The United States Sentencing Commission  recently released a study of sentencing of federal offenders convicted of economic crimes.  The study included within the category of “economic crimes” thus sentenced under §2B1.1 of the United States Sentencing Guidelines (USSG), tax crimes and identity theft.  Tax crimes encompass Title 26 (Internal Revenue Code) violations, conspiracies to defraud the United States of taxes, and the use of stolen identities for filing tax forms (stolen identity refund frauds).

The study focused on offenders sentenced during the fiscal year ended September 30, 2017, but also included some data for fiscal 2013 through 2016.  Some interesting tidbits from the report include:

  1. The median loss of all crimes studied was just over $100,000. Four categories of crimes had over $700,000 median loss:  securities & investment crimes – $2.1 million; health care fraud – $1.08 million; mortgage fraud – $999,000; government procurement fraud – $739,000.  With an average loss of $398,000, tax fraud was well above the median  for all economic crimes but well under the median amounts for the four top categories of economic crimes.
  2. 1% of all federal defendants sentenced in FYE 2017 were sentenced for economic crimes. Tax crimes accounted for less than 5% of all defendants sentenced for economic crimes, or less than 0.5% of all defendants sentenced in fiscal 2017. The two categories of crimes that accounted for most defendants sentenced: drug crimes at 30.6% and unlawful entry into the US (25.5%).
  3. Tax crimes made up the following percentages of defendants sentenced between FYE 2013 and FYE 2017:

2013                2014           2015           2016           2017

2.8%                3.8%           4.5%           5.4%           4.5%

 

  1. The Ninth Circuit, which includes federal district courts in California, accounted for almost half of all defendants sentenced in federal criminal cases in 2017 (44.6%) but only 13.1% of defendants convicted of economic crimes.
  2. The Central District of California accounts for 31.5% of economic crimes sentenced in the Ninth Circuit in 2017 with 251 defendants, which is more than half of the total numbers in the Second Circuit (which includes New York) or the Seventh Circuit (which includes Illinois). Los Angeles leads the way in prosecuting economic crimes.
  3. Tax offenders made up 4% of all federal defendants sentenced for economic crimes in the Ninth Circuit in fiscal 2017. More defendants were sentenced for tax offenses in the Central District of California than in the other three districts in California combined.
  4. The Circuit with the most tax offenders sentenced in fiscal 2017: the Sixth Circuit (Michigan, Ohio and Kentucky), over half of whom were in the Western District of Michigan (think Kalamazoo). There were more defendants sentenced for tax offenses in the Western District of Michigan than in the Third Circuit (which includes Pennsylvania), the Second Circuit (which includes New York), the DC Circuit or the Seventh Circuit (which includes Illinois).
  5. Of defendants sentenced in FYE 2017 for tax crimes, 21.7% were in the 11th Circuit, 22.4% in the 6th Circuit and 11.8% in the 9th
  6. The race of persons sentenced for tax crimes in 2017 were: blacks (55.5%), whites (28.8%) and Hispanic (12.2%).
  7. Women accounted for 13.4% of all defendants sentenced in 2017, but 32.7% of defendants sentenced for economic crimes and 36.8% of defendants sentenced for tax crimes.
  8. The median age for tax offenders was 44; 23.5% had college degrees, 41.5% had some college but didn’t graduate; and the rest (35%) had no college.
  9. The study also looked at sentencing adjustments applied in economic crime cases. The frequency with which adjustments were applied to tax offenders sentenced in 2017:

 

Victim Adjustment (includes a person whose identity

is used unlawfully or without authorization)                          36.4%

Sophisticated means enhancement                                19.9%

Aggravating Role enhancement                                               13.2%

Mitigating Role enhancement                                         5.5%

Abuse of Trust/Use of Special Skill enhancement                   17.3%

 

  1. The sentencing guidelines have offender history categories, which is the number of prior convictions a defendant has. Category 1 (0 or 1 prior offense) is the lowest category.  The higher the category, the higher the potential sentence.  Over half of economic crimes offenders sentenced in 2017 fell into Criminal History Category 1, the highest percentage of any category of crimes.  7% of tax offenders were in category 1.
  2. At sentencing, offenders convicted of economic crimes had the lowest percentage incarcerated (66.3%) compared to 88% for all federal offenders sentenced in 2017 and the highest rate of probation only (20.8% versus 6.9% for all federal offenders). For tax offenders, the percentages were as follows:

Prison only                              71.7%

Prison and confinement           11%

Confinement and probation    6.3%

Probation only                         10%

  1. For those offenders sentenced, the average for all economic offenders in 2017 was 23 months in prison. This compares to an average prison term of 45 months for all federal offenders sentenced to a term of imprisonment.  The average period of imprisonment for tax offenders sentenced to prison was 31 months.

Part of the reason that tax statistics skew they way they do based on race, education and length of sentences is that stolen identity refund fraud is included in the sentencing statistics.  Many of these cases involve organized criminal gangs that obtain stolen identity information (name, social security number, etc.) and, using that information, file false returns to obtain refunds.

Note that the statistics reported by the USSG do not jibe with IRS Criminal Investigation’s statistics about percentage of defendants sentenced to prison and average term of imprisonment.  This is because CI investigates Bank Secrecy Act violations and money laundering and is involved in public corruption and drug prosecutions, among other non-tax crimes.

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez, P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He 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.

