Keeping Yourself and Your Clients Out of Jail

September 18, 2014 

OC Chapter CalCPA Fall Seminar Series 

By David W. Klasing Esq. M.S.-Tax CPA

 

 

This speech is an amalgamation of four different speeches

  • Tax Avoidance and Evasion- Where is the line drawn?Pages 4-26
  • “Spies” Evasion – When does Failure to File Constitute Tax Evasion? Pages 27-90
  • Keeping Your Tax Clients and Yourself Out of Jail & Criminal Tax War Stories from the Trenches Pages 91-114
  • Excerpts from: Representation in Connection with an IRS Audit Pages 115-117

 

Tax Avoidance and Evasion – Where is the line drawn?

 By David W. Klasing Esq. M.S.-Tax CPA 

David Warren Klasing

David KlasingDavid W. Klasing Esq. CPA M.S.-Tax has earned dual California licenses that enable him to simultaneously practice as an Attorney and as a Certified Public Accountant in the practice areas of Taxation, Estate Planning and Business Law.  He provides businesses and individuals with comprehensive Tax Representation, Planning & Compliance Services and Criminal Tax Representation. He has more than 20 years of professional tax, accounting and business consulting experience, coupled with extensive knowledge about federal and state tax codes, regulations and case law.

As a former auditor, Mr. Klasing uses his past experience in public accounting to help his clients avoid tax problems before they develop where possible. As a Combo Attorney CPA he aggressively protects his clients’ interests during audits, criminal investigations or in Tax Litigation. Mr. Klasing has assisted thousands of businesses and individuals through the audit / litigation and appeal process, and Mr. Klasing has a proven and sustained record of achieving favorable results for the clients he serves.

Mr. Klasing is admitted to practice before all California State Courts, the United States District Court for the Central District of California and the United States Tax Court.

Mr. Klasing’s education includes a bachelor’s degree in business administration, with an emphasis in accounting, from California State University Los Angeles, a master’s degree in taxation from Golden Gate University and a Juris Doctor from Western State University College of Law.

Having earned a master’s degree in taxation with an emphasis in the gift and estate tax arena, along with having taken classes in Law School on Estate’s, Trusts and California Community Property, Mr. Klasing practices in the estate, trust and accounting areas.

Mr. Klasing’s professional involvement includes serving as the current chair of the American Association of Attorney – Certified Public Accountant Education Committee, the (2012/2013) chair of the California State Bar Association, Tax Procedure and Litigation Committee, the 2013 chair of the Orange County Bar Association Taxation Section. He is also a member of the American Bar Association Tax Section; the Orange County Bar Association, Tax, Business and Corporate Law, Trust & Estate Sections, the California Society of Certified Public Accountants State Committee on Taxation and the American Association of Attorney Certified Public Accountants. He is an “A” rated current member of the Better Business Bureau.  He has a 10.0 AVVO rating (Superb)

Tax Avoidance vs. Tax Evasion:

Federal tax law attempts to delineate a very clear distinction between tax avoidance, which can at worst only expose the Tax Practitioner and his or her client to potential civil penalties, and tax evasion, for which criminal penalties may apply to all parties concerned. The Supreme Court in Gregory v. Helvering, 293 U.S. 465 (1935) defined permissible tax avoidance as actions that “reduce, avoid, minimize, or alleviate taxes through wholly legitimate means”.  In stark contrast, evasion involves tax avoidance that is ordinarily accomplished via an element of deceit or concealment and at times patently illegal means. Taxpayers are thus legally entitled to choose the most tax efficient alternative to structure a transaction.  The court in Helvering stated “[t]he legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted”…

While it is well settled that taxpayers are entitled to avoid taxes, the historical controversy stems from the fact that in order for the structuring of a tax avoidance transaction (or transactions) to withstand governmental scrutiny and thus fend off being recharacterized or simply disregarded, the transaction structure must comply with the totality of tax law as currently enacted which includes statutory and common-law requirements such as the Economic Substance, Sham Transaction, Step Transaction, and Substance Over Form Doctrines, and the Business Purpose Test

Statutory and Judicial Restraints on Tax Avoidance:

The judicial and statutory constraints on tax reduction strategies of general application including the Economic Substance, Sham Transaction, Step Transaction, and Substance over Form Doctrines, and the Business Purpose Test can all be traced back to the Supreme Court’s holding in Gregory v. Helvering. This case concerned a taxpayer who formed a corporation mainly for the purpose of exploiting the tax free reorganization provisions in order to avoid gain recognition on a planned subsequent sale of stock to be transferred to the newly formed Corporation. The Court in Gregory v. Helvering found that the taxpayer was in compliance with every element required by statute and thus a statutory reorganization was achieved. The court held that the motive of the taxpayer to avoid tax in and of itself did not render impermissible what the reorganization statute clearly allowed,  but went on to focus on whether what was done, apart from the tax motive, was the thing which the statute intended. The court answered that question in the negative holding that reorganization was not accomplished, but it was merely “a transfer of assets by one corporation to another in pursuance of a plan having no relation to the business of either”.

Step Transaction Doctrine:

The step transaction doctrine dictates that the tax consequences of tax planning transactions turn on their substance rather than solely on their form. This is accomplished by collapsing a series of separate steps into a single transaction in order for the government to obtain a clear view of what the separate steps are accomplishing in substance.    The import of the step transaction doctrine is that a statutorily prohibited transaction must not be accomplished by breaking it down into seemingly allowable independent steps and that in determining the legality of the series of transactions the government will weigh the series of steps together in determining the associated tax consequence. The doctrine further dictates that the time interval between related transactional steps is not determinative, but is merely a factor, of whether the transactions will be collapsed for analysis under the step transaction doctrine.

Unfortunately for practitioners and taxpayers, No single judicial standard has been universally accepted by the federal courts in applying the step transaction doctrine.   However, the three most commonly invoked types of “step testing” utilized by the federal courts are:

  • the binding commitment test;
  • the interdependence test; and
  • the end result test;

The Supreme Court first used the binding commitment test in Commissioner V Gordon where the Court refused to treat stock distributions taking place over several tax years as a single transaction for tax purposes. The Court held that if a transaction is to be characterized as a first step there must be a binding commitment to take the later steps.   The binding commitment test as currently applied requires collapsing several transaction steps into a single transaction solely where a binding commitment existed as to the subsequent steps at the time the first step was taken. Subsequent judicial use of the binding commitment test has been sparse, and post Gordon court decisions have tended to confine the test to the facts of that case. On balance, when binding commitments are present, the subsequent steps will be collapsed into a single transaction for analysis purposes.  Where they are not present courts have tended to apply the other two tests.

The interdependence test focuses on the relationship between the individual steps of a series of transactions and analyzes whether the steps have independent significance or whether they have meaning only as part of the larger planned transaction.   A judgment is made as to whether the steps are so interdependent that the legal ramifications of each intermediate transaction would be nil without the completion of the entire series of transactions. When it is apparent that any single step would not have been undertaken except in contemplation of the totality of the associated transactions, the step transaction doctrine will be applied.  If the foregoing analysis does not establish that the first step would not have been taken without contemplation of the later ones, the steps are not integrated.

Under the frequently applied end result test, related but separate transactions are collapsed into a single transaction when the government is of the opinion that they are really related component parts of a single overarching transaction.  The end result test is used when it is clear that a planned tax result is achieved via a series of related transactions that could not be achieved via a single transaction.   However, where a business engages in a series of related transactions that appear to be designed and executed as part of a unitary plan to achieve an intended result, the plan may be viewed in the aggregate regardless of whether the effect of doing so increases or decreases the combined tax effect.

The end result test focuses on intent and where the separate transactions are viewed as a single overarching scheme, they will be collapsed into a single transaction. On the other hand, where is required intent is deemed absent, the steps analyzed are treated as separate.

Sham Transaction Doctrine:

The “sham transaction” doctrine is “judge made law” which will deny advantageous tax treatment where transactions are carried out primarily for tax avoidance purposes and they lack a bonafide business purpose. This doctrine tends to be applied where a taxpayer attempts to disguise a transaction and make it appear to be something that, in reality, it is not, in which case the courts will ignore the form of the transaction and declare it to be a sham and then ascertain the tax impact based upon the courts view of the substantive nature of the transaction.  A transaction that is labeled as a sham where it is deemed to not be motivated by a legitimate business purpose other than its anticipated tax benefits, will be deemed to lack economic substance because there is no reasonable expectation of profit and thus will be disregarded for tax purposes.

Case Law Based Factors Indicative of Sham Transactions:

Transactions are at risk of being recharacterized by the taxing authorities as a sham if no non tax business or investment motive can be identified and the buyer is seen to be under the common control of the seller.  For example, the sale of an asset to a LLC at a price well in excess of the asset’s fair market value will not be respected where the seller and the LLC are under common control.  Likewise when a sole shareholder or group of controlling shareholders sells an asset to their corporation at an inflated price and then retain control over the asset, the transaction is at risk of being disregarded as a sham because the service can argue the transaction is lacking in good faith or finality.

The following factors from case law are what the government will consider in deeming whether a valid sale transaction or a sham has taken place:

  • Is the price associated with the transaction reasonable or overstated?
  • Has common control over the property been retained?
  • Was there a genuine intent to pay the full purchase price by the buyer?
  • Is the seller receiving a real economic benefit from the sale of the property other than purely tax benefits?

Case law has shown that the IRS generally is the sole party that benefits from this substance over form type analysis in deeming if a transaction is a sham. Taxpayers have had to bear a heavy burden in attempting to persuade a court to disregard the form of their own sham transaction and thus have on balance not been successful in doing so.

Another methodology the government has used successfully to set aside a transaction it deems to have been entered into for the sole purpose of creating a tax loss is where it finds the parties have sufficient influence over the transaction as to remove any substantial risk of being unable to return to their previous position by labeling the transaction an accommodation rather than an arm’s length sale, and thus having grounds to disregard it for tax purposes.    Alternatively, the same transaction may be characterized as a sale, but not between the parties involved in the taxpayer’s transaction.

Case Law Examples: 

In D.M. Fender v US, CA-5, 78-2 USTC 9617, 577 F2d 934,  a sale of bonds to a bank where the taxpayers owned the controlling block of stock  was disregarded as non bonafide because they did not  in the government’s opinion suffer a genuine economic loss which is a requirement for a loss deduction.

In T.F. Abbott, Jr. v Commr, 23 TCM 445, Dec. 26,696(M), TC Memo. 1964-65, aff’d, per curiam, CA-5, 65-1 USTC 9331, 342 F2d 997; the Court of Appeals in the 5th circuit affirmed the Tax Court in holding that a major stockholder of a corporation, and not his related corporation, in reality realized a gain from the sale of stock. The major stockholder purportedly transferred stock to the corporation as a capital contribution and then his related corporation turned around and immediately sold the stock at a gain. The Tax Court justified setting aside the form of the transaction by holding that the stockholder in substance had sold stock as an individual using the corporation as a conduit and then contributed the proceeds to the corporation as a capital contribution.

In the Est. of S. Ravetti v Commr, 67 TCM 3064, Dec. 49,893(M), TC Memo. 1994-260, Losses flowing to a limited partner related to a purchase of a film by a partnership were disallowed because the acquisition was held to lack economic substance. Factors that the court focused on to justify the disallowance were over-inflated purchase price for the film in order to support  tax benefits, the lack of personal liability of the limited partner and the transaction was held to not be the result of a true arms-length negotiation.

In H.J. Smith, Jr. v Commr, 50 TCM 1444, Dec. 42,488(M), TC Memo. 1985-567 a sale of stock at auction was held to be invalid where the seller’s son purchased the stock with money given to him by the seller (his father) because the father in economic terms did not receive anything for the stock.

In P.J. Batastini v Commr, 53 TCM 1500, Dec. 44,086(M), TC Memo. 1987-378; Milbrew, Inc. v Commr, 42 TCM 1467, Dec. 38,363(M), TC Memo. 1981-80, aff’d, CA-7, 83-2 USTC 9467, 710 F2d 1302; F.C. LaGrange v Commr, 26 TC 191, Dec. 21,699 (1956) a series of sale-leaseback transactions were disallowed because the court believed the transactions were entered into solely to inflate the value of the assets used in a school bus business.  In reality title to the asset of the business were never transferred to the buyers and the agreed upon purchase price greatly exceeded the true value of the underlying assets.  These factors along with others led to the disallowance under the transaction lacked economic substance by the court.

In W.G. Hock v Commr, 54 TCM 407, Dec. 44,167(M), TC Memo 1987-444, the limited partners in a mining operation’s expenses and losses were disallowed because the investment in the mining operation was held to not be motivated by a valid business purpose. The transactions as a whole lacked economic substance because of the relationship and lack of knowledge or experience in the mining industry of the parties and the overstated purchase price.  Moreover, no ore was ever mined or sold and no payments were actually made to the seller, and factors were apparent that indicated the mine was never a profitable business venture. 

Business Purpose Test:

The business purpose test requires that a transaction, to be respected, must have a business purpose separate and apart from any associated tax advantages. The business purpose test may be viewed as having two elements that, if satisfied, should prevent government scrutiny and adjustment of a transaction under the doctrine.

  1. The acquisition was motivated by a nontax business purpose; and
  2. The method of the acquisition was motivated by a nontax business purpose.

The business purpose requirement came out of case law surrounding government challenges to corporate reorganizations, but as presently applied is not limited to corporate reorgs today.    The most common application of the business purpose test currently, is where a group of corporations can be denied affiliated group status and thus be prohibited from including a corporation on its consolidated return if a business purpose is lacking surrounding the acquisition of the target corporation. Corporate divisions are also closely scrutinized as tax free reorganizations under the business purpose test because they can easily be used in an attempt to convert dividend distributions into capital gain distributions.

The business purpose test judicial doctrine was the predecessor of specific code provisions which exist today that deny the use of the net losses of a target corporation if the major reason of its acquisition was to secure the benefits of the net losses. This series of code provisions prevents the acquiring corporation from utilizing pre-acquisition net operating losses to reduce the taxable income on the associated consolidated group return.

The policy behind the reorganization provisions is to enable the continuation of an ongoing business under modified corporate form without a current tax impact.  In the absence of a valid business purpose underlying a modification to corporate form the government perceives abuses where these provisions are used to improperly achieve non-taxable sale or dividend distributions. To complicate matters, strict literal compliance with the letter of the law surrounding the reorganization statutes may none the less be insufficient to achieve tax-free treatment. The courts have consistently required that the underlying business purpose of the reorganization provisions be complied with as well and have used the business purpose test as a sword to disallow transactions deemed abusive on multiple occasions where they believe taxpayers have not done so.

In reality whenever an exchange, which is intended to be tax free, results in the exchange of materially different properties, realization of gain or loss occurs and this ordinarily has to be recognized for tax purposes unless a tax free exchange non-recognition provision applies.   To qualify as tax free, the reorganization has to be driven by business circumstances rather than solely a desire to lower a company’s tax burden.

Economic Substance Doctrine:

The economic substance doctrine or sham in substance doctrine led to the recent codification found in § 7701 (o), which basically dictates that any transaction where the economic substance doctrine is applicable shall be treated as having economic substance only where:

(A) Entering into the transaction changes in a meaningful way the taxpayer’s economic position, (apart from its Federal income tax effects) and

(B) The taxpayer has a substantial business purpose for entering into such transaction (apart from its Federal income tax effects).

The genesis of the “economic substance doctrine” is a common law doctrine that disallowed the tax benefits associated with a transaction if the transaction was deemed to lack economic substance or a business purpose which in 2010 was codified under IRC §7701(o)(5)(A). IRC §7701(o)(5) specifically states that the prior existing precedent stemming from federal case law on the subject of economic substance is still relevant to the determination of whether §7701 is relevant to a fact pattern and when the application of the doctrine is called for, but it expressly overrules any prior case law which only required one “prong” of the economic substance test to satisfy the doctrine. Prior case law that held that either a meaningful change in economic position or a substantial, non-tax business purpose satisfied the economic substance doctrine was expressly overruled with the enactment of §7701(o)(5). The current codification of the economic substance doctrine requires that both prongs be satisfied (i.e. both a meaningful change and a non-tax purpose is required to satisfy §7701), and consequently any prior case law which only required one prong of the test be satisfied, has limited applicability for tax years subsequent to the enactment of §7701 in 2010.

In applying the §7701 codification standard, the profit generation potential of a transaction is only sufficient if the present value of the reasonably expected pre-tax profit from the transaction is substantial when compared to the present value of the expected federal tax benefits that would be thrown off by the transaction if it were respected for tax purposes. In estimating these benefits, the Service will rely on all available relevant case law precedent and other relevant primary authority. The statue does not provide a safe harbor minimum pretax profit or percentage ratio between the expected profits and expected benefits to satisfy the profit potential test described above.

The following examples of tax shelters were attacked under the economic substance doctrine and helped lead to the drafting of §7701;

  • (BEDS) – Basis-enhancing derivatives structures which are essentially a series of transactions entered into for the purpose of increasing the basis of corporate stock in order to reduce any capital gain on the sale of that stock.
  • (CARDS) – Custom Adjustable Rate Debt Structure transactions, in which the loss from a cross-currency swap is offset against the gain from the sale of an unrelated business.
  • (BLISS) – Basis Leveraged Investment Swap Spread transactions, where a series of connected transactions are executed involving the sale by a subsidiary of substantially all of its assets at a sizeable gain followed by a series of purchases and sales of both long and short options in foreign currency through a method called a digital option spread which the subsidiary then contributes the options to a wholly owned partnership. Simultaneously, the partnership purchases shares of unrelated corporate stock from the open stock market. As a result of the capital contribution of the digital option spread transactions, the subsidiary increases its outside basis in the partnership interest to the point where when the partnership held by the subsidiary liquidates the resulting stock distribution back up to the subsidiary has a basis which will generate a loss when the stock is sold that will offsets the gain from the prior sale of the subsidiary’s assets.
  • (DAD) – A distressed asset/debt transaction, where a foreign retailer in bankruptcy reorganization contributes distressed receivables related to its bankruptcy estate to an American LLC, which is specifically formed to collect the receivables, in exchange for a majority interest in the LLC. The foreign retailer subsequently redeems its interest in the LLC for cash and then the LLC contributes a portion of the receivables in exchange for majority interests in several other newly created LLCs. American investors then are sold membership interests in the LLCs through an additional layer of LLCs, which function as holding companies. The series of related LLCs claim a carryover basis in the receivables based on their face value at contribution and then write off the basis in those receivables as bad debt which generates losses to the American investors.  The original top level LLC than claims losses on the subsequent sale of the layered membership interests in the holding companies.

Substance Over From Doctrine:

Similar to the sham transaction analysis, the substance over form doctrine requires that the associated tax liability stemming from a transaction is required to be determined based on the economic substance of the transaction, and not the particular form the transaction utilized.  This doctrine has been historically utilized by the government to target schemes where taxpayers have purposely mischaracterized a transaction in order to derive beneficial tax treatment. Under the justification found under this doctrine, courts have been known to ignore the form of the transaction utilized and then focus on the underlying economic substance of the transaction in determining what the court deems to be the proper tax consequences of a transaction.

The substance over form doctrine is often used to attack the eligibility of an acquiring corporation to step up the assets of a target to fair market value in an acquisition along with post acquisition events and other facts specified in the regulations under IRC §338.    Analysis under the substance over form doctrine may dictate that in reality the acquiring corporation is not the true purchaser of the target, or that the acquisition was not a qualified stock purchase, which prevents the acquiring corporation from making a valid step-up election.

Judicial Doctrine Summary:

In the planning and executing business transactions, especially in the corporate reorganization arena, the judicial doctrines, some of which have been codified, including the economic substance, sham transaction, substance-over-form, business purpose and step-transaction doctrines have to be considered and planned for. Whether a court or the Service will assert that one or more of these doctrines invalidates a transaction’s claimed tax treatment depends upon each case’s specific facts and circumstances. In conclusion, compliance with the formal regulatory requirements surrounding a business transaction is insufficient.  Simply complying with the rules is not enough, each of the aforementioned judicial doctrines have to be contended with in order to take defensible tax positions when seeking legal tax avoidance otherwise tax can potentially be considered to have been illegally evaded in the most egregious of cases.

Section 269:

Code section 269 was implemented to halt various perceived tax avoidance abuses during World War II.  Because of extremely high surtaxes and excess profit taxes that existed at the time it become very popular for a profitable corporation to acquire a loss corporation.  Consequently, § 269(a) provides that if an individual acquires control of a corporation, or if a corporation acquires the property of a non controlled (at the stockholder and corporate levels) third party target corporation or its stockholders, if the principal purpose for the acquisition is the evasion or avoidance of income tax via the  securing of a deduction, credit, or other allowance which the acquiring individual or corporation would not otherwise benefit from, the government may disallow such deduction, credit, or other allowance.

Case law shows that attacks under section 269 are defensible in proper circumstances. In Plains Petroleum Co. v. Commissioner, T.C. Memo, 1999-241 the court upheld the taxpayer’s reporting of a tax position related to a transaction, stating that section 269 (Treas. Reg. § 1.269-3(a)) applies only if tax evasion or avoidance is the principal purpose for the acquisition. “In the context of section 269, ‘principal purpose’ means that the evasion or avoidance purpose must exceed in importance any other purpose…To prevail, petitioners need prove only that the avoidance or evasion of tax was not the principal purpose for the acquisition. Further in K.H. Love, T.C. Memo. 2012-166 the taxpayer was entitled to arrange his affairs so as to minimize his tax liability by means which the law permits.

Passive Losses:

Generally, a passive activity is any activity that may be considered a trade or business where the taxpayer does not materially participate. Material participation means that a taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis. The participation level is determined on an annual basis.

Passive activity expenses and losses are those attributable to passive activities that generate income. Such expenses and losses can only be used to offset income from passive activities with one exception. Expenses and losses that exceed passive activity gross income may be applied retroactively or carried forward until such excess is used up. Passive activity gross income includes gain from the disposition of property used in a passive activity at the time of the disposition. Passive activity rules apply to individuals, trusts, estates, personal service corporations, and closely held C corporations, but not S corporations or partnerships although they apply to partners and shareholders at the individual level respectively. Note: a taxpayer who owns an interest in an activity as a limited partner is not treated as materially participating in the activity by definition.

At Risk Rules:

Individuals, partners, S corporation shareholders, estates, trusts and certain closely held C corporations are subject to the at-risk rules. Under the at risk rules, deductions for losses stemming from a trade or business, or an activity for the production of income are limited to the amount at risk.  The amount at risk is basically the amount of capital and the adjusted basis of property contributed to the activity.  A taxpayer generally is also at risk for amounts borrowed to fund the business or investment activity if the taxpayer is personally liable for repayment or has pledged property unrelated to the activity under consideration as collateral to securitize borrowed funds unless the taxpayer is in reality insulated against losses. A taxpayer may additionally be at risk where qualified nonrecourse financing for real estate is utilized.

Reportable Transactions:

The reportable transactions rules were drafted in an attempt to identify transactions that result in a tax benefit and are viewed by the government as abusive or have a high potential for abuse. The fact that a transaction is a reportable transaction is not supposed to effect the actual legal determination of whether the taxpayer’s corresponding tax treatment of the transaction is correct. Treas. Reg. § 1.6011-4 dictates that taxpayers that have participated in a reportable transaction are required to complete and file a disclosure statement with the associated tax return for every year the taxpayer continues to participate in a reportable transaction. A copy of the disclosure statement is required to be sent to the Office of Tax Shelter Analysis simultaneously with the filing of the disclosure within a tax return.

Reportable transactions are transactions that:

  1. Are the same or substantially similar to transactions identified as tax avoidance transactions and periodically published by the IRS as “listed transactions”.
  1. Transactions that are offered to a taxpayer under conditions of confidentiality and for which the taxpayer has paid an advisor a minimum fee.
  2. A transaction that contains a contractual protection entitling the taxpayer to a full or partial refund of fees if all or part of the projected tax consequences flowing from the transaction are not sustained if challenged.
  3. Loss transactions resulting in the taxpayer claiming a loss under § 165 (Wagering, theft, capital and disaster losses) of $10 million or greater in any single taxable year or $20 million in total in any combination of taxable years for corporations.
  4. Transactions that are the same as or substantially similar to one of the types of transactions that the IRS has identified and labeled a “transaction of interest”.

See IRS website at: http://www.irs.gov/instructions/i8886/ch01.html

A transaction of interest is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest. It is a transaction that the IRS and Treasury Department believe has a potential for tax avoidance or evasion, but for which there is not enough information to determine if the transaction should be identified as a tax avoidance transaction. The requirement to disclose transactions of interest applies to transactions of interest entered into after November 1, 2006. For existing guidance, see Notice 2009-55, 2009-31 I.R.B. 170, available at www.irs.gov/pub/irs-irbs/irb09-31.pdf. The IRS may issue a new, or update the existing, notice, regulation, or other form of guidance that identifies a transaction as a transaction of interest.

Listed Transactions

The IRS keeps a current listing of tax shelters that it has deemed to be tax avoidance transactions. Practitioners and taxpayers are not prohibited from participating in listed transactions but civil and criminal career ending consequences can be imposed on taxpayers, practitioners and promoters that do not disclose their participation in a listed transaction where they are required to. Note: The IRS requires that all participation in any tax shelter that has the potential for tax evasion or avoidance, listed or unlisted, however the most draconian penalties surround non-disclosure of participation in listed transactions.

The IRS keeps a real time list of “listed transactions on its website that can be accessed here: http://www.irs.gov/Businesses/Corporations/Listed-Transactions—LB&I-Tier-I-Issues

Below are a few examples from the most recent update to the IRS website of Listed Transactions that I chose to show how broad and of wide application a listed transaction can be. Note: a listed transaction includes not only those transactions described on the IRS website but in addition any transaction that is deemed to be the same as or is substantially similar to any of the transactions listed on their website. In addition, reporting requirements exist for all transactions with the potential for tax evasion or avoidance.

Transaction involving:

  • distributions from charitable remainder trusts
  • “loss importation” where foreign entities and offsetting positions with regard to foreign property or currency are utilized to imports losses but not the gains to offset U.S. taxable income
  • distribution of encumbered property in which taxpayers claim tax losses for capital outlays that they have in fact recovered
  • the purchase of a parent corporation’s stock by a subsidiary, a subsequent transfer of the purchased parent company stock from the subsidiary to the parent’s employees, and the eventual liquidation or sale of the subsidiary
  • the acquisition of two debt instruments that have values that are expected to change significantly at about the same time in opposite directions
  • Distressed asset trust (DAT). A DAT is utilized to facilitate the contribution of distressed assets to a trust by a tax disinterested party. A U.S. taxpayer subsequently transfers either cash or a note to the DAT in exchange for becoming a beneficiary of the trust. The trustee of the DAT then creates a subtrust with the purchasing U.S. taxpayer as its sole beneficiary. Distressed property is the transferred to the subtrust. The U.S. taxpayer then claims direct ownership of the property under Code Sec. 678. The taxpayer then writes off the distressed assets as completely worthless under Code Sec. 166 as a bad debt, or the assets are sold and the taxpayer claims a casualty loss under Code Sec. 165.
  • the use of an intermediary to sell the assets of a corporation
  • leasing companies that have been used to avoid or evade federal income tax and employment taxes
  • a loss on the sale of stock acquired in a transfer of a high-basis asset to a corporation and the corporation’s assumption of a liability that the transferor has not yet taken into account for federal income tax purposes
  • one participant claims to realize rental or other income from property or service contracts and another participant claims the deductions related to that income under a  lease strip
  • a taxpayer claims a loss upon the assignment of a contract to a charity but fails to report the recognition of gain when the taxpayer’s obligation under an offsetting transaction terminates
  • a corporation claims inappropriate deductions for payments made through a partnership
  • losses resulting from artificially inflating the basis of partnership interests

Tax Shelters

The Tax Court has consistently disallowed losses, deductions and credits from transactions it deems to be tax shelters via attack as a sham transaction, or by not respecting the form the transactions takes and determines the associated income tax consequences accordingly.  To be respected, transactions are required to be motivated by business considerations rather than by attractive tax avoidance benefits obtained via the use of meaningless labels.

The Tax Court has adopted a unified test to identify generic tax shelters based on the economic substance doctrine and factors associated with the not for profit regulations.

The tax court defines a generic tax shelter as a tax shelter that lacks statutory authority and has the following qualities:

  • The main focus of the associated promotional materials surrounded tax benefits.
  • The taxpayers utilizing the shelter accepted the terms of purchase without price negotiation.
  • The assets purchased consist of prepackaged property rights that are difficult to value in the thin air environment in which they are sold and, invariably, are substantially overvalued in relation to the property rights actually purchased.
  • The property rights were acquired or created at a comparatively low cost shortly before the transactions under scrutiny.
  • The consideration is deferred via promissory notes that are often nonrecourse in form or in substance.

Transactions identified as generic tax shelters in the past have included investments in the cable television industry, master music recordings, inventions, mining activities, films rights, art packages, videotape recordings, and luxury yacht leasing arrangements.

Tax Shelters are Occasionally Attacked under the Code Sec. 183 Hobby Loss Rules:

The following scenarios have drawn an application of Code Sec. 183 form the Service and the Courts:

  • The activity is held to not be engaged in for profit, but the related transactions have economic substance.

Resulting application under § 183: Valid deductions arising from the activity are allowable solely to the extent that they do not exceed the gross income from the tax shelter. This result follows because while the expenditures are actual and the debts (if any) represent bonafide indebtedness and assets are purchased for their real fair market value, the facts and circumstances of the particular set of transactions under scrutiny lead to the Service or the Court’s to the conclusion that the taxpayer never intended to make a profit.

  • All aspects of the activity are found to be lacking economic substance and the activity is held to be a sham.

Resulting application: No deductions or losses are allowed – period.  The § 183 regulations are not operative here because there is no deemed investment or indebtedness, and thus no valid expenses.

  • The activity as a whole is deemed to be engaged in for profit; however, certain aspects of the activity are deemed to lack economic substance.

