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IRS goes after Royce Gracie claiming tax underpayment, fraud totaling $1.15 million

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Royce Gracie isn’t scheduled to fight at Bellator 149 until February, but he’s in a serious fight with the IRS over his taxes, including whether he rightfully claimed a tax credit for the poor.

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Remember the scrawny guy in a gi who smoked the field at UFC 1 and had everyone scratching their heads as to how such a thing was possible? Well Royce Gracie is now a UFC Hall of Famer who's scheduled to come out of an almost nine-year MMA layoff/retirement on Feb. 19 for a trilogy fight with his old archrival Ken Shamrock in Gracie's Bellator promotional debut.

While that fight will be upon us soon enough, few are aware that Gracie is smack dab in the middle of another fight against an even tougher, more battle-tested opponent who can't be grappled into submission: The U.S. Internal Revenue Service (IRS).

Gracie's tax problems appear to have begun in 2012 when he and his wife each received an IRS administrative summons "seeking information about their foreign bank and foreign investment activities." It is unclear exactly how the Gracies first appeared on the IRS's radar, but an investigation began and the IRS needed additional documents for tax years 2007 through 2011 in order to evaluate "among other things, [the Gracies'] liability for civil penalties."

Gift - Gracie-IRS - 1a - U.S. Petition

The Gracies were summonsed to appear before the IRS and produce bank documents. After failing to appear on December 31, 2012 in accordance with the summons, the Assistant U.S. Attorney Chief for the Tax Division filed a legal Petition to enforce said summons, including a declaration from IRS agent Gloria Ybarra stating certain facts as she understood them.

According to the Petition, Agent Ybarra was assigned "to examine potential international tax issues relating to the [Gracies'] federal income tax returns..." She believed she had discovered foreign bank accounts in which the Gracies had signature authority, yet did not disclose to the IRS.

To date, my investigation has revealed that during the years 2008 - 2011: 1) the [Gracies] had signature authority over an [sic] foreign bank account at HSBC bank in Switzerland; 2) the [Gracies] had signature authority over a foreign bank account at Caixa Penedes bank in Spain; 3) the [Gracies] had a foreign bank account at First Gulf Bank in Abu Dhabi; and, 4) the [Gracies] did not disclose the full extent of their foreign bank account activities on their U.S. tax returns (Forms 1040) as required by law.

...

On February 1, 2013, the [Gracies'] attorney sent a letter listing their objections to complying with the summonses. No documents were included with this letter. Among the objections set forth in the letter was a claim that the 2008 year was barred because the IRS had closed its 2008 domestic audit. The [Gracies'] also raised a Fifth Amendment privilege against self-incrimination.

Agent Ybarra believed over $3 million was wired into the U.S. from these bank accounts on behalf of the Gracies, which appeared to be in conflict with their "minimal taxable income" and certain claims for tax credits.

I have determined that during the years 2007 - 2011 over $3M was wired from foreign banks accounts into U.S. bank accounts on behalf of the [Gracies]. These funds were used to pay for, among other things, renovations to their vacation property in Mammoth lakes, California, and personal credit card debts.

In 2008, approximately $350,000 was wired from offshore accounts towards the purchase of the [Gracies'] residence in Palos Verdes, California. In 2010, the [Gracies] purchased real estate in California. $497,972 was wired from an offshore account to make that purchase.

For the years 2008 - 2011, the [Gracies] have filed federal individual tax returns showing minimal taxable income. They claimed a $4000 child tax credit in each of the years under investigation. They claimed an earned income credit in 2009 and 2010.

The Earned Income Credit is essentially a subsidy to low-income, working families, providing a tax credit to the working poor which phases out as a family's income rises. It stands to reason that the IRS would be suspicious as to how Royce Gracie, a UFC Hall of Famer who claims to oversee more than 55 U.S. and international Royce Gracie Jiu-Jitsu Networks, and his wife, a doctor of podiatric medicine, would fall into the category of the working poor.

According to the government, the Gracies met with Agent Ybarra on Apr. 3, 2014 but did not produce most of the required records, leading to a motion to hold them in contempt. The two sides would spar back and forth in legal filings for four months until the IRS finally received the desired bank records and the government withdrew its contempt motion.

On April Fools' Day 2015, the IRS sent the Gracies a completely serious Notice of Deficiency claiming they owe $657,114 in back taxes and $492,835.25 in penalties for Civil Fraud based on IRC 6663(a) which reads, "If any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud."

