This is the sixth of a six part series devoted to utilization of various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques. (FSAT). There are various audit and investigative techniques available to corroborate or refute a taxpayer’s claim about their business operations or nature of doing business. Audit or investigative techniques for a cash intensive business might include an examiner determining that a large understatement of income could exist based on return information and other sources of information. The use of indirect methods of proving income, also referred to as the FSAT, is not prohibited by Code Section 7602(e)[i]. Indirect methods include a fully developed Cash T, percentage mark-up, net worth analysis, source and application of funds or bank deposit and cash expenditures analysis. However, examiners must first establish a reasonable indication that there is a likelihood of underreported or unreported income. Examiners must then request an explanation of the discrepancy from the taxpayer. If the taxpayer cannot explain, refuses to explain, or cannot fully explain the discrepancy, a FSAT may be necessary.

The Net Worth Method for determining the actual tax liability is based upon the theory that increases in a taxpayer’s net worth during a taxable year, adjusted for nondeductible expenditures and nontaxable income, must result from taxable income. This method requires a complete reconstruction of the taxpayer’s financial history, since the government must account for all assets, liabilities, nondeductible expenditures, and nontaxable sources of funds during the relevant period.

The theory of the Net Worth Method is based upon the fact that for any given year, a taxpayer’s income is applied or expended on items which are either deductible or nondeductible, including increases to the taxpayer’s net worth through the purchase of assets and/or reduction of liabilities. The taxpayer’s net worth (total assets less total liabilities) is determined at the beginning and at the end of the taxable year. The difference between these two amounts will be the increase or decrease in net worth. The taxable portion of the income can be reconstructed by calculating the increase in net worth during the year, adding back the nondeductible items, and subtracting that portion of the income which is partially or wholly nontaxable.

The purpose of the Net Worth Method is to determine, through a change in net worth, whether the taxpayer is purchasing assets, reducing liabilities, or making expenditures with funds not reported as taxable income. The use of the Net Worth Method of proof requires that the government establish an opening net worth, also known as the base year, with reasonable certainty; negate reasonable explanations by the taxpayer inconsistent with guilt; i.e., reasons for the increased net worth other than the receipt of taxable funds. Failure to address the taxpayer’s explanations might result in serious injustice; establish that the net worth increases are attributable to currently taxable income, and; where there are no books and records, willfulness may be inferred from that fact coupled with proof of an understatement of taxable income. But where the books and records appear correct on their face, an inference of willfulness from net worth increases alone might not be justified.[ii] The government must prove every element beyond a reasonable doubt, though not to a mathematical certainty.

When to Anticipate an Indirect Method. Circumstances that might support the use of an indirect method include a financial status analysis that cannot be easily reconciled – the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference; irregularities in the taxpayer’s books and weak internal controls; gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry; the taxpayer’s bank accounts have unexplained deposits; the taxpayer does not make regular deposits of income, but uses cash instead; a review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income; there are no books and records (examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, the examiner will attempt to determine who destroyed them, why, and when); no method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income as required by Code section 446(b).

When considering an indirect method, the examiner will look to the industry or market segment in which the taxpayer operates, whether inventories are a principle income producing activity, whether suppliers can be identified and/or merchandise is purchased from a limited number of suppliers, whether pricing of merchandise and/or service is reasonably consistent, the volume of production and variety of products, availability and completeness of the taxpayer’s books and records, the taxpayer’s banking practices, the taxpayer’s use of cash to pay expenses, expenditures exceed income, stability of assets and liabilities, and stability of net worth over multiple years under audit.

[i].  See IRM 4.10.4.6.7.1 (06-01-2004). And Holland v. United States, 348 U.S. 121 (1954).

 

[ii].  Internal Revenue Manual 4.10.4.6.1 sets forth the requirements for examining income and FSATs. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954). “Examination techniques” include examining and testing the taxpayer’s books and records, analytical tests, observing, and interviewing the taxpayer. These techniques are unique to the use of a formal indirect method and will not routinely trigger the limitation of Code Section 7602(e).

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at http://www.taxlitigator.com

What is the Potential Maximum Willful FBAR Penalty? In the wake of United States v. Colliot, here, another district court recently held that the regulation at 31 CFR §1030.820 limits the maximum willful penalty.  In United States v Wadhan, here, (D. Colo. July 18, 2018), the Wadhans had one account at UBS.  They closed the UBS account in 2008 and had the funds transferred to multiple accounts in Jordan.  They did not file an FBAR for 2008.  They filed FBARs for 2009 and 2010.  The FBARs did not list all their offshore accounts and for the ones listed the reported maximum account balance was “over $10,000.”  The 2008 penalty was for 50% of the maximum amount in the UBS account.  For both 2009 and 2010, the IRS assessed a $599,234.54 penalty equal to 50% of the maximum amount in the largest account.  It also assessed multiple penalties of $100,000 for each of the other accounts.

Relying on 31 CFR §1030.820, the Wadhans moved for judgment on the pleadings, which the court treated as a motion for summary judgment.  Holding that the IRS “is not empowered to impose yearly penalties in excess of $100,000 per account,” the court granted the motion.

In granting the motion, the court rejected the Government’s assertion that the 2004 amendment to 31 USC §5321(a)(5)(C), which increased the maximum FBAR penalty from $100,000 to 50% of the maximum balance in the account at the time of the violation, superseded the regulation.  First, both pre- and post-amendment versions of subsection (a)(5)(C) give the Secretary discretion to assess the FBAR penalty.  Second, the regulation is not inconsistent with the statute, since the regulation can be interpreted as an exercise of the Secretary’s discretion to limit the penalty.  Third, since 2004 the Secretary has made at least five adjustments to penalties under 31 CFR §1010.821 but never increased the $100,000 cap.  Finally, the court rejected the Government’s argument that the 1987 preamble to the predecessor of §1010.820, which states that Treasury intended to enforce the Bank Secrecy Act “to the fullest extent possible” without any “safe harbor,” does not indicate that it intended that the regulation would automatically incorporate any changes to §5321.