Result: The deductions claimed as attributable to the aspects of the activity that are deemed to be without economic substance are not respected and thus disallowed. The deductions related to the respected portions of the activity are allowed in full.

  • The activity as a whole is deemed to not be engaged in for profit, but certain aspects have economic substance.

Result: The deductions allocable to the aspects deemed to have economic substance are allowed, but only to the extent of the income from the portion of the activity deemed to have economic substance Code Sec. 183. The deductions claimed that are allocable to the aspects that do not have economic substance are disallowed.

A typical situation where this type of scenario develops is where an activity is deemed a tax shelter which in total is not engaged in for profit, but never the less various out-of pocket expenditures are still allowed.

As an example of this type of attack on an activity, In the case of J.L. Rose, Dec. 43, 687 the Tax Court focused on the lack of profit motive and associated lack of economic substance in attacking what it deemed an “abusive” tax shelter in which investors, with  absolutely no knowledge or experience in the field of art, without obtaining expert advice, and without and challenges to the offering price, purchased purported “reproduction masters” of Picasso paintings at a price that had no reasonable relation to a reasonable fair market value of the property. The purchase was financed largely through nonrecourse notes with their sole security being the reproduction masters themselves and it was shown that the taxpayers did not generate gross income from the activity. The Tax Court labeled the activity a “generic tax shelter” focusing on the following factors:

  • Tax benefits were the focus of the activity’s promotional materials;
  • Investors accept the terms of purchase without any attempts at negotiating a more advantageous price;
  • The assets purchased were deemed to be property rights that were difficult to value in the abstract and substantially overvalued in reality;
  • The actual assets purchased were created at a comparatively small cost immediately before being purchased by the investors; and
  • The majority of the consideration for the assets came from non-recourse promissory notes

Reportable Transactions Civil Penalty Regimes:

The Code provides for several civil penalty regimes that were implemented in an attempt to generate accurate reporting of transactions by taxpayers and practitioners. Under section 6662(a) a 20% penalty is imposed on any portion of an underpayment that is attributable to negligence surrounding the application of codified rules or regulations. It also applies to substantial understatements of income tax, or a substantial valuation overstatement. This penalty is increased to 40% where a gross valuation misstatement occurs and is calculated on 40% of the valuation understatement.  The 40% penalty also applies to undisclosed transaction deemed to lack economic substance and to undisclosed foreign financial asset understatements.

Civil Penalties Related to Tax Shelters

There is a penalty regime surrounding reportable transaction understatements that increase when the underreporting is coupled with non-disclosure and where fraud is deemed to have occurred. Civil penalties can be levied against taxpayers that participate in reportable transactions or abusive tax shelters, and thus understate their tax liability.

The penalty for failure to disclose a reportable transaction is $10,000. If the shelter is a listed transaction, the penalty is $200,000 ($100,000 for individuals).

Civil Penalties Applicable to Shelter Promoters and Material Advisors

Material advisors can be penalized for their failure to satisfy disclosure requirements reportable on Form 8918, “Material Advisor Disclosure Statement”, where they are deemed to have aided, assisted or advised a taxpayer in connection with a reportable or listed transaction.    If a form 8918 is required to be filed and is not, the penalty is $50,000 for reportable transactions other than listed transactions. If the transaction is a listed transaction, the penalty skyrockets to the greater of $200,000 or 50% of the gross income derived from providing aid, assistance, or advice about the listed transaction.  If the failure is intentional the 50% cap increases to 75%. The IRS ordinarily seeks an injunction against the promoter or advisor were additional failures to file the information returns occur after the first Material Advisor Penalty is levied.

Penalty for Material Advisors Who Fail to Keep or Make Available Investor Lists Upon IRS Request

A penalty is imposed on material advisors whom are required to maintain investor lists and fail to keep or make the list available within 20 days after a written request from the IRS under Code Sec. 6708 in the amount of $10,000 for each day of the continued failure that persists after the 20 day notice period. The penalty continues to apply until a “complete” list is supplied. An itemized statement of information including a description of the transaction, and copies of certain documents must also be included with the IRS request.

Penalty for False Statements Related to the Tax Effects of a Listed Transaction

Any promoter who makes a false statement about the tax benefits of a reportable transaction knowing the statement is false or fraudulent is subject to a penalty of 50 percent of the gross income derived from promoting the activity.

Government Regulation of Tax Advisors:

The Treasury Department dictates rules governing practice before the IRS under Circular 230. These rules were substantially strengthened and modified after the IRS identified and attacked several high-profile individual and corporate tax shelters in recent decades. These rules address standards by which tax advisors must conduct their practice and dictate the competence level required of tax advisors that render tax opinions. Under Circular 230 a practitioner rendering a covered opinion must use reasonable efforts to identify and ascertain the pertinent facts and must not base their opinion on unreasonable factual assumptions and must relate the correct applicable tax law to the correct relevant facts. Additionally the opinion must not unreasonably assume a favorable resolution of any significant relevant tax issues addressed and must consider all significant tax issues in reaching the practitioner’s conclusion as to the likelihood that the taxpayer will prevail on the merits with respect to each significant federal tax issue considered in the opinion.  The opinion is prohibited from taking into account the possibility that a tax position will not be audited or that an issue will not be raised in any subsequent audit, or that an issue raised at audit will be favorably resolved through settlement.

The Internal Revenue Service has the power to censure, discipline, fine or remove the right to practice on any practitioner that is proves to be incompetent, disreputable or simply fails to comply with the prohibited conduct standards.  It can do the same where it proves a practitioner willfully and knowingly defrauded, mislead or threatened a client or prospective client.

Potential Tax Practitioner Criminal Liability:

It is important to emphasize the obvious, that tax evasion is a very different concept than tax avoidance is. Tax avoidance involves the careful, legal structuring of one’s affairs so his or her tax liability is legally reduced or minimized. Tax avoidance is legal. As one famous judge put it, “one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934). Tax evasion, by contrast, is not legal and it involves the willful attempt to avoid paying one’s tax liability after it has been incurred.

A tax practitioner can be found guilty to the same extent as the taxpayer who actually owes the taxes. This is because the scope of tax evasion is defined broadly in Section 7201. Specifically, Section 7201 provides that tax evasion includes a person’s attempt “in any manner”—including helping another—“to evade or defeat any tax” or its payment (emphasis added). Thus, the statute allows the IRS to prosecute any person for the evasion of another’s tax liability. The defendant need not be the taxpayer in question.

To successfully prosecute a violation of the aiding or assisting provisions for aiding or assisting another to file a false form, the government must prove beyond a reasonable doubt that:

  1. The defendant aided, assisted, procured, counseled, or advised the preparation or presentation of a document;
  1. The document was false as to a material matter; and
  1. The defendant acted willfully.

Charges under this provision are most often brought against, accountants, bookkeepers and others (including an entity’s employees) who prepare or assist in the preparation of tax returns. However, the statute is not limited solely to the direct preparation of a return, but is actually much broader in that the statute reaches any intentional conduct that contributes to the presentation of a false document to the IRS.

To be charged under these provisions, one need only assist in the preparation of, and need not sign or file, the actual false document. The statute has thus been applied to individuals who communicate false information to their return preparers, thereby causing the tax preparer to file a false return. On the other hand, the statute specifically provides that the taxpayer who signs and files the return or document need not know of, or consent to, the false statement for the aiding and abetting statue to be brought against the preparer. For example, a tax preparer who inflates deductions understates income, or claims false credits on a client’s return may be charged with aiding and abetting even if the taxpayer for whom the return is prepared is unaware of the falsity of the return he signed and filed. Moreover, a tax preparer who utilizes information provided by a client that the preparer knows to be false, in the preparation of a return can be criminally charged with assisting in the preparation of a false return.

The courts that have ruled on what constitutes a material matter have held materiality to be a matter of law to be decided by the court and not a factual issue to be decided by the jury.

To establish willfulness in the delivery or disclosure of a false document, the government need only show that the accused knew that the law required a truthful document to be submitted and that he or she intentionally violated the duty to be truthful. The crime of aiding or assisting in the preparation or presentation of a false return or document requires that the defendant’s actions be willful in that the defendant knew or believed that his or her actions were likely to lead to the filing of a false return. The Ninth Circuit has held that the government must prove not only that the accused knew that the conduct would result in a false return, but must additionally establish that tax fraud was in fact the objective of the allegedly criminal conduct.

The statute of limitations for the crime of aiding or assisting the preparation or presentation of a false return or other document is six years. The statute of limitations for charges involving delivery or disclosure of a false document starts to run from the date the document is disclosed or submitted to the IRS.

Examples of Recent Convictions of Practitioners for Tax Crimes:

In R.J. Ruble, DC N.Y., 2009-2 ustc, a well-known attorney with the law firm of Sidley, Austin Brown and Wood was convicted of income tax evasion for designing and marketing a tax shelter. The government proved that attorney either knew or alternatively consciously disregarded the fact that the tax shelter he designed and marketed lacked economic substance. There was no business purpose to employ the shelter other than to obtain a tax benefit, and that there was no reasonable probability that the shelter would result in any profit apart from the anticipated tax benefits.  He is currently living in a Federal Penitentiary in Lewisburg Pennsylvania and was sentenced to 78 months without the possibility of parole except that it is possible he may serve the last six months in a half-way house or home confinement.

The following BDO Seidman personnel were sentenced for their role in promoting a tax shelter. Patricia Hurtado, an Ex-BDO Seidman Executive was sentenced to 16 months, Charles Bee, the former Vice Chairman of BDO received 16 months, Adrian Dicker, former Vice Chairman of BDO received 10 months and Robert Greisman, a former partner at BDO received 3 months.  All of these sentences were the results of plea bargains and involved cooperation in the prosecution of other related tax shelter promoters the most prominent of which is Paul Daugerdas, out of the Chicago office of the now defunct law firm of Jenkens & Gilchrist.

The reason that a disreputable minority of Accountants and Attorneys risk promoting tax shelters is crystal clear – Greed!  Most partners of law firms and CPA firms are limited to the amount of profit that can make by selling the time and the expertise of themselves and their staff.   Tax shelters are a commodity that can be sold and rapidly replicated in cookie cutter fashion and the profit potential is completely unrelated to the time necessary to provide the services but rather relates more closely to a piece of the tax savings generated by the scheme typically ranging from 3 to 5 % on average.

For example Mr. Bee earned an estimated $23.6 million in fees as a result of promoting tax shelters and is purported to have encouraged other professionals at BDO to do the same even though he’s currently portrayed as part of a rogue group by his old firm.  Paul Daugerdas generated $95 million in fees from the creation and marketing of tax shelters while simultaneously paying less than $ 8,000 in federal taxes when he in actuality owed more than $32 million in federal tax.

Additionally the sentencing can occasionally seems light when compared to the financial damage done to the federal and state tax systems.   For example Mr. Bee only received a 16 month sentence because of evidence and cooperation he provided on Paul Daugerdas (a much larger fish in this example).  The judge was quoted as stating that while he found Bee’s testimony to be credible and his cooperation significant, “it doesn’t change the fact that he helped perpetrate one of the largest tax frauds in the history of the United States.” Daugerdas, (a lawyer and certified public accountant by the way) created and selectively marketed tax shelter schemes named “Short Sales,” “Short Options Strategy,” “Swaps,” and “Homer” that produced $7 billion in fraudulent tax deductions for approximately 1,000 of the mostly wealthy clients of his and a handful of prominent public accounting firms and more than a billion dollars’ worth of sham losses. A report conducted by a consulting firm commissioned by the IRS estimated that illegal tax shelters cost the government between $ 14 and $ 18 billion in lost federal tax revenue in 1999 alone.

While Mr. Bee’s sentence may appear light, the federal government must send out the message that crime does not pay. To that end Paul Daugerdas was convicted and sentenced to 15 years for conspiring to defraud the IRS, aiding and abetting income tax evasion, mail and wire fraud and other crimes. He was ordered to forfeit $164,737,500 in proceeds traceable to his offenses and certain assets were seized including a lakefront home on Lake Geneva in Wisconsin, roughly $20 million in various securities and miscellaneous financial accounts and he was ordered to pay $371,006,397 in restitution to the IRS.

Currently, I suspect that a new generation of greedy tax lawyers has most likely again crossed the line and are covertly working behind closed doors with tax shelter “promoters” that include  prominent public accounting firms, investment banks, and insurance companies, to create and selectively market new varieties of tax shelters. While I expect they are still, as in the past, a minute minority of the Tax Bar, their numbers are likely to have grown dramatically since the government has moved its focus offshore. Today as in the past they most likely occupy prominent positions at prominent firms.  With the government’s focus on offshore evasion the exposure is probably perceived to be even lower than it was seen to be in the late 90’s and I expect that when the government returns their attention to onshore evasion the next round of  investigations and prosecutions will fruitfully ensue.

Exposure of Tax Practitioners to Tax Crimes:

Both the federal and state taxing authorities can bring both felony and misdemeanor tax charges against Tax Attorneys, CPAs E. A.’s,  tax preparers and their client, the most common of which include tax evasion, failure to file a return or pay tax and filing a false return. The IRS also prosecutes taxpayers under the Federal Criminal Code on charges such as presenting false claims to the government, conspiracy, and making false statements.

In order for the federal government to prevail in a criminal prosecution, they must prove each element of an accused tax crime beyond a reasonable doubt. Moreover, the Government must bring the action within the appropriate statute of limitations for prosecution that range from three years to six years under the internal revenue code and within five years for crimes prosecuted under the Federal Criminal Code.

To complicate matters further, individuals can be convicted of committing a tax crime with regards to another person’s or entities tax liability, like for example, where a corporate officer falsifies the associated corporate returns. Corporations and other legal entities such as Estates, LLC and Partnerships may also be prosecuted. Thus, CPA’s should be aware of their own potential liability for tax crimes in preparing returns such as aiding and abetting the commission of an offense or conspiracy to commit tax evasion.  The federal government has recently endeavored to expand the definition of a preparer to extend to anyone that provides advice or an opinion as to a position taken on a tax return which should be of great concern to Tax Attorneys.

Any person who is required to keep any records or supply information and who willfully fails to do so can be convicted of a misdemeanor. A person who willfully delivers or discloses to the Treasury Secretary (or his or her delegate) a list, return, account, statement, or other document that the person knows to be fraudulent or false as to any material matter can be convicted of a misdemeanor.

In doing representation, planning and compliance work Tax Practitioners should be especially aware of the legal definitions of Obstruction and Aiding or Assisting a False Return.

Obstruction

The crime known as “tax obstruction” is found in IRC § 7212, which actually lists several crimes. However, there is one clause in this statute—known as the “Omnibus Clause”—that is the focus here. An Omnibus Clause violation exists when someone (anyone) “in any way corruptly . . . obstructs or impedes, or endeavors to obstruct or impede, the due administration” of the tax laws. § 7212.

To establish a Section 7212(a) omnibus clause violation, the IRS must prove three elements beyond a reasonable doubt: (1) that the defendant made a corrupt effort, endeavor, or attempt (2) to impede, obstruct, or interfere with (3) the due administration of the tax laws (Internal Revenue Code). U.S. v. Wood, 384 Fed. Appx. 698 (10th Cir. 2010).

Aiding or Assisting a False Return

The crime known as “aiding or assisting a false return” is codified in IRC § 7206(2), which essentially makes it a felony for someone to “willfully aid . . . assist, procure, counsel, or advise” someone in the preparation of a document (e.g. a tax document) that is “materially” false.

Broken up into its elements, the government must prove five things, each one beyond a reasonable doubt: (1) the defendant aided, assisted, procured, counseled, or advised another in the preparation of a tax return (or another document in connection with a matter arising under the tax laws); (2) that tax return (or other document) falsely stated something; (3) the defendant knew that the statement was false; (4) the false statement was regarding a “material” matter; and (5) the defendant aided, assisted etc. another willfully (that is, with the intent to violate a known legal duty).

One thinks here of a CPA, enrolled agent, or other tax preparer who is trying to help his or her client pay less tax, but that person (the taxpayer himself or herself) was not involved in the tax preparation process. But the tax crime of aiding another to prepare a false document captures more than just CPAs and enrolled agents. It includes anyone who prepares false documents—for example, an appraiser who values a business interest for tax purposes, or a tax shelter promoter. An appraiser might have to discern the value of a partial interest in a business or other asset contributed to a charity. An inflated value would achieve a higher charitable deduction to the taxpayer, but if that value is not defensible, the appraiser could be charged with “aiding in the preparation of a false return” under § 7206(2).

The basis for aiding and abetting violations is accomplice liability. An individual may be indicted as a principle for committing a substantive offense upon a showing of him or her to be an aider or abettor. In practice this means persons who have aided and assisted another in tax evasion by concealing another person’s sources of income or assets. To prevail in bringing a charge under the federal aiding and abetting statute, the government must prove beyond a reasonable doubt that:

  • A substantive criminal offense was committed.
  • The defendant, by affirmative conduct, participated in, counseled, or assisted in the commission of the substantive offense.
  • The defendant shared with the principal the criminal intent to commit the substantive offense.

An accused must associate themselves in some manner with a criminal venture to be convicted of aiding and abetting the commission of an offense. This is established by a showing of participation in the criminal venture that demonstrates a desire to seek and bring about the criminal result. However, the aider and abettor need not perform the substantive offense nor even know its details to be convicted or even be present when the offense is committed. To be successful in bringing an action for aiding and abetting, the government need only show that the defendant intentionally assisted in the commission of a specific crime in some substantial manor.

In order to sustain a conviction the government must present evidence showing an underlying offense, this means aiding and abetting is not an independent crime. However, the principal who was aided and abetted does not need to be identified or convicted for the government to convict the party accused of aiding and abetting. Moreover, an outright acquittal of the principal will not bar the prosecution of the aider and abettor. Because the aiding and abetting statute does not create a separate offense, the applicable statute of limitations for bringing an aiding and abetting charge is the same as that of the underlying substantive crime that is at issue.

Conclusion

After 20 years as a tax practitioner, I’m amazed at how many shades of grey there appear to be depending upon the point of view of the observer.  Unfortunately, how dark or light a shade of gray is often in the eye of the beholder. I have heard it said that like one man’s tax avoidance is another man’s tax evasion which is invariably affected by which side of the fence the beholder sits on (the government’s or the Tax Profession).  Through the drafting of this paper I’ve come to the conclusion that tax evasion is a lot like the Supreme Court’s holdings on pornography – the government knows it when they think they see it!  In the end the exposure of being on the wrong side of this determination can be a career ender and thus the prudent Tax Practitioner should endeavor to use an abundance of caution, generous amounts of due diligence and common sense in order to avoid “to good to be true” tax planning arrangements like the plague.   A practitioner with a developed sense of smell should be able to detect the odor coming from sham transactions and with ordinary due diligence avoid the life altering consequences encountered by Mr. Bee and Mr. Daugerdas.

Interesting links to IRS website:

http://www.irs.gov/Individuals/How-Do-You-Report-Suspected-Tax-Fraud-Activity%3F
http://www.irs.gov/uac/What-are-some-of-the-Most-Common-Abusive-Tax-Schemes%3F
http://www.irs.gov/Businesses/Corporations/Listed-Transactions—LB&I-Tier-I-Issues
http://www.irs.gov/Businesses/Corporations/Abusive-Tax-Shelters-and-Transactions
http://www.irs.gov/Retirement-Plans/EP-Abusive-Tax-Transactions-Listed-Transactions
http://www.irs.gov/Retirement-Plans/EP-Abusive-Tax-Transactions
http://www.irs.gov/uac/How-Does-the-Taxpayer-Access-the-Funds-in-Offshore-Accounts%3F-Abusive-Tax-Schemes
http://www.irs.gov/pub/irs-utl/TD_9668_6-9-14_Cir%20230_6-9-14_Final_Reg.pdf

Links to the rest of the Daugerdas and BDO stories (an absolutely fascinating read):

http://federaltaxcrimes.blogspot.com/2014/06/bdo-seidman-personnel-sentenced-for.html


“Spies” Evasion – When Does Failure to File Constitute Tax Evasion?

What are the basics Tax Attorneys and CPA’s should know when representing clients with criminal tax exposure? 

By

David W. Klasing Esq. M.S.-Tax CPA

David Warren Klasing

 

The “Spies evasion” doctrine:

The “Spies evasion” doctrine is, essentially, one of the common ways the government convicts a non-filer target of tax evasion. It is essentially a road map for the government to follow that will find a non-filer target criminally liable for felony income tax evasion when the following elements indicative of a non-filer’s willfulness can be proven.  The target willfully (1) fails to file a tax return, and (2) his or her action is coupled with an “affirmative act of evasion,” that is likely to mislead the government.

Sources of federal law that defines “tax evasion” in general:

The specific source of federal law that defines tax evasion is Section 7201 of the Internal Revenue Code. However, that definition has been expanded, amplified, and interpreted by case law, the underlying treasury regulations, and revenue rulings. At a basic level, Section 7201 provides that a person commits tax evasion when he or she “willfully attempts in any manner to evade or defeat any tax or its payment.”

Significance of the Spies evasion doctrine:

Section 7201 “Spies evasion” is a tremendously more serious offense than the seldom charged section 7203 misdemeanor surrounding the non-filing of a tax return. This is because the mere non-filing of a tax return is typically a Section 7203 misdemeanor, while a “Spies Evasion” type fact pattern may cause the Section 7203 offense to rise to the level of a Section 7201 felony. The willful failure to file a return and pay federal income tax where a taxpayer knows federal tax is due is only a misdemeanor United States v. Masat, 896 F.2d 88, 97-99 (5th Cir. 1990).

Tax evasion, however, must be proved by some sort an affirmative act rather than a failure to act.  Tax evasion is most commonly proven by showing the willful filing of a false return.   A “Spies Evasion” type fact pattern will enable the government to establish an affirmative act even where returns are not filed!

In Spies the Supreme Court identified at least seven examples of conduct that constituted affirmative acts of evasion. The Court stated: “We think the affirmative willful attempt may be inferred from conduct such as [1] keeping a double set of books, [2] making false entries of alterations, [3] or false invoices or documents, [4] destruction of books or records, [5] concealment of assets or covering up sources of income, [6] handling of one’s affairs to avoid making the records usual in transactions of the kind, and [7] any conduct, the likely effect of which would be to mislead or to conceal.” Spies v. United States, 317 U.S. 492, 499 (1943).

Unfortunately for many taxpayers, case law has greatly expanded what it means to engage in an “affirmative act of evasion.” By way of example of a recent application of this doctrine, In N. Stierhoff, CA-1, 2009-1 ustc, a target was convicted and sentenced for committing Spies Evasion. The affirmative acts that elevated his non-filing from a misdemeanor into a felony were that the target operated his business under a false name, concealed his identity and income, and of course was a non-filer.

“Egg shell” audit:

An eggshell audit is a civil audit in which the return(s) under examination contain a material understatement of income, material overstatement of deductions or credits were claimed that the taxpayer was not entitled to, the end result of which was that the taxpayer showed less tax liability than they would have owed had a true, complete and accurate return been filed. These errors can be caused by mere negligence, which may result in a 20% negligence penalty on any additional income tax found to be owed under audit, or via willful intent which would indicate underlying criminal issues with the tax filings under audit, which may result in 3 to 5 years in jail and or a 75% fraud penalty.

Reverse “egg shell” Audits:

Reverse egg shell audits are parallel and simultaneous civil and criminal investigations where essentially a criminal tax investigation is disguised as a civil audit. Reverse eggshell audits usually stem from a referral from a civil examiner (revenue agent) to a Fraud Referral Specialist whose sole job it is to work up the case for a handoff to a special agent in the criminal investigation (CI) division or upon a request by CI that a civil auditor be assigned to an ongoing criminal investigation. Ordinarily in a standard civil audit, the auditor is not on notice at the outset of an audit regarding a taxpayer’s potentially criminal tax conduct, however, in a reverse egg audit; it is the taxpayer and potentially their representative who is not on notice about the auditor’s true intentions.

Warning signs to look for in determining if there has been a criminal referral and therefor an egg shell audit has reversed into a reverse egg shell audit:

A criminal referral is likely to follow a civil audit if firm indications of fraud exist in the mind of the civil auditor.  Note: An omission of income greater than $10,000 in a single year will result in an automatic referral to a technical fraud advisor for possible development of the case for a hand off to the criminal investigation division.

Commonly recognized warning signs that precede a criminal referral include:

  • A civil audit may be suspended before completion and referred to CI for criminal investigation without the knowledge of the taxpayer.
  • The Revenue Agent becomes unexplainably unreachable.
  • The Revenue Agent focuses heavily on the “intent” of the client in taking positions on a return or worse yet mentions a pattern of noncompliance on several tax returns.
  • The Revenue Agent focuses prepares a net worth analysis or subpoena’s bank records.
  • The Revenue Agent gathers an excessive amount of documentation or makes excessive copy requests.
  • The Revenue Agent makes undisclosed contact with third parties.
  • The target receives a summons for records or for an appearance.
  • More than one revenue agent, the agent and their manager or worse yet two revenue agents, an attorney from chief counsel’s office and a court reporter attend a client interview.
  • An officer of the IRS wearing a gun and a badge approaches the target and reads them something similar to a Miranda warning (this is an IRS special agent from the criminal investigation division of the IRS). If you have reason to suspect this may happen counsel your client to demand that counsel be present for their questioning and remain silent!

The typical eggshell audit is said to reverse where a temporary suspension of a civil audit occurs which is often indicated where a civil auditor cancels a subsequent appointment and then fails to contact or return the taxpayer’s calls for several weeks while the referral process to CI progresses.

Understanding why a reverse egg shell audit is so dangerous for a taxpayer:

Because of recent changes in IRS internal policy, parallel investigations are on the rise and are rapidly becoming a favorite tool of the IRS. The advantages to the government in utilizing reverse egg shell audits is that the ample investigatory tools available to the average civil auditor such as third party subpoenas to banks and witnesses can be utilized without the taxpayer having the opportunity to utilize the constitutional protections of the due process clause, the fourth amendment privilege against unreasonable searches and seizures, and the fifth amendment right not to self-incriminate which are the most powerful tools available to criminal defense counsel

Ordinarily an IRS civil revenue agent’s primary concern is supposed to be determining the correct civil tax liability for the tax years at issue, while an IRS Special Agent from the Criminal Investigation Division is primarily concerned with gathering evidence to prove criminal violations have occurred and to prove it at trial if need be. CI Special Agents are required to advise taxpayer’s of their constitutional rights against self-incrimination and of the taxpayer’s right to have an attorney present during an interview via a non-custodial reading of their rights which states that anything they say may be used in a subsequent criminal prosecution for tax crimes. Because of this requirement, the initial interview with the special agent will often be delayed while the investigated taxpayer obtains legal counsel. To avoid granting the investigated taxpayer this tactical advantage in a reverse egg shell audit, initial contact is often made via a civil revenue agent to avoid putting the investigated taxpayer on notice that they are under criminal investigation while the civil examiner continues to collect information and conduct interviews with the taxpayer (and more importantly their often unseasoned representative) is none the wiser.

Reverse egg shell audits therefore present grave danger to less informed taxpayers who often tragically employ less sophisticated & often less expensive tax representatives, (i.e.CPAs & E.A.’s) that lack attorney client privilege and usually have a conflict of interest with the client because they prepared the original returns at issue and thus need to protect their own reputation with the taxing authorities. These less sophisticated representatives will often blindly cooperate with the auditor under the misconception that the taxpayer is merely complying with a standard civil audit and thus unwittingly waive the taxpayer’s constitutional rights that experienced criminal tax defense counsel would have exercised if they suspected their client was facing a criminal investigation.

Moreover, Reverse egg shell audits / parallel investigations often involve cooperating federal agencies (such as the SEC, FBI, DEA, ABC and the DOJ) and the civil and criminal investigation functions of the IRS. This flavor of egg shell audits additionally carries the added risk that the examination conducted by the IRS will advance the criminal investigation of the cooperating federal agency.

Lastly, revenue agents commonly continue to collect information after the discovery of firm indications of fraud, and thus procedurally go off the reservation by effectively conducting their own personal reverse eggshell audit. The continued investigation by the revenue agent without proper notice to the taxpayer and their representative that subsequent statements made and information provided will likely be used in a subsequent criminal investigation and prosecution violates the taxpayer’s constitutional rights that would exist if they were approached by the criminal investigation division directly and received a Miranda like reading of their rights.

Effective criminal tax defense counsel’s goals in an egg shell audit:

In the typical eggshell audit criminal tax defense counsel seeks to avert the emergence of a criminal investigation, by attempting to prevent a client from making any criminal admissions. In a reverse eggshell audit, they endeavor to discover any ongoing clandestine criminal tax proceeding and possibly limit the taxpayer’s cooperation in order to protect the taxpayer from criminal prosecution by protecting their constitutional rights against self-incrimination and unreasonable search and seizures.

Methods to obtain the above goals:

Taxpayers facing an egg shell audit should only be represented by experienced criminal tax defense counsel and the CPAs who perform via a Kovel agreement (United States v. Kovel, 296 F.2d 918 (2nd Cir. 1961)) effectively subordinating them to the attorneys supervision and rendering communication between the CPA and the client subject to the attorney client privilege. The original return preparer should never provide representation in an egg shell audit as they do not have attorney client privilege and are often subpoenaed to help make the government’s case in chief against the taxpayer. Also they cannot be trusted to be more concerned with protecting their own reputation than in helping the client avoid criminal prosecution.

Taxpayers faced with an eggshell audit are in dire need of an experienced criminal tax defense attorney who is able to advise the taxpayer on how exactly to comply with the auditor’s data requests, questioning, summonsing of records and all other investigatory techniques while simultaneously preventing the client from making criminal admissions or providing false information that can effectively waive the client’s 5th Amendment privilege against self-incrimination and 4th amendment privilege against unreasonable searches.

