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Alain Leibman writes:

We have previously written about the varying sentencing treatment accorded untaken deductions --some courts of appeal have upheld the reduction of tax loss by application of deductions not originally taken on the taxpayer's filed return (thereby reducing sentencing exposure) (see here), while others have rejected the practice (see here). 

An excellent recent post on this subject appears in Jack Townsend''s blog, Federal Tax Crimes.  In it, Mr. Townsend discusses a recent article by Steven Toscher and Dennis Perez in the Journal of Tax Practice and Procedure, concerning a proposed Sentencing Guidelines amendment intended to allow the consideration of previously unclaimed deductions. Defense counsel who represent taxpayers would be well advised both to familiarize themselves with the proposed change and to frequently review Mr. Townsend's blog for the latest developments in the field.

(Alain Leibman, Esq., the author of this entry and a co-author of this blog, is a partner with Fox Rothschild LLP, based in our Princeton, NJ office. A former decorated federal prosecutor, he practices both criminal defense and commercial litigation in federal and state courts)

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Alain Leibman writes:

Generally, the 6-year statute of limitations prescribed by 26 U.S.C. § 6531(2) for tax evasion offenses under 26 U.S.C. § 7201 runs in cases involving a filed, but false, return -- one that underreports income -- from the date the return was filed with the IRS. But the tax evasion statute comprises two types of evasion offenses: evasion of the determination of the correct tax due and evasion of the payment of taxes. In the former case, which goes to the IRS’s assessment function, the filing date of the false return triggers the statute of limitations.

But what of an evasion of payment case, where the allegations focus on steps taken by a taxpayer to evade paying the IRS that which is acknowledged to be owed, and which implicates the IRS’s collection activity? Recently, in United States v. Irby, 703 F.3d 280 (5th Cir. 2012), the Fifth Circuit joined every other court of appeal in holding that in such cases the statute of limitations runs from the later of two event: either the return’s filing date or the date of the last act of evasion. Well after Irby filed the subject return, he was alleged to have used nominee accounts to hide assets from the IRS. The court held that the later use of the nominee accounts delayed the start of the 6-year limitations period, and made his prosecution timely.
 

(Alain Leibman, Esq., the author of this entry and a co-author of this blog, is a partner with Fox Rothschild LLP, based in our Princeton, NJ office. A former decorated federal prosecutor, he practices both criminal defense and commercial litigation in federal and state courts)

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Alain Leibman writes:

In a previous post, we explored the views of the Tenth Circuit, seconded by the Second Circuit, that a sentencing court could reduce the "tax loss" charged against a defendant by crediting him with deductions not taken on the filed but false tax returns. As noted there, the Seventh Circuit held the contrary view that no offsetting deductions could be recognized.

Appellant in a recent Seventh Circuit case cited to the views of the Tenth and Second Circuits in an effort to persuade the former to overrule its precedent on this issue. He was, however, unsuccessful. In United States v. Psihos, 683 F.3d 777 (7th Cir. 2012), the defendant restaurateur pled guilty to several counts of false subscribing based on his understatement of receipts for one of his restaurants. Unfortunately for him, as part of his effort to sell the restaurant, he and his broker provided prospective buyers with records of sales activity which were at odds with his filed returns' report of such activity. IRS agents, posing undercover as prospective buyers, were provided with that discrepant receipt information, which led to searches of the restaurant and of off-site storage locations, all of which yielded a fairly complete second set of books for the restaurant.

Facing sentencing, Psihos argued that the unreported receipts should be offset by amounts he paid in cash payroll, cash transfers to another restaurant, cash payments for food to the other restaurant and so on. Both the trial court and then the Court of Appeals rejected his efforts to reduce the tax loss. The Court of Appeals reaffirmed the correctness of its earlier decision in United States v. Chavin, 316 F.3d 666 (7th Cir. 2002), which held that intended tax loss, and not actual loss to the IRS, was controlling under Section 2T1.1 of the Guidelines, making previously unreported deductions irrelevant. To Psihos's argument that the Tenth and Second Circuits had the better analysis of the relevant Guidelines section, the Court of Appeals pointed out that even if it followed those other courts, Psihos would do no better because he lacked contemporaneous supporting documentation for his proposed deductions, necessary to have them applied to reduce loss. So the keeper of a double set of books was a double loser, either applying existing and reaffirmed Seventh Circuit law or applying more favorable law from other circuits.
 