           

Sentencing for all serious federal noncapital crimes begins with the United States Sentencing Guidelines (“USSG” or “Guidelines”). The Guidelines establish a series of escalating sentencing ranges based on the circumstances of the offense, e.g., the crimes for which the defendant has been convicted, and the criminal record of the defendant.[1]

For sentencing of federal crimes involving fraud and deceit, one of the circumstances of the offense that can subject a defendant to an increase in his or her Guideline offense level involves where the defendant’s criminal conduct violated “any prior, specific judicial or administrative order.” USSG § 2B1.1(b)(9)(C).[2]  Earlier this week, the Tenth Circuit in United States v. Iley,[3] affirmed the District Court’s application of this enhancement to the sentencing imposed on an accountant, who was the subject of an administrative order for negligent conduct involving his accounting practice, in relation to his conviction for charges involving wire fraud and aiding and abetting in the preparation of a false return.

Donald Iley who, until 2015, was licensed by the Colorado Board of Accountancy (“Board”), performed services for clients that included the calculation of payroll taxes and the preparation of tax forms, as well as the collection and remittance of money to pay these payroll taxes. The Board, having received multiple complaints about Iley’s tax-preparation practices, began an administrative investigation. In resolution of that matter, Iley admitted to engaging in professionally negligent conduct and, pursuant to an administrative order, was placed on a five-year probationary period. Among the acts for which Iley was disciplined was his taking of a client’s money rather than paying it, as intended, over to the IRS to pay the client’s payroll taxes.

While on probation and subject to the administrative order, Iley defrauded his clients of more than $11 million by telling them that he was paying the funds to the IRS for payroll taxes, when, instead, he was using such funds for personal purposes. Ultimately, Iley pleaded guilty to one count of wire fraud and one count of aiding in the preparation of a false tax returns.

Prior to sentencing, the U.S. Probation Office (“USPO”) prepared a Probation Sentence Report (“PSR”) and computed Iley’s advisory Guideline range as 97 to 121 months’ imprisonment. This calculation included a two-level enhancement under § 2B1.1(b)(9)(C) for Iley’s alleged violation of the administrative order. Absent this two-level enhancement, Iley’s advisory Guidelines sentencing range would have been calculated at 77 to 97 months’ imprisonment.

It should also be noted here that a federal judge is not mandated to sentence a defendant within the advisory Guideline range, but instead is limited only by Congressionally established statutory maximum penalties and the minimum penalty, if any, applicable to the federal crime(s) of conviction. In this case, the sentencing court, finding good cause, deviated from the advisory Guideline range and sentenced Iley to 151 months incarceration.[4]  This deviation was a 30-month upward departure from the high-end of the advisory Guideline range of 97-121 months.

Iley ultimately appealed his sentence. His appeal, however, only challenged the two-level enhancement set forth in § 2B1.1(b)(9)(C), asserting two arguments as to why the District Court erred in its application of this enhancement as follows: (1) § 2B1.1(b)(9)(C) only applies when a defendant does something that an agency had expressly forbidden him from doing, and since the administrative order did not expressly enjoy him from committing the same or similar fraudulent conduct for which he was ultimately convicted, he didn’t violate the order; specifically, “the administrative order clearly delineates the conditions of Mr. Iley’s probation, and none of those conditions includes an order not to commit fraud”; and, (2) the administrative order punished him for negligence, not fraud, thus, his fraudulent conduct did not violate the order because negligence and fraud are different.

The Government disagreed with Iley’s arguments and, in support of the District Court’s application of the enhancement argued on appeal that: (1) although the administrative order did not explicitly enjoin Iley from committing the fraudulent conduct underlying the conviction, such conduct was an unmistakable implication of the order; and, (2) it is irrelevant that the administrative order disciplined Iley for negligent conduct, where his subsequent conviction was for fraudulent acts, as by punishing even negligent conduct, the order necessarily prohibited Iley from engaging in the same conduct fraudulently as well.

The Tenth Circuit, finding this issue to be a legal question subject to a de novo standard of review, affirmed the District Court’s application of the two-level enhancement, and set forth the following conclusions: (1) § 2B1.1(b)(9)(C) may apply without an explicit injunction when, as here, the prior order (i) imposed a concrete punishment, such as a fine, on the defendant for the same or similar conduct at issue in the defendant’s subsequent offense; (ii) imposed prospective, remedial conditions or obligations, like practice monitoring and the filing of quarterly reports – through a probationary term or otherwise – that were reasonably calculated to curtail future instances of the conduct at issue; and (iii) nevertheless the defendant perpetrated that prohibited conduct while the order was still in effect; and, (2) there is no reason to read a symmetry-of-mental-state requirement into § 2B1.1(b)(9)(C), where the defendant engages in the same or similar prohibited conduct with a higher level of “aggravated criminal intent” or, put another way, not only would the two-level enhancement apply where the defendant’s subsequent criminal conduct was done with the same level of culpable intent prohibited by the order, but it also applied where the defendant, undeterred from “brazenly upping his game” engaged in the conduct with a higher level of criminal intent.

 

As a result, Iley’s sentence of 151 months was upheld.

 

Sandra R. Brown  ~ is a principal at Hochman Salkin, Toscher & Perez P.C., and specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court.  Prior to joining the firm, she served as the Acting United States Attorney, the First Assistant United States Attorney and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal).  Ms. Brown may be reached at brown@taxlitigator.com or 310.281.3217.