Gift - Gracie-IRS - 1b - IRS Notice of Deficiency

(Writer's note: The IRS redacted the Gracies' Taxpayer Identification Number while Bloody Elbow chose to redact their address.)

The deficiency notice also includes a form containing IRS adjustments to the Gracies documented income for tax years 2007-2012 which Bloody Elbow had reviewed by an independent accounting firm.

According to the Income Tax Examination Changes form, the Gracies claimed taxable income of roughly $38,000 in 2007 and net losses ranging from roughly $66,000 to $204,000 in the years thereafter (Line 3). As a result, the Gracies appear to have reported annual tax liabilities of just $900, $2,545, $170, $0, $0, and $3,925 in 2007-2012, respectively (Line 12). Simply put, the most income tax the Gracies allegedly owed the U.S. government in any year at issue was a little over $3,900, and twice they owed nothing.

If the IRS adjustments are found to be correct, the Gracies' annual tax liability for 2007-2012 will rocket up to $41,577, $91,177, $5,823, $239,756, $138,732, and $123,110 (Line 11), any earned income and additional child tax credits the Gracies may have claimed will be reversed, and a 75% penalty for fraud will potentially be added (Line 17). The grand total of IRS adjustments and penalties is $1,149,949.25.

To fight the IRS, the Gracies filed a Petition last June in U.S. Tax Court outlining four lines of defense. The first two defenses basically claim the IRS is wrong, that it (1) erroneously increased the Gracies income each year and (2) erroneously asserted a civil fraud penalty. The third line of defense claims the statute of limitations has passed for tax years 2007-2011. The last and final line of defense tries to at least protect Gracie's wife by claiming she "is an innocent spouse under IRC Section 6015." This code protects someone filing a joint return who "establishes that in signing the return he or she did not know, and had no reason to know, that there was such understatement."

Not too keen to the Gracies' four defenses, the IRS filed an Answer to the Petition laying out all the facts believed to warrant an increase in income tax and a 75% fraud penalty. According to the Answer, Royce Gracie's income from activities including fighting, martial arts centers, licensing deals, and personal and TV appearances is assigned to his company, Khonkhor Enterprises, of which he and his wife are each 50% shareholders. According to the IRS, Gracie's wife maintains all books and records, pays all bills, and negotiates all business dealings for Khonkhor, which could come into play in the Gracies' "innocent spouse" defense.

The IRS lays out claims in four key parts. The first describes the Gracies' foreign bank accounts and balances, and the determination of funds to be unreported income.

[The Gracies'] Use of Foreign Bank Accounts

(1) [The Gracies] opened an account at HSBC Private Bank SA ("HSBC") in Geneva, Switzerland on April 9, 2002.

(2) For tax years 2007 through 2009, the account held approximately $2 million USD.

(3) On August 11, 2009, $1,456,038 was transferred from the HSBC account to The First Gulf Bank in the United Arab Emirates to open an account there.

(4) The HSBC account was closed in 2009.

(5) [The Gracies] also maintain an account at Caixa Penedes Bank in Spain.

(6) The account at Caixa Penedes was opened in 2004.

(7) In 2007, the highest balance in the Caxia Penedes [sic] account was $235,726.00.

(8) Despite numerous requests by [the IRS], [the Gracies] have refused to disclose the source of the funds in these accounts.

(9) The service has determined that the funds in these accounts were earned by Mr. Gracie and that the income was not reported on any Forms 1040 or Forms 1120 submitted by [the Gracies] or Khonkhor. (Emphasis in original)

The IRS then describes how the Gracies allegedly attempted to conceal and spend money from their foreign bank accounts.

Constructive Dividends of Khonkhor Funds from [the Gracies'] Foreign Accounts

(1) [The Gracies] maintained foreign bank accounts to hide money that petitioner Royce Gracie earned internationally.

(2) [The Gracies] attempted to conceal the existence of these funds and use them to pay for personal expenses by wiring the funds directly from the foreign accounts to the accounts for escrow companies, contractors, and other investments.

(3) During the years at issue, [the Gracies] distributed nearly the entire balance of all three accounts to pay for their personal living expenses in the United States.

(4) The personal expenses include down payments on [the Gracies] personal residences in Palos Verdes, California and Mammoth Lakes, California, payments to contractors to renovate the Mammoth Lakes property, payments to pay off credit cards, and payments to various partnerships and investments that [the Gracies] were involved in.

(5) These distributions constitute constructive dividends from Khonkhor to [the Gracies].