(Alain Leibman, Esq., the author of this entry and a co-author of this blog, is a partner with Fox Rothschild LLP, based in our Princeton, NJ office. A former decorated federal prosecutor, he practices both criminal defense and commercial litigation in federal and state courts)

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A taxpayer who fails to report income, such as the owner of a retail business who skims cash receipts, is usually charged with, and faces a potential jail sentence based on, the tax loss calculated on the omitted gross income, without regard to any offsetting deductions. For example, a car wash owner who takes in, but does not entirely report, his cash proceeds, faces a sentence based on the amount of that omitted income; he may also have incurred deductible salary expenses when paying his employees with cash and so could arguably reduce the income amount and thereby reduce his exposure to jail. Unfortunately, most courts of appeal take the position that the taxpayer is to be sentenced based solely on the unreported income, without any mitigative effect attributed to the unreported deductions. But the Tenth Circuit recently held that a sentencing court has the discretion to offset the income, and therefore lower the critical tax loss computation, by the deductible expenses related to the unreported receipts.

Section 2T1.1 of the Sentencing Guidelines, in which the amount of the “tax loss” to the IRS drives the sentencing exposure, establishes two alternate rules in calculating that loss in cases involving unreported income by an individual: (a) the court is to calculate the loss at 28% of the unreported gross income, “unless” (b) a “more accurate determination of the tax loss can be made.” If the defendant actually filed a tax return for the year in question, the IRS will typically recalculate the return, using previously-claimed deductions and credits, add back the omitted income and determine the resulting additional tax; in the absence of a filed return, the government usually falls back on the 28% rule. Courts of appeal in the 4th, 5th, 7th, 8th, 9th and 11th Circuits have adopted the position that the defendant only receives the detrimental effect of the omitted income amount, not the corresponding benefit of deductions omitted from the filed return, while the 2nd Circuit takes the contrary view.

In United States v. Hoskins, 2011 WL 3528735 (10th Cir., Aug. 12, 2011), the defendant-owner operated a Utah escort service, which apparently generated a large amount of cash receipts which went unreported, but the owner also paid her escort employees with a portion of that cash. Convicted of evading the payment of taxes on the omitted income, the defendant argued at sentencing that the income figure should be offset by the previously-unclaimed and deductible salary payments, resulting in a lower tax loss and lower sentence under § 2T1.1. Although the district court rejected the defendant’s proposed determination, and applied only the lesser deductions taken on the filed return for that year, it did vary downwards to impose a sentence commensurate with the defendant’s, and not the government’s, loss calculation.

On the defendant’s appeal, a divided panel of the Tenth Circuit held that § 2T1.1 did not prohibit a sentencing court from including new deductions to reduce the taxes due on the omitted income. No error was committed here, because the district court simply found the government’s calculation more credible on the point, and credibility will always be important when claiming cash-payment deductions. However, the principle that deductions, if proven, should be counted is a valuable takeaway. The court did emphasize though, that the defendant could only benefit from deductions related to the offense at issue, such as cash payroll in an omitted cash receipts scheme. “Thus, unclaimed deductions for student loan interest or solar energy credits, for example, are not considered ….” Id. at *6 n.9.

(Alain Leibman, Esq., the author of this entry and a co-author of this blog, is a partner with Fox Rothschild LLP, based in our Princeton, NJ office. A former decorated federal prosecutor, he practices both criminal defense and commercial litigation in federal and state courts)

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A recent post discussed the Third Circuit opinion in United States v. Stadtmauer, 2010 WL 3504321 (3d Cir., Sept. 9, 2010) in the context of its approval of the practice of prosecution witnesses opining about the guilty knowledge of other participants in concerted activity. In addition, the court also addressed another interesting topic, the availability to the government of a willful blindness instruction, sometimes called conscious avoidance or deliberate ignorance, in tax fraud cases.