Note that the IRS assessed only one penalty for 2008, but penalties for each account for 2009 and 2010.  Will the Government move for reconsideration on the ground that it is entitled to penalties of $100,000 for each account that was open in 2008?  It has filed a motion asserting it can do so in Colliot.  The statute provides that the Secretary “may impose a civil money penalty on any person who violates, or causes any violation of, any provision of section 5314.”  Note the singular “a civil penalty” which can be imposed on “any person” who violates any provision of the section, not a penalty for each violation.  It does not provide a penalty for “each violation.”

The Balance in the Account at the Time of the Violation? A second point relating to the 2008 penalty:  even if the regulation did not limit the penalty, shouldn’t the maximum penalty for the UBS account have have been the greater of zero or $100,000?  Under §5321(a)(5)(D), the amount is determined by “in the case of a violation involving a failure to report the existence of an account or any identifying information required to be provided with respect to an account, the balance in the account at the time of the violation.”  Emphasis added.  The violation occurs on the date the FBAR was filed or was due to be filed.  On June 30, 2009, the UBS account balance was zero.  Nonetheless, the IRS often assesses penalties based on the maximum account balance during the year for which the report is due, not for the balance on the due date of the FBAR.

An example of the IRS assessing willful penalties that are less than 50% of the maximum balance during the year is the recent decision in United States v. Markus, Civil No. 16-2133 (RBK/AMD) (D. N.J., July 17, 2018).  The defendant served as an Army engineer deployed in Iraq.  For several years he oversaw an oil pipeline project.  He received bribes from several businessmen in exchange for confidential bid information.  He placed some of the bribes in an in Egypt.  The rest he deposited in three accounts in Jordan.  He filed an FBAR for 2008 reporting only one of the accounts in Jordan.  He did not file FBARs for 2007 or 2009.

In 2012, Markus pled guilty to one count of wire fraud and one count of willfully failing to file an FBAR for 2009.  In April 2014, the IRS assessed the following FBAR willful penalties:

Maximum

Year            Bank                    Balance                 Penalty

2007           Egypt Bank          $299,250               $100,000

2007           Jordan I               $744,854               $372,427

2007           Jordan II              $90,000                 $45,000

2008           Egypt Bank           $364,950               $100,000

2009           Egypt Bank           $400,000               $218,225

2009           Jordan III              $680,000               $6,362

Four days before the statute of limitations expired, the Government filed a suit to reduce the FBAR assessments to judgment.  After discovery, it moved for summary judgment.  Markus, who represented himself, raised only legal arguments in his opposition and did not refute the Government’s factual assertions.  Based on Markus’ criminal conviction and his filing an FBAR for 2008, together with his deposition testimony, the court found that Markus willfully failed to file FBARs for 2007 and 2009 in order to hide his taking bribes.  Since the regulation limiting the maximum penalty was not raised in the motion or opposition, the court did not address the issue.  The court  made one modification to the penalties: because the evidence establish that the maximum balance in the Egyptian account was $400,000 in 2009, it reduced the penalty for that year from $218,225 to $400,000.

One peculiarity is that while two accounts had maximum balances of over $200,000 in 2007 and Jordan account III had a balance of $680,000 in 2009, Markus was assessed a 50% penalty for only one account for 2007.  The penalty for 2009, $6,362, was less than 1% of the maximum balance.  No explanation is given, although it should be noted that according to the court Markus transferred $580,000 from Jordan account III to an account in the U.S. in 2009.

Further FBAR news:  Internal Revenue Manual 4.26.16.6.5.1 states that for purposes of the FBAR penalty “willful” is a “voluntary, intentional violation of a known legal duty.”  A Chief Counsel Technical Advice Memo, here, was recently released that states that “willful” is not limited to voluntary and intentional violations but also includes violations due to “willful blindness” and “reckless disregard.”  The TAM also stated that the Government’s burden of proof is by a preponderance of the evidence and not by clear and convincing evidence.

For more information please contact ROBERT S. HORWITZ – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

In 1998 Congress added §7433(e) to the Code.  It provides that a taxpayer can sue the US for damages as a result of collection action that “willfully violates” either the bankruptcy stay imposed by 11 USC §362 or a bankruptcy discharge order under 11 USC §524.  The statute provides:

(e)Actions for violations of certain bankruptcy procedures –

(1) In general:  If, in connection with any collection of Federal tax with respect to a taxpayer, any officer or employee of the Internal Revenue Service willfully violates any provision of section 362 (relating to automatic stay) or 524 (relating to effect of discharge) of title 11, United States Code (or any successor provision), or any regulation promulgated under such provision, such taxpayer may petition the bankruptcy court to recover damages against the United States.

(2) Remedy to be exclusive

(A) In general:  Except as provided in subparagraph (B), notwithstanding section 105 of such title 11, such petition shall be the exclusive remedy for recovering damages resulting from such actions.

(B)  Certain other actions permitted;  Subparagraph (A) shall not apply to an action under section 362(h) of such title 11 for a violation of a stay provided by section 362 of such title; except that—

(i) administrative and litigation costs in connection with such an action may only be awarded under section 7430; and

(ii) administrative costs may be awarded only if incurred on or after the date that the bankruptcy petition is filed.

Despite subsection (e) having been around for twenty years, it was not until June 7, 2018, that a court of appeal issued an opinion interpreting “willful violation.”  In IRS v. Murphy, Dkt. No. 17-1601, the First Circuit considered whether there is a willful violation of a discharge order if the IRS had a good faith belief that its taxes were not discharged.

Murphy filed a bankruptcy petition.  Approximately 90% of his debts were taxes owed the IRS.  He was granted a discharge in February 2006.  Between that date and February 2009 the IRS “repeatedly informed” Murphy that his taxes were not discharged and that it intended to take collection action.  It finally issued levies in February 2009.  Six months later Murphy filed an adversary proceeding to determine that his tax liability was discharged.   In response to Murphy’s motion for summary judgment Assistant U. S. Attorney assigned the case failed to offer any admissible evidence to support the IRS’s fraud claim.  The bankruptcy court determined his liability was discharged.  The Assistant U. S. Attorney was subsequently diagnosed with dementia.

