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).

For over fifty years the Supreme Court has held that the Commerce Clause of the U.S. Constitution prohibits states from collecting sales tax from out-of-state retailers unless the retailer had a physical presence in the taxing state.  National Bella Hess, Inc., v. Ill. Dept. Rev., 386 U.S. 753 (1967); Quill Corp. v. North Dakota, 504 US 298 (1992).  A physical presence normally required the retailer to have employees or physical facilities in the taxing state. On June 21, 2018, the Supreme Court jettisoned its prior interpretation of the Commerce Clause and held that a state can require an out-of-state seller who ships goods into the state to collect and remit sales tax.  South Dakota v. Wayfair, Inc., here,

Like most states, South Dakota has seen a decline in tax revenues.  To increase the amount of sales tax collected, it enacted a law in 2016 requiring out-of-state retailers to collect sales tax on goods shipped to consumers in South Dakota.  An exception was carved out for retailers that annually shipped $100,000 or less of goods or services into the state or engaged in fewer than 200 separate transactions for the delivery of goods or services in state.  The law could not be applied retroactively.  Wayfair, Inc., and several other online retailers who did not have employees or physical facilities in South Dakota challenged the law.  Although the South Dakota high court found the State’s rationale for the law persuasive, based on the physical presence test it held that the law was unconstitutional.   The Supreme Court granted certiorari.  Over forty-one states, two territories and the District of Columbia filed amicus briefs urging the Court to overturn Quill.

In reversing the state court and overruling its prior decisions, the Supreme Court began by focusing on the two “primary principles that mark the boundaries of a State’s authority to regulate interstate commerce.”  These are: 1) a state may not discriminate against interstate commerce and 2) a state may not impose undue burdens on interstate commerce.   The Supreme Court will uphold a state tax “so long as it (1) applies to an activity with a substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce and (4) is fairly related to the services the state provides.  The physical presence rule enunciated in Bella Hess and Quill “is an incorrect interpretation of the Commerce Clause.”

The Court additionally stated that Quill put local and many interstate businesses at a competitive disadvantage to sellers who did not have a physical presence in the state.  This allowed out-of-state sellers to avoid the regulatory burden of tax collection and to offer lower prices, especially since most consumers do not pay use tax on goods purchased from out-of-state sellers.  Overruling the physical presence test ensured that artificial competitive advantages are not created by the Court’s precedents.

The Court further noted that modern ecommerce does not align analytically with a test that relies on Quill’s physical presence test.  Due to targeted advertising and instant access on the internet an out-of-state retailer may be present in a state in a meaningful way without having employees or a physical location in the state.

The Court also rejected the argument that stare decisis required affirmance of the state court’s decision.  First, stare decisis is not an inexorable command.  If a prior decision is incorrect, it should be rejected.  This is especially true where circumstances have radically changed, as occurred with the internet’s prevalence in commerce and the economy.  This has increased the revenue shortfalls faced by states seeking to collect sales and use tax.

Because of South Dakota’s exceptions for out-of-state retailers that do a limited amount of in-state business, the Court did not need to address at what point imposing the duty to collect and remit sales tax on out-of-state retailers imposes an undue burden on commerce.  The Court also did not address whether a complex sales tax system could be unduly burdensome, though it did note that there are various plans to simplify collection and that, since small in-state retailers pay the tax as well the risk of discrimination against out-of-state businesses is avoided.

The exceptions in the South Dakota law also meant that the Court did not have to address whether there was a substantial nexus between the out-of-state retailer and the taxing state.  The Court finally noted that there may be questions of whether other principles in the Commerce Clause could invalidate the law, but these had been neither briefed nor litigated.  Nonetheless several features of the law ensured that it did not discriminate against or place undue burdens on interstate commerce: 1) the safe harbor for those who only did limited business in South Dakota; 2) the law was not retroactive; and 3) South Dakota had adopted the Streamlined Sales and Use Tax Agreement that reduces administrative burdens and provides sellers access to sales tax administrative software paid for by the state.

Justices Thomas and Gorsuch concurred.  Chief Justice Roberts, joined by Justices Breyer, Kagan and Sotomayor dissented.  They argued that while Quill and Bella Hess were wrongly decided, they are stare decisis and any alteration in the rules should be undertaken by Congress.  Additionally, many businesses have acted in reliance on the Court’s prior jurisprudence and changing it may have unintended effects on the growth of ecommerce.  Thus, they would “let Congress decide whether to depart from the physical-presence rule that has governed this area for half a century.”