[1]  How the Federal Sentencing Guidelines Work: An Abridged Overview (2015) https://fas.org/sgp/crs/misc/R41697.pdf

[2] United States Sentencing Commission Guidelines Manual.

[3] United States v. Donald Iley, ___F.3d ___, 2019 WL 418502 (10th Cir. 2/4/19)

[4] https://www.justice.gov/usao-co/pr/parker-cpa-sentenced-125-years-prison-wire-fraud-and-aiding-and-assisting-preparation

I recently blogged about Kimble v. United States, where the Court of Federal Claims granted summary judgment in favor of the Government in an FBAR willful case, holding that the taxpayer’s signing a return that incorrectly checked the “no” box to the question whether she had foreign accounts was sufficient to establish willfulness.  The Kimble court has now been joined by the district court in Maryland in United States v. Horowitz, Case No. PWG-16-1997 (Md., 1/18/19).

Peter Horowitz is an anesthesiologist.  He and his wife Susan lived in Saudi Arabia from 1984-2001, where Peter worked.  In 1988, they set up a joint account at UBS in Switzerland with money earned in Saudi Arabia.  At one point, the account balance reached almost $2 million.  When the couple returned to the U.S., they closed accounts they had in Saudi Arabia but kept open the UBS account.

In late 2008, Peter closed the UBS account and opened an account at Finter Bank in Switzerland.  He planned to open a joint account, but since Susan was not with him, the bank only allowed him to open an account in his name.  After 2008, Susan was added to the account.

Peter provided their CPAs with information to prepare their tax returns.  He did not inform the CPAs about the foreign accounts or ask about whether he was required to report the accounts to the IRS.  The Horowitz’s did not file FBARs for either 2007 or 2008.  Their returns for both years checked “no” to the question on Schedule B whether they had foreign financial accounts.  In 2010 they disclosed their foreign accounts.  They entered the Offshore Voluntary Disclosure program, but in December 2012, opted out.  In June 2014, the IRS assessed FBAR penalties against both Peter and Susan for 2007 and 2008.  Each penalty was equal to 25% of the amount in the account ($247,030) on the date the FBAR was due.  The assessment form was prepared by the FBAR Penalty Coordinator and signed by her manager.  The penalties for 2007 ere based on the UBS account and for 2008 were based on the Finter account.

The taxpayers protested to IRS Appeals.  Appeals requested that the penalty be removed as premature.  The penalty coordinator removed the penalty input date.  After Appeals upheld the penalty, in 2016, the penalty coordinator reentered the penalty input date.

The Government sued to collect the penalties and moved for summary judgment.  The taxpayers filed cross-motions for summary judgment.

The first issue before the Court was whether the maximum penalty was limited to $100,000 based on Treas. Reg. 31 CFR 1010.820(g)(2), which caps the willful penalty at $100,000.  District courts in Texas (U.S. v. Colliot) and Colorado (U.S. v. Wadhan) have held that the regulation controls and, therefore, the penalty may not exceed $100,000.  The Court of Federal Claims in Norman v. U.S. and Kimble held that the regulation conflicts with the statute and is invalid.  The Court found the Kimble case “persuasive” and, relying in part on the Internal Revenue Manual, held that the regulation conflicted with the statute and, therefore, the IRS could assess willful penalties equal to up to 50% of the amount in the account on the date of the violation.

The Court next rejected the claim that the penalty had been reversed in 2014 and was thus time barred.  According to the Court, the Horowitz’s failed to meet their burden of proving the claim was barred.  Assuming removal of the penalty input date was a reversal of the penalty, there was no evidence that the penalty coordinator was authorized to reverse a penalty assessment, no managerial approval of a reversal was shown and since DOJ alone can compromise assessed FBAR penalties of over $100,000, the penalty coordinator could not have validly reversed the assessment.

The Court granted Susan partial summary judgment.  Only a U.S. person with a beneficial interest in or signatory authority over a foreign account is required to file an FBAR.  The 2008 penalty against Susan was based on the Finter account.  She did not have an interest in or signatory authority over that account in 2008.  Thus she was not liable for an FBAR penalty for that year.  That the IRS could have assessed a penalty against her based on the UBS account, which she had an interest in, or could have assessed a 50% penalty against Peter was irrelevant to the question of whether she was liable for a penalty for not reporting the Finter account.

The Court upheld the willful penalties against Peter for both years and against Susan for 2007.  Although there was no evidence that either actually knew about the requirement to file an FBAR and their CPAs did not ask about foreign accounts or explain the FBAR requirements or the Schedule B questions to them, this was irrelevant.  By virtue of signing the return under penalties of perjury and failing to discuss their foreign accounts with their CPAs, they showed a conscious effort to avoid learning about the reporting requirements and thus acted willfully.

For reasons previously discussed in my January 2 blog on Kimble, https://taxlitigator.me/ , I find the willingness of courts to base liability for the FBAR willful penalty on what is constructive knowledge and the cavalier manner in which the Court of Federal Claims dismissed the Colliot decision disturbing.  If the Kimble and Horowitz decisions gain wide acceptance, taxpayers will have virtually no chance of prevailing in a willful penalty case.  And we will see another one and another one and another one bite the dust.

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez, P.C., former Chair of the Taxation Section, California Lawyers’ Association, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He 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.