(6) [The Gracies] also used the funds to pay for corporate credit card expenses, but hid these transactions in the books and records of Khonkhor by calling them "loans" to the corporation.

(7) [The Gracies] also used this money to pay for expenses related to the podiatry business. (Emphasis in original)

In a likely attempt to bolster its fraud claim, the IRS describes an alleged loan application that conflicts with the Gracies' tax return, an alleged fake loan document designed to make funds appear to be borrowed rather than possibly earned, and important alleged non-disclosures to the Gracies' tax preparer and the IRS.

[The Gracies] Made False Statements on Their Returns, to Their Return Preparer, and to the Service

(1) In 2008, while [the Gracies'] 2008 Form 1040 shows an AGI of only $45,352, petitioner Marianne Cuttic [Royce Gracie's wife] signed a loan application for their Palos Verdes personal property on which she stated that she earned $20,000 per month from her base employment income and another $12,000 per month from her second job.

(2) [The Gracies] provided a fake loan document (in Portuguese) from one of petitioner Royce Gracie's relatives in Brazil stating that they had borrowed the funds to purchase one of their personal residences when in fact they had wired the funds from their foreign accounts.

(3) [The Gracies] disclosed their account in Spain to their return preparer, but did not disclose their accounts at HSBC or First Gulf Bank.

(4) [The Gracies] did not disclosure the existence of their accounts at HSBC for [sic] First Gulf Bank during the examination. (Emphasis in original)

Finally, the IRS describes how the Gracies allegedly tried to hide income by falsifying records and sending money directly to third parties.

[The Gracies] Fraudulently and with Intent to Evade Tax Failed to Report Income and Pay Tax on Income on their 2007, 2008, 2009, 2010, 2011, and 2012 Forms 1040

(1) [The Gracies] fraudulently and with intent to conceal income and evade tax caused Khonkhor to make both domestic and foreign account distributions to them to pay for personal living expenses.

...

(4) [The Gracies] fraudulently and with intent to evade tax claimed partnership and NOL losses [Net Operating Losses] without a basis for those losses.

(5) [The Gracies] perpetuated the fraud by keeping false books and records for both of their businesses by hiding corporate income as "personal loans" or using the money to directly pay credit cards instead of reporting the money as income.

(6) [The Gracies] perpetuated the fraud by using wire transfers to move money directly from their foreign accounts to escrow companies, contractors, and other individuals in the United States to avoid detection of these funds in their domestic bank accounts. (Emphasis in original)

The Gracie's Petition and the IRS's Answer lay out the basic framework of the arguments for both sides. Should the case proceed to trial, it is currently scheduled to take place on Jun. 6 at the U.S. Tax Court in Philadelphia, PA.

The allegations against the Gracies are no laughing matter, not the kind that can be resolved with a simple, "Oops, sorry." Claims include the use of company funds to pay for personal living expenses, fake personal loans, direct transfers and payments, fake loan documents, and over $3 million in foreign wire transfers, all while allegedly reporting between $0 and $3,925 in annual income tax liability to the U.S. government. These are very serious and specific allegations and there's no magic submission to hit to make the whole thing go away.

If the IRS's documents are correct, the Gracies paid woefully little in taxes in 2007-2012 while having a lot of unexplained money floating around in overseas bank accounts.

Fight fans are probably wondering if Royce Gracie's tax situation is the reason he agreed to come out of retirement to fight Ken Shamrock in Bellator's main event next month. On one hand, based on the documentation of this case, Gracie doesn't appear to be hurting for money. On the other hand, a good amount of the documented funds were allegedly used on real estate purchases and renovations. While this counts towards Gracie's wealth, it isn't very liquid.

If Gracie's attorneys prepared him for a likely settlement or possible undesirable trial outcome, he may have need for more liquid funds in the near future and fighting Ken Shamrock could be just the ticket.

Generally, in U.S. tax court the petitioners bear the burden of proof, which in this case means the Gracies must prove the IRS's Notice of Deficiency is incorrect (see Rule 142). However, since the case also involves an allegation of fraud with the intent to evade tax, the burden of proof on the specific element of fraud is shifted to the IRS and "is to be carried by clear and convincing evidence."

Bloody Elbow will keep readers informed of any updates as the case progresses. In terms of criminal proceedings, we know that as of Jan. 21, 2014 the IRS had not made a recommendation to the U.S. Department of Justice for criminal prosecution.

Whatever the final outcome, there's one big lesson here: Mess with the IRS at your own 75% penalty peril.

Paul is Bloody Elbow's analytics and business writer. Follow him @MMAanalytics.