We can expect to see a number of states, including California, amend its sales tax statutes to reach out-of-state retailers.  It remains to be seen whether all states will 1) have exceptions similar to South Dakota’s for those that do limited in-state business or 2) have simplified procedures or 3) not apply retroactively.  These are issues that will be litigated in the future.

The Wayfair decision could affect a state’s ability to impose tax on non-residents.  Earlier Supreme Court cases barred a state from taxing an out-of-state lender on interest from loans made to a resident of the state because the out-of-state lender did not have a situs in-state (and the site of a loan is where the state where the lender resides or has business offices).  See Beidler v. South Carolina Tax Comm., 282 U.S. 1 (1930).  Whether any state will argue that these decisions must be overturned in light of Wayfair cannot be predicted.  But probably several state taxing agencies are already thinking about it.

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

Financial Status Audit Techniques. 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 Source and Application of Funds Method is an analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts for the period.[ii] This method is based on the theory that any excess expense items (applications) over income items (sources) represent an understatement of taxable income. Net increases and decreases in assets and liabilities are taken into account along with nondeductible expenditures and nontaxable receipts. The excess of expenditures over the sum of reported and nontaxable income is the adjustment to income. The Source and Application of Funds Method is typically used when the review of a taxpayer’s return indicates that the taxpayer’s deductions and other expenditures appear out of proportion to the income reported, the taxpayer’s cash does not all flow from a bank account which can be analyzed to determine its source and subsequent disposition, or the taxpayer makes it a common business practice to use cash receipts to pay business expenses.

Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately. Specific sources of funds include the decrease in cash-on-hand, in bank account balances (including personal and business checking and savings accounts), and decreases in accounts receivable; increases in accounts payable; increases in loan principals and credit card balances; taxable and nontaxable income, and deductions which do not require funds such as depreciation, carryovers and carrybacks, and adjusted basis of assets sold.

Application of funds are ways the taxpayer used (or expended) money during the year. Examples of applications of funds include increases in cash-on-hand, increase in bank account balances (including personal and business checking and savings accounts), business equipment purchased, real estate purchased, and personal assets acquired; purchases and business expenses; decreases in loan principals and credit card balances, and personal living expenses. Determining the beginning amount of cash-on-hand and accumulated fund for the year is important. See IRM 4.10.4.6.8.3 for possible defenses the taxpayer might raise regarding the availability of nontaxable funds.

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.

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

[i].  See IRM 4.10.4.6.3  (09-11-2007) and United States v. Johnson, 319 U.S. 503 (1943).

[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).

 

It seems like discussions of burden of proof and the definition of “willful” in FBAR cases are getting to be as routine as discussions of what it means to be a “responsible person” and to act “willfully” for the trust fund recovery penalty under Internal Revenue Code sec. 6672.  And the courts have so far fallen in with the line espoused by the Department of Justice.

The latest case in point is United States v. Garrity, No. 3:15-cv-00243 (D. Conn. April 3, 2018), a suit brought to reduce to judgment a penalty assessed under 31 USC sec. 5321(a)(5) for willful failure to file an FBAR, in violation of 31 USC sec. 5314.  The Court had ordered the parties to file pre-trial briefs on the burden of proof and what must be proven to establish “willful.”

The Government argued that its burden of proof is by a preponderance of the evidence rather than by clear and convincing evidence as defendants claimed.  The Court sided with the Government based on Supreme Court cases holding that this is the normal burden of proof in civil cases, including those involving monetary penalties, at least where the interests at stake are only financial and not “important individual rights and interests” that would warrant a higher standard.  The Court rejected defendants’ analogizing the FBAR penalty to a civil fraud penalty, where the Government must prove fraud by clear and convincing evidence.  It also rejected defendants’ assertion that since willful involves a question of intent the burden of proof should be greater.

Every published case involving a willful FBAR penalty has held that the government’s burden of proof is by a preponderance.  This includes the Bedrosian case, which held that the plaintiff did not act willfully.  Practitioners should take comfort that the courts have not held that the assessment of the FBAR penalty is entitled to a presumption of correctness and placed the burden of proof on the person against whom the penalty was assessed.  In a trust fund recovery penalty case, the taxpayer has the burden of proving two negatives: 1) that he was not a responsible person and 2) that he did not act willfully.