 

The Court of Federal Claims (CFC) just  issued its Memorandum Opinion and Final Order granting summary judgment to the Government in Alice Kimble v United States, No. 17-421 (December 27, 2018), an FBAR willful case.  The opinion is a stunning victory for the Government: the Court granted summary judgment on the issue of willfulness based solely on the fact that Kimble signed a 2007 income tax return without first reading it and the return falsely answered “no” to the question whether she had any foreign bank accounts.

Kimble had accounts at HSBC and UBS.  Before late 2008, she had no actual knowledge of the requirement to report foreign accounts to the US.  She was accepted into the 2009 Offshore Voluntary Disclosure Program.  She filed amended returns that reported income from the offshore accounts but, for an unexplained reason, the box on schedule B asking whether she had offshore accounts was checked “no.”  She ultimately withdrew from OVDP on the advice of her attorney because the proposed “offshore penalty” (20% of the maximum account balance over a six year period) was too high.  The IRS assessed an FBAR penalty of $697,229, equal to 50% of the high balance in the account.  Kimble paid the penalty and sued for recovery in the CFC.

After discovery, the parties filed a stipulation of facts and cross motions for summary judgment.  The stipulation included the following facts:

  • Plaintiff did not review her individual income tax returns for accuracy for tax years 2003 through 2008. Stip. ¶46.
  • Plaintiff answered “No” to Question 7(a) on her 2007 income tax return, falsely representing under penalty of perjury, that she had no foreign bank accounts. Stip. ¶48.

The court found that these two stipulations established that plaintiff’s conduct was in “reckless disregard” of the legal duty to file FBAR reports.  According to the court, a taxpayer who signs a tax return is charged with constructive knowledge of its contents and thus cannot claim lack of knowledge.  While acknowledging that Kimble was not obligated to inform her accountant of the offshore accounts or to ask him about reporting requirements, this did “not affect the court’s determination that Plaintiff’s conduct in this case was ‘willful.’”  In effect, the CFC opinion makes the FBAR willful penalty a strict liability statute.  The non-willful penalty would appear to only apply if the taxpayer files an FBAR form listing all accounts but makes a clerical error, such as  in the amount in the account or the account number.

Consistent with the CFC’s earlier decision in Norman v United States, the court also held that the regulation at 31 CFR sec. 1010.820 was rendered nugatory by the 2004 amendment to the FBAR penalty statute.  The court’s resolution of this issue follows:

On October 22, 2004, Congress enacted a new statute that increased the statutory maximum penalty for a “willful” violation to “the greater of [] $100,000, or [] 50 percent of the . . . balance in the account at the time of the violation.” See American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418, 1586, § 821 (Oct. 22, 2004) (“Jobs Creation Act”). And, on July 1, 2008, the IRS issued I.R.M. § 4.26.16.4.5.1, that stated: “At the time of this writing, the regulations at [31 C.F.R. § 1010.820] have not been revised to reflect the change in the willfulness penalty ceiling.” I.R.M. § 4.26.16.4.5.1. The IRS, however, warned that, “the statute [i.e., the Jobs Creation Act] is self-executing and the new penalty ceilings apply.” I.R.M. § 4.26.16.4.5.1. Although, the Jobs Creation Act is inconsistent with 31 C.F.R. § 1010.820(g)(2), it is settled law that an agency’s regulations “must be consistent with the statute under which they are promulgated.” United States v. Larionoff, 431 U.S. 864, 873 (1977). Since the civil penalty amount for a “willful” violation in 31 U.S.C. § 5321(a)(5) (2003) was replaced with 31 U.S.C. § 5321(a)(5)(C)(i) (2004), the April 8, 1987 regulations are “no longer valid.” Norman, 138 Fed. Cl. at 196.

The court ignores the fact that the regulation was renumbered and then amended after 2004 (still maintaining the $100,000 maximum) and regulations were promulgated on adjusting the $100,000 for inflation.  Unless the Federal Circuit reverses the CFC, the CFC will be an unfriendly forum for taxpayers seeking a refund of the FBAR penalty.

Speaking of what is willful, I want to look at how the Third Circuit treated that issue in Bedrosian.   I  recently blogged on the Third Circuit’s holding that the FBAR penalty arose under the internal revenue laws, implicating the Flora full-pay rule, while paying scant attention to the court’s holding that the willfulness standard for the FBAR penalty had two components: knowing conduct and reckless conduct.  Since the district court only decided the knowing component.  The district court was reversed and the case remanded so it could determine whether Bedrosian acted recklessly.

The Third Circuit cited United States v. Carrigan, 31 F3d 130 (3rd Cir. 1994), a trust fund penalty case in which it held that a person “willfully” fails to collect, account for and pay over withholding tax if he “demonstrates a reckless disregard for whether taxes have been paid.”  In Carrigan, the Third Circuit reversed summary judgment in favor of the United States on two grounds: first, there were facts from which a jury could decide the defendant was not a responsible person and second, there were facts from which a jury could find that he did not act with reckless disregard since the only check he signed was to pay the IRS.

The Third Circuit did not invoke the “constructive knowledge” theory relied on by the CFC in Kimble and, previously, by the Fourth Circuit in United States v. Williams and the Utah District Court in United States v. McBride.  Since Bedrosian filed an FBAR for the year in question, but failed to list the larger of his two accounts, the Third Circuit could have held that he is deemed to have constructive knowledge (a) that he was required to report all of his accounts and (b) that he failed to report one account.  It did not.  This could indicate that the Third Circuit does not agree with the constructive knowledge theory.