The Criminal Tax Defense Attorney’s largest concern in an eggshell audit is to dissuade the examining agent from referring the case to the criminal investigation unit of the IRS because CID’s primary mission is to deter the general public from committing tax crimes by criminally prosecuting a sample of taxpayers caught cheating to make an example out of them.

Once a revenue agent discovers significant and affirmative indications of fraud during a civil audit, he will first privately consult with his manager and upon receiving his managers approval he then secretly consults with a “fraud referral specialist” that works directly with the auditor to develop a “fraud development plan,” for the sole purpose of documenting the affirmative acts and firm indicators of fraud in order to refer the case to the criminal investigation function of the IRS. Criminal tax defense counsel must know when to weigh the benefit of continuing to cooperate with the civil revenue agent in an effort to quell the agent’s suspicion before a referral is made or choosing to advise his client to remain silent to protect the taxpayer from self-incriminating themselves by admitting to tax fraud or in making statements that the auditor later proves to be lies which amounts to a felony in and of itself as it is a felony to lie to a federal agent after a referral has been made.

Questioning the auditor regarding whether there is an open criminal investigation, grand jury investigation, associated technical fraud advisor or associated special agent of the criminal investigation division achieves different objectives in an eggshell versus a reverse eggshell audit. In an egg shell audit, this line of questioning may become necessary to protect the taxpayer but must be asked in such a manner as not to raise the auditor’s suspicion that tax fraud exists in the client’s fact pattern. If a reverse eggshell audit is underway, this line of questioning can help protect the taxpayer, because it will alert counsel to the existence of a clandestine criminal investigation or, if the revenue agent provides more than a tacit denial of the existence of a parallel criminal investigation, subsequent information and statements may be suppressible under Tweel.

One of the strongest protections available to criminal tax defense counsel is found under Tweel, which held that any auditor deception in a reverse egg shell audit has to be tacit rather than affirmative otherwise subsequently procured information will be suppressible. Thus when a revenue agent lies when he or she states that there is no parallel criminal investigation underway, a technical fraud advisor has not been associated with the audit, or if they continue their civil investigation after badges of fraud have been detected which are sufficient to trigger a halt to the civil examination and a criminal referral, any subsequently procured documents and statements are suppressible in a subsequent criminal prosecution.

An argument can also be made that all subsequent information and the taxpayer’s statements collected subsequent to the revenue agents original discovery of badges of fraud is inadmissible under Tousaint and thus can be suppressed. However contrary hair splitting case law holds that if the auditor’s conduct is merely a deception that violates IRS procedure but falls short of violating the U.S. Constitution or applicable federal statutes, the evidence collected by the auditor will not be held to be inadmissible in a subsequent criminal prosecution under Caceres and thus will not be suppressed. This split in federal case law creates a continuum of auditor behavior that requires measuring actions taken by an auditor that are often clandestine and thus hard to analyze and therefore makes the reverse egg shell audit extremely risky to the effected taxpayer.

It is often assumed that a taxpayer’s IRS master file is flagged if the taxpayer is involved in a criminal investigation, and thus a civil auditor could theoretically respond to an inquiry by a taxpayer’s representative whether there is an open criminal investigation, grand jury investigation, associated technical fraud advisor or associated special agent of the criminal investigation division. While the civil revenue agent will almost certainly be aware of the coding in the file, when queried, they will have to either answer honestly or more likely refuse to respond at all, in either event the criminal tax defense attorney will have learned something. In my opinion a refusal to deny a parallel tax criminal investigation is underway is as good as an admission that one is.

Accordingly, a taxpayer representative’s failure to ask the right questions at the sensitive juncture between an egg shell audit and it’s progression into a reverse egg shell, or failure to recognize the approaching juncture altogether, may result in a permanent loss of a taxpayer’s constitutional rights and privileges.

DEFENSE TACTICS DURING CIVIL EXAMINATION

A civil examiner is required to refer a case to the Criminal Investigation Division (CID) as soon as a firm indication of fraud is discovered in order to protect the taxpayer’s Fifth Amendment rights against self-incrimination and fourth amendment right against unreasonable searches and seizures. Thus, a civil examination should be immediately suspended while the IRS pursues a criminal tax investigation. However this is occasionally not the case.

Consequently, tax defense counsel should endeavor to prevent their client’s from offering testimony or evidence during a civil examination where it is indicative or probative of criminal intent, including making false statements and creating any record or displaying conduct that is likely to mislead or conceal especially in cases where there is an arguable Fifth Amendment claim. On the other hand, once a civil examination has begun, a taxpayer’s failure to make books and records unconditionally available to the examining agent may result in referral of the matter for criminal investigation. To this end, I routinely counsel my client’s that when speaking to a civil examiner they only have two choices: 1. Tell the truth! 2. Remain silent!

A substantial majority of reported convictions in criminal tax cases involve taxpayers who cooperated fully early in the investigation, without counsel, and either lied or made damaging admissions to CID agents. CID agents have the advantage during the first interview: they have prepared, they have reviewed tax returns, and they know the direction and scope of the investigation, consequently unrepresented taxpayers are at a distinct disadvantage.

A couple of cases are illustrative of the case law in this area that defense counsel can use to his client’s advantage:

In one notable case, taxpayer’s counsel argued that the evidence gathered by the examining agent was inadmissible in a subsequent criminal trial because there had been firm indications of fraud from the beginning of the audit and thus the audit should have been suspended pending a referral of the case to CID which would have put the taxpayer on notice of his criminal tax exposure. The Seventh Circuit held that the consensual search at the exam level was unreasonable under the Fourth Amendment and violated the due process clause of the Fifth Amendment because the taxpayer’s consent was induced by fraud, deceit, trickery or misrepresentation by the examining agent. To prevail under this line of case law, Tax Defense Counsel must establish that the agent affirmatively misled the taxpayer about the investigation and that this deceit was a material factor in the taxpayer’s decision to give information to the agent.

In another illustrative criminal tax case, to find out whether his client’s ongoing investigation was criminal or civil, the taxpayer’s attorney asked the examining agent whether a CID agent was involved in the investigation. The agent correctly responded that no special agent was involved. The Fifth Circuit held that records turned over by the taxpayer’s attorney to the agent could not later be used in a criminal tax case against the taxpayer because the agent deliberately deceived the taxpayer’s attorney by not informing him of the criminal nature of the investigation even though his previous statement was correct. The court held that his deception invalidated the taxpayer’s consent to the examination of his records and made the examination an unreasonable search and seizure in violation of the Fourth Amendment.

By contrast, in another illustrative civil case (non-criminal) before the Tax Court, the Tax Court refused to bar the use of evidence collected in a criminal investigation that was disguised as a civil audit because the taxpayer was aware that the information could be used in a civil case.

In some instances, moreover, the taxpayer’s tax defense counsel may object to the agent’s summonses based on protections of confidentiality that may apply to tax advice given by a federally authorized tax practitioner. The privilege may be asserted only in any noncriminal tax matter before the IRS or in any noncriminal tax proceeding in federal court brought by or against the United States.

LACK OF INTENT

Proving that a taxpayer acted intentionally in violation of a known legal duty is a critical element of most of the government’s criminal tax cases and is often the most difficult one for the prosecution to prove. In the absence of a confession or the testimony of an accomplice, intent usually must be established by circumstantial evidence concerning the taxpayer’s actions. The admissibility of circumstantial evidence is frequently a close question that criminal tax counsel can endeavor to suppress. Questions concerning the admissibility of evidence of intent are best raised with the tax defense counsel at both the Tax Division of the Justice Department and the U.S. Attorney’s office, since both organizations are bound by guidelines and experience that encourage them to consider declination if the only admissible evidence of intent is that of carelessness.

DEFECTS IN METHOD OF PROOF

When the IRS relies on indirect or circumstantial methods of proof, guidelines established by the courts establish safeguards that must be complied with in the use of that circumstantial evidence. Effective Tax Counsel can ensure that these safeguards are complied with.

IMPROBABILITY OF CONVICTION

Both the IRS and the Department of Justice regard the probability of conviction to be an important standard of review. A number of factors that are not sufficient by themselves to cause declination, when viewed together, might be sufficient reason to decline a case. A combination of a health condition, personal tragedy, and prepayment of liabilities could form the basis for declination. If a physical or mental health defense is raised, it should be supported by a medical opinion letter, medical records, and the curriculum vitae of the medical professional who treated the taxpayer.

Potential Tax Practitioner criminal liability:

It is important to emphasize the obvious that tax evasion is a very different concept than tax avoidance is. Tax avoidance involves the careful, legal structuring of one’s affairs so his or her tax liability is legally reduced or minimized. Tax avoidance is legal. As one famous judge put it, “one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934). Tax evasion, by contrast, is not legal and it involves the willful attempt to avoid paying one’s tax liability after it has been incurred.

A tax practitioner can be found guilty to the same extent as the taxpayer who actually owes the taxes. This is because the scope of tax evasion is defined broadly in Section 7201. Specifically, Section 7201 provides that tax evasion includes a person’s attempt “in any manner”—including helping another—“to evade or defeat any tax” or its payment (emphasis added). Thus, the statute allows the IRS to prosecute a person for the evasion of another’s tax liability. The defendant need not be the taxpayer in question.

To successfully prosecute a violation of the aiding or assisting provisions for aiding or assisting another to file a false form, the government must prove beyond a reasonable doubt that;

  • The defendant aided, assisted, procured, counseled, or advised the preparation or presentation of a document
  • The document was false as to a material matter
  • The defendant acted willfully.

Charges under this provision are most often brought against, accountants, bookkeepers and others (including an entity’s employee’s) who prepare or assist in the preparation of tax returns. However, the statute is not limited solely to the direct preparation of a return but is much broader in that the statute reaches any intentional conduct that contributes to the presentation of a false document to the IRS. Case law in the area provides the following examples:

An individual who sold discounted winning horse or dog race tickets to others for cash, thereby causing the filing of a false Form 1099s, as well as the individuals who signed government forms provided to the racetracks that falsely stated that he or she was the winner of the horse or dog race;

A person who knowingly prepared overstated appraisals to substantiate overstated deductions for charitable contributions;

Persons who fabricate and then sell fictitious invoices to others to support nonexistent deductions;

A breeder who, in furtherance of a fraudulent tax shelter, signed back-dated contracts for the purchase of livestock;

An employee who prepared false books and records that were eventually used to prepare the entity’s returns;

The be charged under these provisions one need only assist in the preparation of, and need not sign or file the actual false document. The statute has thus been applied to individuals who communicate false information to their return preparers, thereby causing the tax preparer to file a false return. On the other hand, the statute specifically provides that the taxpayer who signs and files the return or document need not know of, or consent to, the false statement for the aiding and abetting statue to be brought against the preparer. For example, a tax preparer who inflates deductions understates income or claims false credits on a client’s return may be charged with aiding and abetting even if the taxpayer for whom the return is prepared is unaware of the falsity of the return he signed and filed. Moreover, a tax preparer who utilizes information provided by a client that the preparer knows to be false in the preparation of a return can be criminally charged with assisting in the preparation of a false return.

FALSE AS TO MATERIAL MATTER

The courts that have ruled on what constitutes a material matter have held materiality to be a matter of law to be decided by the court and not a factual issue to be decided by the jury.

WILLFULNESS

To establish willfulness in the delivery or disclosure of a false document, the government need only show that the accused knew that the law required a truthful document to be submitted and that he or she intentionally violated the duty to be truthful. The crime of aiding or assisting in the preparation or presentation of a false return or document requires that the defendant’s actions be willful in that the defendant knew or believed that his or her actions were likely to lead to the filing of a false return. The Ninth Circuit (the appeals court for Southern California and thus controlling precedent) has held that the government must prove not only that the accused knew that the conduct would result in a false return, but must additionally establish that tax fraud was in fact the objective of the allegedly criminal conduct.

STATUTE OF LIMITATIONS

The statute of limitations for the crime of aiding or assisting the preparation or presentation of a false return or other document is six years. The statute of limitations for charges involving delivery or disclosure of a false document starts to run from the date the document is disclosed or submitted to the IRS.

Examples of evasion of assessment type convictions of practitioners:

In United States v. Wilson, 118 F.3d 228 (4th Cir. 1997), the court considered the evidence that the government introduced against the defendant that he (the defendant) attempted to mislead the IRS or conceal the taxpayer’s assets. The court considered the following evidence, among others: (1) that the defendant “prepared and executed false, backdated notes;” (2) that he “participated in a meeting where he discussed removing money from [another’s] bank accounts in order to prevent the IRS from attaching the money;” (3) that he provided the IRS revenue officer misinformation; (4) that he “prepared numerous corporate documents for [various parties], knowingly named “strawmen” as officers and directors;” and (5) that he instructed someone “how to funnel money” from one person to another to make it look like one of the parties had made an investment when he had not in fact done so.

In R.J. Ruble, DC N.Y., 2009-2 ustc, a well-known attorney was convicted of income tax evasion for designing and marketing a tax shelter. The government proved that attorney either knew or alternatively consciously disregarded the fact that the tax shelter he designed and marketed lacked economic substance. There was no business purpose to employ the shelter other than to obtain a tax benefit, and that there was no reasonable probability that the shelter would result in any profit apart from the anticipated tax benefits.

Examples of evasion of payment type convictions of practitioners:

In R. Huebner, CA-9, 95-1 ustc a practitioner who routinely serviced tax protesters by drafted sham promissory notes and then claiming the fake debt on the protestor’s bankruptcy petitions to remove IRS wage levies was convicted of aiding and abetting attempted income tax evasion. The practitioner created false claims indicative of financial distress, with the purpose of frustrating the government’s collections under its levies.  Convictions for conspiracy to defraud the United States were also sustained because the false assertions provided the required affirmative act with the intent to deceive the government.

A line of cases, with some variations among the circuits, have held that when a return preparers accepts checks from their clients with the understanding that the funds are to be used to pay the client’s tax liability, any diversion of the earmarked funds for the return preparers’ personal use coupled with a failure to pay the tax is a criminal attempt to evade tax.

Exposure of Tax Practitioners to “tax obstruction” under (§7212):

The crime known as “tax obstruction” is found in IRC § 7212, which actually lists several crimes. However, there is one clause in this statute—known as the “Omnibus Clause”—that is the focus here. An Omnibus Clause violation exists when someone (anyone) “in any way corruptly . . . obstructs or impedes, or endeavors to obstruct or impede, the due administration” of the tax laws. § 7212.

To establish a Section 7212(a) omnibus clause violation, the IRS must prove three elements beyond a reasonable doubt: (1) that the defendant made a corrupt effort, endeavor, or attempt (2) to impede, obstruct, or interfere with (3) the due administration of the tax laws (Internal Revenue Code). U.S. v. Wood, 384 Fed. Appx. 698 (10th Cir. 2010).

Exposure of Tax Practitioners to “aiding or assisting a false return” under IRC § 7206(2):

The crime known as “aiding or assisting a false return” is codified in IRC § 7206(2), which essentially makes it a felony for someone to “willfully aid . . . assist, procure, counsel, or advise” someone in the preparation of a document (e.g. a tax document) that is “materially” false.

Broken up into its elements, the government must prove five things, each one beyond a reasonable doubt: (1) the defendant aided, assisted, procured, counseled, or advised another in the preparation of a tax return (or another document in connection with a matter arising under the tax laws); (2) that tax return (or other document) falsely stated something; (3) the defendant knew that the statement was false; (4) the false statement was regarding a “material” matter; and (5) the defendant aided, assisted etc. another willfully (that is, with the intent to violate a known legal duty).

One thinks here of a CPA, enrolled agent, or other tax preparer who is trying to help his or her client pay less tax, but that person (the taxpayer himself or herself) was not involved in the tax preparation process. But the tax crime of aiding another to prepare a false document captures more than just CPAs and enrolled agents. It includes anyone who prepares false documents—for example, an appraiser who values a business interest for tax purposes, or a tax shelter promoter. An appraiser might have to discern the value of a partial interest in a business or other asset contributed to a charity. An inflated value would achieve a higher charitable deduction to the taxpayer, but if that value is not defensible, the appraiser could be charged with “aiding in the preparation of a false return” under § 7206(2).

Tax evasion and the definition of a “person”:

Section 7201 states that “any person” will be guilty of tax evasion if he attempts to evade or defeat a tax or its payment. The question, however, is whether “person” includes partners of a partnership, or an employee of a corporation, and the like. It does.

The answer is found in Section 7343 of the Internal Revenue Code, which defines “person” for purposes of tax offenses. It explains that “person” includes “officer[s] or employee[s] of a corporation, or member[s] or employee[s] of a partnership,” provided that such person is “under a duty to perform the act” that constitutes the tax offense. In addition case law has extended the term to include tax preparers, and corporations.

Section 7201 – two distinct criminal offenses, or two means of committing one and the same offense?

At first blush, Section 7201 of the Internal Revenue Code would seem to create two criminal offenses. Section 7201 provides that a person commits tax evasion when he or she “willfully attempts in any manner [1] to evade or defeat any tax . . . or [2] [its] payment.”

First, there is the offense for willfully attempting to evade or defeat a tax assessment. Stated simply, a taxpayer commits the crime of “evading of assessment” of a tax when he attempts to prevent the government—that is, the IRS—from determining his true tax liability. This would include, for example, the filing a false income tax return that “low balls” or omits income. It also includes a return that claims deductions that the taxpayer is not entitled to. These actions are a crime because they falsely lower the taxpayer’s “taxable income,” which is the figure ultimately used to compute tax liability.

Second, Section 7201 creates an offense for willfully attempting to evade or defeat the payment of a tax. Typically, this offense arises after the IRS has asserted you owe a tax, and the taxpayer actively conceals money or assets from the government in an attempt to avoid paying his or her tax liability.

Early case law (e.g. Sansone v. United States, 380 U.S. 343, 354 (1965)) said these were two, distinct crimes, but several Circuits have more recently treated them as constituting basically the same offense. These Circuits maintain that they both consist of an Internal Revenue Code Section 7201 offense of tax evasion. Thus, “Section 7201 evasion,” as it is sometimes called, may be committed by either attempting to evade a tax assessment or by attempting to evade its payment. In United States v. Mal, 942 F.2d 682, 686 (9th Cir. 1991), the Ninth Circuit held “that § 7201 charges only the single crime of tax evasion, and that an individual violates the statute either by evading the assessment or the payment of taxes.” Id at 688. Furthermore, even the IRS’s own Tax Crimes Handbook explains that “[t]hese two offenses share the same basic elements necessary to prove a violation of I.R.C. § 7201.” http://www.irs.gov/pub/irs-utl/tax_crimes_handbook.pdf

Section 7201 statute of limitations:

Under I.R.C. § 6531(2) there is a six year limitation period in which the government can charge for the offense of willfully attempting to evade or defeat the payment of any tax. The crime of tax evasion is completed when the false or fraudulent return is willfully and knowingly filed. However, for purposes of the statute of limitations on criminal prosecutions, returns filed before the due date are treated as having been filed on the due date. The affirmative act need not occur before or at the time the return is filed or due. Events occurring after the return is due, such as lying to government agents, are commonly relied on to establish attempted evasion. It is the latest affirmative act of evasion and not the due date of the tax returns at issue that triggers the limitations period.

Differentiation of IRC §7201’s “attempt to evade” and the common-law crime of “attempt”:

IRC Section 7201’s definition of “attempt to evade” is materially different from the common law crime of “attempt”. This was one of the holdings of the Supreme Court in Spies. The distinction between IRC Section 7201’s definition of attempt and the criminal attempt of common law is not a mere hair-splitting matter. The significance is huge. The punishment for attempting a common law crime is ordinarily significantly less severe than accomplishing the completed act of the crime. For example, the punishment for attempted murder (e.g. trying but failing to kill someone) is less severe than for actually committing murder (actually killing the person).

However, that is not how it works with tax evasion. IRC Section 7201 finds a person liable when he “willfully attempts in any manner to evade or defeat any tax.” In Spies the Court stated that this “attempt to evade or defeat” a tax is an “independent crime, complete in its most serious form when the attempt is complete, and nothing is added to its criminality by success or consummation.” In other words, when it comes to tax evasion, attempted “murder equals murder”: attempting to commit tax evasion (whether successful or not) is equally offensive as actually committing tax evasion.

Case law has shown that even an unsigned return or a false return signed by an agent can support criminal charges for income tax evasion.

Governmental evidentiary showing that a target willfully “attempted” to commit tax fraud:

Normally, the IRS seeks to prove the requisite willfulness element by using indirect evidence rather than direct evidence—like the taxpayer’s admission to the investigating agent or a witness or confession—since direct evidence is rarely obtainable. Other direct evidence often comes from inculpatory statements made by a taxpayer’s representative that are within the scope of a valid power of attorney and are often used by the IRS against the taxpayer in a subsequent criminal prosecution.

The Third Circuit said, “[i]n the majority of criminal cases, the element of wilful intent is inferred from circumstantial evidence.” U.S. v. Voigt, 89 F.3d 1050, 1090 (3d. Cir. 1996). These are indirect facts that, when weighed together, suggest that the taxpayer attempted to commit tax fraud. The Supreme Court in Spies tremendously eased the governments’ evidentiary burden by allowing the willfulness requirement to be inferred from “any conduct, the likely effect of which would be to mislead or to conceal.”

It is instructive to point out that circumstantial evidence need not consist of “slam dunk” type facts. For example, a business engaging in only all-cash transactions is not, in itself, a fraudulent action. But, when it is combined together with other facts it could become a “negative” one, which will weigh in the government’s favor. Negative facts are called Badges of Fraud, or facts that the IRS, FTB, other taxing authorities, and the Courts tend to find equate to fraud or run with fraud.

A target’s or his or her defense counsel will often argue that the taxpayers actions were “equally consistent with innocent activity” and thus no direct link exits between their actions and an apparent “motive” or “intent” to evade taxes.  For example in U.S. v. Voigt, 89 F.3d 1050, 1090 (3d. Cir. 1996), the court rejected the taxpayer’s argument that his actions were legally insignificant. In that case, the taxpayer (i) decided against purchasing some jewelry with cash when he discovered that a report to the IRS would be required; (ii) required his clients to fill out certain confidentiality agreements that forbade them from disclosing details of certain transactions; and (iii) maintained an overseas bank account. Taken individually, each of these facts is, strictly speaking, “equally consistent with innocent activity.” But the court found them to be legally significant in finding that the taxpayer had the intent to evade his taxes. The court stated that it had “no difficulty concluding” that based on his actions, when taken together, that they may “provide the jury with sufficient evidence from which it could infer that they were ‘designed’ to evade the payment of admitted tax deficiencies, even if such actions otherwise might constitute wholly innocent conduct.”

The requisite willful intent is often proven by examining the taxpayer’s entire course of conduct and convincing a jury to make reasonable inferences from the course of conduct.  A targets level of education or financial sophistication is relevant in determining willfulness. For example the fact that a target was a lawyer, accountant professional or a sophisticated businessperson may be focused upon as indicative of willfulness, while the fact that a target lacked education and sophistication tends to negate the element of willfulness.

Courts have identified the following list of objective facts that when weighed together tend to indicate willfulness and thus are deemed badges of fraud and thus can be used by the government to establish willfulness for tax crimes or civil fraud penalties. The government need not prove each affirmative act alleged; it is sufficient to prove a single act.

  • Creating false documents;
  • Supplying false information to a return preparer;
  • Failing to keep adequate books or records;
  • Extensive dealing in cash;
  • Failure or refusal to cooperate with, or lying to, investigating agents;
  • Participation in illegal activities;
  • Withholding financial information from accountants;
  • Keeping a safe deposit box under an assumed name;
  • Consistently overstating deductions;
  • Claiming excess withholding exemptions;
  • Claiming a charitable deduction for property when the taxpayer listed the property as his own on financial statements, paid expenses and taxes for the property, and used the property to secure a mortgage;
  • Claiming to be exempt from income taxes;
  • Leaving the United States with valuable assets following an audit determining a tentative deficiency;
  • Maintaining a double set of books or records;
  • Engaging in a pattern of tax evasion in previous years;
  • Taking business deductions for personal expenses;
  • Withholding information from the person or persons responsible for preparing the taxpayer’s return;
  • Failing to file tax returns;
  • Crossing out the verification on a return;
  • Prior warnings by courts or others that a tax practice is unlawful.
  • Making false entries, alterations, invoices, or documents;
  • Destroying books or records;
  • Concealing assets or covering up sources of income;
  • Handling one’s affairs to avoid making the records usual in transactions of the kind;
  • Filing a false Form W-4, Employee’s Withholding Allowance Certificate;
  • Willfully filing a false return;
  • Ignoring books and records in computing gross profit;
  • Filing blank returns with different social security numbers;
  • Failing to report personal expenses paid by a corporation;
  • Concealing assets from revenue officers attempting to collect withholding tax, even though assets were revealed to an agent examining the taxpayer’s income tax return;
  • Instructing employees not to talk to investigating agents about illegal income and advising them to inform their employer of any such contacts.
  • And if none of the above apply – remember the Spies catch all – any conduct, the likely effect of which would be to mislead or to conceal.

Case law examples of badges of fraud relied upon to establish willfulness:

In L.D. Rozin, CA-6, 2012-1 ustc a business owner’s conviction was upheld where he used suspicious loss of income insurance policies to generate tax deductions that were backdated.

In S.R. King, CA-8, 80-1 ustc ¶ 616 F2d 1034 the court held that a consistent pattern of non-reported income is in itself evidence of willfulness.

In R.A. King, CA-7, 97-2 ustc, 126 F3d 987 the filing of fraudulent Forms W-4 which falsely claimed exemption from withholding established willfulness because a reasonable inference could be drawn that the false forms were filed with the primary intent of permanently eliminating income tax withholding.

In L. Beall, CA-7, 92-2 ustc, 970 F2d 343 a subcontractor directed that his paychecks be made payable to a tax avoidance organization. This action coupled with the taxpayer’s admissions made to a co-worker and pattern of non-filed personal returns were indicative of his willful evasion of taxes.

In J.C. Payne, CA-10, 92-2 ustc, 978 F2d 1177 Cert. denied, 113 SCt 2995 a taxpayer who provided false social security numbers to his bank and brokerage firms, which in turn caused these payors to issue Forms 1099 to the IRS under the false social security numbers, was properly convicted on four counts of tax evasion.

In A.K. Khanu, DC D.C., 2009-2 ustc Aff’d, per curiam, CA-D.C., 2011-2 ustc a nightclub owner was convicted for willfully attempting to evade taxes because funds were seized from him that he disclaimed ownership of that could reasonably be inferred represented unreported income.

In R.S. Carlson, CA-9, 2001-1 ustc a dentist opened bank accounts using fake personal information in an attempt to frustrate the IRS’s collection efforts. The dentist deposited large amounts of income from his dental practice to these accounts after first receiving deficiency notices for the tax years at issue. His use of a fake social security number, fake birth place and fake birth date was held to support an inference of tax evasion.

In J. Van Meter, CA-5, 2008-1 ustc a married couple was convicted for evading the IRS’s collection action where they transferred money to an offshore account, titled assets in the name of trusts and used the hidden assets to live a lavish lifestyle.

Taxpayer’s primarily attempt to commit tax evasion when they file a false return. One of the leading cases in California making this point is United States v. Boulware , 384 F.3d 794 (2004), 470 F.3d 931, 934 (9th Cir. 2006)

Taxpayer’s secondarily attempt to commit tax evasion when they file a false amended return. A lead case in California on this point is Norwitt v. United States , 195 F.2d 127, 133-34 (9th Cir. 1952), cert. denied , 344 U.S. 817 (1952).

Case law holds that when a taxpayer engages in a consistent pattern of overstating deductions, it is tax evasion. For example the Eight Circuit explained that a “consistent pattern of overstating deductions” is tax evasion in Zacher v. U.S., 227 F.2d 219, 224 (8th Cir. 1955). The court states that such a “consistent pattern” exists when, for example, the taxpayer “overstate[s] casualty losses, . . . the sales tax deduction claimed exceeded the amount of sales tax paid” and he “overstate[s] [his] repair costs.”

The Government’s burden as to proving tax due and owing:

There is no certain, mathematical “threshold” that must be crossed for the government to meet is burden as to a tax being due and owing. Rather, most courts hold that the taxpayer must understate his tax liability by a “substantial amount” before they can be charged with a tax crime.  Again, not all courts agree. For example, if you live in California, the government need only show that “some tax deficiency” existed. In United States v. Marashi, 913 F.2d 724, 735-736 (9th Cir. 1990), for example, the Ninth Circuit only required that a reasonable “trier of fact could have found some tax deficiency beyond a reasonable doubt”.

The government does is not required to prove a precise amount of tax due and owing. Moreover, the government is not required to show tax due with mathematical certainty. In United States v. Bender, 606 F.2d 897, 898 (9th Cir. 1979), for example, the Ninth Circuit, maintained that evidence of a Section 7201 violation does not need proof of “any specific [tax liability] amount attributable to any tax year that has been unreported. All it needs to establish is ‘some deficiency’ for each year encompassed by the charge.” See also United States v. Keller, 523 F.2d 1009, 1012 (9th Cir. 1975) expressing something similar.

The government employs various standard methods of proof however it may offer any relevant evidence in an effort to establish the existence of a tax deficiency in a tax evasion case. The government may use any one method or may use several to corroborate one another, and may use different methods for different years included in an indictment.

Direct methods include offering proof that the taxpayer omitted or failed to report all or part of a specific item of income, overstated deductions or falsely claimed credits. For example, the government could attempt to prove that the taxpayer failed to report a particular item of income, such as a sales commission, the proceeds on the sale of an asset, or service revenue from a business. The government can also endeavor to show that the taxpayer received a total amount of income greater than that the amount reported on the return as direct evidence of a deficiency. For example the government could attempt to establish through interviews with a Doctor’s clients that the amounts they had paid him during the three examined tax years exceeded the gross receipts the Doctor reported on his returns for those years.