The Garrity Court also held that the Government can prove that the defendant committed a willful violation by showing he acted recklessly, rejecting the defendants’ argument that the Government must prove that the failure to file an FBAR penalty was a voluntary and intentional violation of a known legal duty.

The Court stated that defendants’ arguments “do not account for the well-established distinction between civil and criminal formulations of willfulness.”   The Court relied upon the Supreme Court’s holding in Safeco Insurance Co. v. Burr, 551 US 47 (2007), which held that proof of reckless conduct was sufficient to establish a willful violation of the notice provisions of the Fair Credit Reporting Act.   Since numerous cases have held that reckless conduct is sufficient to establish a willful violation of the FBAR reporting provisions, and the defendants could only point to criminal cases defining willful as a “voluntary and intentional violation of a known legal duty,” the Court found no reason to deviate from the cases holding that reckless conduct equals willful conduct.

The courts in FBAR cases have so far ignored the fact that in civil trust fund recovery penalty cases the courts apply a similar definition of “willful” as is applied in criminal cases: a voluntary, conscious and intentional violation of the known legal duty to pay withholding taxes.   Phillips v. United States, 73 F. 3rd 939 (9th Cir. 1996).  The Ninth Circuit in United States v Easterday, 594 F. 3rd 1004 (2009) and United States v. Gilbert, 266 F. 3rd 1180 (2001), both defined willful for purposes of the criminal trust fund recovery penalty under Internal Revenue Code sec. 7202 in a virtually identical way as it defines willful for purposes of the civil trust fund recovery penalty.  And in Slodov v. United States, 436 US 238 (1978), the Court stated that the same conduct subjecting a taxpayer to liability for the civil trust fund recovery penalty subjects him to liability for the criminal penalty:

Also, §7202 of the Code, which tracks the wording of §6672, makes a violation punishable as a felony subject to fine of $10,000, and imprisonment for 5 years. Thus, an employer-official or other employee responsible for collecting and paying taxes who willfully fails to do so is subject to both a civil penalty equivalent to 100% of the taxes not collected or paid, and to a felony conviction.

436 US at 245.  This would support an argument that willful should be construed in the same way for civil penalties for violating the Bank Secrecy Act provisions as it is for criminal penalties.

The Government has convinced the courts that willful for purposes of the civil FBAR penalty includes both reckless disregard and willful blindness. Under both Williams, 489 Fed. Appx. 655 (4th Cir. 2012) and McBride, 908 F.Supp. 2nd 186 (Utah 2012), a taxpayer’s failure to review a tax return is sufficient to establish a conscious attempt to avoid learning of the FBAR reporting requirements.  Under this reasoning, every person with an offshore account who signs a tax return with a Schedule B and fails to file an FBAR would be liable for the willful penalty.

This interpretation appears to ignore what the Supreme Court held was required to show reckless disregard or willful blindness.  In Safeco Insurance Co., the Court stated:

While “the term recklessness is not self-defining,” the common law has generally understood it in the sphere of civil liability as conduct violating an objective standard: action entailing “an unjustifiably high risk of harm that is either known or so obvious that it should be known.”  Farmer v. Brennan511 U. S. 825, 836 (1994); see Prosser and Keeton §34, at 213–214. The Restatement, for example, defines reckless disregard of a person’s physical safety this way:

“The actor’s conduct is in reckless disregard of the safety of another if he does an act or intentionally fails to do an act which it is his duty to the other to do, knowing or having reason to know of facts which would lead a reasonable man to realize, not only that his conduct creates an unreasonable risk of physical harm to another, but also that such risk is substantially greater than that which is necessary to make his conduct negligent.” Restatement (Second) of Torts §500, p. 587 (1963–1964).

It is this high risk of harm, objectively assessed, that is the essence of recklessness at common law. See Prosser and Keeton §34, at 213 (recklessness requires “a known or obvious risk that was so great as to make it highly probable that harm would follow”).

In Global-Tech Appliances, Inc. v. SEB SA, 563 U.S. 754 (2011), the Court held that in a civil case alleging inducement to violate a patent the defendant’s knowledge can be established by showing willful blindness, which requires more than negligence or recklessness.  Relying on criminal cases, the Court stated:

While the Courts of Appeals articulate the doctrine of willful blindness in slightly different ways, all appear to agree on two basic requirements: (1) the defendant must subjectively believe that there is a high probability that a fact exists and (2) the defendant must take deliberate actions to avoid learning of that fact

According to the Court these “requirements give willful blindness an appropriately limited scope that surpasses recklessness and negligence. Under this formulation, a willfully blind defendant is one who takes deliberate actions to avoid confirming a high probability of wrongdoing and who can almost be said to have actually known the critical facts.”  Deliberate indifference is insufficient to establish that the person acted knowingly or willfully.

