Business Owner’s Tax Fraud Illustrates Potential Harshness of Tax Loss Calculations

Business Owner’s Tax Fraud Illustrates Potential Harshness of Tax Loss Calculations

The matter of U.S. v. Sanchez, 117 AFTR 2d 2016-866, (DC NY), stems from a ten-count indictment against defendant Javier Sanchez. Sanchez was accused of participating in an array of tax improprieties and tax fraud due to his handling of his S-Corporation’s payroll tax and other tax concerns. Sanchez faces tax charges including four counts of submitting false corporate tax returns and six counts of submitting false individual tax returns. The affected tax years for the corporate returns are 2006 through 2009 while the affected tax years for the personal returns are 2004 through 2009.

The defendant pleaded guilty to these counts on January 15, 2015. While pleading guilty, Sanchez indicated that he was the sole shareholder of his company, Imperial Glassworks, Inc. Sanchez also admitted that he, “reviewed and signed the returns despite knowing that they under-reported the gross income that he and Imperial received during the tax years for which they were filed.” Thus, Sanchez will face punishment for these tax crimes.

However, still at issue was the overall tax loss created by Sanchez’s fraudulent activities. Sanchez argued that certain items should not be included in the calculation of loss. Tax loss calculations should, “reflect the revenue loss to the government resulting from defendant’s conduct.” Sanchez citing the United States v. Gordon 291 F.3d 181, 187 [89 AFTR 2d 2002-2757] (2d Cir. 2002). However, there was a significant dispute over the amount of unreported income, whether city and state income and corporate taxes should be included in the calculation of loss, and whether the court should grant Sanchez’s requests for deduction of “off the books” payroll expenses and check cashing fees.

State and City Taxes Are Properly included in the Calculation of Tax Loss

As a threshold matter, the court held that the government’s method for calculating the tax loss was appropriate. The government calculated the loss by “’by starting with the federal income tax returns the defendant did file’ and ‘making adjustments to reflect the additional unreported income and related credits and deductions that would have been applied had the defendant truthfully reported his cash income.’”

Further at dispute in regard to the tax loss calculation, was whether unpaid state and city taxes could be included as part of the calculation. The government claimed that Sanchez and Imperial had failed to pay New York State income taxes from 2004 through 2009 and New York City income taxes from 2004 through 2007. The government argued that the commentary accompanying the relevant sentencing provision stated that this income should be included in the loss calculation. The commentary states, “all conduct violating the tax laws should be considered as part of the same course of conduct or common scheme or plan unless the evidence demonstrates that the conduct is clearly unrelated.” USSG § 2T1.1, comment. (n. 2).

Sanchez attempted to avoid the imposition of these liabilities in the loss calculation with two arguments. First, he argued that the commentary relied upon by the government referred to tax evasion cases. Tax evasion was not charged in this matter. Second, the defendant argued that the “tax loss ‘shall be treated as equal to 28% of the unreported gross income’ and make no reference to including any state or local tax liability.” Sanchez citing USSG § 2T1.1(c)(1) n. (A).

As for the first argument, the court found that the language of the sentencing guidelines undercut the defendant’s evasion argument. The court found that the relevant guideline applied to conduct under both 26 USC Sections 7206 Fraud and false statements and 7201 Attempt to evade or defeat tax (Tax Evasion). The sentencing guidelines simply do not distinguish between the crimes and treat both in the same way. As to the second argument, the court found that the defendant was overly selective in the text cited regarding the 28 percent rule and that the rule applies only when a more accurate determination of the amount of tax loss is not possible to be made.

While Sanchez also raised a residency argument regarding the New York City taxes, this argument was quickly dismissed by the court on the basis that Sanchez provided no evidence except for self-serving testimony regarding his residency. The court decided that it was appropriate to include both unpaid state income and local income taxes in the tax loss calculation.