Indirect methods are typically used when the taxpayer has no books and records or where the government cannot obtain, understand or has no faith in the books and records produced by the taxpayer. Moreover, the use of indirect methods may be resorted to when the taxpayer has purportedly complete books and records as a way of obtaining corroborating indirect evidence to support incomplete or insufficient direct evidence. For a complete discussion of indirect methods see the question entitled

Criminal Investigation Division methodology of choosing and investigating a case:

From a policy perspective, CID chooses Cases for full investigation with the goal of deterring Criminal Tax violations by covering a wide cross section of taxpayers. CID’s aim is to encourage voluntary compliance throughout the nation by covering the widest possible cross section of taxpayers. In the past, subjects of Criminal Tax investigations have included persons from every economic and vocational group and every geographic location.

Cases are selected in areas of the tax spectrum that the IRS believes have significant compliance problems. The IRS attempts to identify the specific types of individuals and businesses responsible for the greatest amount of tax fraud. CID has in the past focused on dishonest return preparers and persons engaged in the underground economy, believing these groups are involved in dishonest practices and make up a large portion of tax cheats.

Cases believed to result in high-publicity are occasionally selected to publicize the enforcement effort often involving public figures such as movie stars and musicians. By contrast, media coverage of convictions of local citizens may be limited or nonexistent. Cases involving organized crime figures, narcotics traffickers, dishonest politicians, and other types of celebrities, often generate significant publicity for CID’s enforcement efforts.

Criminal investigations are extremely expensive, because of the time required for a full investigation (often more than a year) and the expense of securing and examining books and financial records. Criminal Investigation Division personnel from experience know that some cases have a higher chance of resulting in a conviction while other cases have a small likelihood of success due to factors such as the advanced age of the defendant, the unavailability of witnesses, or the Justice Department’s dislike for a particular type of case. Annually CID has historically only had the resources to initiate less than 7,000 investigations nationally. Consequently, decisions to undertake an investigation or not often rest on the availability of resources as much as on any other factor.

Historically, the IRS has not prosecuted cases in which there is only a small deficiency at stake. The IRS’s internal CID guidelines require that a tax deficiency be at least $10,000 over three tax years to bring a tax evasion prosecution. Prosecution for signing false returns or failure to file requires a tax deficiency of at least $2,500 over three years. However, case law has shown that a taxpayer can be successfully prosecuted for filing a false return even when no deficiency is proven.

Special agents receive assignments from their managers as to information items or for full-scale investigations. Information item assignments are usually limited inquiries to determine whether sufficient potential exists to conduct a full-scale investigation of a taxpayer. If a full-scale investigation is authorized, one or more special agents are assigned and the investigation continues until the evidence is sufficient for the agent to recommend prosecution or until there is no longer reason to believe that a prosecutable case can result with available resources. An agent conducting an information assignment normally reviews the taxpayer’s returns and other related IRS documents. If the case has been referred from within the IRS, the referring employee is interviewed. Informants, if any, are also interviewed. The special agent often confers with supervisors or senior agents concerning the potential of the case, and recommends whether the case merits full-scale investigation or should be returned for civil disposition. The District Chief of the Criminal Investigation Division (CID) or the Chief’s designee makes the final decision.

Criminal Investigation Division (CID) special agents have broad powers in securing evidence, including authority to administer oaths, to take testimony of witnesses, to examine books and records, to serve administrative summonses, and to execute search and arrest warrants.

Taxpayers who are placed under arrest must be given Miranda warnings. The extent to which a taxpayer will be given Miranda warnings depends on whether he is in custody at the time of first contact by the special agent. If he is under arrest or imprisoned, the special agent must give the full Miranda warnings, even though there is no relation between the tax investigation and the reasons that the taxpayer is in custody. Interviews conducted in an IRS office or at the taxpayer’s home or business are normally noncustodial. Case law establishes that the filing of a Form 2848, Power of Attorney and Declaration of Representative, is not an invocation of the right to counsel that precludes the special agent from interviewing the signer without the representative present.

A taxpayer who was made aware that he was being investigated is generally notified when the investigation is terminated. A case in which an investigation is terminated may be referred back to the Examination or Collection Division of the IRS. If additional indications of fraud are found after the criminal investigation is discontinued, the revenue agent must refer the matter back to the Criminal Investigation Division (CID).

Methods of gathering circumstantial evidence commonly employed by the IRS Criminal Investigation Division:

The strongest evidence of a taxpayer’s willfulness is typically the size of taxpayer’s tax deficiencies that can be proven to occur over a number of years. Experience has shown the Government that a greater amount of tax deficiency can usually be established by including the use of circumstantial evidence than by the use of direct evidence of omitted income alone.

Circumstantial Methods of Proof:

Net Worth Method

Under the net worth method, the taxpayer’s net worth (total assets minus total liabilities) at the end of one year is compared with his or her net worth at the end of the next year. The method calculates net income for a year by measuring the increase in net worth over a particular year which is reduced by any nontaxable sources of income received by the taxpayer such as loan proceeds or inheritances. The agent then compares the taxable income reported for the year being tested with the results of the net worth computation and thereby identifying any unexplained increase in net worth for the year tested as unreported income.

Expenditures Method

The expenditures method for uncovering omitted income is similar to the net worth method and is sometimes referred to as the cost-of-living test. This method focuses on the amount of income needed to cover the taxpayer’s identified personal expenditures for the year being tested. The agent totals all the identified personal expenditures of the taxpayer for the year tested and reduces the total by any nontaxable sources of income used to pay for the expenditures. Since one possible source of nontaxable income for the expenditures tested is wealth acquired and taxed in previous years, the agent must take into consideration all of the taxpayer’s assets and liabilities at the start of the prosecution period, in the same manner as in a net worth case. Commonly the IRS combines the net worth and personal expenditures methods to assure that its computations reflect the income used to purchase assets as well as the income used for personal expenditures.

Bank Deposits Method

Taxpayers who run Schedule C businesses and make periodic deposits to at best, a business bank account, and at worst, a commingled personal account, are typically investigated by the IRS using the bank deposits method. The agent totals deposits to all accounts (bank and brokerage) under the taxpayer’s control and then eliminates any deposits from identified nontaxable sources, such as gifts, loans, and transfers between accounts. The adjusted total of deposits is considered income. The IRS uses these methods to establish an income-producing business which allows the jury to infer how the unreported taxable income was generated. This method is also commonly used for businesses run through entities such as LLCs, S and C Corporations, and Partnerships.

Specific Item Method

Under the specific item method of proof, the government attempts to show that the taxpayer’s return at issue inaccurately reflects a specific transaction, or set of transactions, such that income is omitted, deductions are inflated or a source of income is falsified. The government is not burdened with having to prove an exact amount of unreported income to prevail but rather must prove that a substantial amount of income was unreported.

Extraordinary Criminal Investigation Division Techniques

Where appropriate, CID special agents employ surveillance, issue search warrants, implant undercover agents and utilize scientific experts to aid in a criminal investigation. For example, CID Agents have been known to go so far as to sift through a suspect’s trash to secure evidence. Note: Courts have held that you generally have no expectation of privacy in your trash and thus you were not subjected to an unreasonable search. Good defense attorneys can sometimes suppress evidence obtained by the IRS using these extraordinary techniques. In one reported case, the IRS obtained a search warrant to search a taxpayer’s real estate office and seized all the documents contained therein. At trial, none of the documents seized were allowed to be introduced because defense counsel successfully argued that the search warrant was overbroad. Defense Counsel can also exploit the detailed restrictions on the use of these extraordinary techniques as contained in the Internal Revenue Manual.

Common tactics employed by the Criminal Investigation Division in conducting an investigation:

A special agent usually begins an investigation by gathering background information about the taxpayer. Other steps in the investigation may include interviewing the taxpayer his return preparer, examining the taxpayer’s books and records and returns from prior years, investigating the taxpayer’s education and employment history, and locating the taxpayer’s bank accounts.

Taxpayers can become the target of a criminal tax investigation by failing to file returns, by failing to pay taxes when due, by providing incorrect information to the IRS, or by being mentioned in an informant’s report. All the defense alternatives available to a taxpayer under investigation pose risks, including the risk of imprisonment, a substantial civil fraud penalty, and the loss in standing with business associates and neighbors when agents question them in connection with the criminal investigation. A broad investigation may produce evidence of the taxpayer’s poor reputation for truthfulness, which can be used by the government to rebut defense character witnesses.

CID’S INTERVIEWING OF THE TAXPAYER AND WITNESSES ASSOCIATED WITH THE TAXPAYER

When initially contacted by the special agent, it is a common mistake for the taxpayer to agree to answer questions without first making use of his or her Fifth Amendment privilege against self-incrimination and his or her right to have an attorney present. Taxpayers are often shown copies of their previous returns and asked whether all his or her income has been reported on them in order to elicit a false exculpatory statement. By requiring narrative (as opposed to yes or no) answers the agent encourages the unsuspecting taxpayer with substantial opportunity to mislead or to confess in order to obtain circumstantial evidence of willfulness. Therefore, Counsel as soon as retained should request that the client write up his or her recollection of the initial interview with CID. If Possible, know Witnesses related to the client’s case should be requested to obtain copies of their statements made to the IRS for use in preparing the client’s defense.

TAKING RETURN PREPARER STATEMENTS

Unfortunately, a client’s return preparer or accountant is usually placed in a position of great trust. The bad news here is that ordinarily the vast majority of what is communicated by a client to their accountant or preparer is not privileged and they can and routinely are forced to be a Witness Against the client. CID knows that the testimony of the person who prepared the returns in question often is crucial to the client’s case. If the CID special agent establishes that the taxpayer misled the preparer or withheld material information from him or her, then he or she has shown substantial evidence of criminal intent. To make matters worse, it is in the preparer’s best interest to throw the client under the bus rather than lose their own ability to practice in front of the IRS. This is why counsel should instruct client’s to distance themselves from their preparers where a possible Tax Crime or even Civil Examination with potential criminal exposure is concerned. CID knows that it is quite difficult to prove a taxpayer’s criminal intent if the preparer takes all the blame for errors on a return. However, this is not likely to occur because preparer’s know that they may become an additional target of a client’s criminal investigation if it appears that he or she conspired with or aided the client in making false representations to CID or in preparing false returns.

Special agents generally requests or subpoena’s the accountant’s workpapers used in preparing the returns and take a statement concerning the records supplied by the taxpayer for the preparation of those returns. Evidence of intent may be found if the taxpayer supplies only summary sheets to the preparer without the underlying data. Since the preparer’s testimony is so critical to CID’s case, counsel should encourage client’s to make sure that counsel is present when the preparer is interviewed if at all possible.

REVIEWING TAXPAYER’S BOOKKEEPING

In reviewing the taxpayer’s books and records, CID special agents may find evidence of intent if the books are inadequate, falsified, a duplicate set of books is discovered or the books and records are destroyed prematurely. Unorthodox books that do not follow generally accepted accounting principles, and other accounting practices that yield deceptive results that understate income or overstate expenses may also be used to indicate criminal intent. If the records are kept by anyone other than the taxpayer, the CID agent may question the accountant extensively about instructions received from the taxpayer on how records should be kept, and also about any indications that may have be communicated to the taxpayer by the bookkeeper or accountant that something was wrong with the taxpayer’s accounting system.

EXAMINING PRIOR YEARS’ RETURNS

The CID special agent will often investigate the taxpayer’s old returns even if the statute of limitations bars prosecution for those years. The IRS will use the old returns to attempt to establish a pattern of underreporting over a substantial period of time, thus evidencing willfulness. These prior returns may also be used to counter a taxpayer’s defense of reliance on a professional, by showing that a pattern of underreporting may have occurred where the taxpayer either prepared their returns personally or employed different return preparers than the professional that prepared the returns at issue. Special attention is paid by CID to the use of and prior fictitious names used by the taxpayer and to any extravagant expenses, since these matters may indicate willful misconduct.

CANVASSING FINANCIAL INSTITUTIONS

CID agents use IRS computers to attempt to locate all bank accounts and brokerage accounts in which the taxpayer had any interest. Agents will review the deposits to the accounts discovered in an attempt to locate additional sources of previously unreported income. In some instances an analysis of deposits reveals hidden accounts, which are further evidence of willfulness. In other cases, large amounts of business deposits may indicate that income must have been underreported on returns.

DEFENSE TACTICS DURING CID EXAMINATION

Because of the case law surrounding the fourth and fifth amendments in the tax arena, cooperation with CID special agents may not be the best tactic for every taxpayer and the decision to do so is best left to competent tax defense counsel. For some situations, a more appropriate course of action is to monitor and anticipate the course of an investigation in the hopes of limiting or where possible eliminating potential criminal tax exposure. To this end, potential witnesses can be interviewed by the taxpayer’s tax defense counsel, or an investigator hired by counsel, before the CID special agent has made contact. Defense counsel should warn taxpayers under CID investigation that statements made to business associates, friends, his accountant, or an investigator may be passed on to the special agent because they are not privileged communications. An accountant who was not the preparer of the returns being investigated or investigator should be hired under the protection of a “Kovel” letter in attempt to bring the work of the accountant or investigator within the attorney client privilege by the taxpayer’s tax defense counsel to assist in following the special agent’s progress and in preparing a defense. The communication between the accountant or investigator and the taxpayer can be protected by the attorney-client privilege if specified conditions are met. The attorney must formally retain the accountant to assist the attorney in rendering legal services to the taxpayer, not merely providing accounting services. The retention letter must confirm the reason for the retention, that communications between the accountant and the attorney’s client are confidential and only made to assist the attorney in giving legal advice, and that records created by the accountant belong to the attorney.

ENTRAPMENT

If tax defense counsel can prove that a government agent induced a taxpayer to commit a tax crime that the taxpayer otherwise would not have committed, the defense of entrapment may be available. However, merely allowing a taxpayer to continue criminal conduct that was already started is not entrapment. The key to this defense is that the disposition to commit the crime must come from the government agent and not the taxpayer.

There are two elements to the defense of entrapment: 1. the government induced the crime, and 2. no predisposition to commit the crime is evident on the part of the defendant. To establish inducement as a matter of law, the defense counsel must be able to produce undisputed evidence making it patently clear that the government induced an otherwise innocent the defendant to commit the illegal act by trickery, persuasion, or fraud on the part of a government agent. If tax defense counsel meets this burden, then the prosecution must then prove beyond a reasonable doubt that the defendant was predisposed to commit the crime prior to first being approached by government agents. Case law shows that five factors are relevant to determining such a predisposition: (1) the defendant’s character and reputation; (2) whether in fact the government initially suggested criminal activity; (3) whether the defendant engaged in the activity for profit; (4) whether the defendant showed any reluctance; and (5) the nature of the government’s inducement.

Information commonly contained in a CID special agent’s report recommending criminal prosecution for a tax crime:

The special agent’s report (SAR) normally contains a narrative of the agent’s investigative findings. Attached to the report are commonly exhibits containing statements of witnesses that were interviewed, copies of documentary evidence, schedules and computations of income prepared by the agent, and any other materials necessary for a fair administrative review of the case. The SAR and the exhibits are normally the only material on which reviewing attorneys at the District Counsel and the Justice Department base their recommendation either to prosecute or to return the case to the IRS for processing as a civil case.

Access to the SAR and accompanying exhibits are seldom available to the Taxpayer or Tax Counsel before charges are filed. Requests for the special agent’s investigation materials under the Freedom of Information Act (commonly called a FOIA request) have been consistently denied under the investigatory record exemption and the exemption for material exempt by statute. Courts have occasionally required the government to supply an index of material contained in the SAR. The complex interaction among the Freedom of Information Act, the Privacy Act of 1974, and the disclosure provisions of the Code have left many questions unresolved. The SAR should become available to the taxpayer’s tax counsel at any trial in which the agent testifies. For this reason, the IRS usually has two agents present for every interview so that the government can present its case at trial without calling the special agent to testify that wrote the SAR. In such cases, the SAR is never disclosed.

The discovery process in a criminal tax case:

Discovery is the legal process whereby one party to a legal action goes about learning information known by the other party to the same legal action. From a criminal tax defendant’s perspective, discovery in a criminal case usually begins with a written request submitted with the applicable federal court that requests the court to order the government to provide a bill of particulars to the defendant. The bill of particulars will be ordered by the court because it allows the defendant to prepare an appropriate defense, prevents double jeopardy where the defendant may have been charged a second time for the same previously adjudicated crime, and helps to avoid surprise or prejudice at trial. However, the court will not require that information that is evidentiary in nature be included in the bill of particulars.

Historically courts have required that Taxpayers be provided with the following types of information, where applicable, in a bill of particulars:

  • The identity of any co-conspirators
  • A description of any means of deception the government was planning on proving at trial
  • A description of which of the taxpayer’s records the government copied

Historically Taxpayers have not been entitled to the following information in a bill of particulars because this type of information is considered “evidentiary”:

  • Alleged dates, times, and places that the taxpayer received items of gross income;
  • Details of a conversation that the government alleged as an overt act that it intends to offer as proof of willfulness;

In federal criminal cases, depositions ordinarily are not allowed to be taken of government personnel or other witnesses by the defendant. However, under exceptional circumstances when a deposition is held to be in the interest of justice, the taxpayer may depose prospective witnesses to preserve their testimony for trial if some doubt exists as to the witnesses’ availability for appearance at a subsequent trial. Where a court does allow a deposition it might additionally order that any book, document, record, recording, or other non-privileged material be produced at the time and place of any such deposition.

In a federal criminal case, the taxpayer is entitled to discover:

  • Any relevant written or recorded statements the government asserts were made by the taxpayer and the substance of any oral statement made by the taxpayer;
  • A copy of the taxpayer’s prior criminal record if applicable;
  • The existence of photographs, books, papers, tangible objects, documents, and buildings and places that are relevant to preparing the taxpayer’s defense, that are intended by the government to be used as evidence at the trial, or that were obtained from or belong to the defendant by the government.
  • The results and associated reports of any physical or mental examinations and scientific tests and or experiments that are material to the taxpayer’s defense or that are intended by the government to be used at trial.

Except as delineated above, the memoranda, reports, or other internal documents prepared by the government in connection with the case are not subject to discovery by the defendant. Moreover, statements made by government witnesses can only be obtained in limited circumstances as provided in the Jencks Act. Under the Jencks Act, no statement or report of a government witness in a federal criminal prosecution can be discovered until after the witness has testified on direct examination in the trial of the case at issue. Only after the witness has testified on direct examination, can the taxpayer draft a motion to compel the United States produce any statements of the witness that relates to the subject matter of the testimony given at trial.

Lastly, a defendant can often obtain significant discovery of the government’s case through pre-indictment conferences held with the IRS and Justice Department. I do not recommend attending such a conference without having the protection of criminal tax counsel. Instead of benefiting from discovery you will more likely aid the government in patching up any remaining weaknesses in their case.

Role that the Grand Jury plays in the prosecution of a tax crime:

A federal grand jury must vote in favor of issuing an indictment for a taxpayer to be charged with a tax felony. A grand jury is granted substantial investigatory powers, including the power to compel testimony and require production of physical evidence to facilitate this process. Tax misdemeanors need not be approved by grand juries, but prosecuting attorneys usually elect to present misdemeanors to the grand jury for investigation and vote when accompanied by a Felony Tax Crime charge. The grand jury’s is asked to weigh if it is more likely than not that a federal crime has been committed and is to weigh whether there is probable cause to believe that the crime was committed by a particular person under the same standard. A grand jury is composed of from 16 to 23 persons chosen at the direction of the appropriate U.S. District Court. In all cases, at least 12 jurors must vote to return an indictment. In cases where a grand jury declines to charge a person, a decision called a no true bill or a no bill is recorded.

The work of the grand jury is required by law to proceed in secret and therefore only the grand jurors, the government attorneys, the court reporter, and witnesses may be present during the Grand Jury investigation. Grand jury investigation is usually chosen as an alternative to administrative investigation when the IRS is informed that an existing nontax motivated criminal investigation has uncovered evidence of tax crimes and the U.S. Attorney desires to combine all criminal charges, including tax crimes, into one indictment. Other common reasons for the use of grand jury investigation are the need to investigate quickly, and the need to grant use immunity to reluctant witnesses. Since grand jury investigations occasionally begin without a definite target, a defendant’s counsel is wise to assess if a client has potential exposure to prosecution at the earliest practicable time within the course of the Grand Jury Investigation. If defense counsel determines it is in the client’s best interest to negotiate a plea to potential criminal offenses or to secure use immunity, defense counsel’s leverage in the associated negotiations is strongest at the start of the grand jury investigation. If defense counsel’s timing in the negotiation is off, other potential defendants could strike a deal with the prosecutor first, leaving little new material to offer in a plea negotiation, and worse yet, leaving open the possibility of the other potential defendants obtaining immunity in exchange for becoming a key witness in the government Criminal Tax Case against the defense counsel’s client.

Government’s required content to include in an indictment or an information in a criminal tax case:

An indictment is required by law to contain the elements of the offense the defendant is charged with and must fairly inform the defendant of the offense so charged. The defendant is also entitled to conduct discovery as to material considered relevant to the government’s case him or her. At any subsequent trial, the Government is prohibited from presenting evidence of other crimes for the sole purpose of showing that the defendant was likely to have committed the charged offense, however other crimes may be used to show criminal intent for the charged offense if they are held to be relevant by the court. For example, if the defendant is an admitted tax protester and was previously convicted of tax evasion the previous conviction would be relevant to show the defendant most likely intended to evade taxes as to the current charges and thus the previous conviction would most likely be admitted by the current court of law.

Felonies, (defined as crimes punishable by a sentence exceeding one year), must be charged by an indictment returned by a grand jury, unless the defendant waives the right to be indicted. Misdemeanors (defined as crimes punishable by a maximum sentence of one year or less), may be charged by grand jury indictment or by information. An information is legal document listing the charges against a defendant and is filed by the appropriate federal prosecutor. An indictment or information, must be written in plain, concise, and definite terms and must include a statement of the essential facts the government is asserting constitute the charged offense.

Effective Defense strategies:

At a general level, any defense strategy will go to attacking one of the “elements” of the crime. In the case of attempted tax evasion, for example, the IRS must prove three elements beyond a reasonable doubt: that the target owed tax, acted willfully, and committed an affirmative act of evasion. Thus, a legal defense against an evasion charge will seek to deny one or more of these various elements.

One of the methods of presenting a defense is to discredit the evidence offered against the target, either because it is false or, even if it is true, try and find an argument to render it “inadmissible.” Technical rules exist regarding when evidence is admissible at trial. Often times these rules bend in favor of the taxpayer. For example, in one case, the IRS alleged that the taxpayer committed an “affirmative act” of evasion before the date of his tax deficiency. The indictment, however, only mentioned that the “crime date” was the date of the deficiency—the IRS failed to mention the pre-deficiency period. Thus, because the government made a technical error with the indictment, the IRS was precluded from using any evidence during the time prior to the deficiency. As a result, the taxpayer had a stronger defense. United States v. Voight, 89 F.3d 1050, 1089-90 (3d Cir.), cert. denied, 519 U.S. 1047 (1996).

Attacking the element of tax due and owing:

To illustrate defending the element of tax due and owing let’s consider a distribution from a C Corporation to a shareholder that was unreported and thus underlies a tax evasion charge. If possible counsel should make a showing that the taxpayer did not, in fact, have a tax liability.

It is often a contested issue as to whether a distribution received by a taxpayer from a C Corporation is taxable income or just a return on the shareholder’s (taxpayer’s) investment. That is, the taxpayer’s counsel might argue the distribution is not taxable income because it is simply a return of a portion of the taxpayer’s capital investment in the corporation. To argue the contrary, the IRS must prove that the corporation possessed accumulated earning’s and profits (“E&P”) at the time of the distribution because a shareholder receives taxable income only when the C corporation makes a distribution from earnings and profits. Therefore, as a technical defense against the IRS’s charge that a shareholder/taxpayer committed tax evasion a taxpayer’s counsel could attempt to prove that the C Corporation lacked accumulated earnings and profits at the time of the distribution.

See J. D’Agostino, CA-2, 98-1 ustc, 145 F3d 69 where a couple was accused of diverting funds from their wholly owned corporation and it was held that the funds could not be taxed to them personally as a constructive dividend because the company at the time of the distribution had no earnings or profits. Instead, the diverted funds were held to constitute a nontaxable reduction of the couple’s shareholder loan account.

Occasionally defense counsel has sought to show that the income from an alleged tax deficiency was not, in fact, “taxable income” as defined by the Internal Revenue Code. See I.R.C. Section 61. The general rule is that “gross income means all income from whatever source derived” and the Code goes on to list various, specific types of income. However, there are various items of gross income that are not expressly identified in the Code but are identified as income through case law. For example, gambling winnings. Unfortunately, in most cases, a taxpayer must pay taxes even on his net winnings. This was the holding of an important case in the Ninth Circuit from the 1970s. See Garner v. United States, 501 F.2d 228 (9th Cir. 1974), aff’d on other grounds, 424 U.S. 648 (1976). Even income from illegal activities counts as “gross income” for purposes of Section 61 of the Code and, therefore, for purposes of proving tax evasion, if the taxpayer failed to pay taxes on those proceeds. See Moore v. United States, 412 F.2d 974, 978 (5th Cir. 1969).

However, not every dollar received by a taxpayer is “income,” and thus he or she need not pay tax on it. For example, if a taxpayer borrows money from someone, the bank, or in most cases even from certain life insurance policies, it is not “income” to the taxpayer and thus they need not pay taxes on it. The effect of this is that if the government’s argument that a taxpayer committed tax evasion because they did not pay tax on this borrowed amount will fail; it will fail because the third element of the offense—that there be a tax “due and owing”—will not be satisfied. However note that bona fide loans must be distinguished from “false loans”—loans where the transferee and the transferor never “really” expect there to be repayment. Such “loan” proceeds are, in disguise, gross income, and tax must be paid on them. See United States v. Curtis, 782 F.2d 593, 596 (6th Cir. 1986) for an example like this.

 Attacking the element of willfulness:

The hardest element of the a government’s case to prove in charging a taxpayer with a tax crime is usually the element of willfulness because of the lack of direct evidence on this element in the absence of a confession on the taxpayer’s part. Because of the usual lack of direct evidence on willfulness, (testimony or admissions on the part of the defendant taxpayer or his counsel), the government is left to prove willfulness through the use of circumstantial evidence, such as a taxpayer’s act of keeping a double set of books or concealing assets. To attempt to prevent the government from establishing that the defendant taxpayer’s acts were willful, he or she may try to show that the defendant’s actions were merely inadvertent or that the current state of the law is uncertain as whether the taxpayer’s actions were willful. However, showing that a taxpayer disagreed with a law, was a tax protester, objects to taxes on religious grounds, or has personal problems are generally not effective defenses to willfulness.

Willfulness Defined

Most criminal tax offenses require that the defendant acted willfully. Criminal tax offenses include attempted evasion, failure to file a return or pay tax, making a false return, and aiding or assisting the preparation of a false document. The Supreme Court has held that the word “willfully” has the same meaning in all the criminal tax statutes whether they be felonies or misdemeanors.

In defining willfulness, Federal Courts have consistently stated that, despite their earlier references to “bad faith and evil intent”, a current finding that a defendant acted willfully does not require any proof of motive other than an intentional violation of a known legal duty. Courts have consistently held that willfulness may be negated by establishing good faith claim of ignorance or misunderstanding of the law or a belief that there was no violation of the law by a taxpayer, regardless of whether the taxpayer’s belief appears to be objectively reasonable. However, establishing a good faith taxpayer belief that the tax laws are unconstitutional will not negate the element of willfulness.

An intentional violation of a known legal duty can be shown by a taxpayer’s reckless disregard for the law. Courts have held that a taxpayer’s knowledge of the law is not limited to his actual knowledge but includes a reckless disregard of a legal obligation that the defendant can be shown he or she was aware of in some manner. For example, to prove that a taxpayer attempted to evade taxes the government needs only show that the taxpayer had the specific intent to evade a tax that the taxpayer knew was owing. Similarly, to prove that a taxpayer willfully failed to file a return, all that need be shown is that the taxpayer knew of the obligation to file the return and intentionally failed to do so.

Willfulness & Failure to Pay Offenses

The willfulness requirement in failure to pay taxes cases raise the issue of whether a defendant’s inability to pay the tax in and of itself negates the element of willfulness or whether the government must present evidence to show that the defendant was financially able to pay the tax on or about the time the tax was due to establish willfulness.

Proof of Willfulness

The government’s production of proof on willfulness ordinarily consists of admissions made by the defendant (often in the absence of counsel) to government investigators or witnesses that are called to establish willfulness (often employees, whistleblowers and ex-spouses). Statements tending to indicate willfulness made by a taxpayer’s representative under a power of attorney on behalf of a defendant may also be used by the IRS in a criminal prosecution. However, absent an admission by the defendant or his counsel, the government will attempt to prove willfulness through the use of circumstantial evidence. The government will attempt to meet its burden of proof as to willfulness by examining the taxpayer’s entire course of conduct and will encourage a Jury to make reasonable inferences that can be properly drawn from the examined conduct. Historically, the government has had great success in establishing willfulness based on proper inferences drawn from any conduct that appears to have been engaged in by a defendant in order to mislead or conceal.

Understatement of Income

While the understatement of income in and of itself is usually insufficient to establish willfulness, a proven pattern of substantial understatement can successfully be used by the government to establish the element of willfulness.

State of Mind

When a taxpayer’s state of mind on a particular date is critical to the government’s case on willfulness, as in willful failure to file cases, the government will present evidence of events that occurred after that particular date as evidence of the taxpayer’s earlier state of mind. Both the government and the taxpayer generally can admit evidence on subsequent events for the facts that can reasonably be inferred from them. For example, evidence of a taxpayer’s previous noncompliance with the filing rules and requirements in a year immediately subsequent to the tax year or years at issue has been deemed relevant by the court’s to show the taxpayer’s willfulness and absence of mistake in filing false returns during the tax years at issue.