This doesn’t square with the willfulness standard adopted in the reported FBAR cases, where several courts have deemed that a taxpayer has constructive knowledge of the contents of his tax return, which contains on Schedule B, Part III, a statement that if you have a foreign financial account you may have to file FinCen Form 114 and directs the taxpayer to the form and its instructions.   Are the Courts saying that a taxpayer who fails to read every line on his return is willfully blind or acting with reckless disregard?  If so, I think the courts are jettisoning the mens rea requirement of sec. 5321(a)(5).

Perhaps the courts are turning around.  In Norman v United States, No. 15-872 (Court of Fed. Claims), the government moved for summary judgment on the ground that the fact that Ms. Norman signed a return that checked the No box to the question of whether she has a foreign return is enough to prove willfulness because a taxpayer has constructive knowledge of the contents of the return, and thus is deemed to know of the requirement for filing an FBAR and she thus willfully failed to do so.  Convoluted, but it is a logical reading of Williams and McBride.  The court in an order denied the motion on the ground that there were material facts in dispute requiring trial.

The Court in Garrity did not say would establish recklessness.  I hope, after trial, the courts in Garrity and Norman will hold that willfulness requires at a minimum knowledge that the law requires a person knew he may have to report offshore accounts to the Government.

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 first of a six part series devoted to sensitive issue examinations of cash intensive businesses. In these situations, examiners frequently utilize various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques (FSAT). FAST’s include 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). 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.

Cash Intensive Businesses. A cash intensive business is one that receives a significant amount of receipts in cash. 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. This can be a business such as a restaurant, grocery or convenience store that handles a high volume of small dollar transactions. It can also be an industry that practices cash payments for services, such as construction or trucking, where independent contract workers are generally paid in cash.

The IRS has long been interested in business operations that receive most of their income in cash. Since certain businesses do not always deposit all of their cash receipts, there are various methods by which an examiner may be able to reconstruct total gross receipts and expenditures. Cash transactions are believed by some to be anonymous, leaving no trail to connect the purchaser to the seller, which may lead some individuals to believe that cash receipts can be unreported and escape detection. If cash is misappropriated a business by being skimmed from receipts and pocketed before it is recorded, the skim will likely not be discovered by auditing the books.

A significant indicator that income has been underreported is a consistent pattern of losses or low profit percentages that seem insufficient to sustain the business or its owners. Other indicators of unreported income include a life style or cost of living not fully supported by the reported income; a business that continues to operate despite losses year after year, with no apparent solution to correct the situation; a Cash T shows a deficit of funds; bank balances, debit card balances and liquid investments increase annually despite reporting of low net profits or losses; accumulated assets increase even though the reported net profits are low or a loss; debt balances decrease, remain relatively low or don’t increase, but low profits or losses are reported; a significant difference between the taxpayer’s gross profit margin and that of their industry; and unusually low annual sales for the type of business.

If the IRS examiner believes the business may not be reporting all of its income, the examiner may issue a summons to suppliers and other third-parties for records of sales or deliveries to the business, including original purchase invoices, during the period under examination. The examiner may then mark-up the purchases by a reasonable amount based upon industry standards to determine what are known as the audited sales for the business. Absent a reasonable explanation for a discrepancy between audited sales and reported sales, the IRS will determine income tax adjustments (and maybe penalties) based upon the discrepancy.

The IRS examiner will formulate taxpayer interview questions based on the preliminary Cash-T information, and, at the initial interview, inquire regarding possible loans or gifts received or whether a cash hoard maintained. When questioned, some taxpayers wrongfully respond that unexplained deposits or cash represents loans and gifts from relatives who may live outside the United States although there are no records to support the claim that the amounts are loans or gifts, except a copy of a letter from a relative stating that the relative gave the amounts at issue.

If the examiner believes the unexplained amounts represent unreported income, the examiner may ask the taxpayer for the specific dates and amounts of the currency received from friends or family – a vague and self serving letter from a friend or relative is not likely a sufficient response. The examiner will inquire about exactly how much currency was received on each specific date. Was it U.S. currency or foreign currency? Can the loan be verified by any other source? Can the lender show it was withdrawn from their bank on that date? Were FinCEN forms filed if currency was brought into the country? What day did the taxpayer get the money? How much did the taxpayer receive on that day? What did the taxpayer do with the money that day?