So far one district court has explicitly rejected the constructive knowledge theory.  The court in United States v Flume, 2018 WL 4378161 (S.D. TX Aug. 22, 2018), denied the Government’s summary judgment motion.  It held that the defendant’s declaration claiming he did not know of the FBAR requirement and disputing testimony by other witnesses was sufficient to raise a material issue of fact over whether Flume acted willfully.  That Flume’s declaration was self-serving was irrelevant for purposes of a summary judgment motion since the court was prohibited from making credibility determinations.

Having rejected the Government’s contention that Flume had actual knowledge, the court then addressed the issue of whether Flume acted with reckless disregard.  It rejected the Williams and McBride holdings that a taxpayer is deemed to have “constructive knowledge” of the FBAR requirement from the fact that he signed an income tax return.  The court gave three grounds for finding this theory unpersuasive:  1) it ignores the distinction between willful and non-willful violations since, if every taxpayer by signing a return is presumed to know of the need to file an FBAR “it is difficult to conceive of how a violation could be nonwillful”; 2) it would require the court to presume that Flume had examined his returns and thus knew of the FBAR requirement, which it would not do on summary judgment; 3) the theory is “rooted in a faulty policy argument”  since constructive knowledge means that even though  a person does not have actual knowledge, the law pretends you do for policy reasons.

The Flume court also held that summary judgment was not appropriate on the question of whether Flume acted recklessly. Although Flume admitted he did not read the FBAR instructions, the court gave two reasons why this may not have been reckless: a) Flume may have relied on his CPA to read the instructions and b) since the instructions stated that there were exceptions, Flume might have believed his CPA determined an exception applied.

I had hoped that the district court’s order in Flume was a sign that the constructive knowledge theory is losing ground in the courts.  Apparently it is not.  Based on the CFC’s opinion in Kimble expect to see the Government moving for summary judgment in more FBAR cases.  Whether more courts will accept the constructive knowledge theory in FBAR cases or whether they will imbue the term “willful” with meaning is still an open question.  In any event, it will a long time before we have any definitive answer on this issue.

As an aside, Flume was the petitioner in an earlier case involving his foreign accounts: Flume v Commissioner, T.C. Memo. 2017-21, a collection due process case where the Tax Court held that the Flume was liable for penalties under IRC sec. 6038(b) for failing to file Forms 5471.  Flume’s two cases highlight the fact that often a taxpayer who fails to file an FBAR may also face penalties for failing to file foreign information reports required by secs. 6038-6038D.

Another aside, are the courts wrong in treating “reckless” conduct as willful?  Reckless and willful are not treated as identical by Congress.  Sec. 6662(c), which imposes a negligence penalty, states “the term ‘disregard’ includes any careless, reckless, or intentional disregard.”  Congress clearly distinguished intentional conduct from reckless conduct, so why can’t the courts, especially if, as the Third Circuit found, the FBAR penalty is an “internal revenue law”?

A few other asides on Bedrosian.  If the Third Circuit is correct that the FBAR penalty arises under the internal revenue laws, then 26 USC §7422 applies, which presents some unanswered questions.  Section 7422 waives sovereign immunity for suits seeking the refund of “any internal revenue tax … or any penalty,” and requires that a claim for refund be filed as a prerequisite to filing a lawsuit.  So to sue to recover payments toward an FBAR penalty, a claim for refund would need to be filed.  The period of limitations for refund suits would also apply to FBAR suits.  26 U.S.C. §6532(a)(1) provides that no suit “for the recovery of any internal revenue tax, penalty, or other sum” until 6 months after a claim for refund is filed nor more than two years after the date a notice of claim disallowance is mailed.  Since the period of limitation for filing a refund claim only applies a claim for refund or credit of “any tax imposed by this title,” 26 U.S.C. §6511(a), that period would not apply to claims for refund of FBAR penalty payments.  Neither would the general 6-year limitation on filing civil actions against the United States, which only governs commencement of judicial proceedings.

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez, P.C., former Chair of the Taxation Section, California Lawyers’ Association, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He 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.

Federal sentencing reform has been gathering steam over the past few years, as the chorus of voices critical of mandatory minimum sentences has reached a crescendo.  Congress first tackled the disparity between crack and powder cocaine sentences in the Fair Sentencing Act of 2010, which addressed a tiny, but important, sliver of oft-criticized drug sentences.  In November 2018, the Federal Sentencing Guidelines were modestly revised, encouraging judges to impose non-custodial sentences on nonviolent first offenders who are unlikely to reoffend.

On December 21, 2018, against the backdrop of a partial government shutdown looming due to a partisan divide over the Border Wall, President Trump signed the solidly bipartisan First Step Act.  Though criticized by some as too small a step, in today’s political environment any bipartisan step toward sentencing reform is praiseworthy.

What does the First Step Act do?

