Tax Court Upholds $780K in Deficiencies and Fraud Penalties Against Tax Preparer for Underreporting Income

Tax Court Upholds $780K+ in Fraud Penalties Against Preparer for Diverting Client Refunds

On September 17, 2026, the U.S. Tax Court issued a Memorandum Opinion sustaining deficiencies and fraud penalties totaling $780,251 against tax preparer Dawn C. Cottman for tax years 2009–2011. The court upheld the IRS’s determination that Cottman diverted client refunds into her personal accounts, a scheme that triggered the fraud exception under § 6501(c)(1), eliminating the statute of limitations. Despite Cottman’s prior criminal conviction for tax fraud in 2024, the Tax Court sustained the penalties, reinforcing that fraud in tax preparation carries irreversible civil consequences.

The Tax Court’s ruling invokes § 6501(c)(1), which eliminates the three-year statute of limitations when fraud is proven. The court found that Cottman’s conduct met the clear and convincing evidence standard under § 7454(a), reinforcing the Tax Court’s expansive authority in fraud cases. For tax professionals, the decision serves as a cautionary tale: fraud triggers indefinite IRS scrutiny and eliminates time-based defenses.

The Scheme: Diverting Client Refunds into Personal Accounts

Dawn C. Cottman operated 40 AM Tax Service from her Maryland home, preparing approximately 1,219 federal and state income tax returns for clients between 2009 and 2013. Despite presenting herself as a tax professional, she never obtained a PTIN and omitted her identity from returns. Her scheme involved directing the IRS to deposit client refunds directly into accounts she controlled, a tactic that ultimately triggered civil fraud penalties.

Cottman opened over two dozen accounts across multiple financial institutions, depositing client refunds into accounts she controlled. She reported 40 AM’s earnings on her Schedule C but failed to disclose client refunds as taxable income or maintain records of claimed disbursements. The IRS later treated these deposits as unreported income due to the lack of substantiation.

Cottman’s criminal conviction in 2018 exposed the full scope of her deception. A federal grand jury indicted her on 14 counts, including conspiracy to defraud the U.S. (18 U.S.C. § 286), filing false claims (18 U.S.C. § 287), wire fraud (18 U.S.C. § 1343), aggravated identity theft (18 U.S.C. § 1028A(a)(1)), and filing false tax returns (§ 7206(1)). The jury found her guilty on all counts, confirming her scheme to fraudulently inflate refunds, file returns in clients’ names without consent, and divert refunds into her personal accounts. She served over three years in prison, but the IRS continued pursuing civil fraud penalties.

The civil examination faced obstacles due to grand jury secrecy rules and Cottman’s incarceration. Revenue Agent Samuel Herr conducted Bank Deposits Analyses (BDAs) for 2009 and 2010, comparing deposits to reported income and treating withdrawals without substantiation as unreported income. Cottman’s lack of cooperation and incarceration prevented her from providing additional records. By February 2022, the IRS proposed civil fraud penalties under § 6663, which were issued in January 2023.

Cottman filed for bankruptcy in July 2023, but the discharge did not resolve her fraudulent tax debts. Revised BDAs reduced unreported income for 2009 and 2010, while records obtained in 2025 revealed $1,165,007 in unreported income for 2011. The IRS did not seek an increased deficiency, and Cottman failed to respond to requests for documentation. The trial proceeded on April 15, 2025.

The Dispute: Fraud vs. Sloppy Recordkeeping

At the Tax Court trial on April 15, 2025, the IRS argued that Cottman’s failure to report income, inability to substantiate withdrawals, and criminal convictions demonstrated fraudulent intent. Cottman countered that the income belonged to her clients, she lacked access to records due to incarceration, and the IRS’s BDA was flawed.

The IRS argued that Cottman’s failure to report income deposited into her accounts violated § 61(a)(1), constituting an underpayment under § 6663(a). Her inability to maintain records under § 6001, criminal convictions (18 U.S.C. § 286 and § 7206(1)), and lack of cooperation during the examination further supported a finding of fraud.