The examiner may ask for the name, address, telephone number of each person providing cash loans and inform the taxpayer that the examiner will be contacting these individuals for proof, including requesting copies of their tax returns or other documents. How the foreign currency was converted to U.S. currency? Where did the lender convert the currency? The examiner will ask for a copy of the exchange receipt issued by the bank or whomever exchanged the foreign currency for U.S. currency. If the lender converted the currency and brought it into the U.S., the examiner will request a copy of their passport showing entry to the U.S. on that day. If the taxpayer converted the currency,  the examiner will request a copy of the exchange receipt.

When foreign currency is given by gift or loan, exchange rates can be found for the transfer dates. If they were not favorable, it is unlikely a friend or relative would have exchanged the currency at that time unless it was absolutely necessary. And, if it was absolutely necessary, the money would go into the bank or into the business immediately. If the amounts in issue are asserted to be a loan, the examiner will inquire about repayment and how interest is calculated. The loan will have occurred in the examination year, and by time of the later examination, the taxpayer should have paid some of it back. If the taxpayer is repaying by taking currency to the foreign country, the examiner will ask for the same type of specific information (exchange receipts and copies of their passport, etc.). Does the business show enough profit to be able to pay back loans on those dates If only one payment is made during the year, it would likely be a larger than normal loan payment. Can withdrawals be found in the amount claimed to be paid back? Examiners will analyze the cash receipts and disbursements for the week of the repayment.

Examiners often request to interview the lenders and review their tax returns. They will inquire about the specific dates and amounts provided to the taxpayer? Was it foreign or U.S. currency? Who converted the currency to U.S.? When? Where? What records do you have to prove this? What records do you have to guarantee the money will be repaid? Have any repayments been made? When? Where? How much? If not, why not? They will ask to see copies of their passports to show they traveled into the country when they say they did and copies of their bank withdrawals if money was withdrawn to lend to the taxpayer. It is possible that, when face to face with the examiner, the lender will make statements inconsistent with the taxpayer’s statements or give some evidence that they did not really have the ability to make these suggested loans.

Typical Interview Questions Addressing Accumulated Funds. Taxpayers often assert that unexplained amounts represent accumulations of wealth over a period of time. Common interview questions include whether the taxpayer keeps more than $1,000 on their person, at home, at their business, or in any other location? What do the accumulated funds consist of? (For example, paper money, coin, money orders, cashier checks, etc.). In what denominations were the funds accumulated? Where are the accumulated funds maintained? How long have the accumulated funds been kept in the foregoing location? What kind of container were the accumulated funds kept in?

Further questions could include how much accumulated funds did the taxpayer have on hand at the beginning and end of the year under audit? How much in accumulated funds does the taxpayer have on hand presently? Over what period of time were the funds accumulated? Do the accumulated funds solely belong to the taxpayer or does it belong to more than one person? Identify each person having ownership of these accumulated funds. Do any of the other owners have access to these accumulated funds? Identify the increase or decrease in accumulated funds for each access. Identify the type of records kept to identify the name(s), date(s) and effect on the accumulated funds each time there was an access.

Why were the funds accumulated and not deposited in a financial account? What is the original source of the money included in the accumulated funds? How often are the accumulated funds accessed? What is the effect of each access? Are there additions or withdrawals from the accumulated funds? Was the taxpayer accompanied by another individual when the accumulated funds were accessed? If yes, provide the name and address of the persons involved. Does the taxpayer count the accumulated funds every time they are accessed? If not, provide the dates and purpose for when the funds were counted. Does anyone else know about the accumulated funds? If yes, provide the name, relationship, address, and phone number for the person. Also determine whether these persons have access to the accumulated funds and if so, the manner and circumstances under which their access was made (i.e., debit cards, etc.).

Summary. Every examination of a cash intensive business must be handled with extreme care. The practitioner should verify each response before it is provided to the IRS examiner during the examination. In certain circumstances, an accountant should be appropriately engaged by counsel in a Kovel arrangement (see previous article regarding retention of a Kovel accountant). IRS Audit Techniques Guides (ATGs) can be helpful in identifying potential areas where the examiner might be particularly interested for various types of businesses or tax issues (many ATGs are available for review at IRS.gov). Preparation and diligence in representation should help streamline the examination process.