Stadtmauer, an officer in several related real estate partnerships, was found guilty of subscribing to false tax returns for the entities, based on overstated and improper business deductions carried forward by accountants from internal books and records to filed returns. It is well established in non-tax fraud cases that, if the record contains the necessary factual support, the government is entitled to a “willful blindness” instruction when it lacks direct evidence that a defendant acted “willfully” (that is, consciously, with awareness, and not by accident or mistake), but can point to circumstantial evidence that the defendant turned a blind eye to facts which should have made his aware. Extension of this principle to tax cases was in doubt, however, by virtue of the Supreme Court’s decision in Cheek v. United States, 498 U.S. 192 (1991). The Cheek Court held that Title 26 prosecutions carry a more rigorous “willfulness” element than other offenses because of the complexity of the tax laws; the government must in tax cases prove not just voluntary and intentional conduct, but a violation of a known legal duty, and a defendant who in subjective good faith is unaware of that legal duty cannot be guilty of tax fraud.

Stadtmauer argued on appeal that his trial jury was wrongly instructed on “willful blindness” because such an instruction can never be used to prove the requisite knowledge of the tax code’s provisions. The court of appeals disagreed,. holding that Cheek’s beefed-up mens rea requirement did not exempt tax prosecutions from the potential application of a willful blindness instruction. A defendant who deliberately avoids learning of his tax reporting obligations has a culpable state of mind, and is unlike one who in good faith is unaware of those obligations and is therefore not culpable. So, a willful blindness instruction is available on the element requiring knowledge of the legal duty under the tax code.

Unfortunately for Stadtmauer, the Third Circuit found no error on this record in the trial judge’s having given the instruction to the jury. There was “abundant evidence” that Stadtmauer was intimately involved with the operations of the entities and was aware of how they characterized capital expenditures, charitable contributions, and gift and entertainment expenses in the general ledgers and financial statements. The jury was entitled to consider whether his failure to ask questions about the reporting of these expenses on the returns which he signed was a deliberate effort to avoid gaining guilty knowledge.
 

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It can be crucial in successfully defending tax evasion and false subscribing charges to obtain a jury charge to the effect that the defendant-taxpayer relied in connection with a particular tax return or return line-item entry on the advice provided by a tax preparer. A recent Eleventh Circuit opinion emphasizes just how minimal a trial record is needed to justify such an instruction.

In United States v. Kottwitz, 2010 WL 3258299 (11th Cir., Aug. 19, 2010), the convictions of the defendants on various tax fraud charges were vacated because the trial court failed to provide the jury with their requested charge that they took certain tax positions in good faith reliance on advice provided to them by an accountant, even though the jury had been given a general instruction that a taxpayer’s good faith is a complete defense to the intent needed to prove tax fraud. The defendants, principals of a carpentry contractor, never testified at trial, but their theory of good faith reliance was developed through the cross-examination of their tax preparer, a government witness, and through their counsel’s opening and summation. The government argued that this was an insufficient basis on which to predicate a good faith reliance charge, and that the general good faith instruction was sufficient. The Eleventh Circuit disagreed.

In order to obtain a good faith reliance on expert instruction a defendant is required to show both that he fully disclosed all relevant facts to his tax preparer and relied in good faith on the resulting advice, although the court added in passing that the expert must be at least be “competent.” But the showing of these elements needed to trigger the instruction is quite minimal, since the defendant can point to any foundation in the record to secure the instruction, even if the evidence is weak, doubtful, unbelievable, or frivolous (court’s emphasis, citing earlier 11th and 5th Circuit decisions). Moreover, while this trial court held that Kottwitz had failed to carry his burden, the appeals court noted that it is for the jury, and not for the trial judge, to determine if the taxpayer fully disclosed all relevant facts or concealed information from the preparer. The reliance instruction is proper where the only support for it comes from the defendant’s own testimony or even where the defendant fails to testify, and is appropriate even where the accountant is a co-defendant. The more general charge regarding a good faith which negates the intent necessary to find a violation was not a sufficient substitute on these tax charges.
 

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The Supreme Court last week applied a newly-invigorated Confrontation Clause to deny the admission at trial of drug lab test certificates in an opinion which may unintentionally prove very useful to attorneys defending criminal tax cases.