Common defense tactics that make it hard for the government to prove willfulness:

Inadvertence and Negligence

Because willfulness requires an intentional violation of a known legal duty, the element of willfulness can be negated by a producing evidence to show that the defendant’s conduct was inadvertent, careless, or otherwise negligent. The government will attempt to refute this defense by showing that the defendant’s conduct is inconsistent with the claimed inadvertence or neglect. For example, in failure to file cases, the government usually relies on multiple, consecutive failures to file to negate any claimed inadvertence or neglect.

Uncertain Legal Duty

Willfulness requires that there be a legal duty with which the taxpayer fails to comply. The courts have consistently held that where the state of the law is uncertain as to whether there is a legal duty, criminal liability will not be imposed. Moreover, the weight of legal authority in this area is that the taxpayer’s actual knowledge regarding the unsettled state of the law is irrelevant. The bottom line here is that if the law is in fact uncertain, the taxpayer has not committed a crime.

Mistake

Since the government’s burden in establishing willfulness requires that the taxpayer violate a known legal duty, it is a viable defense to offer evidence that the taxpayer did not know of the specific duty at issue. The Supreme Court itself has held that willfulness may be negated by a good faith claim of ignorance or misunderstanding of the law or a good faith belief that there was no violation of the law, regardless of whether the belief was objectively reasonable. One rationale for this “good faith” defense is the criminal tax provisions were not drafted with the intention of penalizing a taxpayer for innocent mistakes caused by the inherent complexities of the Tax Code.

The Supreme Court’s line of decisions in the area have held that a taxpayer is not guilty of willful failure to file if he honestly believed his income was too low to require him to file a return or if the taxpayer believed that he was not required to file a return if he was unable to pay.

The defense of mistake is not limited solely to mistakes of law. A defendant who, through a mistake of fact, unknowingly violates a statute also does not act willfully.

 Reliance on Others

Evidence establishing that a taxpayer relied on the advice of counsel or an accountant may successfully be used to negate willfulness if it can be shown that the taxpayer acted in good faith and that he or she provided the preparer with full and accurate information at the time the advice was sought. This defense may not be successful if the government can establish that full disclosure to the attorney or accountant was not made at the time the advice was rendered. Reliance on a lawyer’s advice has occasionally been held a valid defense, even where such reliance was objectively unreasonable.

Mental Disease or Defect

Because the government’s burden in proving willfulness requires a showing of a specific intent to disobey the law, the courts have consistently permitted expert medical testimony to establish that the defendant has developed a delusion about the tax laws that interfered with the mental ability to form the specific intent to disobey the law.

Filing of Amended Return or Late Payment of Tax

Under the government’s voluntary disclosure policy published in the Internal Revenue Manual, a taxpayer who, in essence admits to a potential tax crime by filing an amended or delinquent return may avoid prosecution, provided the disclosure was voluntary and made before the taxpayer was first contacted by the IRS regarding a potential problem with the tax liability. However, amended or delinquent returns filed after a taxpayer has been contacted by the IRS do not qualify for the voluntary disclosure policy, even though the courts tend to hold that the filing of delinquent or amended returns or the late payment of tax is admissible by a defendant on the issue of willfulness. The filing of amended returns after notice by the IRS that a particular return is under investigation is a patently bad idea. Case law shows that in numerous instances, the very act of filing of a delinquent or amended return during the course of an IRS investigation has been presented as a key piece of evidence that eventually led directly to a taxpayer’s indictment. Case law also shows that the government routinely relies on delinquent and amended returns as the very admission that establishes the existence of an understatement in tax liability of the original return.

Unsuccessful Defenses to Willfulness

When a taxpayer’s conduct can be shown to be intentional and knowing, the taxpayer’s personal reasons for taking the criminal action are irrelevant. Accordingly, presenting evidence of, a taxpayer’s disagreement with the law, inability to pay, marital or financial difficulties, or fear of filing are generally not effective defenses. Moreover, defenses that tend to explain a taxpayer’s reasons for taking an action, or refusing to act, that do not effectively rebut the required specific intent to disobey the law are not effective defenses to willfulness. Thus, presenting evidence to show that a taxpayer was a political tax protester, had religious objections or personal problems, and are generally not effective defenses to negate the element of willfulness.

Evidence on, personal problems or preoccupation with business affairs may, where extreme, tends to negate willfulness if it can be used to show that the taxpayer may have been so disturbed by the problems that they prevented the formation of a specific intent violate the law. However case law shows that such defenses are rarely successful.

While inability to pay in and of itself is not generally an effective defense, such evidence may be a defense if it can be sown that the taxpayer had the erroneous belief that returns could not be filed without the associated payment of tax. Additionally a taxpayer’s inability to pay also can be an effective defense to a failure to pay charge if it can be shown that the defendant’s inability to pay was not the result of lavish and extravagant living.

ARGUING THE STATUTE OF LIMITATIONS FOR THE SPECIFIC TAX CRIMES HAS TOLLED

Each specific tax crime has its own statute of limitations which establishes a time frame under which a criminal charge must be brought or else the charge is mute under law. However, before this defense is relied upon it must be noted that under specified circumstances, the statute of limitations may be extended. For example, when a taxpayer’s tax counsel brings or intervenes in an action to quash an IRS summons issued to a third-party record-keeper, the statute of limitations for criminal prosecution of that taxpayer is suspended for the period during which the proceeding (including appeals) concerning enforcement of the summons is pending. As an additional example, the statute is also suspended for the period that the person committing an offense is outside the United States or is a fugitive from justice.

DEFENSES COMMONLY RAISED DURING THE ADMINISTRATIVE REVIEW LEVEL OF THE CRIMINAL TAX PROCESS:

During administrative review level of potential criminal prosecution cases, effective tax defense counsel has the ability to raise several defenses that if successful may cause case to be declined. These include lack of criminal intent, no tax due, defects in method of proof, dual prosecution, health, and the improbability of a conviction. A taxpayer may avoid prosecution by showing that he was previously prosecuted for substantially the same acts. The poor health of a taxpayer will not prevent prosecution. However, if poor health and other factors creating sympathy for the taxpayer make it unlikely that the taxpayer will be convicted, prosecution may be declined.

Attempting to stop the progression of a criminal case at the District Counsel review level of the IRS or at the Department of Justice level:

Every CID recommendation to prosecute taxpayers for a Tax Crime are reviewed by District Counsel attorneys. An opportunity therefore exists for a Taxpayer’s representative to present defenses at a requested District Counsel conference. The reality is that District Counsel must be satisfied that evidence gathered by CID is sufficient to establish that a tax crime was committed and that reasonable probability of conviction exists. District Counsel is faced with two choices, decline to prosecute or return a particular case for additional investigation by CID. It is to be noted however that once a case is worked up and presented for review by District Counsel, Few cases are in fact declined.

If IRS District Counsel determines that prosecution is warranted or that grand jury investigation should take place, the case is referred to the Department of Justice. This referral takes place via a letter referred to as a Criminal Reference Letter (CRL), which sets forth the recommendation of District Counsel for prosecution, the evidence supporting the recommendation, details concerning the technical aspects of the case, and an assessment of possible prosecution problems. The CID special agent’s report and exhibits are also enclosed. A copy of the CRL is sent to the appropriate U.S. Attorney within the Department of Justice with instructions to charge specific crimes against the taxpayer and designating one or more major counts which may premise a plea agreement. Referral to the Department of Justice terminates the IRS’s authority to issue or enforce any further summonses to investigate the Criminal Tax matter. Declination, or refusal to take the case, by the Department of Justice restores the IRS’s authority to use administrative process. Cases that meet all the other requirements for prosecution may nevertheless be declined by the Justice Department simply because their trial attorneys are of the opinion that no jury would convict due to a combination of circumstances, such as the taxpayer’s age and health, the fact that the taxpayer has already suffered enough, or other circumstances likely to evoke jury sympathy. Defenses based on the lack of probability of conviction are of greatest value when conferring with the Department of Justice’s trial attorneys.

Ineffective Defense strategies:

Attempting to cure tax evasion in year 1, with carry back losses from Year 2:

It is obviously a crime to knowingly overstate one’s deductions under I.R.C. Section 7201 for example. The posed by a desperate target is whether a target’s overstatement of his or her deductions (for example) somehow may be “justified” or “cured” by his later, fortuitous, losses which are carried back to prior years.

The answer to the question is a resounding “No.” The criminal action of overstating deductions (or any act resulting in evasion) cannot be “wiped out” by subsequent and legitimate losses, however convenient that approach might appear to be. This matter was address in the Fifth Circuit in the 1960s. In Willingham v. U.S., 289 F.2d 283 (5th Cir. 1961), the taxpayer made some false deductions in 1953 in attempt to evade the tax liability. Two years later, in 1955, he sustained legitimate losses. Thus, the taxpayer desired to carry back those loses as a defense against the government.

How would this create a defense? It is a clever argument. To prove tax evasion, the government must show, among other things, that there was a tax due and owing. By carrying back net operating losses to prior years (i.e. the years when one falsely claimed a deduction), he attempted to “wipe out” his tax liability for those years (i.e. so there would be no tax “due and owing”). In this way, the taxpayer sought to “justify” his original overstatement of deductions.

Unfortunately for taxpayers, the court ruled that this argument is too clever. The courts to date frame the matter in terms of when the taxpayer’s intent to commit tax evasion is complete. The Fifth Circuit maintains that the intent is complete in the year the false deduction is claimed. Thus, later “adjustment[s] that may be permissible resulting from subsequent losses does not prevent [a prior] fraud committed . . . from being [tax evasion].” Willingham v. U.S., 289 F.2d 283, 288 (5th Cir. 1961), cert. denied, 368 U.S. 826 (1961)

Taxpayer arguments that federal taxation is unconstitutional:

Taxpayer arguments that federal tax laws are unconstitutional will not be a valid defense any more than maintaining that, say, murder is not illegal. Although certain factions have maintained that the tax laws are invalid, the Supreme Court of the United States has proclaimed the Federal Governments right to tax under the Taxing and Spending Clause of the Constitution found in Article I, Section 8. Clause 1, reads: “The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defense and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States.”

In a recent case, a court entertained the taxpayer’s argument for the unconstitutionality of a certain tax law. The court basically held that the taxpayer had an erroneous belief and still found him liable for his tax. After the taxpayer attended various seminars and devoted himself to arguing against a legal basis for the federal taxing system, the court held against him: “We do not believe that Congress contemplated that such a taxpayer, without risking criminal prosecution, could ignore the duties imposed upon him by the Internal Revenue Code and refuse to utilize the mechanisms provided by Congress to present his claims of invalidity to the courts and to abide by their decisions.” Cheek v. United States, 498 U.S. 192, 205-06 (1991). The court went on to explain that if the taxpayer thought a tax law was invalid, his proper procedure is to first pay the tax, and then file for a refund which, if denied, he could take to the courts to ascertain the tax law’s validity and constitutionality.

SELECTIVE PROSECUTION CLAIMS

Defendants occasionally allege that they have been the victims of unlawful selective prosecution in tax cases by the government. These allegations are historically summarily dismissed. To prove unconstitutional selective prosecution the defendant must establish that others similarly situated have not been prosecuted and the decision to prosecute was based upon an impermissible consideration such as race, religion, or the desire to prevent the exercise of constitutional rights which places an almost impossible burden on the defendant.

PAYMENT OF TAX DUE OR ARGUING THAT NO TAX IS DUE

When a criminal prosecution is based on a taxpayer’s failure to report income, the government must establish that the taxpayer knew that the income was taxable. Therefore a claim that no tax is due because the taxpayer has paid the tax following commencement of the audit or now stands ready to pay all deficiencies and penalties is unlikely to prevent prosecution of the taxpayer. Payment after an audit or investigation has begun does not change the fact that the crime was complete at the time the taxpayer violated a known legal duty. However, proving additional deductible expenses can reduce the tax deficiency and make a case less attractive for prosecution. Note however that the filing of amended returns and paying the tax due to correct previous criminal actions before an audit has begun under a Voluntary Disclosure can be quite effective at preventing criminal prosecution.

Mitigation techniques available to an actual or potential criminal charge:

COMPROMISE

Under the law, statutory authority exists for the Secretary of the Treasury and the Attorney General to compromise criminal tax cases without prosecution. However, this authority to compromise criminal cases is rarely used because allowing a defendant to buy his way out of criminal prosecutions would in effect create separate systems of justice for the rich and the poor.

IMMUNITY

Defense counsel may attempt to convince CID or Grand Jury investigators that his or her client is much more valuable to them as a witness against other potential or actual targets than as a criminal tax defendant. As a witness for the prosecution, the defense counsel’s client may receive a grant of use immunity, under which he or she cooperates fully with the IRS in exchange for an agreement that charges will not brought against him or her. Complete immunity from prosecution arising out of a transaction is called transactional or pocket immunity. Although courts have historically expressed displeasure with pocket immunity it currently continues to be routinely granted.

It is important to note that testifying under a grant of immunity is not without risks. Witnesses who receives immunity are prohibited from subsequently refusing to testify on the grounds that they might incriminate themselves. Moreover, if a case can be built against the immunized witness on evidence that is independent of the immunized testimony, the immunized witness may still face criminal prosecution. Lastly, testimony subsequently proven to be perjured, given under a grant of use immunity can also be used against the witness who made the false statements.

PLEAS

Historically, by far the vast majority of the criminal tax indictments brought result in pleas. Each U.S. Attorney is authorized to accept a plea of guilty to the major count of an indictment without prior approval of the IRS. Federal prosecutors are required to initially charge the most serious, readily provable offenses that are consistent with the defendant’s alleged conduct. Typically, once charges are brought, they will not be dismissed or dropped under a plea agreement unless the prosecutor has a good faith doubt about the government’s ability to prove a charge based on either a perceived legal or evidentiary weakness in the case.

By contrast, the IRS does not typically settle civil tax matters as part of a plea agreement although it has the statutory authority to do so. This rational for this is to avoid the appearance that the IRS uses the criminal process to coerce the collection of civil tax liabilities. This policy does not prevent the defendant from agreeing to civil admissions, such as receiving unreported income or claiming fraudulent deductions, as part of the criminal plea agreement. Information that the taxpayer provides in a civil case may also be used in a criminal case against the taxpayer. Thus, cooperating with a criminal investigation with or without proper legal counsel may have unexpected drawbacks for the taxpayer.

Tax Evasion or Fraud and Voluntary Disclosures:

Historically, between 1934 and 1952, the IRS had a written policy of refraining from prosecuting taxpayers who made a voluntary disclosure. Today, that written policy has changed so that a taxpayer’s voluntary disclosure is a factor that is weighed in a facts-and-circumstances evaluation, but the actual of practice of the IRS is quite similar to its past written policy.

The IRS’s behavior is indicative of its true policy. Since 1952, the IRS has only decided to prosecute a handful of cases after the taxpayer’s voluntary disclosure. Because of the IRS’s previous written policy and the IRS’s lack of prosecution of voluntary disclosure cases, tax attorneys are generally convinced that the IRS has an unwritten de facto disclosure policy of refraining from prosecution.

The IRS’s unwritten policy can be seen from its behavior, specifically, its decision to decline prosecution. One court admits, “there appears to have been few, if any, prosecutions of true voluntary disclosures [by] the IRS.” United States v. Hebel, 668 F.2d 995, 998 (8th Cir. 1982).

Indeed, the IRS’s conduct seems to show that it will prosecute after a voluntary disclosure only when extraordinary facts and circumstances are present. A number of tax scholars agree: “[T]he practice of the IRS has been that it will not prosecute taxpayers who satisfy all of the requirements of the voluntary disclosure program because, if it did initiate such prosecutions, no taxpayers ever would be willing to make a voluntary disclosure in the future.” New York University Annual Institute on Federal Taxation § 27.06 (2010).

Thus, even though the IRS’s official, written position is to leave the door open to pursuing criminal prosecution after a voluntary disclosure, it is unlikely it will do so.

Voluntary disclosures typically occurs in two situations:

(a) The taxpayer’s wrongdoing is disclosed to his attorney or accountant because he wants to set matters straight; or
(b) The taxpayer discloses his wrongdoing to an attorney or accountant after he has been personally contacted by the IRS.

Generally, if a taxpayer has not been contacted by the IRS, or is not currently under audit, examination, or investigation, it is not likely he will be prosecuted after a voluntary disclosure – unless the IRS disputes the voluntary disclosure, or the IRS believes the taxpayer has engaged in an illicit income-producing activity (or is a threat to the voluntary assessment system, where the taxpayer is deemed a tax protester).

The following bolded content is the actual language of the IRS’s Voluntary Disclosure Practice:

It is currently the practice of the IRS that a voluntary disclosure will be considered along with all other factors in the investigation in determining whether criminal prosecution will be recommended. This voluntary disclosure practice creates no substantive or procedural rights for taxpayers, but rather is a matter of internal IRS practice, provided solely for guidance to IRS personnel. Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution.

A voluntary disclosure will not automatically guarantee immunity from prosecution; however, a voluntary disclosure may result in prosecution not being recommended. This practice does not apply to taxpayers with illegal source income.

A voluntary disclosure occurs when the communication is truthful, timely, complete, and when:

The taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his or her correct tax liability; and

The taxpayer makes good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable.

A disclosure is timely if it is received before:

The IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation;

The IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance;

The IRS has initiated a civil examination or criminal investigation which is directly related to the specific liability of the taxpayer; or

The IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena).

Any taxpayer who contacts the IRS in person or through a representative regarding voluntary disclosure will be directed to Criminal Investigation for evaluation of the disclosure. Special agents are encouraged to consult Area Counsel, Criminal Tax on voluntary disclosure issues.

Examples of voluntary disclosures include:

A letter from an attorney which encloses amended returns from a client which are complete and accurate (reporting legal source income omitted from the original returns), which offers to pay the tax, interest, and any penalties determined by the IRS to be applicable in full and which meets the timeliness standard set forth above.

A disclosure made by an individual who has not filed tax returns after the individual has received a notice stating that the IRS has no record of receiving a return for a particular year and inquiring into whether the taxpayer filed a return for that year. The individual files complete and accurate returns and makes arrangements with the IRS to pay the tax, interest, and any penalties determined by the IRS to be applicable in full. This is a voluntary disclosure because the IRS has not yet commenced an examination or investigation of the taxpayer or notified the taxpayer of its intent to do so and because all other elements of (3), above, are met.

While making a Voluntary Disclosure is not completely without risk and does not provide an absolute guarantee that the IRS will not refer the taxpayer to the Department of Justice for criminal prosecution, it is the IRS’s long-standing policy to refrain from referring for prosecution taxpayers who make a full Voluntary Disclosure of their transgressions by substantially complying with all of the terms of the IRS’s program. As a matter of public policy it makes little sense to prosecute those who attempt to correct their indiscretions voluntarily as this would discourage others that are similarly situated. However, on the other hand, any material indiscretion that is not corrected and subsequently discovered by the IRS is very likely to draw criminal charges as a matter of public policy to discourage others from like behavior.

Given the nature of this program, voluntary disclosures are extremely sensitive and are accompanied by strict rules and guidelines. Once taxpayers are accepted into the voluntary disclosure program, they must provide the IRS with what amounts to a signed confession upon entering the program and full cooperation while their case is being reviewed and processed. Entering the program is a one way trip that cannot be walked away from and thus, a taxpayer’s eligibility for this program must be carefully scrutinized and evaluated prior to contacting the Criminal Investigation Division of the IRS. As a prudent precaution, counsel should submit a “pre-check” of a taxpayer’s identifying information to the IRS which establishes a taxpayer’s basic eligibility for the program before submitting any potentially incriminating information to the government.

Making the Disclosure (Loud versus Quiet)

Currently, in the legal profession there are two main schools of thought (and considerable controversy) regarding how to go about making a voluntary disclosure. The first school of thought is that it should be done “quietly” by sending in delinquent original or amended prior tax returns, with a check(s) in full payment through normal channels and gambling that the returns get processed without the taxpayer every hearing from the Criminal Investigation Division of the IRS because of the sheer volume of returns the taxing authority processes. Many Tax Attorneys prefer and thus direct their clients toward this method because in their opinion this method decreases the likelihood that the delinquent original or amended returns will be audited upon submission and avoidance of a perceived negative impact on a taxpayer’s ongoing reputation with the affected taxing authorities which occurs where a taxpayer makes a loud disclosure by knocking on the door of the criminal investigation division and makes the required “loud” admission of the fraudulent activity that is to be corrected.

Our office (The Tax Law Offices of David W. Klasing) generally prefers “loud” disclosure over “quiet” disclosures because if a taxing authority has begun an investigation prior to receipt of the “quiet” submission the “quiet” disclosure will not be deemed to be voluntary and thus will not comply with its Voluntary Disclosure Practice. To make matters exponentially worse, the amended return could potentially be viewed as a criminal admission of the amount by which the tax liability was understated on the original return. Thus the amended returns intended to mitigate the client’s criminal exposure can be used by the IRS to meet its burden of proof as to willfulness (which is by far the hardest element of its case to prove) if it decides to prosecute. Additionally there is some support for a growing government position stemming from the 2009 and 2011 Offshore Voluntary Disclosure Initiatives that a quiet disclosure does not comply with the terms of its Voluntary Disclosure Practice because a quite disclosure bypasses the required communication with the Criminal Investigation Division of the IRS and only the Criminal Investigation Division of the IRS can recommend that the taxpayer not be referred to the Justice Department for Criminal Investigation.

On Point Selections from The:

TAX CRIMES HANDBOOK

The entire handbook can be found at: http://www.irs.gov/pub/irs-utl/tax_crimes_handbook.pdf

TITLE 26 TAX VIOLATIONS

TAX EVASION – I.R.C. § 7201

Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined* not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.

 * As to offenses committed after December 31, 1984, the Criminal Fine Enforcement Act of 1984 (P.L. 92-596) enacted as 18 U.S.C. § 3571, increased the maximum permissible fines for felony offenses set forth in section 7201. The maximum permissible fine is $250,000 for individuals and $500,000 for corporations.

[1] Two kinds of tax evasion.

Section 7201 creates two offenses: (a) the willful attemp to evade or defeat the assessment of a tax, and (b) the willful attempt to evade or defeat the payment of a tax. Sansone v. United States, 380 U.S. 343, 354 (1965). See also, United States v. Shoppert, 362 F.3d 451, 454 (8th Cir.), cert. denied, 543 U.S. 911 (2004); United States v. Mal, 942 F. 2d 682, 687-88 (9th Cir. 1991) (if a defendant transfers assets to prevent the I.R.S. from determining his true tax liability, he has attempted to evade assessment; if he does so after a tax liability has become due and owing, he has attempted to evade payment).

[a] Evasion of assessment. The most common attempt to evade or defeat a tax is the affirmative act of filing a false return that omits income and/or claims deductions to which the taxpayer is not entitled. The tax reported on the return is falsely understated and creates a deficiency. Consequently, such willful under reporting constitutes an attempt to evade or defeat tax by evading the correct assessment of the tax.

[b] Evasion of payment. This offense generally occurs after the existence of a tax due and owing has been established (either by the taxpayer reporting the amount of tax or by the I.R.S. assessing the amount of tax deemed to be due and owing) and almost always involves an affirmative act of concealment of money or assets from which the tax could be paid. As discussed in Section 1-1.04 below, it is not essential that the I.R.S. have made a formal assessment of taxes owed and a demand for payment in order for tax evasion charges to be brought. Tax deficiency can arise by operation of law when there is a failure to file and the government later determines the tax liability. United States v. Daniel, 956 F.2d 540, 542 (6th Cir. 1992).

Note: These two offenses share the same basic elements necessary to prove a violation of I.R.C.

1-1.03 Evasion of Assessment

[1] Elements of the Offense:

[a] An attempt to evade or defeat a tax or the payment of a tax;

[b] An additional tax due and owing; and,

[c] Willfulness.

Sansone v. United States, 380 U.S. 343, 351 (1965); Spies v. United States, 317 U.S. 492 (1943); United States v. Lavoie, 433 F.3d 95, 97-99 (1st Cir. 2005); United States v. Farnsworth, 456 F.3d 394, 401-03 (3d Cir. 2006); United States v. Nolen, 472 F.3d 362, 376- 77 (5th Cir. 2006); United States v. Cor-Bon Custom Bullet Co., 287 F.3d 576, 579 (6th Cir.), cert. denied, 537 U.S. 880 (2002); United States v. Daniels, 387 F.3d 636, 639 (7th Cir.), cert. denied, 544 U.S. 911 (2004); United States v. Shoppert, 362 F.3d 451, 454 (8th Cir.), cert. denied, 543 U.S. 911 (2004); United States v. Kayser, 488 F.3d 1070, 1073 (9th Cir. 2007); United States v. Anderson, 319 F.3d 1218, 1219-20 (10th Cir. 2003); United States v. Mounkes, 204 F.3d 1024, 1028 (10th Cir.), cert. denied, 530 U.S. 1230 (2000); United States v. Daniel, 956 F.2d 540, 542 (6th Cir. 1992); United States v. Masat, 896 F.2d 88, 97-99 (5th Cir. 1990).

Each element must be proved beyond a reasonable doubt. United States v. Marashi, 913 F.2d 724, 735-36 (9th Cir. 1990); United States v. Williams, 875 F.2d 846, 849 (11th Cir. 1989).

[2] The Attempt

[a] Attempt to evade assessment. The taxpayer must undertake some action, that is, engage in an affirmative act for the purpose of attempting to evade or defeat the assessment of a tax. This element requires more than passive neglect of a statutory duty. A mere act of willful omission does not satisfy the affirmative act requirement of I.R.C. § 7201. United States v. Masat, 896 F.2d 88, 97-99 (5th Cir. 1990).

[b] Examples of affirmative acts include: 

  1. Filing of a false return. United States v. Habig, 390 U.S. 222, 223 (1968); Sansone v. United States, 380 U.S. 343, 351-52 (1965); United States v. Coppola, 425 F.2d 660 (2d Cir. 1969); United States v. Gricco, 277 F.3d 339, 351-52 (3d Cir. 2002); United States v. Boulware, 384 F.3d 794 (2004), 470 F.3d 931, 934 (9th Cir. 2006), reversed on other grounds, 128 S. Ct. 1168, 1182 (2008).
  1. Filing of a false amended return. United States v. Samara, 643 F.2d 701, 704 (10th Cir. 1981); Norwitt v. United States, 195 F.2d 127, 133-34 (9th Cir. 1952), cert. denied, 344 U.S. 817 (1952).
  1. Failure to file return coupled with an affirmative act of evasion is commonly referred to as a “Spies evasion.” Passive failure to file tax returns is not tax evasion. If the taxpayer failed to file a return, an evasion case can be maintained only if the taxpayer engaged in an affirmative act to conceal or mislead. Spies v. United States, 317 U.S. 492, 498-99 (1943). By way of illustration, and not by way of limitation, the Supreme Court in Spies set out examples of conduct which can constitute affirmative acts of evasion: 

  Keeping a double set of books.

  Making false or altered entries.

  Making false invoices. 

  Destruction of records.

  Concealing sources of income.     

  Handling transactions to avoid usual records. 

(G) Any other conduct likely to conceal or mislead.

See also, United States v. Brooks, 174 F.3d 950, 954-56 (8th Cir. 1999); United States v. Meek, 998 F.2d 776, 779 (10th Cir. 1993).

  1. Filing False W-4’s plus Failure to file a Return Equals Evasion. Filing false and fraudulent Forms W-4 claiming to be exempt from federal taxation in combination with failure to file tax returns for each year can constitute an affirmative act of evasion. See, United States v. Brooks, 174 F.3d 950, 954-56 (8th Cir. 1999); United States v. King, 126 F.3d 987, 991-94 (7th Cir. 1997) (filing false forms W-4 is an affirmative act despite the fact that those forms had expired); United States v. Willams, 928 F.2d 145, 147-49 (5th Cir.), cert. denied, 502 U.S. 811 (1991); United States v. Connor, 898 F.2d 942, 944-45 (3d Cir.), cert. denied, 497 U.S. 1029 (1990); United States v. Copeland, 786 F.2d 768, 770-71 (7th Cir. 1985); United States v. Willis, 277 F.3d 1026, 1031 (8th Cir. 2002).
  1. False statements to Treasury agents relating to the fraud. United States v. Beacon Brass Company, Inc., 344 U.S. 43, 45-46 (1952); United States v. Wilson, 118 F.3d 228, 236 (4th Cir. 1997); United States v. Winfield, 960 F.2d 970, 973-74 (11th Cir. 1992). But see, United States v. Romano, 938 F.2d 1569, 1573 (2d Cir. 1991)(equivocal statements to officials do not constitute an affirmative act).
  1. Corporate officer’s diversion of corporate funds to pay personal expenses. United States v. Boone, 951 F.2d 1526, 1540-41 (9th Cir. 1991); Katz v. United States, 321 F.2d 7, 10 (1st Cir.), cert. denied, 375 U.S. 903 (1963); United States v. American Stevedores, Inc., 310 F.2d 47, 48 (2d Cir. 1962), cert. denied, 371 U.S. 969 (1963); United States v. Brill, 270 F.2d 525, 526 (3d Cir. 1959).
  1. Sluicing off corporate income to principal shareholders in the guise of commissions or salaries out of proportion to the value of service rendered to the corporate taxpayer. United States v. Ragen, 314 U.S. 513, 525-26 (1942); United States v. Keenan, 267 F.2d 118, 123 (7th Cir.), cert. denied, 361 U.S. 863 (1959).
  1. Consistent pattern of overstating deductions. Zacher v. United States, 227 F.2d 219, 224 (8th Cir. 1955), cert. denied, 350 U.S. 993 (1956); United States v. Trevino, 394 F.3d 771, 777-78 (9th Cir. 2005), cert. denied, 547 U.S. 1022 (2006).
  1. Concealment of bank accounts. United States v. Wilson, 118 F.3d 228, 236 (4th Cir. 1997); Paschen v. United States, 70 F.2d 491 (7th Cir. 1934). Using a false SSN on bank accounts. United States v. Carlson, 235 F.3d 466, 469 (9th Cir. 2000), cert. denied, 121 S.Ct. 1627 (2001).
  1. Holding property in nominee names. United States v. Shoppert, 362 F.3d 451, 460 (8th Cir.), cert. denied, 543 U.S. 911 (2004); United States v. Wilson, 118 F.3d 228, 236 (4th Cir. 1997); United States v. Peterson, 338 F.2d 595, 597 (7th Cir. 1964), cert. denied, 380 U.S. 911 (1965).
  1. Representing political gratuities as gifts. Murray v. United States, 117 F.2d 40, 43-45 (8th Cir. 1941).
  1. Doing business in diverse names and keeping large sums of cash in safe deposit boxes in numerous banks. United States v. Zimmerman, 108 F.2d 370, 379 (7th Cir. 1939).
  1. Failure to file declaration of estimated tax, concealing or attempting to conceal true income, failure to pay income tax due, and filing frivolous returnsa purported income tax return (tax of $10.75) and an amended return (tax of $312.67). United States v. Afflerbach, 547 F.2d 522 (10th Cir. 1976). 
  1. Structuring cash transactions to evade the filing of Bank Secrecy Act reports. United States v. Mounkes, 204 F.3d 1024, 1030 (10th Cir.), cert. denied, 530 U.S. 1230 (2000).