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

In civil tax audits that include potentially sensitive issues, counsel will often engage a team of representatives, including a forensic accountant. Engagement of the accountant by counsel should be carefully designed to extend the attorney-client privilege to communications with the accountant pursuant to the engagement by counsel.

The Kovel Accountant. Although Code Section 7525 extends common law protections of confidentiality to tax advice rendered between a taxpayer and a federally-authorized tax practitioner (to the extent such communications would be considered privileged if they occurred between a taxpayer and counsel), this statutory privilege only applies to non-criminal tax matters before the IRS and non-criminal tax proceedings in federal court. The protections afforded by Code section 7525 are not available when truly needed the most — when a civil tax proceeding moves into the criminal arena.  It also may not be available in state-related tax proceedings, or non-tax civil litigation.

Pursuant to United States v. Kovel, 296 F.2d 918 (2nd Cir. 1961), the attorney-client privilege is extended to an accountant retained specifically to assist an attorney in rendering legal services to a client, both during the investigative stages of the case and if necessary, during trial. If the accountant is appropriately engaged by counsel, the common law attorney-client privilege will apply to all communications rendered in furtherance of the legal services being provided to the client, both during the examination stages of the audit and, if necessary, during any subsequent civil or criminal proceedings.

A critical inquiry is often whether counsel should retain the taxpayer’s prior accountant or a new accountant. Many practitioners prefer to engage a new accountant to avoid the necessity of delineating between non-privileged communications (communications prior to counsel’s engagement of the accountant), and privileged communications (communications following counsel’s engagement of the accountant). Retention of a new accountant avoids issues relating to whether information possessed by the accountant may have been obtained prior to the accountant’s engagement by counsel.

Counsel’s engagement of the accountant should be in writing, and should indicate that the accountant is acting under the direction of counsel in connection with counsel’s rendering of legal services to the client, communications between the accountant and the client are confidential and are made solely for purposes of enabling counsel to provide legal advice; the accountant’s work-papers are held solely for counsel’s use and convenience and subject to counsel’s right to demand their return; and the accountant is to segregate their work papers, correspondence and other documents gathered during the course of the engagement and designate such documents as property of counsel.

Assistance in Indirect Method Audits. Historically, conventional audit techniques have been discovered to be grossly inadequate for the purpose of demonstrating an understatement of taxable income. In such event, the government has often resorted to one or more indirect methods of detecting unreported income by essentially auditing a taxpayer, rather than a return.

The use of indirect methods of proving income, historically referred to as the IRS Financial Status Audit Techniques (FSAT), is not prohibited by Code Sec. 7602(e). If the examiner has a “reasonable indication” that unreported income exists, the IRS has the authority to use an indirect method of reconstructing income to determine whether or not the taxpayer has accurately reported total taxable income received. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances.

The use of a “formal” indirect method, however, is not precluded by the presentation of books and records. Use of an indirect method is often supported by circumstances that, individually or in combination, would support: (1) a financial status analysis that cannot be balanced; i.e., 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; (2) irregularities in the taxpayer’s books and weak internal controls; (3) gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry; (4) the taxpayer’s bank accounts have unexplained items of deposit; (5) the taxpayer does not make regular deposits of income, but instead uses cash for many transactions; (6) a review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income; (7) 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, determine who destroyed them, why, and when); or (8) no method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income.

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 under-reported or unreported income. Examiners will 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 government routinely uses the various indirect methods to reconstruct income including specific item; net worth plus expenditures; bank deposits; and a combination of the above methods. The accountant may be called upon to analyze indirect methods used by government to develop unreported income.

Relevant inquiries include the standard of living of the taxpayer. What do the taxpayer and their dependents consume economically? How much does it cost to maintain this consumption pattern? Is reported net income sufficient to support this standard of living? What are the possible sources of funds to support these expenditures?

What is the accumulated wealth of the taxpayer? How much has the taxpayer expended in the acquisition of capital assets? When and how was this wealth accumulated? Has reported income been sufficient to fund the accumulations? What is the economic history of the taxpayer? What is the long term pattern of profits and return on investment in the reported business activity? Is the taxpayer’s business expanding or contracting? Does the reported business history match the changes in the taxpayer’s standard of living and wealth accumulation? Is reported interest income increasing or decreasing?