Cottman argued that the income belonged to her clients and was held in trust, blaming record unavailability on IRS confiscation in 2013 and her incarceration. She claimed the IRS’s BDA was flawed for treating all deposits as taxable income and failing to account for nontaxable transfers. She also contended that her inadequate recordkeeping was due to the cash-intensive nature of her business, not an intent to conceal. Cottman further argued that her criminal convictions were unrelated to the tax years at issue and did not prove fraudulent intent.

The Court's Hammer: How Badges of Fraud Sealed the Deal

The Tax Court did not mince words in its fraud analysis, methodically dismantling the petitioner’s arguments by weighing the evidence against the eleven recognized "badges of fraud." The court’s reasoning hinged on the IRS’s burden of proof—§ 7454(a), which requires the IRS to establish fraud by clear and convincing evidence—and the fraud exception to the statute of limitations under § 6501(c)(1), which removes the three-year limitations period if fraud is proven. The court’s analysis was not a mere recitation of legal standards but a surgical application of circumstantial evidence to the facts, leaving little room for the petitioner’s defenses.

The court began by rejecting the petitioner’s claim that her criminal convictions were irrelevant to the tax years at issue. While § 7206(1)—the criminal statute for false tax returns—does not per se prove fraudulent intent for civil penalties, the court found that the petitioner’s 2011 conviction under § 7206(1) estopped her from disputing an underpayment for that year. The conviction specifically stated that she had reported "amounts on her 2011 tax returns that were substantially different from the correct amounts," which the court held necessarily implied an underpayment. The court further extended this logic to 2009 and 2010, citing the petitioner’s 18 U.S.C. § 286 conviction—which found she had "added materially false information to tax returns" and "prepared and filed income tax returns in other people’s names without their knowledge or consent"—as persuasive evidence of underpayments for all three years. The court also relied on the IRS’s Bank Deposits Analysis (BDA), which showed gross receipts underreported by 1,235% in 2009, 255% in 2010, and 685% in 2011, as "clear and convincing evidence of underpayments."

The court then addressed fraudulent intent, requiring proof of intentional evasion of tax, not mere negligence. Relying on the eleven badges of fraud (Gottesman v. Commissioner, T.C. Memo. 2025-94), the court evaluated Cottman’s conduct. Seven badges overwhelmingly favored the IRS, including her staggering pattern of underreporting income: she reported gross receipts of $11,550 (2009), $114,575 (2010), and $151,200 (2011), but the IRS’s BDA revealed unreported amounts of $142,622, $291,982, and $1,035,559, respectively (1,235%, 255%, and 685% discrepancies). The court treated these as calculated omissions designed to evade tax, far exceeding the 100% threshold cited in Cooley v. Commissioner, T.C. Memo. 2004-49.

The court evaluated seven badges of fraud favoring the IRS:

1. Inadequate records: Cottman’s failure to maintain invoices, client agreements, or ledgers was highly suspicious for a tax preparer. The IRS’s BDA exposed her lack of documentation as a calculated effort to obscure earnings.

2. Concealment of income: She diverted over $780,000 in client refunds into her personal accounts without their knowledge, a "classic scheme of fraud" enriching herself at the expense of clients and the IRS.

3. Illegal activities: Her criminal convictions (18 U.S.C. § 286) covered her conduct from January 2009–March 2013, encompassing all tax years at issue. The court held her intent to evade tax was evident in her criminal conduct, including filing returns in clients’ names without consent.

4. Implausible explanations: Cottman claimed the unreported income belonged to clients, but her sheer volume of unreported income and lack of contemporaneous records made this explanation not credible. Her testimony was self-serving and inconsistent.

5. Filing false documents: She materially altered returns to inflate refunds, a hallmark of fraud when done repeatedly over multiple years.

6. Cash dealings without records: Despite operating a cash-intensive business, she failed to maintain receipts, invoices, or bank records, designed to avoid detection by tax authorities.