[c] Affirmative acts pre-dating the date of deficiency.

If the indictment mentions only the date of deficiency as the date of the crime and fails to mention the predeficiency period, then the government is precluded from relying on evidence of acts occurring in the predeficiency period as evidence of affirmative acts of evasion. United States v. Voight, 89 F.3d 1050, 1089-90 (3d Cir.), cert. denied, 519 U.S. 1047 (1996).

[d] Affirmative acts serving purposes other than tax evasion.

 If tax evasion motive plays any part in defendant’s conduct, the offense of tax evasion may be made out even though the conduct may also serve purposes other than tax evasion. United States v. Voight, 89 F.3d 1050, 1090 (3d Cir.), cert. denied, 519 U.S. 1047 (1996).

[3][3] Additional Tax Due and Owing

[a] Generally. The government must demonstrate the existence of a tax due and owing, i.e., a tax deficiency, to prove tax evasion. The government must prove the criminal tax adjustments include evidence of criminal intent. Defense counsel will attack this element of the case if at all possible. Therefore, it is important to verify that the income from which the tax deficiency resulted was in fact taxable income. See, I.R.C. §§ 61, 62 and 63.

[b] Examples of taxable income not expressly specified in the Code, include:

  1. Gambling. Garner v. United States, 501 F.2d 228 (9th Cir. 1974), aff’d on other grounds, 424 U.S. 648 (1976); McClanahan v. United States, 292 F.2d 630, 631-32 (5th Cir.), cert. denied, 368 U.S. 913 (1961)
  2. Campaign contributions used for personal purposes. United States v. Scott, 660 F.2d 1145, 1152 (7th Cir. 1981), cert. denied, 455 U.S. 907 (1982).
  1. Embezzlement. James v. United States, 366 U.S. 213, 221-22 (1961); United States v. Eaken, 17 F.3d 203 (7th Cir. 1994); United States v. Kleifgen, 557 F.2d 1293,
    • 9th Cir. 1977).
  2.  Extortion Proceeds. Rutkin v. United States, 343 U.S. 130, 136-39 (1952); United States v. Cody, 722 F.2d 1052 (2d Cir. 1983), cert. denied, 467 U.S. 1226 (1984).
  3. Fraud Income. United States v. Dixon, 698 F.2d 445, 446 (11th Cir. 1983) (gross income includes proceeds from investment fraud scheme); Moore v. United States, 412 F.2d 974, 978 (5th Cir. 1969)(income includes gains from illegal activities).
  1. Loans received with no intent to repay. United States v. Curtis, 782 F.2d 593, 596 (6th Cir. 1986); United States v. Swallow, 511 F.2d 514, 519 (10th Cir.), cert. denied, 423 U.S. 845 (1975); United States v. Rosenthal, 470 F.2d 837, 842 (2d Cir. 1972), cert. denied, 412 U.S. 909 (1973); United States v. Rochelle, 384 F.2d 748, 751-52 (5th Cir. 1967), cert. denied, 390 U.S. 946 (1968).
  1. Kickbacks. United States v. Sallee, 984 F.2d 643 (5th Cir. 1993); United States v. Cody, 722 F.2d 1052 (2d Cir. 1983); United States v. Fogg, 652 F.2d 551, 555 (5th Cir. 1981), cert. denied, 456 U.S. 905 (1982); United States v. Swallow, 511 F.2d 514, 519 (10th Cir.), cert. denied, 423 U.S. 845 (1975); United States v. Wyss, 239 F.2d 658, 660 (7th Cir. 1957).

[c] Tax deficiency does not include interest and penalties if the violation is evasion of assessment. United States v. Mal, 942 F. 2d 682, 687 (9th Cir. 1991).

[d] Evading another’s tax liability. A tax deficiency may be predicated on taxable income that was taxable either to the person charged or another person or entity. United States v. Trov, 293 U.S. 58 (1934); United States v. Aracri, 968 F.2d 1512, 1523 (2d Cir. 1992); United States v. Frazier, 365 F.2d 316, 318 (6th Cir. 1966), cert. denied, 386 U.S. 971 (1967); Tinkoff v. United States, 86 F.2d 868, 876 (7th Cir. 1937).

[e] Assessment and demand not required. If the prosecution theory is evasion of assessment, there need not be a prior formal tax assessment or demand for payment. Tax deficiency can arise by operation of law when there is a failure to file and the government later determines the tax liability. United States v. Daniel, 956 F.2d 540, 542 (6th Cir. 1992); United States v. Dack, 747 F.2d 1172, 1174 (7th Cir. 1984).

[f] Amount of tax to be proven. The government need not prove a precise amount of tax

due and owing or prove its case to a mathematical certainty. United States v. Johnson, 319 U.S. 503, 517-18 (1943); United States v. Mounkes, 204 F.3d 1024, 1028 (10th Cir.), cert. denied, 530 U.S. 1230 (2000); United States v. Bender, 606 F.2d 897, 898 (9th Cir. 1979); United States v. Keller, 523 F.2d 1009, 1012 (9th Cir. 1975).

  1. Most circuits require the government to show that a substantial tax deficiency existed with respect to the years involved in the charge. United States v. Burkhart, 501 F.2d 993, 995 (6th Cir. 1974), cert. denied, 420 U.S. 946 (1975); United States v. Marcus, 401 F.2d 563, 565 (2d Cir. 1968), cert. denied, 393 U.S. 1023 (1969); Swallow v. United States, 307 F.2d 81, 83 (10th Cir. 1962), cert. denied, 371 U.S. 950 (1963); United States v. Alker, 260 F.2d 135, 140 (3d Cir. 1958), cert. denied, 59 U.S. 906 (1959).
  2. In the Seventh and Ninth Circuits there is no statutory requirement of substantiality, so showing some tax deficiency suffices. United States v. Daniels, 387 F.3d 636, 641 (7th Cir.), cert. denied, 544 U.S. 911 (2004); United States v. Marashi, 913 F.2d 724, 735-736 (9th Cir. 1990); United States v. Bender, 606 F.2d 897, 898 (9th Cir. 1979).

[g] Technical defenses.

  1. Loss carryback or “Lucky Loser Argument” is no defense. Net operating losses which occur after tax returns are required to be filed cannot be carried back to eliminate a tax liability. Such carryback losses cannot be used to reduce or eliminate misstatements of tax liability when fraudulently made. Willingham v. United States, 289 F.2d 283, 287-88 (5th Cir. 1961), cert. denied, 368 U.S. 826 (1961).
  2. Insufficient Earnings and Profits (E&P). Many tax schemes involve shareholders of closely held C corporations (corporations that pay tax) diverting corporate receipts to themselves or their family members, having the corporation pay their personal expenses, and other schemes where the corporate funds are distributed to the shareholders without the shareholders reporting any gross income and the corporation’s taxable income being understated. In United States v. Boulware, 128 S.Ct. 1168, 1182 (2008), the Supreme Court held that in determining the taxable amount of any such corporate distributions to the shareholder the distribution rules of I.R.C. §§ 301 and 316 apply.In general, the distribution rules of sections 301 and 316 provide that corporate distributions to shareholders are paid first out of current E&P, second out of accumulated E&P, and third out of capital (if the distribution exceeds current and accumulated E&P and the shareholder’s basis in the stock of the corporation, then such excess is taxed as a capital gain). The defense is that the corporation lacked current or accumulated E&P; therefore, any distributions by the corporation to the shareholder are a non-taxable return of capital.To overcome this defense, the government must prove the corporation had current or accumulated E&P. To compute E&P, start with the taxable income of the corporation as corrected. A number of technical adjustments are made to the taxable income, most of which would not be at issue in a criminal tax case, so the amounts of these adjustments from the corporation’s records could be used. Reduce the adjusted taxable income, by the tax due on the corrected taxable income to arrive at E&P. Any distributions paid out of E&P are taxable (constructive) dividends to the shareholder.In deciding Boulware, the Supreme Court adopted the holding of the Second Circuit Court of Appeals in United States v. D’Agostino, 145 F.3d 69 (2d Cir. 1998), and rejected the following circuit court decisions: United States v. Williams, 875 F.2d 846 (11th Cir. 1989); United States v. Thetford, 676 F.2d 170 (5th Cir. 1982), cert. denied, 459 U.S. 1148 (1983); United States v. Miller, 545 F.2d 1204 (9th Cir. 1976), cert. denied, 430 U.S. 930 (1977); and Davis v. United States, 226 F.2d 331 (6th Cir. 1955), cert. denied, 350 U.S. 965 (1956).
  3. Reclassify business expenses. In United States v. Kayser, 488 F.3d 1070, 1073 (9th Cir. 2007), a divided panel of the 9th Circuit overturned defendant’s conviction by allowing him to reclassify previously claimed corporate business expenses as personal business expenses which offset unreported income and resulted in no tax due and owing. The court did not overrule United States v. Miller, 545 F. 2d 1204 (9th Cir. 1976), cert. denied, 430 U. S. 930 (1977), which had held otherwise, but interpreted Miller’s holding as being consistent with the court’s decision.
  4. Different method of reporting or accounting. As a general rule, the Government must use the taxpayer’s method of accounting in computing the income. Fowler v. United States, 352 F.2d 100, 103 (8th Cir. 1965), cert. denied, 383 U.S. 907 (1966); United States v. Vardine, 305 F.2d 60, 64 (2d Cir. 1962); United States v. Hestnes, 492 F. Supp. 999, 1000-01 (W.D. Wis. 1980). If the taxpayer used a particular method of reporting income, then the taxpayer is bound by that choice at trial. The taxpayer cannot report his income on the cash method and then at trial, allege that on an accrual basis unreported income would be a less than the Government proved on a cash basis. Clark v. United States, 211 F.2d 100, 105 (8th Cir. 1954), cert. denied, 348 U.S. 911 (1955). See also, United States v. Helmsly, 941 F.2d 71, 86-87 (2d Cir. 1991)(defendant not free to re-calculate taxes resorting to one of four depreciation methods to defend the charge by showing that another depreciation method would have resulted in no tax liability); United States v. Hecht, 705 F. 2d 976, 977-78 (8th Cir. 1983).
  5. A legitimate claim to a foreign tax credit is a defense. United States v. Cruz, 698 F.2d 1148, 1152 (11th Cir. 1983); United States v. Campbell, 351 F.2d 336, 338-39 (2d Cir. 1965), cert. denied, 383 U.S. 907 (1966). Liability for the foreign tax credit must be fully established as an amount owed to the foreign government.

[4] Willfulness

[a] Willfulness is defined as the “voluntary, intentional violation of a known legal duty.” Cheek v. United States, 498 U.S. 192, 200-01 (1991); United States v. Pomponio, 429 U.S. 10, 12 (1976); United States v. Bishop, 412 U.S. 346, 360 (1973); United States v. Pensyl, 387 F.3d 456, 458-59 (6th Cir. 2004); United States v. George, 420 F.3d 991, 999 (9th Cir. 2005).

[b] Subjective Test. A defendant’s good faith belief that he is not violating the tax laws, no matter how objectively unreasonable that belief may be, is a defense in a tax prosecution. Cheek v. United States, 498 U.S. 192, 199-201 (1991). See also, United States v. Grunewald, 987 F.2d 531, 535-36 (8th Cir. 1993); United States v. Pensyl, 387 F.3d 456, 459 (6th Cir. 2004).

  1. Erroneous beliefs. A defendant’s erroneous belief that tax laws are unconstitutional is no defense to tax evasion. Cheek v. United States, 498 U.S. 192, 205-06 (1991).
  2. Law is vague or unsettled.

(A) Where the law is vague or unsettled as to whether a transaction has generated taxable income, courts have found the defendant lacked willfulness. For instance: (i) Payments given by wealthy widower to mistresses where civil tax cases had held such payments were gifts. United States v. Harris, 942 F.2d 1125, 1131 (7th Cir. 1991). (ii) Prior Tax Court case accepting income reporting method made it inappropriate to impose criminal liability for using that method. United States v. Heller, 830 F. 2d 150, 154-55 (11th Cir. 1987). (iii) Novel issue of tax treatment of money received from sale of rare blood. United States v. Garber, 607 F.2d 92, 100 (5th Cir. 1979). (iv) Business income on Indian reservation in light of conflict among government branches on the issue. United States v. Critzer, 498 F.2d 1160, 1162 (4th Cir. 1974).

(B) The fact that an appellate court has not decided an issue does not mean that the law is vague or unsettled if established principles of tax law clearly delineate the scheme’s illegality. See, e.g., United States v. Tranakos, 911 F.2d 1422, 1430-31 (10th Cir. 1990)(addressing use of sham transactions to avoid taxation); United States v. Krall, 835 F.2d 711, 714 (8th Cir. 1987)(regarding use of sham trusts to avoid taxation); United States v. Crooks, 804 F.2d 1441 (9th Cir. 1986) (concerning principle favoring tax treatment of substance over form); United States v. George, 420 F. 3d 991, 995-96 (9th Cir. 2005)(concerning allocation of receiver fees by a cash basis taxpayer).

(C) The fact that the law is vague or unsettled does not negate willfulness if the defendant is not also subjectively uncertain of the law or if bad faith can be inferred from the defendant’s conduct. Factual evidence of the defendant’s state of mind is required to negate willfulness. United States v. Harris, 942 F.2d 1125, 1128-29 (7th Cir. 1991); United States v. Curtis, 782 F.2d 593, 598-600 (6th Cir. 1986)(rejecting defense because it allows a finding that there was no willfulness even if defendant was unaware of the legal uncertainty and because it distorts the roles of experts, judges, and juries with respect to questions of law); United States v. MacKenzie, 777 F.2d 811, 816-17 (2d

11 Cir. 1985); United States v. Mallas, 762 F .2d 361, 363 (4th Cir. 1985); United States v. Ingredient Technology, 698 F.2d 88, 96-97 (2d Cir.), cert. denied, 462 U.S. 1131 (1983).

  1. Where the defendant concealed assets or covered up sources of income, willfulness is present and good faith may not be used as a defense. United States v. Brooks, 174 F.3d 950, 954-55 (8th Cir. 1999).
  1. A willful blindness or deliberate indifference jury instruction permits a jury to infer knowledge if it finds the defendant closed his eyes to what was obvious to him. United States v. Willis, 277 F.3d 1026, 1031-32 (8th Cir. 2002); United States v. Dean, 487 F.3d 840, 851 (11th Cir. 2007).

[c] Absent an admission, confession or accomplice testimony, willfulness is rarely subject to direct proof and generally must be inferred from the circumstances of the case. United States v. Wilson, 118 F.3d 228, 236 (4th Cir. 1997); United States v. Ashfield, 735 F.2d 101, 105 (3d Cir.), cert. denied, 469 U.S. 858 (1984); United States v. Spinelli, 443 F.2d 2, 3 (9th Cir. 1971); United States v. Magnus, 365 F.2d 1007, 1011-12 (2d Cir. 1966); Paschen v. United States, 70 F.2d 491 (7th Cir. 1934).

[d] Willfulness may be inferred from “any conduct, the likely effect of which would be to mislead or to conceal.” Spies v. United States, 317 U.S. 492, 499 (1943). The following are examples of conduct from which willfulness has been inferred:

  1. Signing return knowing that the contents of that return understated income. United States v. Olbres, 61 F.3d 967, 970-71 (1st Cir.), cert. denied, 516 U.S. 991 (1995).
  2. Substantial understatement of income in successive years. United States v. Lavoie, 433 F.3d 95, 98-99 (1st Cir. 2005); United States v. Kim, 884 F.2d 189, 192-93 (5th Cir. 1989); United States v. Krzyske, 836 F.2d 1013, 1019-20 (6th Cir. 1988); United States Skalicky, 615 F.2d 1117, 1120 (5th Cir.), cert. denied, 449 U.S. 832 (1980); United States v. Larson, 612 F.2d 1301, 1305 (8th Cir.), cert. denied, 446 U.S. 936 (1980); United States v. Gardner, 611 F.2d 770, 776 (9th Cir. 1980).
  3. Prior and subsequent similar acts reasonably close to the prosecution years. United States v. Johnson, 386 F.2d 630, 631 (3d Cir. 1967); United States v. Magnus, 365 F.2d 1007, 1011-12 (2d Cir. 1966); United States v. Alker, 260 F.2d 135, 156-57 (3d Cir. 1958), cert. denied, 359 U.S. 906 (1959).
  1. Failure to supply an accountant with accurate and complete information. United States v. Lavoie, 433 F.3d 95, 99 (1st Cir. 2005); United States v. Bishop, 291 F.3d 1100, 1106- 08 (9th Cir. 2002), United States v. Olbres, 61 F.3d 967, 970-71 (1st Cir.), cert. denied, 516 U.S. 991 (1995); United States v. Brimberry, 961 F.2d 1286, 1290-91 (7th Cir. 1992); United States v. Chesson, 933 F.2d 298, 304-05 (5th Cir. 1991); United States v. Michaud, 860 F.2d 495, 500 (1st Cir. 1988); United States v. Meyer, 808 F.2d 1304, 1306 (8th Cir. 1987); United States v. Ashfield, 735 F.2d 101, 106-07 (3d Cir.), cert. denied, 469 U.S. 858 (1984); United States v. Samara, 643 F.2d 701,703-04 (10th Cir.), cert. denied, 454 U.S. 829 (1981).
  1. Making false exculpatory statements to agents or causing them to be made. United States v. Chesson, 933 F.2d 298, 304-05 (5th Cir. 1991); United States v. Frederickson, 846 F.2d 517, 520-21 (8th Cir. 1988); United States v. Walsh, 627 F.2d 88, 92 (7th Cir. 1980).
  2. Destroying, throwing away, or “losing” books and records. United States v. Chesson, 933 F. 2d 298, 304-05 (5th Cir. 1991); United States v. Walker, 896 F.2d 295 (8th Cir. 1990); United States v. Conforte, 624 F.2d 869, 875-76 (9th Cir.), cert. denied, 449 U.S. 1012 (1980); United States v. Garavaglia, 566 F.2d 1056, 1059-60 (6th Cir. 1977).
  1. Making or using false documents, entries in books and records, or invoices. United States v. Chesson, 933 F.2d 298, 304 (5th Cir. 1991); United States v. Walker, 896 F.2d 295, 297-300 (8th Cir. 1990). This includes backdating documents such as receipts and contracts to gain a tax advantage. United States v. O’Keefe, 825 F.2d 314, 318 (11th Cir. 1987); United States v. Drape, 668 F.2d 22, 25-26 (1st Cir. 1982).
  1. Keeping a double set of books. Spies v. United States, 317 U.S. 492, 499 (1943); United States v. Daniels, 617 F.2d 146, 148 (5th Cir. 1980).
  1. Placing property or business in the name of another. United States v. Brooks, 174 F.3d 950, 954-55 (8th Cir. 1999); United States v. Daniel, 956 F.2d 540, 543 (6th Cir. 1992); United States v. Peterson, 338 F.2d 595, 597 (7th Cir. 1964), cert. denied, 380 U.S. 911 (1965); United States v. Woodner, 317 F.2d 649, 650 (2d Cir.), cert. denied, 375 U. S. 903 (1963).
  1. Extensively using currency and cashier’s checks. United States v. Daniel, 956 F.2d 540, 543 (6th Cir. 1992); United States v. Holovachka, 314 F.2d 345, 357-58 (7th Cir.), cert. denied, 374 U.S. 809 (1963); Schuermann v. United States, 174 F.2d 397, 398 (8th Cir.), cert. denied, 338 U.S. 831 (1949).
  1. Spending large amounts of cash which could not be reconciled with reported income or engaging in surreptitious transactions using cash, money orders, or cashier’s checks. United States v. Kim, 884 F.2d 189, 192-93 (5th Cir. 1989); United States v. Skalicky, 615 F.2d 1117, 1120 (5th Cir.), cert. denied, 449 U.S. 832 (1980); United States v. Holladay, 566 F.2d 1018, 1020 (5th Cir.), cert. denied, 439 U.S. 831 (1978); United States v. Mortiner, 343 F.2d 500 (7th Cir.), cert. denied, 382 U.S. 842 (1965).
  1. Holding bank accounts under fictitious names. United States v. Ratner, 464 F.2d 101, 105 (9th Cir. 1972); Elwert v. United States, 231 F.2d 928, 936 (9th Cir. 1956).
  1. Handling one’s affairs to avoid making the usual records required for such transactions. United States v. Dowell, 446 F.2d 145, 147-48 (10th Cir.), cert. denied, 404 U. S. 984 (1971); Gariepy v. United States, 189 F.2d 459, 461-63 (6th Cir. 1951).
  1. General educational background and experience may be considered as bearing on a taxpayer’s ability to form a willful intent. United States v. Smith, 890 F.2d 711, 715 (5th Cir. 1989)(entrepreneurial experience); United States v. Segal, 867 F.2d 13 1173, 1179 (8th Cir. 1989)(successful and sophisticated businessman). See also, United States v. Tarwater, 308 F.3d 494, 506-07 (6th Cir. 2002); United States v. Coblentz, 453 F.2d 503, 505 (2d Cir. 1972); United States v. Ostendorff, 371 F.2d 729, 731 (4th Cir.) cert. denied, 386 U.S. 982 (1967).
  1. The defendant’s attitude toward the reporting and payment of taxes generally. United States v. Hogan, 861 F.2d 312, 316 (1st Cir. 1988); United States v. Stein, 437 F.2d 775 (7th Cir.), cert. denied, 403 U.S. 905 (1971); United States v. O’Connor, 433 F.2d 752, 754-755 (1st Cir. 1970), cert. denied, 401 U.S. 911 (1971).
  1. Ignorance of law and claims that tax laws are not constitutional. Cheek v. United States, 498 U.S. 192, 199-201 (1991); United States v. Pensyl, 387 F. 3d 456, 458-60 (6th Cir. 2004), and United States v. Hancock, 231 F. 3d 557, 561-62 (9th Cir. 2000).

[5] Venue

 [a] Under the Constitution, venue lies in the judicial district where the crime has been committed. U.S. Const. art. II, § 2, cl. 3; U.S. Const. amend. VI.

[b] Unless otherwise permitted by statute or rule, criminal prosecution must take place “in a district in which the offense was committed.” Fed. R. Crim. P. 18.

[c] Venue is appropriate in any judicial district where the return was:

  1. made;
  2. subscribed; or
  3. filed.

See, e.g., United States v. Marchant, 774 F.2d 888, 891-92 (8th Cir. 1985), cert. denied, 475 U.S. 1012 (1986)(venue appropriate where accountant prepared return); United States v. King, 563 F.2d 559, 562 (2d Cir. 1977), cert. denied, 435 U.S. 918 (1978)(prepared and signed); United States v. Gross, 276 F.2d 816, 819 (2d Cir.), cert. denied, 363 U.S. 831 (1960) (prepared); United States v. Albanese, 224 F.2d 879, 882 (2d Cir.), cert. denied, 350 U.S. 845 (1955)(prepared and mailed).

[d] Venue is also appropriate in any district where any act of the offense was begun, continued, or completed. United States v. Rooney, 866 F.2d 28, 31-32 (2d Cir. 1989).

[e] For offenses begun in one district and completed in another, or committed in more than one district, venue lies in each district in which such offense was begun, continued, or completed. 18 U.S.C. § 3237(a).

[f] General considerations in recommending venue:

  1. The underlying basis for venue is the taxpayer’s Sixth Amendment right to trial in the judicial district where the crime was committed.
  1. Bringing prosecution in taxpayer’s home judicial district obviates motion by defendant to change venue. Publicity more likely in defendant’s home district.
  1. Proof of venue is by a preponderance of the evidence. United States v. Maldonado-Rivera, 922 F.2d 934, 968 (2d Cir. 1990), cert. denied, 501 U.S. 1210 (1991); United States v. Griley, 814 F.2d 967, 973 (4th Cir. 1987). It is enough if the testimony justifies the reasonable inference that the violation occurred at the place alleged in the indictment. United States v. Mendell, 447 F.2d 639, 641 (7th Cir.), cert. denied, 404 U.S. 991 (1971).
  1. Improper venue may be waived by a defendant. United States v. Netz, 758 F.2d 1308, 1311 (8th Cir. 1985); United States v. Powell, 498 F.2d 890, 891 (9th Cir. 1974). See also, Fed R. Crim. P. 58(c)(2).

[6] Statute of Limitations

[a] There is a six (6) year limitation period for the offense of willfully attempting to evade or defeat any tax. I.R.C. § 6531(2).

[b] The general rule is that the limitation period begins to run 6 years from the date of the last affirmative act that took place or the statutory due date of the return, whichever is later. Specific applications of the rule are:

  1. Statutory due date where no return is filed or where the return is filed early. United States v. Butler, 297 F.3d 505, 511 (6th Cir. 2002), cert. denied, 123 S.Ct. 2074 (2003); United States v. Williams, 928 F.2d 145, 149 (5th Cir.), cert. denied, 502 U.S. 811 (1991); United States v. Myerson, 368 F.2d 393, 395 (2d Cir. 1966), cert. denied, 386 U.S. 991 (1967).
  1. Actual filing date where the tax return is filed late. United States v. Habig, 390 U.S. 222, 225-27 (1968); United States v. Daniels, 387 F.3d 636, 641-42 (7th Cir.), cert. denied, 544 U.S. 911 (2004).
  1. Date of the last affirmative act of evasion where acts of evasion occur after the due date. United States v. Beacon Brass, 344 U.S. 43, 45-46 (1952); United States v. Anderson, 319 F.3d 1218, 1219-20 (10th Cir. 2003); United States v. Carlson, 235 F.3d

466, 470-71 (9th Cir. 2000), cert. denied, 532 U.S. 983 (2001); United States v. Winfield, 960 F.2d 970, 973 (11th Cir. 1992); United States v. DiPetto, 936 F.2d 96, 98 (2d Cir.), cert. denied, 502 U.S. 866 (1991); United States v. Ferris, 807 F.2d 269, 271-72 (1st Cir. 1986). Contra, United States v. Uscinski, 369 F.3d 1243, 1247 (11th Cir. 2004)(the filing of a false income tax return completes the offense of tax evasion). Note: This can be problematic if act does not relate to evasion but, rather may be viewed as a separate coverup.

[c] Tolling, Suspension, and Extension of Statute 

  1. Tolling. Under I.R.C. § 6531, the statute of limitations is tolled while a person who has committed tax code violations is outside the United States or is a fugitive from justice.
  • “Outside the United States” has been interpreted to mean “whenever [such persons] cannot be served criminal process within the jurisdiction of the United States under Fed. R. Crim. P. 4(d)(2).” United States v. Marchant, 774 F.2d 888, 891-92 (8th Cir. 1985), cert. denied, 475 U.S. 1012 (1986).
  • This includes ordinary business or pleasure trips outside U.S. jurisdiction. United States v. Myerson, 368 F.2d 393, 395 (2d Cir. 1966), cert. denied, 386 U.S. 991 (1967).
  1. Suspension. Under I.R.C. § 7609(e)(1), the statute of limitations is suspended in certain types of summons enforcement proceedings. Generally, where an intervener in a summons enforcement proceeding is the person with respect to whose liability the summons is issued, the running of any period of limitations under section 6531(relating to criminal prosecutions) with respect to such person shall be suspended for the period during which such a proceeding, and appeals therein, with respect to the enforcement of such summons is pending.
  2. Time Extension. Under I.R.C. § 6531, the statute of limitations may be extended. When an adequate complaint is instituted before a commissioner of the United States within the prescribed limitation period, the period is extended 9 months from the date of the complaint. This extension of time is not meant to allow the government additional time to develop its case, but rather is designed for use when the grand jury would not be able to return an indictment within the statutory time because of its schedule. See, Jaben v. United States, 381 U.S. 214, 219-20 (1964).

1-1.04 Evasion of Payment

[1] Elements of the Offense:

[a] An attempt to evade or defeat the payment of a tax;

[b] An additional tax due and owing; and,

[c] Willfulness.

Sansone v. United States, 380 U.S. 343, 351 (1965); Spies v. United States, 317 U.S. 492, 493- 94 (1943); United States v. Daniel, 956 F.2d 540, 542 (6th Cir. 1992); United States v. Masat, 948 F.2d 923, 931 (5th Cir. 1991).