  • Makes retroactive the Fair Sentencing Act, thereby allowing defendants sentenced for crack cocaine crimes to apply for a reduction in their sentences. This will provide substantial work for the Department of Justice and U.S. Attorney’s Offices, as well as defense counsel who focus on such motions.
  • Allows certain incarcerated offenders – generally, low-risk – to obtain additional “good time” and “earned time” credits, after having been assessed by the Department of Justice for suitability for early release. As this assessment process doesn’t exist, DOJ is required to implement and periodically update a risk-assessment regime using evidence of what works and what doesn’t, and which offenders are likely to reoffend.
    • Good time credits already exist, as inmates can earn up to 15% good time credits, thereby only serving 85% of their imposed sentence. This simply increases their availability.
    • Earned time exists in a limited circumstance (the RDAP program for drug and alcohol abusers that can knock off up to 12 months from a sentence) and will now apply to inmates who participate in vocational, educational, substance abuse, mental health, anger-management, faith-based, and similar programs. These low-risk inmates will be allowed to move to halfway houses or home confinement more quickly than under prior law, thereby reducing the prison population in a way that should not materially increase the crime rate.
    • The list of those ineligible for such credits contains the usual suspects, such as murder, assassination, arson, kidnapping, terrorism, and child sexual abuse.
  • Expands the application of “safety valve” exception to mandatory minimum drug sentences.
  • Addresses a handful of “quality of life” issues affecting inmates. This includes prohibiting shackling inmates during pregnancy and shortly after delivery, eliminating solitary confinement for juveniles, releasing terminally ill and elderly offenders to home confinement, and prioritizing placing inmates near their families.

What’s in it for tax and white-collar defendants?

The First Step Act is the first tangible move by Congress toward what the United States Sentencing Commission has been urging for the past two years: using evidence-based decisions to place and rehabilitate inmates, instead of simply punishing and warehousing offenders.

The Act’s most-direct benefit for white collar offenders is the new mandate that the Bureau of Prisons maximize home confinement as allowed by law, which unfortunately is limited to the lesser of 10 percent of the imposed sentence or six months, whichever is less.  This should prove to be a small, but important, benefit to tax offenders, who along with other white-collar offenders overwhelmingly will fall into the low-risk designation, as they tend to be older, better-educated, non-violent, and have no criminal history.

Further, because many tax- and white-collar offenders are on the older end of the age spectrum, the liberalization of rules sending “elderly” offenders to home confinement, should also help.  The Act drops the age at which an offender is considered elderly, from 65 to 60 years old.  Other requirements favor fraud offenders, as to be eligible an offender must not have ever been convicted of a violent crime, never escaped from custody, and must be “at no substantial risk” of reoffending.  As noted in an article Steve Toscher and I wrote two years ago, available at http://www.taxlitigator.com/wp-content/uploads/2017/02/Proposed_Amendments.pdf , the recidivism rate for tax offenders is, as a category, perhaps the lowest of any other type of offender.  Particularly regarding FBAR offenders, who tend to be both at a very low risk of reoffending as well as at the higher end of the age spectrum, this change is good news for both currently incarcerated offenders as well as for defendants awaiting sentencing and looking for arguments in favor of a non-custodial sentence.

The indirect benefits, however, may be even more substantial than the direct ones.  With the First Step Act, Congress is signaling that incarceration is not the right answer for persons who are at a low risk of recidivism.  It prioritizes recidivism and rehabilitation over deterrence and imposing a “just punishment.”  This dovetails with recent amendments to the federal Sentencing Guidelines, which took effect in November 2018, and state that courts should consider a non-imprisonment sentence for nonviolent, first offenders who fall in Zones A and B of the Sentencing Table.  https://www.ussc.gov/sites/default/files/pdf/amendment-process/reader-friendly-amendments/20180430_RF.pdf.  Although many tax offenders fall in Zones C and D of the Table, the one-two punch of the First Step Act and the Guideline amendments provide powerful support for non-incarceration sentences for tax and other white-collar first offenders.

Because DOJ Tax and USAOs still seek the Guidelines sentence in most cases, we should expect to see the chasm between what defendants seek and what prosecutors recommend grow even wider.  If history is a good predictor, judges will move toward the defense recommendations more frequently than the prosecution recommendations in tax cases, as sentences have been dropping ever since the Supreme Court rendered the Guidelines advisory in United States v. Booker in 2005.

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 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 (Streamlined Procedures and otherwise).

 

In Bedrosian v United States the plaintiff paid 1% of a $975,789 FBAR penalty.  Not disputing jurisdiction, the Government counterclaimed for the unpaid balance with interest.  The district court held that Bedrosian was not liable for a willful FBAR penalty, even though he had known about the FBAR filing requirement.  The Government appealed to the Third Circuit.

On appeal, the parties agreed that the Little Tucker Act, 28 U.S.C. §1346(a)(2)  gave the district court jurisdiction, since it was a claim against the United States that did not exceed $10,000.  The Third Circuit issued its opinion, here, yesterday  Addressing an issue not raised by the parties, the Third Circuit held that  Bedrosian’s claim did not give the district court jurisdiction under the Little Tucker Act.  The Court reasoned that 28 U.S.C. §1346(a)(1) gives the district courts jurisdiction over actions for refund of any tax or penalty wrongfully collected “under the internal revenue laws.”  The Court reasoned that “internal revenue laws” encompass more than the Internal Revenue Code.  Since one of the reasons for enactment of the FBAR statute was to deter wealthy individuals from using offshore accounts to evade taxes, and the IRS has been delegated authority to enforce and assess FBAR penalties, the Court concluded the FBAR statute was an internal revenue law.  The Court was inclined to believe that the rule of Flora v. United States, 362 US 145 (1960) applied, which would mean that the district court had no jurisdiction over  Bedrosian’s initial claim since he did not full pay the assessment.  The Government’s counterclaim, however, gave the district court jurisdiction

