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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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