In Melendez-Diaz v. Massachusetts, 2009 U.S. LEXIS 4734 (June, 25, 2009), the Court unremarkably extended the reach of Crawford v. Washington, 541 U.S. 36 (2004) to the test reports of crime laboratories, holding that the admission in a Massachusetts trial of a laboratory report showing that a seized substance was cocaine violated the defendant's Confrontation Clause rights; the State was obliged instead to produce witnesses in court to establish the drug's chain of custody and the testing conclusion. The dissent argued less forcefully that the majority's conclusion was unwarranted or surprising after Crawford, and more effectively that a practical consequence of the decision would be to strain the resources of crime labs everywhere.

But one legal argument posited by the four Justices in dissent was that the lab certificate of results was akin to a business records certificate offered under FRE 803(6), which, even after Crawford, may be admitted in the absence of a live witness. Justice Scalia, writing for the five-Justice majority, dismissed this comparison. First, the business of a crime lab is to produce evidence for use at trial and so it does not share the routineness and regularity of a true business, leaving the former's products -- drug test reports -- outside the scope of Rule 803(6). Second, true business records are neutrally created for the purpose of administering an entity, rendering them non-testimonial when offered in a criminal trial and thus outside the Confrontation Clause, while police lab reports are prepared specifically for use at such a trial and to inculpate a defendant, so are testimonial and subject to the Confrontation Clause. Id. at *31-33.

To further make its point, the majority contrasted non-testimonial clerks' certificates as to records located in a business or government office with "those cases in which the prosecution sought to admit into evidence a clerk's certificate attesting to the fact that the clerk had searched for a particular relevant record and failed to find it … the clerk's statement would serve as substantive evidence against the defendant whose guilt depended on the non-existence of the record for which the clerk searched. Although the clerk's certificate would qualify as an official record [in the sense of FRE 803(6) and 803(8)] the clerk was nonetheless subject to confrontation." Id. at *31.

In myriad criminal cases the government is required as an essential element to prove the absence of an official record in order to establish guilt, but perhaps this is most often true in tax prosecutions. Whether seeking to prove a misdemeanor failure to file returns, 26 U.S.C. § 7203, or a felony Spies tax evasion where an act in furtherance is the failure to file returns, 26 U.S.C. § 7201, the prosecutor typically relies on a certificate from the IRS records center that no return is on file for the given year(s). Defense attorneys can now use Melendez-Diaz to argue that any and all IRS personnel involved in the search for the missing filing must be called as live witnesses in court, since the IRS certificate of non-filing cannot be admitted without violating the defendant-taxpayer's constitutional right of confrontation.
 

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It is nearly an article of faith that, in negotiating a guilty plea to a Title 26 offense, the prosecutor and the CI agent working the case for the IRS will invariably agree to take into consideration in reaching a "tax loss" number for sentencing purposes a wide array of tax return considerations which effectively reduce the taxes due and owing. Chief among the considerations which traditionally serve to allow a reworking, and lowering, of the tax loss figure are deductions or credits which the target's attorney and/or accounting expert can identify as having been overlooked on the filed return. Occasionally, the argument that a target taxpayer should be allowed to alter filing status will serve to pave the way for agreement on a reduced tax loss.

But if plea negotiations fail, and the taxpayer now charged as a defendant pursues a similar formula for reducing "tax loss" before the court, the near-universal position of the federal courts is that those considerations are of no avail. In United States v. Clarke, 2009 U.S. App. LEXIS 6169 (11th Cir., March 20, 2009), the Eleventh Circuit joined the Fourth, Fifth, Sixth, Seventh, Eighth, Ninth, and Tenth Circuits in holding that the "tax loss" calculated under U.S.S.G. § 2T1.1 is the loss intended by the defendant and not the actual loss to the IRS, precluding consideration of overlooked and recalculated deductions or credits, or for altered filing status. Only the Second Circuit (United States v. Gordon, 291 F.3d 181, 188 (2nd Cir. 2002)) requires the consideration of unclaimed deductions in calculating "tax loss" for sentencing purposes.
 

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