately determines the total deficiency in the income tax. This means that while the
burden of proof falls to the Commissioner with respect to the issue of whether some of
the Expenses are described in § 162(c)(1) or (c)(2), the Commissioner retains the
presumption of correctness in regard to the determination of any deficiencies. The
burden of proof regarding Taxpayer’s deficiency does not shift to the Commissioner
unless a separate provision shifts that burden. For example, § 7491(a) shifts the
burden of proof as to all issues relevant to the amount of the taxpayer’s liability if the
taxpayer introduces credible evidence, substantiates items, maintains required records,
and fully cooperates with the Commissioner’s requests.

Here, the Commissioner is required to prove by clear and convincing evidence, by
considering the entire record, that Taxpayer made some payments that are kickbacks
described in § 162(c)(1) or (c)(2). Once the Commissioner has met this burden of proof,
he or she may disallow Taxpayer’s deductions for Expenses by making a determination
of deficiency. This determination has a presumption of correctness. The Commissioner
does not bear the burden of proving by clear and convincing evidence that each
individual payment is a kickback described in § 162(c)(1) or (c)(2).

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

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