Unpaid Corporate Taxes Are Also Properly Included in the Calculation

Also at issue was whether the unpaid corporate taxes incurred by Imperial should also be included in the tax loss calculation. While the defenses raised by Sanchez are not entirely clear, the court concluded that these unpaid taxes should be included in the calculation. The court found that the business was based and physically located in New York City. Furthermore, since New York City treats S-Corps as C-Corps for tax purposes, the entity was also required to pay taxes in addition to the taxes paid by Sanchez due to the pass-through. Imperial’s unpaid corporate taxes were found to be part of the same scheme or plan and included in the loss calculation.

Court Denies Deductions for “Off the Books” Payroll Expenses and Check Cashing Fees

Sanchez attempted to mitigate the tax loss liability he would face by claiming certain deductions for expenses. The government agreed with Sanchez that he was free to claim previously undeclared legitimate deductions. The parties disagreed whether expenses paid to a check cashing facility and “under the table” wages paid to workers could qualify as a legitimate deduction.

On the “off the books” payroll issue, Sanchez had previously admitted that he made cash payments to undocumented workers. He did not withhold payroll taxes for these employees nor did he file 1099 reports for the amounts he claims he paid. While in the initial hearing the defendant indicated that he knew his payroll practices were “improper and unlawful,” in testimony in later proceedings defendant seemed to attempt to characterize these payments as lawful.

The court found that the cash payments made to undocumented workers were “plainly” unlawful. The court cites at least three unlawful acts in regard to the payroll:

  1. It is unlawful to hire an undocumented working knowing that they are not authorized to work in the United States.
  2. Assuming the workers are employees, it is unlawful to fail to withhold payroll tax.
  3. Regardless of whether the workers are employees or independent contractors, it is unlawful to not provide a report of income

These facts and a general presumption against encouraging unlawful activity through the tax code doomed Sanchez’s argument that commentary added to USSG § 2T1.1, comment. (n. 3) announced a new rule regarding the deductibility of “under the table” payments. The court found that the language Sanchez cited actually applied to a no longer relevant circuit split. Furthermore, the facts of precedent raised by Sanchez were not particularly compatible. In any case, the expenses paid to undocumented workers were excluded from the deductions by the court.

As for the check cashing issue, the defendant attempted to claim a new deduction for more than $100,000 he paid in check cashing fees to convert corporate checks into cash. Typically, under 26 USC Section 162(a) an expense is deductible only when it is “ordinary and necessary to running a taxpayer’s business.” Sanchez claimed that check cashing services were ordinary and necessary to the business because state law would have otherwise required him to pay his workers for the time they spent cashing their check.

Unfortunately, for Sanchez, during proceedings, it emerged that Sanchez had maintained a corporate checking account and had access to a line of credit. The court also found the check cashing services to be part of a scheme to conceal the fraud by avoiding depositing the checks in the corporate account and revealing the income to his accountant and tax authorities. Sanchez also apparently used the check cashing services to create cash for his own personal expenses. Sanchez was not permitted to deduct these expenses paid for check cashing because of his own wrongdoing and failure to show that the service was an: “ordinary and necessary” expense.

Facing Corporate Tax Charges? Work with a Strategic Attorney

The above matter illustrates how quickly a tax scheme can unravel and how admissions of wrongful conduct can continue to affect a taxpayer and further exacerbate the consequences he or she faces. When facing a criminal tax prosecution, it is essential to proceed strategically.

The tax attorneys and CPAs of the Tax Law Offices of David W. Klasing may be able to fight for you if you are facing an audit or have been accused of tax fraud. David Klasing is a former public accounting auditor and can often anticipate the strategy and requests of the taxing authority’s auditors. Through guiding this process, the likelihood of facing criminal tax charges can often be effectively managed. If you are already facing tax charges, we may be able to advocate on your behalf to mitigate the consequences you face. To schedule a confidential reduced-rate consultation, call the firm at 800-681-1295 or online today.