In February 2011 Murphy petitioned the bankruptcy court under §7433(e).  The bankruptcy court held there was a willful violation of the discharge order.  The district court reversed and remanded the case to the bankruptcy court to determine whether the Assistant U. S. Attorney’s dementia collaterally estopped the IRS from litigating the issue of whether the tax was discharged. The parties settled.  The IRS agreed to pay Murphy $175,000 subject to a final determination that its collection action was a “willful violation.”  The First Circuit held that a good faith belief that the tax was discharged does not shield the IRS from liability for a willful violation of the discharge order.

The Court looked at the definition of “willfully violates” in the context of bankruptcy cases existing on the date §7433(e) was enacted.  As of 1998, the courts had held that there is a willful violation of the automatic stay if a person knows of the stay and intentionally acts to violate the stay.  There was no good faith defense.  Shortly after enactment of the statute the First Circuit applied the same definition of “willfully violates” to violations of the stay and of the discharge order.

To further support its decision, the First Circuit turned to Internal Revenue Manual, which provides that a willful violation of the stay occurs when the IRS receives notice of the bankruptcy filing or discharge order and does not timely act to stop collection action.

The Court rejected the IRS’s argument that “willfully violates” should be narrowly construed because §7433(e) is a waiver of sovereign immunity.  The Court reasoned that its construction of “willfully violates” was consistent with the purpose of the bankruptcy code to provide debtors with a fresh start.  It also rejected the IRS’s argument that a ruling that good faith is not a defense would require it to seek a pre-enforcement determination that its tax was not discharged before it could ever take action to collect taxes post-discharge.  The Court stated that the IRS does not need to seek a pre-enforcement determination.  It can just collect and then defend if the taxpayer challenges the IRS claim that the tax was not discharged.

Judge Lynch dissented. He construed the statute as waiving sovereign immunity only where the IRS action is not reasonable and in good faith and interpreted “willfully violates” as an intentional violation of the discharge order rather than an intentional act that violates the order.  He pointed out that several appeals court cases decided before 1998 supported the IRS’s interpretation.  Finally, he believed that the Court’s decision would wrap the IRS up in time consuming and often pointless litigation to determine whether its tax was discharged.

The majority however may be correct in its interpretation of Congressional intent.  Subsection (e) was added to the Code as part of the 1998 IRS Restructuring and Reform Act, part of whose purpose was to provide taxpayers with the means to slow down the IRS collection process, such as collection due process rights.  The majority’s reading of “willfully violates” is consistent with this purpose.

Prior to enactment of subsection (e) a number of cases had applied the First Circuit’s reading of “willfully violates” to cases in which the IRS violated the automatic stay.   But the automatic stay is a bright red line.  Once a bankruptcy case is filed any collection action is prohibited unless the creditor obtains an order lifting the stay.  The discharge order does not contain a bright line for taxes.  While some taxes are discharged, others are not, including priority taxes, taxes where a return was not filed, taxes where there was fraud and taxes where there was an intent to evade or defeat.  For many types of tax (i.e., those for which a return was due within three years of bankruptcy, withholding tax, etc.) it is easy to determine whether the tax is discharged.  Others (i.e., fraud where there is no prior judicial determination, an attempt to evade or defeat) require intensive factual determinations.  While the First Circuit’s decision may make the IRS’s collection efforts post-discharge more problematic for the latter types of liabilities, ultimately it may not severely impact the IRS’s collection efforts any more difficult.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz, horwitz@taxlitigator.com or 310.281.3200.  Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

 

For more than a decade, the Supreme Court has been chipping away at the notion that periods of limitation for filing suit are necessarily jurisdictional.  See Kontrick v. Ryan, 540 U.S. 443, 455 (2004).  The Supreme Court has held that a filing deadline is almost never jurisdictional unless Congress makes clear that it is.  United States v. Wong, 135 S. Ct. 1625 (2015).  In Nauflett v Commissioner, Docket No. 17-1986 (3d Cir. June 14, 2018), the Third Circuit joined the First and Second Circuits to hold that the ninety-day period for filing a petition for innocent spouse relief in Tax Court is jurisdictional.

Ms. Nauflett’s request for innocent spouse relief was denied by the IRS.  The deadline to file a petition with Tax Court was September 15, 2015. She filed on September 22 due to being misinformed by IRS employees as to the filing date.  The Tax Court dismissed her petition for lack of jurisdiction.  Ms. Nauflett appealed.

To decide the issue, the Third Circuit first looked at the statutory language, Internal Revenue Code §6015(e)(1)(A), which provides that an innocent person claiming innocent spouse relief may petition the Tax Court (and the Tax Court shall have jurisdiction) to determine the appropriate relief available to the individual under this section if such petition is filed—

(i) at any time after the earlier of—

(I) the date the Secretary mails, by certified or registered mail to the taxpayer’s last known address, notice of the Secretary’s final determination of relief available to the individual, or

(II) the date which is 6 months after the date such election is filed or request is made with the Secretary, and

(ii) not later than the close of the 90th day after the date described in clause (i)(I).

According to the Court, under the plain language of §6015(e)(1)(A), jurisdiction was granted the Tax Court only if the petition was filed within the 90-day period.  Thus, the filing period was jurisdictional.

The Court found further support for its understanding of Congressional intent from the context of the subsection.  Section 6015(e)(1)(B) prohibits the IRS from collection action until the end of the ninety-day period.  It also grants the Tax Court jurisdiction to enjoin collection activity if a timely petition is “filed under subparagraph (A).”  It rejected Ms. Nauflett’s arguments as “strained.”

In a previous blog, here, I commented on the Ninth Circuit’s decision in Duggan v Commissioner, and noted that based on the Supreme Court’s recent cases on filing limits, the 90-day period for filing a petition to challenge a deficiency may not be jurisdictional.  It turns out that there are two cases currently pending in the Ninth Circuit raising that issue, Organic Cannabis Foundation v Commissioner, Docket No. 17-72874, and Northern California Small Business Assistants v Commissioner, Docket No. 17-72877.

