Tax Dispute a Nightmare for Orange Couple : Courts: The Franklins claim they filed returns; the IRS says they didn't. The outcome of their case may depend on a former IRS employee who says the agency has lost, misfiled and even shredded returns.

By MICHAEL FLAGG

Sept. 20, 1992 12 AM PT

TIMES STAFF WRITER

LAGUNA NIGUEL —

They were . . . The Tax Returns From Hell!

And they’re still a nightmare, 14 years after Richard A. Franklin decided to stop paying his taxes. Now that Franklin has taken the Internal Revenue Service to court, there’s more than a cool $150,000 riding on them.

If the 60-year-old former tax protester can prove that he had a change of heart in 1984 and filed returns for the previous six years, he might just get to keep all that money.

The IRS, however, says he didn’t file until 1988. That means that the tax man still has time to take all that money in back taxes, penalties and interest.

Not so, says Franklin: The IRS must have lost the returns he filed in 1984.

If that sounds like the adult version of “The dog ate my homework,” check this out: Franklin’s lawyer has turned up a former IRS revenue officer who says it’s plausible; she says returns were lost, misfiled and even shredded like so much taco lettuce.

Here, in short, is where the case turns into something quite different from your garden-variety tax dispute.

Whether Richard Franklin and his wife prevail against the IRS may depend on Carole S. Nelson, for 11 years an IRS employee in the Laguna Niguel district; that district covers Southern California from San Diego to the southwestern corner of Los Angeles County--one of the most populous districts in the United States.

Nelson left the IRS nearly five years ago to start her own business; she is now an enrolled agent representing taxpayers before the IRS.

Typical of her horror stories is this one: Around 1980, she says in a written statement to the court, officials at the former IRS office in Santa Ana told a mail clerk to shred incoming mail because--Nelson says the mail clerk told her--the mail had stacked up too high to be processed quickly enough.

And that was small potatoes. The next year, Nelson says she and other revenue officers were told by superiors that a semitrailer full of unopened mail was shredded at the Fresno service center, where most taxpayers send their returns each spring.

“I realize that this may be shocking to the court,” Nelson says in the statement.

“Needless to say, we were told not to tell any of this to taxpayers,” she says, “but we were also told that they could be correct on their claim that they sent the document.”

The government argues that Nelson isn’t a proper expert on the IRS and asked the judge to exclude her from the Franklins’ trial.

It also maintains that most of her allegations are “wild speculation” and “secondhand hearsay.”

Still, she has quite a lot of them. There was the time in 1983, for instance, when Nelson’s boss asked her to clean up 300 collection cases that had been sitting around for two years. Revenue officers collect back taxes and make sure tardy taxpayers file returns.

When Nelson looked through the files, she found tax returns that had never been processed and payments that were never credited to taxpayers’ accounts.

Many “were simply dumped into boxes” and weren’t in the correct file, she says.

In late 1984, she says, IRS auditors told the revenue officers that they wanted to get more tardy tax returns so they could audit them.

The revenue officers sent them a flood of returns. But the next year, stuffed into dozens of boxes, all the returns came back to Laguna Niguel from the auditors in Fresno. Few--if any--appeared to have been audited, she says.

What’s more, many of the boxes contained original tax returns that had never even been processed. In other words, there was no record these people had paid their taxes.

“As you might imagine, this discovery caused an uproar,” says Nelson in her statement.

“We revenue officers were told there would never be any written acknowledgment that this problem existed.”

Instead, Nelson says, they were told that if a taxpayer claimed he had already filed a return, they were to give him the benefit of the doubt.

“The IRS,” says Nelson in the statement, “attempts to project a public image that all of the original returns and other documents which it receives are processed flawlessly.

“This is simply not the case.”

The Franklins aren’t the only people to accuse the IRS of keeping sloppy records recently. A Spokane, Wash., woman sued to get her $3,655 refund after the IRS said it had no record she had filed in time. And she hadn’t sent it registered mail, so she couldn’t produce a receipt for certified mail that the IRS said it wanted for proof.

Three federal appeals court judges ruled in June that she should get her refund. The reasons: She had a witness saying she had mailed the return in time and--said the judges--because “the government admitted losing tax documents that had been mailed and delivered.”

But that was a matter of a couple thousand dollars. There’s a lot more money at stake in the Franklins’ case. And there are a lot more potentially embarrassing allegations of IRS bungling, which tax lawyers say isn’t often used as a defense by taxpayers.