There was another implication of the Little Tucker Act addressed by the Court: if Bedrosian’s claim was based on the Little Tucker Act, under 28 U.S.C. sec. 1295(a)(2) the Federal Circuit would have exclusive jurisdiction of appeals.  Sec. 1295(a)(2) gives the Federal Circuit exclusive jurisdiction over appeals from district court decisions where a claim arises under the Little Tucker Act, with certain exceptions.  In letter briefs filed with the Third Circuit, both parties argued that the exception in sec. 1295(a)(2) for claims founded upon a statute or regulation “providing for internal revenue” applied, but that Bedrosian’s claim for refund of the FBAR penalty was not a claim for refund of a penalty under the internal revenue laws, so sec. 1346(a)(1) did not apply.  The Third Circuit held that since the FBAR statute was an internal revenue law, the Third Court held it had jurisdiction over the appeal.

The Court then addressed the issue of whether the district court erred in holding that Bedrosian did not act willfully.  The Court held that willfulness encompasses not only voluntary, intentional or knowing violations, but also violations that are “reckless.”  While voluntary, intentional or knowing is a subjective standard, whether conduct is reckless is determined by “’an objective standard: action entailing “an unjustifiably high risk of harm that is either known or so obvious that it should be known’” Safeco, 551 U.S. at 68.”  Because the district court based its determination on  Bedrosian’s motivation and the egregiousness of his conduct compared with the conduct of taxpayers in other FBAR willful cases, the Circuit Court held  the district court did not conduct the correct analysis of whether Bedrosian’s conduct “satisfies the objective recklessness standard articulated in similar contexts” and  remanded the case back to the district court for further consideration.

Prior to the Third Circuit’s decision, both private practitioners and the Government viewed the FBAR statute as not being an internal revenue law.  If the Third Circuit is correct, a host of new issues come into play: a) is the FBAR penalty to be assessed like a tax under the Internal Revenue Code; b) do the claim for refund provisions apply: c) would IRS assessment and collection procedures apply; d) does a person against whom an FBAR penalty is assessed have CDP rights; e) can the IRS settle assessments for over $100,000 without DOJ approval; f) if a person had several offshore accounts, is the penalty to be treated as a divisible tax for purposes of ; and g) a  host of other issues.

Well, at least the Bank Secrecy Act originated in the House of Representatives, so Article I Section 7 of the Constitution is not implicated.

 

The Tax Court in Estate of Streightoff v. Commissioner, T.C. Memo 2018-178, here, faced two issues: whether an interest in a family limited partnership was an assignee interest and what discount should be applied.  Holding for the Commissioner, it determined that the interest was a partnership interest and not an assignee interest.  And since the expert for the Estate’s opinion was based on the assumption that the interest was an assignee interest, the Court sided with the Commissioner on the discount to be applied.

The facts are straight forward:  The decedent formed Streightoff Investment, L.P., on October 1, 2008, which held publicly traded securities, municipal bonds, mutual funds and cash.  Under the partnership agreement, partners holding 75% of the limited partnership interest were needed to change the general partner and approve the admission of a new limited partner.

The decedent gifted to his daughters, his sons and a former daughter-in-law limited partnership interest totaling 10.01% of the partnership.  He transferred 1% to Streightoff Management, LLC, as general partner, with his daughter as manager of the LLC.  He retained an 88.99% limited partnership interest, which he assigned to his living trust.  His daughter, as his power of attorney, signed all documents on the decedent’s behalf.

The decedent died on May 6, 2011.  The estate tax return reported a gross estate, less exclusion, of $5.051 million.  On the valuation date, the net asset value of the partnership was $8.212 million.  The estate tax return reported the value of his interest as $4.588 million after discounting it by 37.2% for lack of marketability, lack of control and lack of liquidity.  After an audit, the IRS issued a notice of deficiency determining that the value of the decedent’s interest in the partnership was $5.99 million.  The issues before the Court were 1) whether the Estate had a partnership interest or an assignee’s interest and 2) what the value was of that interest.

The first issue was a question of state law.  Under Texas law, an assignee of a partnership interest who has not been admitted to the partnership has the right to receive allocations of income, gain, loss and deduction and the right to receive distributions but does not have a the right to exercise any of the rights or powers of a partner.  The Estate argued the Trust was not admitted as a substitute partner and thus had only the rights of an assignee.  The Court did not buy the Estate’s argument.  The Federal tax effect of a transaction is governed by its substance and not its form and the Court looks beyond the formalities of intra-family partnership transactions.  The Court noted that the decedent assigned all his rights associated with his limited partnership interest, which included his right to vote as a limited partner, and all other rights under the partnership agreement and the trust agreed to abide by all provisions of the partnership agreement.  The Court held that based on the economic realities, and the fact that there was no significant difference between a limited partner and an assignee of a limited partnership interest, the transfer was of a limited partnership interest.