The argument advanced in support of the taxpayers is that §6213(a), which provides that a taxpayer may petition the Tax Court for redetermination of a deficiency within 90-days (or 150-days if the notice is addressed to a person outside the United States) after mailing of the deficiency notice, does not grant the Tax Court jurisdiction .  Jurisdiction over deficiency petitions is granted in §6214.   Thus, there is no clear indication that Congress intended to make the period for filing a petition jurisdictional.  The taxpayers and amicus note that the Ninth Circuit in Volpicelli v. United States, 777 F.3d 1042 (9th Cir. 2015), held that the time period for filing a wrongful levy action is not jurisdictional.  Additionally, they note that there are no Supreme Court cases holding that the period for filing in Tax Court is jurisdictional.  They also argue that equitable tolling applies to §6213(a).  The taxpayers in both cases are represented by Doug Youmans and Matthew Carlson of Wagner Kirkman Blaine Klomparens & Youmans, LLP, of Sacramento.  Amicus briefs on behalf of the taxpayers were filed by the Keith Fogg of the Harvard Law School Tax Clinic and Carlton Smith of New York.  These are important cases that could have major repercussions.  Keep an eye out for further developments.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

 

 

 

This is the fifth of a six part series devoted to utilization of various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques. (FSAT). There are various audit and investigative techniques available to corroborate or refute a taxpayer’s claim about their business operations or nature of doing business. Audit or investigative techniques for a cash intensive business might include an examiner determining that a large understatement of income could exist based on return information and other sources of information. The use of indirect methods of proving income, also referred to as the FSAT, is not prohibited by Code Section 7602(e)[i]. Indirect methods include a fully developed Cash T, percentage mark-up, net worth analysis, source and application of funds or bank deposit and cash expenditures analysis. However, examiners must first establish a reasonable indication that there is a likelihood of underreported or unreported income. Examiners must then request an explanation of the discrepancy from the taxpayer. If the taxpayer cannot explain, refuses to explain, or cannot fully explain the discrepancy, a FSAT may be necessary.

The Markup Method produces a reconstruction of income based on the use of percentages or ratios considered typical for the business under examination in order to make the actual determination of tax liability.[ii] It consists of an analysis of sales and/or cost of sales and the application of an appropriate percentage of markup to arrive at the taxpayer’s gross receipts. By reference to similar businesses, percentage computations determine sales, cost of sales, gross profit, or even net profit. By using some known base and the typical applicable percentage, individual items of income or expenses may be determined. These percentages can be obtained from analysis of Bureau of Labor Statistics data or industry publications. If known, use of the taxpayer’s actual markup is required.

The Markup Method is similar to how state sales tax agencies conduct audits. The cost of goods sold is verified and the resulting gross receipts are determined based on actual markup. The Markup Method is often used when inventories are a principal income producing factor and the taxpayer has nonexistent or unreliable records or the taxpayer’s cost of goods sold or merchandise purchased is from a limited number of sources such that these sources can be ascertained with reasonable certainty, and there is a reasonable degree of consistency as to sales prices.[iii]

When to Anticipate an Indirect Method. Circumstances that might support the use of an indirect method include a financial status analysis that cannot be easily reconciled – the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference; irregularities in the taxpayer’s books and weak internal controls; gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry; the taxpayer’s bank accounts have unexplained deposits; the taxpayer does not make regular deposits of income, but uses cash instead; a review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income; there are no books and records (examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, the examiner will attempt to determine who destroyed them, why, and when); no method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income as required by Code section 446(b).

When considering an indirect method, the examiner will look to the industry or market segment in which the taxpayer operates, whether inventories are a principle income producing activity, whether suppliers can be identified and/or merchandise is purchased from a limited number of suppliers, whether pricing of merchandise and/or service is reasonably consistent, the volume of production and variety of products, availability and completeness of the taxpayer’s books and records, the taxpayer’s banking practices, the taxpayer’s use of cash to pay expenses, expenditures exceed income, stability of assets and liabilities, and stability of net worth over multiple years under audit.

[i].  Internal Revenue Manual 4.10.4.6.1 sets forth the requirements for examining income and FSATs. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954). “Examination techniques” include examining and testing the taxpayer’s books and records, analytical tests, observing, and interviewing the taxpayer. These techniques are unique to the use of a formal indirect method and will not routinely trigger the limitation of Code Section 7602(e).

[ii].  See IRM 4.10.4.6.5.1 (08-09-2011) and United States v. Fior D’Italia, Inc., 536 U.S. 238 (2002).

[iii].  See IRM 4.10.4.6.5.2 (05-27-2011).

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at http://www.taxlitigator.com

 

Despite the fact that the new partnership audit rules are effective for tax years that began after December 31, 2017, TEFRA will remain relevant for a number of years, as can be seen by several recent decisions.

Foster v United States, Dkt. 1:06-cv-00818 (W.D. TX June 19, 2018), involved a TEFRA partnership’s 1984 tax year.  The taxpayers were partners in two farming partnerships set up by American Agri-Corp (“AMCOR”).  The partnerships filed timely 1984 partnership returns that were signed by an officer of AMCOR.  The taxpayers filed their 1984 returns and reported their share of partnership losses.  In 1991, the IRS issued Final Partnership Administrative Adjustments (“FPAA”) to the partnerships.  The taxpayers were non-notice partners and were not notified of the FPAAs.  Petitions were filed in Tax Court.  Among other things, the petitions asserted that the FPAAs were untimely.  The two partnerships in which plaintiffs’ invested agreed to be bound by proceedings in other AMCOR cases.  The Tax Court ultimately held that the returns were not valid returns since they were not signed by the tax matters partner.  As a result, the FPAAs were timely because. In 2002, the tax matters partner agreed to an entry of a decision that resulted in decreasing expenses reported by the partnerships.

