How Section 7491 Shifts the Burden of Proof in Tax Cases

Tax disputes between the IRS and taxpayers often hinge on who bears the burden of proof. Typically, taxpayers must substantiate their claims, while the IRS’s determinations are presumed correct. However, Section 7491 of the Internal Revenue Code can shift this burden under certain conditions, offering taxpayers a potential advantage in litigation.

This shift is not automatic and depends on meeting specific criteria. Understanding how and when it applies is essential for anyone facing an IRS challenge.

Statutory Criteria for Taxpayers

For the burden of proof to shift under Section 7491, taxpayers must fully cooperate with the IRS, which includes providing requested records, attending interviews if necessary, and responding to inquiries. Filing a tax return alone is insufficient—active participation in the audit process is required.

Taxpayers must also maintain proper records as mandated by the Internal Revenue Code. This includes receipts, invoices, and bank statements to substantiate income, deductions, and credits. Section 6001 requires taxpayers to retain records as long as they may be relevant to tax administration. Without adequate documentation, the burden of proof remains with the taxpayer.

Additionally, taxpayers must meet substantiation requirements for deductions and credits. Certain deductions, such as charitable contributions or business expenses, require specific forms of proof. Donations of $250 or more must have a contemporaneous written acknowledgment from the charity, as outlined in Section 170(f)(8). Business expenses must be documented with receipts and an explanation of their purpose. Without proper substantiation, the IRS is not obligated to accept a taxpayer’s claims, and the burden of proof does not shift.

Role of Credible Evidence

To shift the burden of proof under Section 7491, taxpayers must present credible evidence supporting their claims. This evidence must be persuasive enough that, if unchallenged, it would lead a reasonable person to conclude the taxpayer’s position is correct.

Courts assess credibility based on the quality and consistency of documentation. For example, a substantial business deduction is more convincing when supported by dated invoices, contracts, and payment confirmations. Testimony alone, without supporting documents, is generally insufficient. In Higbee v. Commissioner, courts ruled that uncorroborated statements do not meet the threshold for credible evidence, reinforcing the importance of thorough recordkeeping.

Original documents, such as bank statements or signed agreements, carry more weight than self-prepared summaries or estimates. If records appear altered, incomplete, or inconsistent with other filings, they may be disregarded. Expert testimony can sometimes serve as credible evidence, particularly in cases involving valuation disputes or technical tax issues. A certified appraisal for property donations, for instance, is far more effective than a taxpayer’s personal estimate.

Relevance to IRS Examinations

During an IRS examination, the agency reviews a taxpayer’s filings for accuracy and compliance. Audits can be triggered randomly but often result from discrepancies in reported income, excessive deductions, or patterns that deviate from industry norms. The IRS uses data-driven methods, such as the Discriminant Function System (DIF), to identify returns with high potential for adjustments. When selected for review, taxpayers must substantiate their positions with clear, organized documentation.

The complexity of the examination process depends on the taxpayer’s financial situation. Correspondence audits, which involve document requests by mail, are common for individual filers with relatively simple issues such as unverified charitable contributions or missing 1099 forms. More detailed office and field audits require in-person meetings, where IRS agents may request explanations for business expenses, travel deductions, or asset valuations. For taxpayers with investments, rental properties, or self-employment income, the IRS may scrutinize depreciation schedules, capital gains calculations, and basis adjustments.

Taxpayers undergoing an examination must also be aware of potential penalties if discrepancies are found. Accuracy-related penalties under Section 6662 apply when understatements exceed the greater of 10% of the correct tax liability or $5,000. If the IRS determines negligence or substantial understatement, penalties can reach 20% of the underpaid amount. In cases of fraud, penalties can soar to 75% of the deficiency, making proper preparation and record retention essential.

Effect on Tax Deficiencies

A tax deficiency arises when the IRS asserts that a taxpayer owes additional tax beyond what was reported. The burden of proof determines whether the IRS must justify this claim with substantive evidence or if the taxpayer must disprove it. If Section 7491 applies, the IRS must establish the accuracy of the proposed deficiency rather than relying on its initial presumption of correctness.

For taxpayers engaged in complex financial transactions, the allocation of the burden of proof can shape the outcome of disputes involving partnership income, capital gains, or loss carryforwards. If the IRS challenges the legitimacy of a business deduction or the classification of an expense, the agency must present compelling evidence if the burden has shifted. This is particularly relevant under Section 162(a), which governs the deductibility of ordinary and necessary business expenses. If a taxpayer meets the requirements of Section 7491, the IRS cannot simply disallow an expense without substantiating why it fails to meet statutory requirements.

Exceptions to the Burden Shift

While Section 7491 allows taxpayers to shift the burden of proof onto the IRS, there are notable exceptions based on the taxpayer’s conduct, the nature of the tax liability, and specific statutory exclusions.

Taxpayer Misconduct or Fraud

If the IRS determines that a taxpayer engaged in fraud, the burden of proof remains with the taxpayer regardless of whether they meet the general requirements of Section 7491. Fraud includes deliberately underreporting income, falsifying records, or engaging in schemes to evade taxes. Under Section 6663, the IRS must prove fraud by clear and convincing evidence, but once established, the taxpayer loses any opportunity to shift the burden. Courts have consistently upheld this principle, as seen in Niedringhaus v. Commissioner, where intentional misstatements prevented the taxpayer from benefiting from burden-shifting provisions.

Additionally, if a taxpayer fails to fully cooperate with an IRS examination—such as refusing to provide requested documents or obstructing the audit—they forfeit the protections of Section 7491. Cooperation goes beyond submitting records; it includes timely responses, attending scheduled meetings, and providing explanations when requested. A lack of transparency or failure to comply with procedural requirements allows the IRS to maintain its presumption of correctness.

Taxpayer’s Net Worth and Certain Tax Cases

Section 7491 applies only to individual taxpayers and certain small businesses with a net worth not exceeding $7 million at the time of litigation. This limitation prevents large corporations and high-net-worth individuals from shifting the burden in disputes involving substantial tax liabilities. The rationale is that wealthier taxpayers typically have greater resources to substantiate their claims and should bear the responsibility of proving their positions.

The burden shift does not apply to cases involving penalties, additions to tax, or interest determinations. For example, if the IRS imposes an accuracy-related penalty under Section 6662, the taxpayer must prove they acted with reasonable cause and in good faith. Similarly, disputes over foreign income reporting, such as penalties under the Foreign Account Tax Compliance Act (FATCA), remain the taxpayer’s responsibility to contest. These exclusions ensure that Section 7491 is not used to avoid accountability where the taxpayer’s actions directly contributed to the tax deficiency.