[2] The Attempt

[a] Attempt to evade payment. Affirmative acts of evasion of payment almost always involve some form of concealment of money or assets with which the tax could be paid or the removal of assets from the reach of the I.R.S. Merely failing to pay assessed taxes, without more, does not constitute evasion of payment (though it may constitute willful failure to pay taxes under § 7203). Thus, in the absence of an affirmative act, obstinate refusal to pay taxes due and the possession of the funds needed to pay the taxes is insufficient for an evasion charge

[b] Affirmative acts of evasion of payment generally involve schemes to deal in currency, place assets in the names of others, transfer assets abroad or omit assets on a Form 433-A, Collection Information Statement. Examples include:

  1. Concealing assets by using bank accounts of family members and coworkers. United States v. Shoppert, 362 F.3d 451, 460 (8th Cir.), cert. denied, 543 U.S. 911 (2004); United States v. McGill, 964 F.2d 222, 233 (3d Cir. 1992).
  2. Making expenditures extensively by cash and through the use of third parties’ credit cards and placing assets in the names of third parties. United States v. Shoppert, 362 F.3d 451 (8th Cir.), cert. denied, 543 U.S. 911 (2004); United States v. Daniel, 956 F.2d 540, 543 (6th Cir. 1992).
  3. Taxpayer’s false statement to I.R.S. agent that she owned no real estate and had no other assets with which to pay tax. United States v. Shoppert, 362 F.3d 451, 460 (8th Cir.), cert. denied, 543 U.S. 911 (2004); United States v. Brimberry, 961 F.2d 1286, 1290-91 (7th Cir. 1992).
  4. Maintaining a cash lifestyle by conducting all personal and professional business in cash, possessing no credit cards, bank accounts, or accounting records and never acquiring any attachable assets. United States v. Shorter, 809 F.2d 54, 56-57 (D.C. Cir.), cert. denied, 484 U.S. 817 (1987).
  5. Bankruptcy fraud. A legitimate goal of a bankruptcy petitioner may be immediate protection from I.R.S. collection activities (stay of collection and removal of levies). While the act of voluntarily filing a petition for bankruptcy may not constitute an affirmative act in and of itself, if it can be shown through other affirmative acts (e.g., predicating the petition on false or fraudulent obligations) that the petitioner’s purpose in filing the bankruptcy petition was to prevent or delay I.R.S. collection efforts, the act of filing may constitute an affirmative act of evasion. See, e.g., United States v. Huebner, 48 F.3d 376, 379-80 (9th Cir. 1994)(the defendant, having created false loan documents and then filed for bankruptcy, was successfully prosecuted for evasion of payment.).
  6. See also, United States v. Hook, 781 F.2d 1166, 1169 (6th Cir.), cert. denied, 479 U.S. 882 (1986); United States v. Lamp, 779 F.2d 1088, 1092-93 (5th Cir. 1986); United States v. Swallow, 511 F.2d 514, 521 (10th Cir.), cert. denied, 423 U.S. 845 (1975); United States v. Trownsell, 367 F.2d 815, 816 (7th Cir. 1966); Cohen v. United 17 States, 297 F.2d 760, 762 (9th Cir.), cert. denied, 369 U.S. 865 (1962); United States v. Mollet, 290 F. 2d 273, 274-75 (2d Cir. 1961), for additional examples of acts to evade payment.

[c] Evasion of payment may involve a single affirmative act intended to evade the payment of several years of tax due. In this situation, it is permissible to charge multiple years of evasion in one count. United States v. Shorter, 809 F.2d 54, 56-57 (D.C. Cir.), cert. denied, 484 U.S. 817 (1987)(upholding use of a single count of tax evasion covering twelve years of evasion of payment where the underlying basis of the count is an allegedly consistent, long-term pattern of conduct directed at the evasion of payment of taxes for those years). See also, United States v. Hook, 781 F.2d 1166, 1169 (6th Cir.), cert. denied, 479 U. S. 882 (1986).

[3] Additional Tax Due and Owing

 [a] Generally. The government must demonstrate the existence of a tax due and owing, i.e., a tax deficiency, to prove tax evasion. For further information see discussion of this element in the evasion of assessment section above.

[b] It is not essential that the I.R.S. have made a formal assessment of taxes owed and a demand for payment in order to bring tax evasion charges on an evasion of payment theory. Tax deficiency can arise by operation of law when there is a failure to file and the government later determines the tax liability. See, United States v. Daniel, 956 F.2d 540, 542 (6th Cir. 1992); United States v. Hogan, 861 F.2d 312, 315-16 (1st Cir. 1988).

The law is not so clear in the Third Circuit. See the discussion in United States v. Farnsworth, 456 F.3d 394, 402-03 (3d Cir. 2006), where the court stated that no assessment is required but noted that United States v. McGill, 964 F.2d 222, 233 (3d Cir. 1992), suggested otherwise.

[c] Right of defendant to dispute assessment. Although an assessment is prima facie proof of a tax deficiency, the defendant has a constitutional right to present rebuttal evidence and have the jury decide his guilt on each element of the crime. United States v. Silkman, 156 F.3d 833, 835 (8th Cir. 1998).

[4] Willfulness

 [a] Willfulness is defined as the “voluntary, intentional violation of a known legal duty.”

Cheek v. United States, 498 U.S. 192, 201 (1991); United States v. Pomponio, 429 U.S. 10, 12 (1976); United States v. Bishop, 412 U.S. 346, 360 (1973). See discussion of this element in the evasion of assessment section above.

[b] Willfulness is subjectively measured. A defendant’s good faith belief that he is not violating the tax laws, no matter how objectively unreasonable that belief may be, is a defense in a tax prosecution. Cheek v. United States, 498 U.S. 192, 199-201 (1991). See also, United States v. Grunewald, 987 F.2d 531, 535-36 (8th Cir. 1993).

[c] Indirect proof of willfulness is the typical means of establishing the element. Willfulness may be inferred from “any conduct the likely effect of which would be to mislead or to conceal.” Spies v. United States, 317 U.S. 492, 499 (1943).

[d] Conduct from which the willful evasion of payment can be inferred includes conduct designed to place assets beyond the government’s reach after a tax liability has been assessed. United States v. Mal, 942 F. 2d 682, 687 (9th Cir. 1991); United States v. Dunkel, 900 F.2d 105, 107 (7th Cir. 1990); United States v. Masat, 896 F.2d 88, 97-99 (5th Cir. 1990).

[e] Paying taxes due after the criminal investigation commenced does not negate willfulness. United States v. Pang, 362 F.3d 1187, 1194 (9th Cir.), cert. denied, 543 U.S. 943 (2004).

[5] Venue

[a] Venue is appropriate in any judicial district where the return was:

  1. made;
  2. subscribed; or
  3. filed.

See, e.g., United States v. Marchant, 774 F.2d 888, 891-92 (8th Cir. 1985), cert. denied, 475 U.S. 1012 (1986) (venue appropriate where accountant prepared return); United States v. King, 563 F.2d 559, 562 (2d Cir. 1977), cert. denied, 435 U.S. 918 (1978) (prepared and signed); United States v. Gross, 276 F.2d 816, 819-20 (2d Cir.), cert. denied, 363 U.S. 831 (1960) (prepared); United States v. Albanese, 224 F.2d 879, 882 (2d Cir.), cert. denied, 350 U.S. 845 (1955)(prepared and mailed).

[b] Venue is also appropriate in any district where any act of the offense was begun, continued, or completed. United States v. Rooney, 866 F.2d 28, 31-32 (2d Cir. 1989).

[c] For offenses begun in one district and completed in another, or committed in more than one district, venue lies in each district in which such offense was begun, continued, or completed. 18 U.S.C. § 3237(a).

[6] Statute of Limitations

 To determine whether the statute of limitations is open for evasion of payment cases, begin with the present date, and inquire whether affirmative acts in furtherance of the crime were committed in the preceding 6 years. United States v. Shorter, 809 F.2d 54 (D.C. Cir.), aff’g 608 F. Supp. 871, 873-74, and cert. denied, 484 U.S. 817 (1987); United States v. Hook, 781 F.2d 1166, 1171-73 (6th Cir. 1986). For example, in United States v. Voorhies, 658 F. 2d 710 (9th Cir. 1981), the defendant committed five affirmative acts of evading payment within six years prior to the date he was indicted.

1-1.05 Collateral Estoppel

I.R.C. § 7201 is a broad provision and carries the most severe penalty of the criminal tax offenses. Since criminal convictions are founded on the beyond a reasonable doubt standard, a conviction for tax evasion will collaterally estop denial of the civil fraud penalty under I.R.C. § 6663 for the same taxpayer, tax year, and type of tax. See Wright v. Commissioner, 84 T.C. 636 (1985); Amos v. Commissioner, 43 T.C. 50 (1964).

1-1.06 Lesser Included Offenses

[1] Lesser included offenses are offenses whose statutory elements comprise part of the

elements needed to prove another offense, i.e., they are a subset of a “greater” or “major” offense. For example, filing a false return or failing to file a return are each substantive tax offenses which under certain circumstances could be a lesser included offense of tax evasion. Filing a false return may constitute an affirmative act of tax evasion, and when coupled with a tax deficiency, could form the basis for an evasion charge. Similarly, failing to file a return, when coupled with the requisite affirmative act(s) of evasion and a tax deficiency, also may support an evasion charge. Accordingly, such offenses are considered lesser included offenses of the major offense of tax evasion.

[2] Congress, in fixing varying penalties for offenses of attempting to evade federal income tax and for willfully making and subscribing a tax return not believed to be correct, did not intend to pyramid penalties and authorize a separate penalty for a lesser included offense, which arose out of the same transaction and which would be established by proof of guilt of the greater offense of attempting to evade income tax. United States v. Lodwick, 410 F.2d 1202, 1206 (8th Cir.), cert. denied, 396 U.S. 841 (1969). See also, United States v. Dale, 991 F.2d 819, 858-59 (D.C. Cir. 1993); United States v. Kaiser, 893 F.2d 1300, 1307 (11th Cir. 1990); United States v. Citron, 783 F.2d 307, 312-14 (2d Cir. 1986). Thus, in cases where a § 7203 or § 7206(1) violation is a predicate offense to a § 7201 violation, the § 7203 or § 7206(1) violation would be considered a lesser included offense in the § 7201 offense.

[3] The Department of Justice, Tax Division, has adopted the so-called “elements” test for lesser included offenses from Schmuck v. United States, 489 U.S. 705, 709-10 (1989). The standard is whether the statutory elements of the lesser offense are a subset of the elements of the greater offense. Schmuck, 489 U.S. at 709-10.

[4] One result of this policy is that an instruction of failure to file is not automatic in a Spies evasion case involving failure to file, failure to pay, and an affirmative act of evasion. If there is any doubt as to the strength of evidence on any section 7201 element, charging a section 7203 violation should also be considered.

[5] Similarly, charging both sections 7201 and 7206(1) should be considered in evasion cases where filing a false return can be established, but the evidence supporting a tax deficiency may not be strong enough for an evasion conviction.

Keeping Your Tax Clients and
Yourself out of Jail

&

Criminal Tax War Stories from the Trenches

 By

David W. Klasing Esq. M.S.-Tax CPA

 

David Warren Klasing

 

Ethical requirements for CPA’s in the face of possible criminal tax issues raised by a current or potential client.

CPA’s are often faced with existing as well as potential new clients coming into their office, seeking advice because they have taken actions within their previous tax and or information filings that could potentially lead to prosecution for a tax crime. On rare occasions an existing client may come into the CPA’s office and state that they may already be under criminal investigation by the IRS or by another state or federal taxing authority.

Unfortunately for CPA’s, the CPA that prepared the tax returns at issue for such clients are usually the first person the client will contact in the face of a possible criminal investigation or where their past cheating starts to keep them up at night. The CPA must know in advance what the correct legal and ethical considerations he or she should consider in order to protect his or her client from criminal prosecution where his or her client is being investigated or merely faces the potential to be investigated. Moreover, the CPA must know what to do to protect his or her self from their own ethical and criminal misconduct exposure. After all, a CPA’s license is often the most valuable asset he or she possesses.

Moreover, CPA’s should be aware of the potential consequences that clients face as a result of undergoing a criminal investigation by the IRS or other taxing authority. Clients in these situations potentially face jail sentences and large financial penalties. If the client has a professional license they also could lose their livelihood in the process. While CPA’s, under ordinary circumstances, offer their clients invaluable professional advice regarding tax procedure and administration, once the CPA recognizes the emergence of a possible criminal issue in a client’s fact pattern, he or she should halt the client interview immediately and refer the client to an experienced criminal tax attorney.

The CPA should resist the urge to fully drill down on the potential criminal tax issue as the CPA can be forced to testify against the client. Because of the fiduciary relationship between client and CPA, the CPA often is the most damaging witness the government can muster against the accused taxpayer. Sometimes the greatest service a CPA can provide to a client is to protect them from themselves by resisting a client’s often desperate pleas for help in this scenario.  You can comfort them by telling them to quit talking and listen.  Then explain to them why you cannot fully discus their issue with them because of the potential for you to be called as a witness against them.

Moreover, if the CPA had no knowledge of the method by which the client evaded taxes, or if he or she is the preparer of the return or returns under investigation, the CPA has a very real and pronounced conflict of interest with the investigated client.    The CPA has a vested interest in protecting his or her own reputation with the investigating tax authority which places him or her at odds with the needs of his client to protect their own reputation. The bottom line is eventually the taxing authority is going to be able to determine it has returns in front of them that do not reflect the correct tax liability.  The question then becomes, whose fault is that?  The client or the CPA’s?  Unfortunately, in the face of a criminal prosecution by the client, and in the face of possible suspicion of the CPA’s work product, a he said she said situation is very likely to unfold.  This is the reason that CPAs are systematically trained to document the information provided by the taxpayer in the preparation of the return. The evidentiary waters become even murkier where the CPA compiled, reviewed or audited the accounting that underlies the returns under investigation.

Because of the high stakes consequences to both the client and CPA, It is important for CPA’s to know the legal and ethical issues surrounding criminal investigations and prosecutions in order to know when referral is needed as well as to protect themselves from their own ethical, civil and criminal exposure.

Common   Misunderstanding   by   the   CPA   of   the Privileges Conferred by IRC Section 7525

Practitioners authorized to practice in front of the Internal Revenue Service may claim an attorney-client privilege in non-criminal tax matters under limited circumstances. Misconceptions surrounding the strength of the protection provided by Section 7525 can present quite a dangerous dilemma for CPAs. Many CPAs mistakenly believe that their client communications are protected when representing an audited client.  This is partially true where they did not prepare the original returns being audited. The dilemma occurs once that examination turns criminal where the CPA can find themselves compelled to divulge all the client’s previously discussed secrets to the IRS under the IRS’s subpoena power. Moreover, communications surrounding the preparation of the original return being audited are never privileged (even where the original return was prepared by an attorney) given that a tax return is a public disclosure and thus no expectation of confidentiality surrounded the communications at issue.

The 6th Circuit court of appeals has held that statements made in a civil examination may be admitted as evidence in a subsequent criminal prosecution.  In U.S. v. Rutherford, 555 F.3d 190 (6th Cir. 2009), the defendants were represented by a CPA when the civil interviews were being conducted. Because the case was not handed over to a criminal tax attorney at the phase where the CPA should have realized that the taxpayers were in need of legal representation, the taxpayer’s ability to protect his constitutional rights were weakened. Ultimately the statements made during the civil audit while the client was represented by a CPA, led directly to the taxpayer’s criminal prosecution.

Protection Afforded to a Client Where the CPA Works for an Attorney under a Kovel Agreement

In order to protect the client’s constitutional rights where a possible criminal tax violation is identified by the CPA, the client should be referred to a criminal tax attorney at the earliest possible signs of a potential criminal tax violation with as little said between the CPA and the client as possible. Where the Attorney deems it advantageous for his or her client, the Attorney may engage the referring CPA under a Kovel Agreement to help him or her represent the client in the criminal tax matter. The Kovel arrangement generally assures that communications between the CPA and the client fall under the attorney client privilege and the work papers prepared by the CPA generally fall under the Attorney’s work product privilege by making the CPA and his or her staff an extension of the Attorney’s firm as to the common clients representation.

It is important to note that the Attorney’s duty of loyalty is to the client and not to the referring CPA. In situations where the CPA prepared the returns that are now under criminal investigation or where too much was said between the referring CPA and the client prior to the referral to the Tax Attorney being made, the Attorney might opt to advise the client to engage a disinterested third party CPA in order to avoid the procedural confusion that follows where pre Kovel letter communications and work papers prepared by the referring CPA are non-privileged as opposed to post Kovel Letter communications and work papers that are privileged.

Ethical Requirements under the AICPA Statement on Standards for Tax Services

The AICPA Statement on Standard for Tax Services also gives insight into the CPA’s responsibilities when taking on new clients.  (SSTS)  no.  6, Knowledge  of  Error:  Return Preparation and Administrative Proceedings states that when the CPA has a reason to believe that a taxpayer may be charged with any type of fraud or criminal violation, the client should be advised to consult with a tax attorney before speaking to the CPA in regard to the matter at hand. The CPA should also consider whether he is still able to represent the client in any role, or whether he should withdraw entirely from the relationship with the client.

The CPA should be aware of the fact that he or she could be subject to an investigative summons or grand jury subpoena as to any communication between him or herself and a client in a criminal context. Therefore, when the CPA is faced with a situation where a client has unfiled tax returns in years where they earned reportable amounts of income or  where the CPA has identified intentional client errors on previously filed tax returns, the CPA should urged the client to speak with a tax attorney before proceeding with providing additional services.

Basic Criminal Tax Violations

Both federal and state taxing authorities can bring both felony and misdemeanor tax charges against a CPA’s client, the most common of which include tax evasion, failure to file a return or pay tax and filing a false return.  The IRS also prosecutes taxpayers under the Federal Criminal Code on charges such as presenting false claims to the government, conspiracy, and making false statements.

In order for the federal government to prevail in a criminal prosecution, they must prove each element of an accused tax crime beyond a reasonable doubt. Moreover, the Government must bring the action within the appropriate statute of limitations for prosecution which range from three years to six years under the internal revenue code and within five years for crimes prosecuted under the Federal Criminal Code.

To complicate matters further, individuals can be convicted of committing a tax crime with regards to another person’s or entities tax liability, like for example, where a corporate officer falsifies the associated corporate returns. Corporations and other legal entities such as Estates, LLC and Partnerships may also be prosecuted.

Lastly, CPA’s should be aware of their own potential liability for tax crimes in preparing returns such as aiding and abetting the commission of an offense or conspiracy to commit tax evasion.

Tax Crimes Synopsis

A taxpayer can be simultaneously charged with a greater offense and with a lesser included offense within the legal definition of the greater offense (which often carries a lower burden of proof), and can be convicted of either individual charge, or both charges, although the law does not allow for consecutive sentences where a defendant is convicted of both the greater and the lesser included offenses. A single action on the part of a taxpayer may constitute a violation of several criminal tax statutes. When both criminal and civil remedies are available to the government, it has the discretion to pursue either criminal remedies, civil remedies or both under the law.  The  IRS  will  not  rule  in  advance  (private  letter  ruling)  on  whether  a  proposed transaction would subject a taxpayer to a criminal penalty.

  • A defendant can be convicted of attempting to evade tax if, a tax deficiency can be proven to exist between the return at issue and the correct amount of tax as proven by the government, the government can prove that the defendant took affirmative actions in an attempt to evade or defeat the correct amount of tax and the defendant acted willfully.
  • A defendant who is required to file a return and who willfully fails to file the return by the due date (or extended due date) can be convicted of failure to file a return.
  • A defendant who is required by law to pay tax and who willfully fails to pay the tax as it becomes due can be convicted of failure to pay tax.
  • A defendant can be convicted of making and subscribing a false return or other document if it can be proven that they willfully made and subscribed a return, the return contained a statement or included another document that included a statement that it is made under the penalties of perjury, and it can be proven that the defendant did not believe that the document was true and correct as to every material matter at the time of signature. Tax Preparers can also be convicted of the same crime if it can be proven that they aided or assisted in the preparation or presentation of a false return or other docum This creates an inherent conflict of interest between the tax preparer and the defendant taxpayer.
  • Any person who is required to collect, account for and pay over any tax and who willfully fails to do so can be convicted of a felony.
  • It is a crime for an employer to willfully fail to furnish, or to furnish a false or fraudulent, Form W-2, Wage and Tax Statement, to an em
  • Convictions can be obtained under the Federal Criminal Code offenses include aiding and abetting the commission of a substantive offense, presenting the government with false or fraudulent claims, conspiring to commit a substantive offense, making a false statement to the United States or any of its agencies, using the mails to execute a fraudulent scheme, bribery, and forgery. Note: Preparers and promoters are often prosecuted under these code section
  • Other miscellaneous tax crimes include making false statements, falsifying or destroying records or books, concealing property in connection with a compromise or a closing agreement, removing and concealing property that is subject to levy with the intent to evade or defeat tax, interfering with the administration of the internal revenue laws, and making unauthorized disclosures or inspections of returns or return inform
  • Any person who is required to keep any records or supply information and who willfully fails to do so can be convicted of a misdem
  • A person who willfully delivers or discloses to the Treasury Secretary (or his or her delegate) a list, return, account, statement, or other document that the person knows to be fraudulent or false as to any material matter can be convicted of a misdem

Defenses to Tax Crimes Synopsis

Willfulness is defined under the law as a voluntary and intentional violation of a known legal duty and several defenses focus on preventing the government from being able to establish this element.  Defenses  available  to  defeat  the  element  of  willfulness  include  inadvertence, negligence, mistake, uncertain legal duty, reliance on others and diminished mental capacity.

Note: Willfulness is often the easiest element of a tax crime to defeat because the government is basically required to prove to a jury what he defendant’s state of mind was at the time of the complained of offense. The government is usually forced to resort to circumstantial evidence to establish this element.  For this reason the government usually will not prosecute unless a pattern of complained of behavior can be established. The existence of the pattern itself tends to indicate to a jury that the behavior was intentional and willful rather than mere negligence for example. This is the reason that three years are often at issue in a criminal investigation.

Defenses commonly used in defending tax crimes by Tax Attorneys typically focus on the protecting   the   client’s   fifth   amendment   privilege   against   self-incrimination   and   fourth amendment privilege against unreasonable searches and seizures.

A Taxpayer’s lack of education and personal difficulties such as health, advanced age or family problems generally are not considered defenses per se but may be used to attempt to discourage prosecution as they might make it harder to convince a jury to convict by creating sympathy for the defendant.

Vicarious Liability Involving Corporations and Other Entities

Although most tax crimes involve a taxpayer’s own tax liability, a defendant may have vicarious criminal liability concerning actions he or she has taken regarding another person or entity’s tax liability in a multitude of ways. Through the legal concept of vicarious liability, a corporate officer, director or employee could possibly be accused and convicted of attempted evasion of the related corporation’s taxes. A corporations’ attorney or CPA could possibly be convicted of attempted evasion of their client’s taxes through vicarious liability as well. Similarly through the doctrine  of  vicarious  liability,  it  is  a  crime  to  willfully  subscribe  false  documents  and accordingly, third party individuals are occasionally convicted for signing false documents relating to the tax liability of others, for example where a tax preparer knowingly signs a false return prepared for his or her client.

Another source of vicarious liability for third parties is the general federal aiding and abetting statute. This statute makes any person who aids or abets another person or entity in the commission of a federal offense subject to punishment as a principal. For the Government to impose aiding and abetting liability on a third party, it will be required to prove that third party defendant affirmatively assisted another person or entity to commit a federal crime and that they shared the criminal intent with the person or entity they acted on behalf of to commit the criminal offense. For example, a corporate officer may be criminally convicted of a corporation’s willful failure to pay trust fund taxes. In many of the situations where a charge of aiding and abetting is appropriate, the government can also charge third parties with the general federal conspiracy statute, for entering into an agreement with another person or entity to commit a federal crime.

Under Federal Law, the term “person”, which is used to describe corporations and other legal entities, is deemed to include corporate officers, partners, members, and even may include employees who have a duty to perform an act for their related corporation or entity for which a criminal violation occurs because the act does not occur as required. The government typically uses this definition of “person” in charging crimes involving a failure to act against third parties. For example, the president and sole operating officer of a corporation is held to be under a legal duty to file the related corporation’s tax returns and thus may be criminally prosecuted for failing to file those returns. In summary, a “person” includes an individual, a trust, an estate, a partnership, an association, a company or a corporation. Of course, corporations and other legal entities may themselves be subject to prosecution for tax crimes. Corporations or other entities are held liable for the criminal acts of its employees and owners if the criminal act is done on its behalf and the criminal act was within the scope of the employee’s or owner’s authority. For example, a corporation can be convicted of filing a false return where its president and majority owner deliberately caused it to file a false return, even though the individual employee who signed the return was unaware of the return’s falsity. Moreover, even though a partnership is not subject to income tax at the entity level, it can still be subject to criminal prosecution at the entity level for crimes committed on its behalf by its owner’s and employee’s such as attempted evasion or failure to file.

Aiding and Abetting a Criminal Tax Violation and the Associated CPA

Several crimes set forth in the Federal Criminal Code can apply to CPAs in their capacity as tax preparers, advisors and representatives of clients. They most commonly charged include aiding and abetting, presenting a false, fictitious, or fraudulent claim to the government, conspiracy, making false statements to a U.S. agency, mail fraud, bribery, and forgery.

In practice, the aiding and abetting violations has historically been charged against persons who have aided and assisted another in tax evasion by concealing another person’s sources of income or assets, such as CPA’s.

Elements of the Offense

To prevail in bringing a charge under the federal aiding and abetting statute, the government must prove beyond a reasonable doubt that:

  • A substantive criminal offense was committed
  • The defendant, by affirmative conduct, participated in, counseled, or assisted in the commission of the substantive offense
  • The defendant shared with the principal the criminal intent to commit the substantive offense.

Any person who aids or abets the commission of a substantive federal offense is punishable as a principal in the underlying substantive federal offense. The principal who was aided and abetted does not need to be identified or convicted for the government to convict the party accused of aiding and abetting. Moreover, an outright acquittal of the principal will not bar the prosecution of the aider and abettor.

An accused must associate themselves in some manner with a criminal venture to be convicted of aiding and abetting the commission of an offense. Additionally they must participate in the criminal venture in a manner that demonstrates that it is something that they wish to bring about and seek by their actions to make succeed. However, the aider and abettor need not perform the substantive offense nor even know its details to be convicted. Moreover, the aider and abettor need not have been present when the offense was committed. To prevail in bringing an action for aiding and abetting, the government need only show that the defendant intentionally assisted in the commission of a specific crime in some substantial manor. For example, convictions for aiding and abetting have been secured against individuals who advised others to file false Form W-4 – Employee’s Withholding Allowance Certificates.

Because the aiding and abetting statute does not create a separate offense, the applicable statute of limitations for bringing an aiding and abetting charge is the same as that of the underlying substantive crime that is of issue.

False, Fictitious, or Fraudulent Claims

It is a felony to present to the government a false, fictitious, or fraudulent claim, which on occasion involves a CPA where a taxpayer submits a false claim for refund of taxes. This crime is punishable by imprisonment of up to five years, a fine of up to $10,000, or both.

This statute has been applied to:

  • a defendant who filed an income tax return falsely claiming a refund based on backdated documents
  • a defendant who filed duplicate returns, one in his name and one in a fictitious name
  • a defendant who filed returns claiming refunds in the names of other persons but using his own address

 Elements of the Offense

 For the government to secure a conviction for the presentation of a false claim, it must prove beyond a reasonable doubt that:

  • The defendant made or presented a claim for money or property to a department or agency of the United States Government;
  • The claim was false, fictitious, or fraudulent;
  • The defendant knew that the claim was false, fictitious, or fraudulent at the time presented.

The statute of limitations for prosecution for making a false claim to the government is five years. 

Conspiracy

It is a felony to conspire with another to commit a crime. Conspiracy is much more likely to be charged when the complained of charge is against the United States. Conspiracy in the tax world is usually found where an agreement by two or more people if formed to commit an offense against, or to defraud, the United States usually involving income tax evasion or a false refund claim. Conspiracy is chargeable as a felony or a misdemeanor depending on whether the underlying criminal objective of the conspiracy is punishable as a felony or as a misdemeanor. If the underlying criminal objective of the conspiracy is a felony, conviction for conspiracy is punishable by imprisonment for up to five years and a fine of up to $10,000. If the underlying criminal objective of the conspiracy is punishable as a misdemeanor, conviction for conspiracy is punishable to the same extent as is the underlying misdemeanor criminal objective. In both felony and misdemeanor cases, greater fines may be imposed under the alternative maximum fine provisions.

Case law in this area shows the charges for conspiracy to defraud the United States have been use to attack agreements to impede, impair, obstruct, or defeat the lawful functions of governmental agencies such as the IRS. The IRS has used conspiracy charges surrounding attempts to impede and or impair the IRS in the lawful assessment or collection of revenue as a weapon in complex tax prosecutions typically involving corporations, abusive tax shelters and money-laundering schemes.

Elements of the Offense

For the government to earn a conviction for conspiracy it must prove beyond a reasonable doubt that:

  • Two or more persons made an agreement
  • The substance of the agreement was to commit an offense against the United States or to defraud the United States
  • One or more of the conspirators committed an overt act in furtherance of the agreem

A six-year statute of limitations applies to offenses arising under the conspiracy provisions of the Federal Code.

Agreement between Two or More Persons

The agreement to violate the law does not have to be reduced to an express or formal agreement. Convictions have occurred where nothing more than a mere tacit understanding was able to be inferred from the apparent concert of action by two or more persons which evidenced a single design to accomplish a common criminal purpose. However, evidence presented by the government must be sufficient to show beyond a reasonable doubt that the conspirators had reached a mutual understanding involving the essential nature of the criminal plan. In the Tax arena for example, all that must be shown in a conspiracy to evade taxes case, is that the defendant knew of the conspiracy to evade taxes and knowingly participated in it. Moreover, the government is not required to establish that the conspirators agreed to the details of the plan for which the conviction was charged.

A corporation as a legal person can also be charged with conspiracy. Courts have held that a corporation may conspire with its officers or with its employees. Husband and Wife may also be found guilty of conspiring together against the United States.

The underlying substantive offense and the conspiracy to commit that offense are two separate and distinct offenses. Thus a person may be charged with both the commission of the underlying offense and with conspiracy to commit the underlying offense.  Moreover, a conspiracy to commit an offense may be established even when the underlying substantive offense was not actually accomplished. Aiding and abetting the commission of an offense.