Since the adjustments did not require partner level determinations, the IRS assessed taxes against the taxpayers, who paid and, two years later, filed refund claims.  In 2006, they filed refund suits in district court.  The cases were stayed pending resolution of related litigation.  After the stay was lifted, the taxpayers and the Government filed for summary judgment.  The taxpayers argued that the assessments were untimely because the timeliness of an assessment at the partner level is an affected item which is determined by whether the FPAA was issued while the statute of limitations for both the partnership and the partner was open and while the statute of limitations against the partnership was open.  The court rejected this argument.  Because the returns were invalid, the FPAA was timely; in any event, whether the FPAA was timely was a partnership item that had to be raised in partnership level proceedings.  Thus, regardless of whether it had been litigated in the partnership-level proceedings, the taxpayers could not challenge the timeliness of the FPAA in their individual proceeding.

The court also held that the refund suit was untimely. Under TEFRA, a partner who is assessed additional tax as a result of a partnership adjustment can only challenge the computation of the amount owed.  To do so, he must file a refund claim within six months of mailing of the notice of computational adjustment.  Since the taxpayers did not file a refund claim until two years after issuance of the notice, the refund claim was untimely.

In Dynamo Holdings Limited Partnership v Commissioner, 150 T.C. No. 10 (May 7, 2018), the tax years in issue were 2005, 2006, and 2007.  The FPAAs were issued in 2010.  A trial was held in early 2017.  Subsequent to the Tax Court’s opinion in Graev v. Commissioner, 149 T.C. ___, holding that part of the Commissioner’s burden of production as to penalties is to present evidence of written supervisor approval, the Commissioner moved to reopen the record to present evidence of supervisory approval and the taxpayer moved to dismiss as to penalties on the ground that the Commissioner failed to offer evidence of written supervisory approval.

Sec. 7491(c) places the burden of production on the IRS with respect to the liability of an individual for penalties and additions to tax.  This was a case that the Tax Court had not squarely addressed.  The Court noted that under the plain language of the statute, a partnership-level proceeding is not with respect to the liability of an individual.  The Tax Court’s jurisdiction is to determine to the tax treatment of partnership items.  It does not determine the liability of any partner.  Once the partnership-level proceeding is over, the partner’s individual liability is determined either by a computational adjustment or a notice of deficiency.  If a penalty is assessed, the partner can raise any individual defenses to liability.

The Court further held that §7491(c) is inconsistent with partnership level proceedings, which does not focus upon liability of any partner for tax or penalties.  Requiring the Commissioner to bear the burden of production would require the Court to look through the partnership to the individual partners who may be liable for the tax, which would adversely affect judicial and administrative efficiency.  Because reopening the record would not affect the outcome the Commissioner’s motion to reopen was denied.  And because the Commissioner does not bear the burden of production, the partnership’s motion to dismiss as to penalties was denied.

These cases are only two examples of recent decisions in TEFRA cases involving tax years that are more than ten years old.  See also RB-1 Investment Partners v. Commissioner, T.C. Memo. 2018-64 (involving the 2000 tax year).  Thus, we will have to deal with, and remain conversant with, TEFRA for a long time to come.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

 

 

 

This is the fourth of a six part series devoted to utilization of various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques (FSAT). There are various audit and investigative techniques available to corroborate or refute a taxpayer’s claim about their business operations or nature of doing business. Audit or investigative techniques for a cash intensive business might include an examiner determining that a large understatement of income could exist based on return information and other sources of information. The use of indirect methods of proving income, also referred to as the FSAT, is not prohibited by Code Section 7602(e)[i]. Indirect methods include a fully developed Cash T, percentage mark-up, net worth analysis, source and application of funds or bank deposit and cash expenditures analysis. However, examiners must first establish a reasonable indication that there is a likelihood of underreported or unreported income. Examiners must then request an explanation of the discrepancy from the taxpayer. If the taxpayer cannot explain, refuses to explain, or cannot fully explain the discrepancy, a FSAT may be necessary.

The Bank Deposits and Cash Expenditures Method is distinguished from the Bank Account Analysis by the depth and analysis of all the individual bank account transactions, and the accounting for cash expenditures, and a determination of actual personal living expenses.  The Bank Deposits and Cash Expenditures Method computes income by showing what happened to a taxpayer’s funds based  on the theory that if a taxpayer receives money it can either be deposited or it can be spent[ii]. This method is based on the assumptions that proof of deposits into bank accounts, after certain adjustments have been made for nontaxable receipts, constitutes evidence of taxable receipts; expenditures as disclosed on the return, were actually made and could only have been paid for by credit card, check, or cash. If outlays were paid by cash, then the source of that cash must be from a taxable source unless otherwise accounted for and it is the burden of the taxpayer to demonstrate a nontaxable source for this cash.

The examiner will consider whether there are unusual or extraneous deposits which appear unlikely to have resulted from reported sources of income? The examiner may limit the examination to large deposits or deposits over a certain amount. However, the identification of smaller regular deposits may be indicative of dividend income, interest, rent, or other income, leading to a source of investment income. An item of deposit may be unusual due to the kind of deposit, check or cash, in its relationship to the taxpayer’s business or source of income. An explanation may be required if a large cash deposit is made by a taxpayer whose deposits normally consist of checks. Also, a bank statement noting only one or two large even dollar deposits, in lieu of the normal odd dollar and cents deposits, would be unusual and require an explanation.

Many taxpayers, due to the nature of their business or the convenience of the depository used, will follow a set pattern in making deposits. Deviation from this pattern may be reason for more in depth questioning. Bank statements or deposit slips which indicate repeat deposits of the same amount on a monthly basis, quarterly or semi-annual basis may indicate rental, dividend, interest or other income accruing to the taxpayer.

The examination of deposit slips may indicate items of deposit which appear questionable due to the location of the bank on which the deposited check was drawn. It is common practice when preparing a deposit slip to list either the name of the bank, city of the bank or identification number of the bank upon which the deposited check was drawn. If an identification number is used, the name and location of the bank can be determined by reference to the banker’s guide. In all cases, if the location of the bank on which the check for deposit was drawn bears little relation to the taxpayer’s business location or source of income, it may indicate the need for further investigation.