Richard Franklin’s troubles started when he decided that a guy named Armen B. Condo made a lot of sense. That was in 1978; Franklin was an investment broker from Orange and Condo was president of a tax protest group called Your Heritage Protection Assn. It was said to be the largest such group in the nation at the time, with 27,000 members. Condo liked to describe himself as the greatest threat to the IRS in America.

Back then, in the heyday of the tax protest movement, the Heritage people were arguing that paper money is worthless because it’s no longer backed by gold and silver; therefore it shouldn’t be subject to taxes.

That argument, needless to say, didn’t cut it with the IRS or the courts. Neither did the one about the 16th Amendment never having been ratified by the states in 1913. (That’s the amendment to the Constitution that allowed government to tax incomes.)

The IRS also didn’t seem amused by this one: Having to fill out a Form 1040 violates the Fifth Amendment, which guarantees that you don’t have to incriminate yourself.

Condo went to jail in 1982; after the government seized the group’s Garden Grove headquarters, Condo’s successor--a guy who called himself “Maverick Minister II”--broke into the Garden Grove building to hold a tax protest meeting and was packed off to jail in 1986.

Prosecutors went after 30 more members of Your Heritage and dozens of people from other groups in the early 1980s. By the middle of the decade, a lot of steam had gone out of the tax protest movement.

Franklin’s wife, Bernadette--who sells insurance--never liked the protest group. And as the 1970s turned into the 1980s and the couple filed no tax returns, she got more worried. She argued with her husband. In 1984, the IRS began peppering the Orange couple with letters demanding that they file returns. The state garnished Bernadette’s wages.

Finally Richard Franklin relented.

Around Halloween of 1984, the Franklins hired an accountant to do their tax returns; the couple insist that they filed the returns--for 1978 through 1983--around the same time.

The next year they agreed to pay the IRS all those back taxes in installments, and they did--in fact--pay more than $100,000, according to their lawyer.

But the IRS never got paid in full; and even though the Franklins filed a return on time for 1986, they say they were so tapped out from paying back taxes that they couldn’t scrape up the money to pay their 1986 taxes.

In 1988, a revenue officer assigned to get the Franklins to cough up what they owed noticed that IRS records showed the Franklins had never filed returns for 1981, 1982 and 1983.

Richard Franklin brought in copies of the returns that he says he had hand-delivered to a revenue officer in 1984. The feds took a look, said they didn’t believe him and assessed penalties of $21,000 on $38,000 in unpaid taxes from 1982 and 1983.

Meanwhile, the interest on all those taxes amounted to $55,000, for a total of $114,000.

Now the Franklins’ lawyer argues that if they filed returns in 1984, as they say, then the three-year IRS statute of limitations had run out by the time the IRS began demanding its money in 1989.

Therefore, says their lawyer--A. Lavar Taylor of Irvine, a former IRS lawyer--the Franklins don’t owe the IRS anything .

Same thing goes for their 1981 taxes, says Taylor, which the Franklins have already paid. He says they should get that money back from the government; that amount would then pay the $40,000 in taxes, interest and penalties the Franklins owe for 1986. (The Franklins, on Taylor’s advice, declined to comment on any of this.)

The IRS, on the other hand, insists that it has no record the Franklins filed those returns until they got called on the carpet in 1988.

And that’s where Nelson, the former IRS officer, comes in. She was, by the way, allowed to testify in the Franklins’ civil trial in federal Bankruptcy Court in Santa Ana just before Labor Day, although the judge refused to qualify her as an expert on the IRS. (The case is in bankruptcy court because the Franklins filed for Chapter 11 protection from creditors last year after the feds threatened to seize and sell their four-bedroom house in Orange.)

The IRS provided another revenue officer--to whom, the Franklins insist, they hand-delivered their returns in 1984.

That revenue officer insists that she never met the Franklins until 1985.

If they win, the Franklins will have beaten the system Richard Franklin set out to protest in 1978; they will have gotten off the hook for three years’ worth of taxes and they will have embarrassed the IRS.

If they lose, they may have to sell their house to pay off the $114,000 the IRS says they owe.

Closing arguments in the trial are scheduled for the end of the month.

Greetings from the IRS Last year, you were more likely to be audited if you filed your return in the Los Angeles or the Laguna Niguel districts. The Laguna Niguel district was also second in the nation in number of tax returns filed. Returns Filed (in millions)

Newark, N.J.: 7.13

Laguna Niguel: 7.11

Chicago: 7.00

Detroit: 7.00

Philadelphia: 6.30

Los Angeles: 6.10

Returns Audited

Los Angeles: 52,816

Laguna Niguel: 41,406

Dallas: 41,108

Atlanta: 35,239

Chicago: 33,061