Filing a False Return and the Associated CPA

The CPA should be aware that filing a false return could lead to criminal prosecution of both the client and the CPA. The CPA should also be aware that client’s will often time try to point the blame at the preparer when the client faces the mere possibility prosecution as occurs during an audit of the false return. CPA’s should be mindful when preparing returns to withdraw from representation when there is evidence that the client is not being truthful such as where the client’s books have been purposefully manipulated to understate income or where extensive, unnecessary and unexplained use of cash has been made. 

Case Law Examples:

  • The 6th circuit held that a CPA was guilty of the crime of filing false returns when he set up S-Corporations and Partnerships (which is the unauthorized practice of law by the way) that owned his client’s personal residences by which the client’s claimed personal living expenses as business deductions.
  • The S. Tax Court held that a preparer who overstated income to assist a client in obtaining an SBA-guaranteed loan was subject to prosecution for filing a false return.

To successfully prosecute a violation of the aiding or assisting provisions for aiding or assisting another to file a false form by a CPA, the government must prove beyond a reasonable doubt that;

  • The defendant CPA aided, assisted, procured, counseled, or advised the preparation or presentation of a document
  • The document was false as to a material matter
  • The defendant CPA acted willf

Charges under this provision have historically been brought against accountants, bookers and an entity’s employees who prepare or assist in the preparation of false tax returns. However, the statute is not limited solely to the direct preparation of a tax return but is much broader in that the statute reaches any intentional conduct that contributes to the presentation of a false document to the IRS.

To be charged under these provisions the accused need only assist in the preparation of, and need not sign or file the actual false document. The statute has thus been applied to individuals who communicate false information to their return preparers, thereby causing the tax preparer to file a false return. On the other hand, the statute specifically provides that the taxpayer who signs and files the return or document need not know of, or consent to, the false statement for the aiding and abetting statue to be brought against the preparer. For example, a tax preparer who inflates deductions, understates income or claims false credits on a client’s return may be charged with aiding and abetting even if the taxpayer for whom the return is prepared is unaware of the falsity of the return he signed and filed. Moreover, a tax preparer who utilizes information provided by a client that the preparer knows to be false in the preparation of a return can be criminally charged with assisting in the preparation of a false return.

False as to Material Matter:

The courts that have ruled on what constitutes a material matter have held materiality to be a matter of law to be decided by the court and not a factual issue to be decided by the jury.

Willfulness:

To establish willfulness in the delivery or disclosure of a false document, the government need only show that the accused knew that the law required a truthful document to be submitted and that he or she intentionally violated the duty to be truthful. The crime of aiding or assisting in the preparation or presentation of a false return or document requires that the defendant’s actions be willful in that the defendant knew or believed that his or her actions were likely to lead to the filing of a false return. The Ninth Circuit (the appeals court for Southern California and thus controlling precedent) has held that the government must prove not only that the accused knew that the conduct would result in a false return, but must additionally establish that tax fraud was in fact the objective of the allegedly criminal conduct.

Statute of Limitations:

The statute of limitations for the crime of aiding or assisting the preparation or presentation of a false return or other document is six years. The statute of limitations for charges involving delivery or disclosure of a false document starts to run from the date the document is disclosed or submitted to the IRS.

How to Help Your Clients Avoid Possible Criminal Tax Prosecution

In a Criminal tax context, the CPA should be very diligent that the client does not share any information with the CPA in regards to possible criminal actions. The CPA should use zeal in order to make sure that the client does not put the CPA in a position where he or she can be a possible witness against the client. The client should be told to discuss the matter with a tax attorney at the first possibility of a fact pattern that indicates criminal tax exposure.

As  a  preparer,  the  CPA  can  help  clients  avoid  criminal  tax  prosecution  by  knowing  the procedures that the IRS uses to prosecute taxpayers. The majority of criminal tax investigations start as regular audits of returns in which the Examiner discovers possible taxpayer fraud.

The Internal Revenue Manual instructs IRS personnel on how to identify indicia of fraud during routine examinations. See IRM Part 25. The IRM instructs the agent to look for signs such as taxpayer or representative procrastination, uncooperative attitude, quick agreement to proposed audit adjustments or desire to immediately closing the case. Many other indicia of fraud, commonly called “badges of fraud” are identified in the IRM. Any one or a combination of these “badges of fraud” may then be interpreted as indicia of fraud and subject the taxpayer to a potential fraud investigation.

Once a Revenue Agent decides that there is a high indication that fraud is involved in a civil examination, they will ordinarily contact employees within the IRS called Fraud Referral Specialists. The Fraud Referral Specialist’s job is to determine whether this is solely a civil issue in a given examination, or whether the case should be referred to the Criminal Investigation Division for development for possible criminal prosecution. In the past, a Revenue Agent would suspend the audit without telling the taxpayer or the CPA the reason for the sudden and unexplained suspension. This made the seasoned and enlightened CPA’s job easy since the CPA would recognize the tell-tale signs that his client’s audit most likely has gone criminal. The seasoned and enlightened CPA would then consider withdrawing from the representation and refer their client to consult with a reputable criminal tax attorney.

However, in 2009, the IRS changed their fraud procedures in a very quiet manner by not publicizing the change and by instituting the use of parallel criminal investigations while the civil audit is still ongoing creating a dangerous scenario for both the CPA and his or her client. The Revenue Agents are instructed not to tell the taxpayer, or his representative that a criminal investigation has started or is ongoing. These types of audits are commonly called “eggshell audits” in the Tax Controversy Representation legal community.

This change in policy obviously makes the CPA’s representation in an audit much more critical in minimizing his or her client’s criminal exposure and thus creates much more malpractice exposure for the CPA. The CPA, now, more than ever, needs to be very diligent in regards to being cognizant of the additional risks faced by his or her client in light of this policy change. CPAs should investigate for any issues in a client’s fact pattern that could turn criminal prior to the outset of a routine civil audit. If indicia of fraud is detected the CPA should advise the client of the possibility that the issue may silently turn criminal during the civil examination and advise the client to consult with a tax attorney.  It is also advisable that the CPA seek the counsel of an experienced tax attorney themselves about whether or not it is a good idea to continue representation in light of all the facts of the particular case especially where the client refused to seek legal counsel.

Teaming up With a Tax Attorney to Solve a Current or Potential Client’s Criminal Tax Issues.

The CPA can play a major an invaluable role in helping a client avoid criminal conviction by entering into a Kovel Agreement with a Tax Attorney in appropriate circumstances. The 2nd  Circuit case US v. Kovel established that a CPAs communication with a client and work product can fall under the attorney-client and work product privileges where the attorney, hires the CPA, rather than the CPA being hired directly by the client. In Kovel, the accountant in questions was actually a former IRS agent, and he was hired by a law firm to advise the law firm’s clients. The clients were under IRS criminal investigation. The IRS subpoenaed Mr. Kovel to testify against the law firms clients. Mr. Kovel rightfully refused to respond to questioning claiming that the communications he had with the Law Firm clients were privileged but he was wrongfully sentenced to a year in prison for his refusal. The 2nd circuit then overturned the decision, and established the current precedent that and accountant’s communications are privileged, if he or she is hired by an Attorney.

A Kovel agreement will generally protect communications and work papers not used in the production of the tax or information returns at issue before a court of law from discovery though IRS summons enforcement or at trial, since the communications and work papers fall under the attorney client privilege and work product doctrine.

Kovel has been under attack and has been somewhat limited through subsequent challenges by the IRS. In US v. Adlman, the court held that the work product protection of Kovel only applies to materials prepared by the CPA in anticipation of litigation. In Adlman, the corporation’s accountant prepared a study for the entity’s attorney that assessed what the outcome would be in the event of litigation in the event the IRS ever audited the company. The trial court concluded that the main purpose of the report was not made in anticipation of litigation and thus the report was not privileged.

The court of appeals vacated and remanded the trial court’s decision, and stated that the documents included “mental impressions, conclusions, opinions and theories” and that it did not lose its work product privilege protection just because it was prepared primarily to support future business decisions. The appeals court held that because the study evaluated the tax implications surrounding a large net operating loss which would have resulted in a large tax refund, litigation with the IRS was almost a certainty.

The 2nd circuit, however, created precedent in Adlman that creates a window where the IRS might possibly undermine Kovel where the IRS is able to make a showing to the court that the document it is attempting to discover is otherwise unavailable.

In the Kovel setting, the CPA is able to provide valuable services to the attorney in anticipation of any possible litigation including the possibility of a criminal prosecution of the attorney and CPAs common client.

Voluntary Disclosures

Another way in which the CPA and Attorney can team up is in making voluntary disclosures to the IRS on behalf of a common client.  You will know when you have a voluntary disclosure opportunity where the client will come into your office, state that he or she has cheated on their taxes but now they can’t sleep at night and want your advice on what to do about it.  Again resist the urge of drilling down into the facts until retained by a Tax Attorney and make the referral. You can explain the basic process to your client however in anticipation of teaming with a Tax Attorney to fix the problem should the attorney deem it advisable to use your services in doing so.  However, remember that pre Kovel communications are not privileged and this presents exposure to your client and possibly yourself.

A voluntary disclosure is a process whereby the client’s tax attorney basically knocks on the door of the IRS Criminal Investigation Division and states something to the effect as this:  I’m bringing in a tax cheat.  The tax cheat is willing to correct their previous behavior by amending previously filed fraudulent tax filings and make payment, or arrangements to pay, of the additional tax interest and penalties owed in exchange for the IRS passing on criminal prosecution.

Historically, between 1934 and 1952, the IRS had a written policy of refraining from prosecuting taxpayers who made a voluntary disclosure. Today, that written policy has changed so that a taxpayer’s voluntary disclosure is a factor that is heavily weighted in a facts-and-circumstances evaluation of whether or not to prosecute, but the actual of practice of the IRS is quite similar to its past written policy.

Adapted from my website: http://www.klasing-associates.com/Tax-Law/Tax-Evasion-Fraud- Representation.shtml

The IRS’s behavior is indicative of its true policy. Since 1952, the IRS has only decided to prosecute a handful of cases after a receiving a taxpayer’s valid voluntary disclosure. Because of the IRS’s previous written policy and the IRS’s lack of prosecution of valid voluntary disclosure cases; many tax attorneys are generally convinced that the IRS has an unwritten de facto disclosure policy of refraining from prosecution.

The IRS’s unwritten policy can be seen from its behavior, specifically, its decision to decline prosecution. One court admits, “there appears to have been few, if any, prosecutions of true voluntary disclosures [by] the IRS.” United States v. Hebel, 668 F.2d 995, 998 (8th Cir. 1982).

Indeed, the IRS’s conduct seems to show that it will prosecute after a voluntary disclosure only when extraordinary facts and circumstances are present. A number of tax scholars agree: “[T]he practice  of  the  IRS  has  been  that  it  will  not  prosecute  taxpayers  who  satisfy  all  of  the requirements of the voluntary disclosure program because, if it did initiate such prosecutions, no taxpayers ever would be willing to make a voluntary disclosure in the future.” New York University Annual Institute on Federal Taxation § 27.06 (2010).

Thus, even though the IRS’s official, written position is to leave the door open to pursuing criminal prosecution after a voluntary disclosure, it is unlikely it will do so.

Voluntary disclosures typically occurs in two situations:

(a) The taxpayer’s wrongdoing is disclosed to his attorney or accountant because he wants to set matters straight; or

(b) The taxpayer discloses his wrongdoing to an attorney or accountant after he has been personally contacted by the IRS.

Generally, if a taxpayer has not been contacted by the IRS, or is not currently under audit, examination, or investigation, it is not likely he will be prosecuted after a voluntary disclosure – unless the IRS disputes the voluntary disclosure, or the IRS believes the taxpayer has engaged in an illicit income-producing activity (or is a threat to the voluntary assessment system, where the taxpayer is deemed a tax protester).

Note: The decision whether or not to make a voluntary disclosure to the IRS is not a simple one and should never be made without the counsel of an experienced tax attorney.

The following bolded content is the actual language of the IRS’s Voluntary Disclosure Practice:

It is currently the practice of the IRS that a voluntary disclosure will be considered along with all other factors in the investigation in determining whether criminal prosecution will be recommended. This voluntary disclosure practice creates no substantive or procedural rights for taxpayers, but rather is a matter of internal IRS practice, provided solely for guidance to IRS personnel. Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution.

A voluntary disclosure will not automatically guarantee immunity from prosecution; however, a voluntary disclosure may result in prosecution not being recommended. This practice does not apply to taxpayers with illegal source income.

A voluntary disclosure occurs when the communication is truthful, timely, complete, and when:

  1. The taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his or her correct tax liability; and
  2. The taxpayer makes good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable.

 A disclosure is timely if it is received before:

  1. The IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation;
  2. The IRS  has  received  information  from  a  third  party  (e.g.,  informant,  other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance;
  3. The IRS has initiated a civil examination or criminal investigation which is directly related to the specific liability of the taxpayer; or
  4. The IRS  has  acquired  information  directly  related  to  the  specific  liability  of  the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena).

Any taxpayer who contacts the IRS in person or through a representative regarding voluntary disclosure will be directed to Criminal Investigation for evaluation of the disclosure. Special agents are encouraged to consult Area Counsel, Criminal Tax on voluntary disclosure issues.

Examples of voluntary disclosures include:

A letter from an attorney which encloses amended returns from a client which are complete and accurate (reporting legal source income omitted from the original returns), which offers to pay the tax, interest, and any penalties determined by the IRS to be applicable in full and which meets the timeliness standard set forth above. 

A disclosure made by an individual who has not filed tax returns after the individual has received a notice stating that the IRS has no record of receiving a return for a particular year and inquiring into whether the taxpayer filed a return for that year. The individual files complete and accurate returns and makes arrangements with the IRS to pay the tax, interest, and any penalties determined by the IRS to be applicable in full. This is a voluntary disclosure because the IRS has not yet commenced an examination or investigation of the taxpayer or notified the taxpayer of its intent to do so and because all other elements of (3), above, are met. 

It has been our experience that taxpayers who have in many times blatantly and knowingly violated the tax laws, are none the less able to effectively avoid prosecution by self-reporting their prior tax violations to the IRS before the IRS has had the opportunity to begin an investigation by taking advantage of the IRS Voluntary Disclosure Program for domestic or international issues.

Making the Disclosure (Loud versus Quiet)

Currently in the legal profession there are two main schools of thought (and considerable controversy) regarding how to go about making a voluntary disclosure. The first school of thought is that it should be done “quietly” by sending in delinquent original or amended prior tax returns, with a check(s) in full payment through normal channels and gambling that the returns get processed without the taxpayer every hearing from the Criminal Investigation Division of the IRS because of the sheer volume of returns the taxing authority processes. Many Tax Attorneys prefer and thus direct their clients toward this method because in their opinion this method decreases the likelihood that the delinquent original or amended returns will be audited upon submission and avoidance of a perceived negative impact on a taxpayer’s ongoing reputation with the affected taxing authorities which occurs where a taxpayer makes a loud disclosure by knocking on the door of the criminal investigation division and makes the required “loud” admission of the fraudulent activity that is to be corrected.

Our office generally prefers “loud” disclosure over “quite” disclosures because if a taxing authority has begun an investigation prior to receipt of the “quiet” submission the “quite” disclosure will not be deemed to be voluntary and thus will not comply with its Voluntary Disclosure Practice. To make matters exponentially worse, the amended return could potentially be viewed as a criminal admission of the amount by which the tax liability was understated on the original return. Thus the amended returns intended to mitigate the client’s criminal exposure can be used by the IRS to meet its burden of proof as to willfulness (which is by far the hardest element of its case to prove) if it decides to prosecute. Additionally there is some support for a growing government position stemming from the 2009 and 2011 Offshore Voluntary Disclosure Initiatives that a quiet disclosure does not comply with the terms of its Voluntary Disclosure Practice because a quite disclosure bypasses the required communication with the Criminal Investigation Division of the IRS and only the Criminal Investigation Division of the IRS can recommend  that  the  taxpayer  not  be  referred  to  the  Justice  Department  for  Criminal Investigation.

The most common way the government establishes the element of willfulness is to subpoena the original tax preparer, or subsequent non attorney tax adviser, to testify regarding the client’s conversations. Many taxpayers mistakenly believe that the communication privilege they enjoy surrounding communications with their CPAs and enrolled agents can be asserted in a criminal matter. Once an attorney has been engaged, the attorney can engage an accountant to assist him in the calculation of the correct tax under a “Kovel letter” in order to bring the client’s communications with the accountant within the umbrella of the attorney client privilege.

Once again, the CPA’s first responsibility will be to tell the client to not discuss the matter with the CPA, and consult a tax attorney. Although the purpose of the voluntary disclosure is to prevent cases from becoming criminal, a tax attorney needs to be consulted for various reasons. First, the attorney will need to identify whether the client is eligible for a voluntary disclosure. The attorney needs to contact the IRS with the client’s information and do a “pre-check” to see whether the client can enter the voluntary disclosure process. If the client is accepted in the pre-check stage, the voluntary disclosure can begin. If the client is not accepted, it may mean that a criminal investigation has already begun.

In the voluntary disclosure process, the attorney will use the services of the CPA to amend all false and incorrect previous returns and submit these returns with the extra income, and the penalty calculations associated with the disclosure to the IRS.

Criminal Tax reference tools for CPA’s.

The following are just a number of good reference tools for further reading on criminal tax issues:

  • Criminal Tax Fraud by George Crowley
  • BNA portfolio on Tax Crimes by Hochman, Perez, Popoff Rettig and Tosc
  • BNA Treatise on Criminal Tax, Money Laundering and Bank Secrecy Act Litigation by Peter Hardy.
  • Tax Fraud  &  Evasion:  Money  Laundering,  Asset  Forfeiture,  Sentencing  by  Harris,  Feld, Comi
  • IRS Criminal Tax Bulletin, published Semi-Annually by Office of Chief Counsel Criminal Tax
  • Client Criminal Matters and the CPA: AICPA Practice Guide by JAMES H. SCHLESSER, CPA
  • Strategies for Criminal Tax Cases: Leading Lawyers on Navigating Tax Law, Understanding Disclosure Guidelines, and Responding to Government Investigations, by Brian Andreoli and Caroline Ciraolo
  • Tax Crimes by John Townsend, Larry Capagna et al.
  • Representation in Criminal Tax Matters, a practical guide by Cary Martinez 

California Tax Crimes and Tax Enforcement.

California has very similar statutes regarding tax crimes as the Federal Government. In addition, in California there are some statutes which also makes it a misdemeanor for failure to file or pay, or  file  a  false  or  fraudulent  return,  even  without  a  showing  of  intent  or  willfulness.  Thus California has a strict liability statute where a defendant can be convicted for failure to file, regardless of his intent.

The Franchise Tax Board has in recent years stepped up their criminal investigation section. The criminal investigation section states their mission as being to:

  • Identify, investigate,  and  effect  prosecution  of  tax  evasion,  fraud,  and  employee mi
  • Encourage compliance with the California income tax laws.
  • Maintain the public’s trust through publicity.

The FTB currently has 42 special agents working in the criminal investigation division.

They maintain case inventories consisting of failure to file, and false income tax return cases; refund fraud cases, and joint task force operation cases. Joint task force operation cases can involve local, state, and/or federal agencies. Crimes typically investigated and prosecuted with income tax violations include identity theft, embezzlement, grand theft, money laundering, workers’ compensation insurance fraud, employment taxes and labor crimes, medical fraud, and “capping.” Capping is soliciting business for another, and becomes a crime when the business objectives include fraud and deception (recruiting patients for unnecessary medical procedures, for example).

The FTB states that the Special Agents perform most of the duties associated with a “peace officer” role. They write and serve search warrants, gather and analyze evidence, interview witnesses, interrogate suspects, make recommendations to prosecute, serve arrest warrants, assist prosecutors through all stages of the prosecution, track and apprehend fugitives, and monitor terms of probation.

While the FTB Special Agent force is currently relatively small, the FTB has showed intent to pursue criminal matters with vigor. I have had clients come into my office that was part of an FTB sting operation. More than 20 special agents with guns drawn showed up at my client’s home and business simultaneously, for failure to file tax returns.  They also visited the client’s CPA at the same time… 

Examples of Taxpayers that ended up on the Wrong Side of Criminal Tax Law and How They Were Punished.

IRS Criminal Investigations usually lead to criminal tax convictions. Below are some recent statistics:

FY 2011 FY 2010 FY 2009
Investigations Initiated 4720 4706 4121
Prosecution Recommendations 3410 3034 2570
Information/Indictments 2998 2645 2335
Total Convictions 2350 2184 2105
Total Sentenced* 2206 2172 2229
Percent to Prison 81.7% 81.5% 81.2%

 

Sentence  includes  confinement to federal prison, halfway house, home detention, or  some combination thereof.

The IRS often prosecutes high profile taxpayers in order to send a message to all citizens that the IRS will prosecute tax crimes.

Recent Examples of Tax Practitioners That Were Prosecuted and What They did wrong.

 The following examples of abusive return preparer investigations are taken from public records consisting of court records in the judicial district in which the cases were prosecuted.

Two CPAs Sentenced in Tax Shelter Case

Chied U.S. District Court Judge John C. Coughenour has sentenced two Anderson’s Ark & Associates (AAA) accountants for aiding and assisting in the preparation and filing of fraudulent income tax returns.

 Tara LaGrand, of Naples, Florida, was sentenced to 24 months in prison, to be followed by one year of supervised release. Lynden Bridges, of Wheat Ridge, Colorado, was sentenced to 18 months in prison, to be followed by one year of supervised release.

LeGrand and Bridges, each a Certified Public Accountant, were part of AAA, an organization through which fraudulent tax shelters and investment scams were promoted and sold. From 1996 through 2001, AAA had approximately 1,500 clients, nearly 300 of whom reported over $120 million in fraudulent income tax deductions.

California Return Preparer Sentenced for Defrauding IRS of Nearly $8 Million

On April 24, 2012, in Los Angeles, Calif., Mario Placencia, an accountant and tax return preparer, was sentenced to 60 months in prison and ordered to pay $1,213,789 in restitution to the Internal Revenue Service (IRS).  Placencia pleaded guilty in July 2011 to two counts of aiding and assisting in the preparation of fraudulent tax returns and one count of submitting false documents to the IRS in an attempt to substantiate the false deductions taken on tax returns.  According to the plea agreement, for the tax years 2003 through 2009, Placencia admitted that he caused the government to incur a tax loss of $7,982,043 by intentionally inflating the amounts of home mortgage interest that he reported on his clients’ federal income tax returns.  Some of Placencia’s clients received notices of audits for the 2004, 2005, and 2006 tax years.  During the audits, Placencia provided the IRS with false documents to convince auditors that the clients had incurred expenses that he knew the clients had not incurred and were entitled to deductions that Placencia knew had been fabricated.

Former Partner at Major International Accounting Firm Sentenced for Tax Crimes

On April 16, 2012, in Newark, N.J., Stephen A. Favato, of Point Pleasant Beach, N.J., was sentenced to 18 months in prison for tax crimes. Favato was convicted in August 2010 by a jury of one count of corruptly endeavoring to obstruct and impede the Internal Revenue laws and one count of aiding and assisting in the preparation and filing of a false income tax return.  Trial evidence proved that from late 2001 through April 2005, Favato attempted to obstruct the IRS by, among other conduct, advising his client on how to include false items on the   2002,   2003   and   2004   joint   income   tax   returns   for   the   client   and   his   then- wife.  Additionally, Favato knowingly prepared and signed false joint income tax returns for the client resulting in an over $114,000 tax loss to the IRS for 2002 and attempting to cause an  over  $70,000  tax  loss  for  tax  years  2003  and  2004.  Favato advised the client to significantly reduce his salary payments from his corporation and to instead have this compensation paid to a limited liability company, Great Escape Yachts LLC, in the form of purported lease payments for the client’s yacht.  However, his corporation had not leased the yacht.  This course of action enabled the client to fraudulently deduct his personal yacht expenses as business expenses.  In addition, Favato advised the client on how to falsely increase his expenses to fraudulently eliminate a portion of the gain on three properties he sold in 2002 and 2004.  Favato also advised the client to report inflated charitable contributions on his 2003 tax return.

 California Tax Preparer Sentenced for Presenting False Income Tax Returns

On February 6, 2012, in Fresno, Calif., Bertha Renell Vaughn, aka Bertha Renell Milton, of Bakersfield, was  sentenced  to  30  months  in prison,  one  year  of  supervised  release,  and ordered  to  pay  more  than  $1  million  in  restitution  to  the  Internal  Revenue  Service (IRS).  Vaughn pleaded guilty in November 2011 to aiding and assisting in the presentation of false income tax returns.  According to court documents, Vaughn owned and operated a tax preparation   business,   Nationwide   Tax   Solution,   also   referred   to   as   Vaughn’s   Tax Service.  Vaughn willfully prepared the false income tax returns by adding false items in the return, such as deductions, losses, income, wages, and withholdings. The added items were not claimed by the taxpayers, but were fabricated and created by Vaughn. The more complicated the return, the more Vaughn charged in professional fees to her clients. Vaughn added the false items on the tax return to have the IRS generate a refund to the taxpayer and to charge her clients the higher fees. Documents filed with the court showed that over 90 percent of the taxpayers using Vaughn’s services received a tax refund from the IRS. 

California Tax Return Preparer Sentenced for Filing Fraudulent Tax Returns

On November 28, 2011, in Los Angeles, Calif., Simon Jenkins, owner of Jenkins Tax Service, was sentenced to 15 months in prison, one year of supervised release, and ordered to pay $238,024 in restitution to the Internal Revenue Service (IRS).  Jenkins pleaded guilty in August 2011 to preparing and filing false tax returns.  According to court documents, during the  2005  through  2009  tax  filing  seasons,  Jenkins  prepared  at  least  45  tax  returns  that contained false information by overstating the amount of one or more items claimed on the tax return.  Jenkins prepared tax returns which included false deductions and expenses to obtain larger refunds with the IRS.

 (Excerpts from)

Representation in Connection with an IRS Audit

 By

David W. Klasing Esq. M.S.-Tax CPA

David Warren Klasing

Representation in Connection with an IRS Audit – Do you have to allow your client to be interviewed during an audit?

Overview of authority on point with this issue – Do I have to produce my client?

The investigative tools of an administrative agent are wide and varied. These include the use of informants, surveillance, and sometimes sting operations performed by persons in undercover roles. However, the most effective information  gathering  device  is  the  ability  to  conduct  interviews  and  gather witness statements. The purpose of an initial interview is to obtain an understanding of the taxpayer’s financial history, business operations, and the accounting records. This information is then used to evaluate the accuracy of the books and records and determine the depth and scope of the examination. To facilitate investigations, agents are endowed with the power to issue a summons. A summons is an administrative discovery device similar in intent and reach to a grand jury subpoena, which commands the summoned person to appear, testify, or produce documentary evidence.

 Power and Procedure for a Summons

 Like other investigative tools, the Service may issue a summons for several purposes, among them: 1) determining the correctness of any return; 2) making a return where none has been made; 3) determining the liability of any person for any federal tax; 4) collecting any internal revenue tax; and 5) inquiring into any offense connected with the administrative or enforcement of the tax code. The evidentiary standard for the issuance or enforcement of an administrative summons is lower than in the criminal sense. Principally, the Service needs only to show that the summoned information is relevant and material. In the past summons have been upheld for such items as business records, handwriting samples, videotapes, and computer software.

In the event a summoned party does not submit, it is not within the Service’s power to compel compliance. Rather, the Service must elect whether to request the Department of Justice to bring an enforcement action. Such actions are generally brought in federal district court for the district where the summoned party resides or is found and the burden lies with the Service. An order enforcing or denying the summons is final and appealable. Moreover, at the court’s discretion sanctions may be brought against a party that does not comply with the court’s order. However, it should be noted that a person summoned does not have to wait for an enforcement action to quash the summons.

A summons may target directly the taxpayer whose liability is being investigated or some third party. According to the IRS Restructuring and Reform Act of 1998 the Service may not contact a third party about the determination or collection and a taxpayer’s liability without providing notice to the taxpayer.  A third party administrative summons is typically aimed at financial institutions, employers, and business associates.  It is issued in the ordinary course and must identify the target the taxpayer by name as well as allow sufficient time for the summoned party to gather the requested information. The taxpayer is normally given three days notice after service is made on the third party. Unlike the taxpayer, a third party does not have the right to attempt to quash the third party summons. Rather, the taxpayer has 20 days from the date notice of the third party summons is given to sue in district court to quash the summons and block the third party from disclosing any information to the Service.

Client’s Right to Representation

 IRC §7521(c) permits a representative authorized by a taxpayer to represent him or her at any interview. Generally, the taxpayers’ presence is not required unless an administrative summons has been issued so long as the representative: 1)has first-hand knowledge of the taxpayer’s business, business practice, bookkeeping methods, accounting practices, and the daily operations of the business; 2) provides factual, reliable information to questions asked by the examiner; 3) timely provides follow-up information for any questions that could not be answered at the time of the initial interview; and 4) has properly executed Form 2848 or Form 8821. However, if the examiner concludes that the representative does not have sufficient knowledge or refused to comply, the examiner should request an interview with the person that possesses the information i.e. the taxpayer. For purposes of this section a representative may be an attorney, certified public accountant, enrolled agent, enrolled actuary, or other appointed person by the taxpayer.

At the outset of an interview or audit, Service personnel are required to supply taxpayers with Publication 556, which explains the examination process. Additionally, the agent must inform the taxpayer of his or her rights including the right to seek the advice of a tac professional at any time. If a taxpayer invokes this right the agent must immediately halt the examination and permit the taxpayer counsel. But if the interview is compelled by the court order or pursuant to an administrative summons, the interview will not be suspended. Where an agent or Service employee disregards such provisions a civil suit may be brought under IRC §7433.