The examiner should identify all loan proceeds, collection of loans, or extraneous items reflected in deposits. If loan proceeds are identified, the examiner may request the loan application documents to verify the source and amount of the nontaxable funds and attempt to determine whether such information is consistent with other information; i.e., cash flows, assets, anticipated gross receipts, etc.

If repayments of loans are identified, the examiner will request the debt instruments to establish that a loan was made, the terms of the debt, and the repayment schedule. Before an examiner can reach any conclusion about the relationship between deposits and reported receipts, transfers and redeposits must be eliminated. For example, if a taxpayer draws a check to cash for the purpose of cashing payroll checks and then redeposits these payroll checks, the examiner would be incorrect if total deposits were compared to receipts reported without adjusting for this amount. The taxpayer has done nothing more than redeposit the same funds in the form of someone else’s checks.

When to Anticipate an Indirect Method. Circumstances that might support the use of an indirect method include a financial status analysis that cannot be easily reconciled – the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference; irregularities in the taxpayer’s books and weak internal controls; gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry; the taxpayer’s bank accounts have unexplained deposits; the taxpayer does not make regular deposits of income, but uses cash instead; a review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income; there are no books and records (examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, the examiner will attempt to determine who destroyed them, why, and when); no method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income as required by Code section 446(b).

When considering an indirect method, the examiner will look to the industry or market segment in which the taxpayer operates, whether inventories are a principle income producing activity, whether suppliers can be identified and/or merchandise is purchased from a limited number of suppliers, whether pricing of merchandise and/or service is reasonably consistent, the volume of production and variety of products, availability and completeness of the taxpayer’s books and records, the taxpayer’s banking practices, the taxpayer’s use of cash to pay expenses, expenditures exceed income, stability of assets and liabilities, and stability of net worth over multiple years under audit.

[i].  Internal Revenue Manual 4.10.4.6.1 sets forth the requirements for examining income and FSATs. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954). “Examination techniques” include examining and testing the taxpayer’s books and records, analytical tests, observing, and interviewing the taxpayer. These techniques are unique to the use of a formal indirect method and will not routinely trigger the limitation of Code Section 7602(e).

[ii].  See IRM 4.10.4.6.4.1 (09-11-2007) and Gleckman v. United States, 80 F.2d 394 (8th Cir. 1935).

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at http://www.taxlitigator.com

The Fifth Circuit recently reversed summary judgment in favor of the Government in a $4.3 million trust fund recovery penalty (“TFRP”) case. McClendon v. United States, Dkt. No. 17-20174 (June 14, 2018), at  http://www.ca5.uscourts.gov/opinions/pub/17/17-20174-CV0.pdf.   The TFRP, Internal Revenue Code §6672, allows the IRS to assess against any person responsible any withholding tax that was not collected, accounted for or paid over to the IRS, including income and social security tax withheld from employees’ wages.

The taxpayer, Dr. McClendon, founded a medical association that grew large enough to hire a CPA, Richard Stephen, as CFO in 1994.  Stephen regularly reported to the board that the association was doing well financially and that its tax obligations were being met.  Stephen had, in fact, been embezzling funds from the association.

In May, 2009, the board learned from the IRS that 23 quarters of employment taxes were not paid and that the association owed over $11 million in payroll taxes.  On the advice of counsel, the association turned over to the IRS all its receivables.  It also remitted to the IRS a $250,000 insurance recovery and made payments to the IRS of an amount equal to the balance in its account in May 2009.  Dr. McClendon loaned $100,000 to meet the association’s final payroll.

Stephen was convicted of felony theft in state court and sentenced to ten years imprisonment.  The IRS assessed a $4.3 million TFRP against both Dr. McClendon and Stephen.  McClendon paid a nominal amount toward the assessments, filed a refund claim and sued for a refund.  The Government counterclaimed against Dr. McClendon and joined Stephen as a counterclaim defendant.  After discovery, the Government moved for summary judgment, which the district court granted.  Dr. McClendon moved for reconsideration, arguing that based on his declaration, deposition testimony, and copies of checks, he established that all available funds were used to pay tax after he learned of the liability.  The Government opposed the motion on procedural grounds; it also claimed that Dr, McClendon was required to give a full accounting of all available funds from the time he learned of the tax liability.  The district court denied the motion.

The Fifth Circuit reversed, holding that McClendon produced sufficient evidence to raise an issue of material fact as to whether all available funds were used to pay the IRS after he learned of the tax liability.  There was both a concurring and a dissenting opinion.

So what leads to musings on “willful?”  In both the district court and the Fifth Circuit the Government argued that Dr. McClendon was grossly negligent in failing to properly supervise Stephen, and thus his failure to collect, account for and pay over tax was willful.  The concurring opinion notes:

First, I don’t see how, under the circumstances before us, the district court could rule on now-deceased Dr. McClendon’s “reckless” disregard of his tax duties as a matter of law. Given that he and his partners employed Stephen for a decade before the CPA started embezzling, their reliance on his handling of their business affairs seems at least plausible. Second, it takes some chutzpah for the IRS, which submitted 285 pages of exhibits including FPA business records in support of summary judgment, now to assert McClendon did not bear “his” burden to articulate precisely how those records demonstrated whether there were insufficient funds to cover the unpaid withholding taxes and whether all available receipts were in fact paid to the IRS. Is it too much to assume the tax collectors can read bank and financial records adeptly, and that ethically, they wouldn’t make claims without factual foundations of which they ought to be aware? To challenge the legal consequences of McClendon’s $100,000 cash infusion is one thing; to claim, in the face of his sworn affidavit and documents, and their own access to corroborative financial records, that this isn’t enough to raise a fact issue is irresponsible at best. Slip Op. at 17.