What is the business environment for the taxpayer’s industry? What is “typical” profitability and return on investment for the taxpayer’s market segment and locality? What are typical patterns of non-compliance in the taxpayer’s market segment? What are the competitive pressures and economic health of the market segment within which the taxpayer operates?

Has the taxpayer made assertions to receipts of funds which were considered to be non-taxable? Do claims of non-taxable sources of support make economic sense (cash hoard, credit history)? How credit worthy is the taxpayer in view of the taxpayer’s assertion that funding was secured from loans? In situations where the taxpayer has asserted that funds were received from other than conventional lending institutions, what was the lender’s source of funds? Was it a disguised loan of funds that originated with the taxpayer?

The Kovel accountant’s responsibility in analyzing the above indirect methods of proof may include analyzing bank statements and financial information; assisting the attorney in interviewing witnesses; developing a cash-on-hand figure; assisting the attorney in developing questions for the agent which may highlight weaknesses in the government’s position; and joining the attorney in meetings with the examining agent in an attempt to further explain and highlight weaknesses in the agent’s position.

A civil examination involving potentially sensitive issues where civil or criminal fraud potential exists requires the utmost of judgment, discretion and caution. The primary examination objectives are to limit the scope of the inquiry; to avoid the presentation of false or misleading information; to avoid false statements by the taxpayer or the taxpayer’s representative; and to limit the information provided so as to avoid the waiver of the privilege against self-incrimination.

Notwithstanding extreme resource challenges, the IRS remains well equipped to identify potentially fraudulent returns as a result of increased transaction and information reporting, better developed audit plans and techniques which focus on specific industries, substantially increased access to computerized data banks and an overall increased level of scrutiny of the taxpayer, the taxpayer’s business, the taxpayer’s standard of living and how these relate to issues reported – or not – on the return under examination.

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

Section 5321(a)(5)(A) provides that the Secretary of Treasury “may impose a civil money penalty” on anyone who violates the FBAR reporting requirements.  Originally, the penalty for willful violation was the greater of the amount in the account (not to exceed $100,000) or $25,000. In 2004, Congress amended the FBAR penalty provision to increase the maximum willful penalty from the amount in the account (up to $100,000) to the greater of $100,000 or 50% of the amount in the account.  Section 5321(a)(5)(C)(i). Based on the statute, the IRS has routinely imposed FBAR penalties equal to 50% of the high balance in the taxpayer’s offshore accounts, sometimes for several years.  As a result, taxpayers have been faced with millions of dollars in FBAR penalties.

Along with a handful of other commentators, I had pointed out that these confiscatory penalties violate a Treasury regulation issued after sec. 5321(a)(5(C)(i) was amended.  That regulation, 31 C.F.R. sec. 1010.820, provides that the maximum FBAR penalty is $100,000.  See “Is it Illegal for the IRS to Assess More than $100,000 for a Willful FBAR Violation?” posted November 17, 2017.

On May 16, 2018, a District Court held that a willful FBAR penalty of over $100,000 was illegal.  United States v. Colliot, Docket No. 1:16-cv-01281 (W.D. Tex.). The Government sued Mr. Colliot to collect FBAR willful penalties assessed against him for 2007, 2008, 2009 and 2010. The penalties assessed were $548,773 for 2007 and $198,082 for 2008. The penalties for 2009 and 2010 were smaller. Mr. Colliot moved for summary judgment on the ground that the IRS improperly assessed penalties of over $100,000 in violation of the regulation. The Government opposed the motion on the ground that regulation was invalidated by the statute. The Court disagreed.

The Court found that there was “little reason to believe” the statute “implicitly superseded or invalidated” the regulation. The maximum penalty is discretionary and the regulation, issued by notice-and-comment rulemaking, “is consistent with § 5321’s delegation of discretion to determine the amount of penalties to be assessed.”  The regulation was neither unreasonable nor contrary to the provisions of the statute. As a result the IRS acted “arbitrarily and capriciously” when it when it assessed penalties in excess of the regulatory cap.

The Court left open the issue of the appropriate relief in this situation: could the IRS still collect up to $100,000 per year if it proved willful violations or was the entire penalty invalid?

This case is a significant victory for taxpayers.  Persons who did not go into the Offshore Voluntary Disclosure Program and are facing 50% penalties have a new weapon to defeat the IRS. The Government will have to consider whether it wants to appeal the decision or just promulgate a new regulation that authorizes a penalty of up to 50% of the maximum balance in the undisclosed offshore accounts.

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

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