The court considered Cottman’s delayed and evasive responses and inconsistent testimony as neutral factors, further undermining her credibility. While no single badge was dispositive, the combination of seven badges favoring fraud, her criminal convictions, and staggering underreporting left no reasonable doubt of her intent to evade tax. The court applied collateral estoppel for 2011 based on her § 7206(1) conviction, extending the logic to 2009–2010 using her § 286 conviction and the IRS’s BDA. This streamlined the fraud analysis, allowing the court to focus on intent without re-litigating underpayments.

The court’s holding was unflinching, quoting Midwest Med. Aesthetics Ctr. v. Commissioner, T.C. Memo. 2024-32, that "fraud is never presumed and must be established by independent evidence of a taxpayer’s fraudulent intent." The totality of the badges of fraud provided that evidence, leaving no room for Cottman’s defenses. The decision was not a close call but a decisive rejection of her arguments, underscoring the Tax Court’s willingness to exercise its full authority in fraud cases.

This case serves as a cautionary tale for tax preparers and taxpayers: the Tax Court will not hesitate to impose fraud penalties when evidence is overwhelming. The court’s willingness to disregard implausible explanations and rely on circumstantial evidence signals a tougher stance on fraud, particularly in cases involving cash businesses, unreported income, and criminal convictions. For future taxpayers, the lesson is clear: fraud is not a game of chance—it is a game of evidence, and the IRS holds all the cards.

Key Takeaways for Tax Preparers and Taxpayers

The Tax Court’s ruling in T.C. Memo. 2026-XX sends a clear warning: commingling client refunds with personal funds and failing to report them as income triggers fraud penalties. The decision underscores that fraud is a matter of intent, not negligence, and circumstantial evidence alone can seal a taxpayer’s fate. For practitioners, the implications are stark: the IRS and Tax Court are increasingly willing to infer fraud from patterns of behavior, particularly when refunds vanish into personal accounts without explanation.

The court’s reliance on badges of fraud signals a shift in civil fraud adjudication. Unlike criminal prosecutions, civil fraud under § 6663 requires only clear and convincing evidence, a lower threshold the IRS is exploiting more frequently. The ruling also reinforces collateral estoppel, where a prior criminal conviction for tax fraud (e.g., § 7206(1)) can preclude denying fraud in civil proceedings. This creates a double jeopardy-like scenario, where a single fraudulent act can trigger both criminal liability and crippling civil penalties.

For tax preparers, the case highlights the perils of poor recordkeeping and commingling funds. The court rejected Cottman’s argument that refunds were "loans" or "gifts," reflecting a broader trend: the IRS and Tax Court view such explanations as implausible when refunds are systematically diverted. Preparers must treat client refunds as sacrosanct, documenting every transaction and ensuring all income—including refunds—is properly reported. The court’s refusal to accept vague assertions of "poor bookkeeping" underscores that fraud penalties apply even to rudimentary failures to maintain records.

The interplay between criminal convictions and civil fraud penalties complicates the landscape. The court’s decision to uphold fraud penalties despite Cottman’s prior criminal conviction suggests civil fraud penalties can stand independently. This means even if a preparer avoids jail time, the IRS can impose 75% penalties under § 6663, effectively doubling the financial burden. Practitioners must proactively disclose errors—voluntary disclosure may mitigate penalties, but silence is treated as an admission of fraud.

Finally, the court’s rejection of the bankruptcy discharge argument under 11 U.S.C. § 523(a)(1)(C) serves as a cautionary tale: fraudulent tax liabilities are permanent. Once fraud is proven, the debt follows taxpayers indefinitely, whether through civil penalties, criminal prosecution, or the inability to discharge the liability in bankruptcy.

The message to tax preparers is unambiguous: fraud is not a game of chance but a game of evidence, and the IRS holds all the cards. The Tax Court’s ruling is a harbinger of stricter enforcement—one where circumstantial evidence, prior convictions, and the absence of credible explanations outweigh plausible denials. For practitioners, the lesson is simple: document everything, report everything, and never commingle client funds. The alternative is a 75% penalty, an open statute of limitations, and a permanent stain on your professional reputation.