Traditionally, to establish willfulness the Courts have required that “the responsible person acts with a reckless disregard of a known or obvious risk that trust funds may not be remitted to the Government, *** such as by failing to investigate or to correct mismanagement after being notified that withholding taxes had not been duly remitted.”  Mazo v. United States, 591 F. 2d 1151, 1154 (5th Cir. 1979); see also, Leuschner v. United States, 336 F.2d 246 (9th Cir. 1964); Kalb v. United States, 505 F.2d 506 (2nd Cir. 1974) (rejecting Government claim that “should have known” is sufficient to establish willfulness); Godfrey v. United States, 3 Ct. Cl. 595 (1983); Calderone v. United States, 799 F.2d 254 (6th Cir. 1986).

Despite the requirement for at the very least “reckless disregard” the Government has been pushing for the Courts in FBAR willful cases to hold that signing a return with the box on Schedule B checked no is automatically willful with some success.  Recently, in Kimble v. United States, Ct. Fed. Cl. Dkt 1:17-cv-00421, the Government moved for summary judgment on the ground that Ms. Kimble had constructive knowledge of the contents of the return and thus her failure to file an FBAR was willful.  The Government lost a similar motion recently in Norman v. United States, another Court of Federal Claims case, but that doesn’t deter the Government from its quest to minimize its burden of proving willful.

Speaking of the FBAR penalty, on June 1, 2018, the Government filed a post-trial brief in Norman on the validity of the Treasury Regulation that limits the maximum willful penalty to $100,000.  The Government’s position is that the regulation is outdated, that the 2010 amendment that contains the regulation was not meant to be a substantive change.  It was  merely a reorganization of the Bank Secrecy Act regulations and “not an exercise of the Treasury Secretary’s rulemaking” and that the Court should accept as controlling the Government’s interpretation of its own regulation, i.e., that the 2010 regulation was superseded by the 2004 amendment to 31 USC §5321.   I guess the Treasury Department’s promulgation of the regulation in 2010 was not “willful.”

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

In the years following the Mortgage Crisis many taxpayers did short-sales of their homes.  Many of them tried renting their homes before doing a short sale or allowing the home to go into foreclosure. Guidance on the tax consequences of short sales have been non-existence.  It only recently, in Simonsen v Commissioner, 150 T.C. No. 8 (March 15, 2018), that the Tax Court addressed the tax consequences of a short sale that occurred after the taxpayers converted their home to a rental property.

The Simonsens purchased a condominium in 2005 in San Jose for $695,000.  They put 20% down and borrowed the remainder of the purchase price from Wells Fargo Bank.  The condominium was their principal residence until late 2010, when they moved to southern California. They converted the condominium to a rental unit.  In late 2011, they negotiated a short sale of the property for $363,000.  After $26,000 in costs, the balance went to Wells Fargo Bank which applied it to pay down the loan.  It wrote off the unpaid balance of the loan and issued a Form 1099-C to the Simonsens for $219,270 of cancellation of debt income.

The Simonsens used Turbo-Tax to prepare their return.  They treated the short sale as two separate transactions: a sale of the condominium and a cancellation of debt.  Since the price, $363,000, was less than the cost basis less depreciation, they reported a loss on the sale of $216,000.  Under the 2007 Mortgage Forgiveness Debt Relief Act, a taxpayer does not recognize cancellation of debt income from “qualified principal residence indebtedness.”  Consequently, they did not report cancellation of debt income.

Not so fast said the IRS.  The IRS took the position that since the Simonsens had converted their residence to a rental, the condominium was not their “principal residence” for purposes of the exclusion.  Further, the short sale was really a sale for the amount of the note, which was $555,960.  Finally, the IRS determined that when they converted the property to a rental unit, the Simonsens’ basis became the fair market value on the date of the conversion.  Since this was $495,000, instead of a loss and no COD income the Simonsens had taxable gain of $60,000.  The IRS also asserted an accuracy penalty.

The first issue was whether the condominium was the Simonsens’ principal residence.  Pointing to sec. 121, the Simonsens argued that since they resided there at least two of the preceding five years, it was their principal residence.  The IRS argued that since they had converted the property to a rental unit prior to the short sale, it was no longer their principal residence.  The Court considered this a difficult issue.  It therefore sidestepped it by going on to the question of whether the short sale was one or two transactions.   It was one.  The short sale was coordinated with the bank and could not have gone forward unless the bank agreed to release its deed of trust from the property.  It was nothing more than a substitution for a foreclosure.  Thus the Simonsens erred in treating the short sale as two transactions.  Since the loan was nonrecourse, the amount realized was the amount of the debt, or $555,960.

This lead to the question of whether there was gain or loss on the short sale.  The Court noted something that the parties had overlooked:  although when a property is converted to a rental unit its basis is the value at the time of the conversion, under Treas. Reg. §1.165-9(b)(2), the value at the time of conversion is only used to compute loss.  To compute gain, you use the taxpayer’s adjusted cost basis.  The amount realized from the sale (the $555,960 owed on the note) was more than property’s fair market value at the time of conversion but less than the Simonsens’ adjusted cost basis.  So what happens when the amount realized from the sale is more than the basis used to compute loss but less than the basis used to compute gain?  As noted by Judge Holmes, this is a conundrum that only a tax lawyer could love.  There were no cases on point, but there was an analogous situation under the gift tax regulations.   A donee’s basis in property acquired by gift is the donor’s basis.  Under the regulations, where the donee sells the property, she computes gain using the donor’s basis and loss using the lesser of the donor’s basis and the fair market value of the property on the date of the gift.  The regulations provide that if the sale price falls between the donor’s basis and the value on the date of the gift, there is neither gain nor loss.  The Court found this a logical way to resolve the issue of whether there was gain or loss.

This left the issue of penalty.  The Court found that the Simonsens were not liable for the accuracy penalty.  First, the IRS failed to meet its burden of proving that it complied with the requirement for written managerial approval before issuance of the notice of deficiency.  Even if it had, the Court found that the taxpayers acted with reasonable cause and in good faith.  First, while Wells Fargo issued a Form 1099-C for cancellation of debt income, the title company issued a Form 1099-S for the sale of the property.  This supported their belief that there were two transactions.  Second, the IRS had not issued any regulations addressing the Mortgage Debt Relief Act, case law was scarce and it was not clear what “principal residence” means for purposes of the Act.  Additionally, the IRS pamphlets on cancellation of debt indicate that a basis adjustment is only necessary if you continue to own the property after the debt is cancelled.  The Court therefore found “that the Simonsens’ 2011 reporting errors were the result of an honest misunderstanding of the law that was reasonable considering their lack of tax knowledge, the complexity of the issues, and the information returns that they received. And we are convinced, based in large part on Christina’s honest and believable testimony, that the Simonsens acted in good faith.”

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

Two weeks ago, the Supreme Court reinforced that a felon’s liberty interest outweighed inconveniencing the district court when the Court held that appellate courts must send cases back to the district court where the district court made a mistake in calculating the federal sentencing guidelines.  Rosales-Mireles v. United States, 585 U.S. ___ (2018), available at https://supreme.justia.com/cases/federal/us/585/16-9493/.

In 7-2 victory for justice over expediency, the Court slammed the Fifth Circuit Court of Appeals’ overly stringent standard for granting a defendant a new sentencing hearing after the parties discovered for the first time on appeal that the district court’s guideline calculation was erroneous.

In the real world of federal sentencing, the “advisory” federal sentencing guidelines determine the sentence in most cases, even though they are supposed to be just the first step in an analysis that accounts for the defendant’s history and characteristics, among other factors.  United States Probation Officers – employed by the district court – prepare a presentence report that includes a calculation of the guideline sentence based on the offense level and criminal history.

Florencio Rosales-Mireles’ guideline sentence was erroneously calculated because the Probation Officer double-counted a misdemeanor conviction and increased his criminal history level.  This increased his guideline sentence from 70-87 months to 77-96 months.  The district court imposed a 78-month sentence, which was within both the correct and erroneous guideline ranges.  Only on appeal did anyone notice the double-counting.  Because Mr. Rosales-Mireles didn’t object to the error in the district court, the Court of Appeals used a difficult-to-show “plain error” standard that required the defendant to demonstrate, among other things, a reasonable probability that the error affected his sentence and that it seriously affected the fairness and integrity of his sentencing.

The parties agreed that the incorrect guideline likely affected his sentence (even though the imposed sentence was still within his correct guideline sentence range), but disagreed whether the plain sentencing error implicated the fairness and integrity of his sentencing.  Siding with the government and adopting a test that would make few sentencing errors reversible, the Fifth Circuit held that only sentencing errors that “shock the conscience” are reversible.  The Fifth Circuit was an outlier, as most other circuits including the Ninth Circuit had adopted a lower standard for reversing sentencings based on erroneous guideline calculations.

The Supreme Court granted certiorari to resolve the circuit split, and reinforced that inconveniencing district judges for a few hours isn’t a sufficiently important concern when balanced against ensuring the integrity and public confidence in sentences.  The Court emphasized the convicted defendant’s perspective: “To a prisoner,” this prospect of additional “time behind bars is not some theoretical or mathematical concept.”  However, the Court didn’t lose sight of judicial efficiency, noting resentencing hearings are relatively low-cost, compared to a costly new trial.  The implication: less-egregious mistakes at sentencing can warrant remand, whereas only more-serious mistakes at trial will warrant a new trial.

Getting the guidelines right wasn’t just about the defendant being sentenced, as the Court noted that sentencing data is used to revise the guidelines, among other things, and not correcting guideline errors would skew the data.  Protecting sentencing data justified requiring a new sentencing hearing in this case, even though Mr. Rosales-Mireles’ 78-month sentence was within the correct guideline range and, according to other precedent, was presumptively reasonable as a result.

The opinion was laced with lofty quotations from earlier Supreme Court cases and, interestingly, an appellate court decision penned by Judge (not-yet-Justice) Gorsuch of the Tenth Circuit:

In considering claims like Rosales-Mireles’, then, “what reasonable citizen wouldn’t bear a rightly diminished view of the judicial process and its integrity if courts refused to correct obvious errors of their own devise that threaten to require individuals to linger longer in federal prison than the law demands?”

United States v. Sabillon-Umana, 772 F. 3d 1328, 1333–1334 (CA10 2014) (Gorsuch, J.).

The next question: will the Supreme Court and lower courts elevate fairness and integrity over expediency in situations where a new trial would have to result?  Although the Supreme Court noted the relatively low cost of resentencing in support of remanding to correct a guideline error, the Court’s remaining arguments in favor of remand would apply with even more force to errors that affected guilt.  It’s important to ensure a defendant like Rosales-Mireles doesn’t have to spend seven extra months in custody based on a guideline error, but isn’t it even more important to ensure that a defendant wasn’t convicted as a consequence of an error at trial in the first place?

EVAN J. DAVIS – For more information please contact Evan Davis – davis@taxlitigator.com or 310.281.3288. Mr. Davis is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) handling civil and criminal tax cases and, subsequently, of the Major Frauds Section of the Criminal Division of the Office of the U.S. Attorney (C.D. Cal) handling white-collar, tax, and other fraud cases through jury trial and appeal.  He served as the Bankruptcy Fraud coordinator, Financial Institution Fraud Coordinator, and Securities Fraud coordinator for the USAO’s Criminal Division, and the U.S. Attorney General awarded him the Distinguished Service Award for his work on the $16 Billion RMBS settlement with Bank of America.

Mr. Davis represents individuals and closely held entities in criminal tax investigations and prosecutions, civil tax controversy and litigation, sensitive issue or complex civil tax examinations and administrative tax appeals, and federal and state white-collar criminal investigations including money laundering and health care fraud.  He is significantly involved in the representation of taxpayers throughout the world in matters involving the ongoing, extensive efforts of the U.S. government to identify undeclared interests in foreign financial accounts and assets and the coordination of effective and efficient voluntary disclosures (OVDP, Streamlined Procedures and otherwise).

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