The Court then turned to valuation.  The fair market value standard uses a hypothetical willing buyer and a hypothetical willing seller, both of whom are “presumed to be dedicated to achieving the maximum economic advantage.”  Since the Estate acquired an 88.99% limited partnership interest, and thus could remove the general partner and effectively control the partnership, the Court sided with the IRS expert and determined that there was no discount for lack of control.  The experts for both sides applied a discount for lack of marketability.  The IRS expert used an 18% discount while the Estate’s expert used a 27.5% discount.  Since the Estate’s expert assumed that the interest was that of an assignee, the Court adopted the discount used by the IRS expert.

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez, P.C., former Chair of the Taxation Section, California Lawyers’ Association, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He 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

On November 20, 2018, the IRS rolled out its new updated procedures for taxpayers who wish to make voluntary disclosures.  The notice emphasizes that the voluntary disclosure procedures are designed for taxpayers who could face potential criminal prosecution.  Taxpayers who do not face potential criminal prosecution but failed to report all income from foreign sources or to file all forms to report foreign accounts or assets can come into compliance through the Streamlined Filing Compliance Procedures, the delinquent FBAR submission program, or the delinquent international information return submission procedures.  Other taxpayers who do not face potential criminal prosecution “can continue to correct past mistakes” by filing amended or past due tax returns.  To determine whether to apply for admission into the voluntary disclosure program, a taxpayer should consult with an attorney experienced in criminal tax cases who can advise on whether the taxpayer could face criminal prosecution.

The new program applies to any voluntary disclosures received after the date the 2014 Offshore Voluntary Disclosure Program closed, September 28, 2018.  Any taxpayer wishing to make a voluntary disclosure after that date must request preclearance from Criminal Investigation by either fax (267-466-1115) or by mail addressed to “IRS Criminal Investigation/Attn: Voluntary Disclosure Coordinator/2970 Market St./1-D04-100/Philadelphia, PA 19104.”  If CI grants preclearance, a taxpayer is then required to submit all required voluntary disclosure documents using an updated Form 14457, which will require detailed information from the taxpayer.  A copy of the current Form 14457 is here.  If CI preliminarily accepts the taxpayer’s voluntary disclosure, the case will then go to Large Business & International in Austin, Texas, which will route the case for civil examination.

Civil examiners are to apply a “civil resolution framework” to all cases.  The framework will require a taxpayer to file returns and reports and be examined for a six-year period.  This compares with the eight year period under the 2014 OVDP.  A taxpayer who makes a voluntary disclosure will be subjected to a 75% fraud penalty under either §6651(f) (fraudulent failure to file) or 6663 (fraudulent return) for the year with the largest tax liability.  If the taxpayer failed to file FBARs, willful penalties will be imposed in accordance with the guidelines in IRM 4.26.16 and 4.26.17.  These guidelines allow a penalty equal to 50% of the highest aggregate account balance and, where there are multiple years for which a willful penalty applies, an amount of up to 100% of the highest aggregate account balance.  The IRS examiner, at his or her discretion, can assert fraud penalties for more than one year “based on the facts and circumstances of the case” and can also assert penalties for failure to file information returns, again based on facts and circumstances.  If the taxpayer “fails to cooperate and resolve the examination by agreement” the examiner can apply a fraud penalty for more than six years.  IRS managers are to ensure that “penalties are applied consistently, fully developed and documented” in every case.  Taxpayers who fail to cooperate with civil disposition of the case can have preliminary acceptance revoked.

The text of the civil framework is:

  1. a) In general, voluntary disclosures will include a six-year disclosure period. The disclosure period will require examinations of the most recent six tax years. Disclosure and examination periods may vary as described below:
  2. In voluntary disclosures not resolved by agreement, the examiner has discretion to expand the scope to include the full duration of the noncompliance and may assert maximum penalties under the law with the approval of management.
  3. In cases where noncompliance involves fewer than the most recent six tax years, the voluntary disclosure must correct noncompliance for all tax periods involved.

iii. With the IRS’ review and consent, cooperative taxpayers may be allowed to expand the disclosure period. Taxpayers may wish to include additional tax years in the disclosure period for various reasons (e.g., correcting tax issues with other governments that require additional tax periods, correcting tax issues before a sale or acquisition of an entity, correcting tax issues relating to unreported taxable gifts in prior tax periods).

  1. b) Taxpayers must submit all required returns and reports for the disclosure period.
  2. c) Examiners will determine applicable taxes, interest, and penalties under existing law and procedures. Penalties will be asserted as follows:
  3. Except as set forth below, the civil penalty under I.R.C. § 6663 for fraud or the civil penalty under I.R.C. § 6651(f) for the fraudulent failure to file income tax returns will apply to the one tax year with the highest tax liability. For purposes of this memorandum, both penalties are referred to as the civil fraud penalty.
  4. In limited circumstances, examiners may apply the civil fraud penalty to more than one year in the six-year scope (up to all six years) based on the facts and circumstances of the case, for example, if there is no agreement as to the tax liability.

iii. Examiners may apply the civil fraud penalty beyond six years if the taxpayer fails to cooperate and resolve the examination by agreement.

  1. Willful FBAR penalties will be asserted in accordance with existing IRS penalty guidelines under IRM 4.26.16 and 4.26.17.
  2. A taxpayer is not precluded from requesting the imposition of accuracy related penalties under I.R.C. § 6662 instead of civil fraud penalties or non-willful FBAR penalties instead of willful penalties. Given the objective of the voluntary disclosure practice, granting requests for the imposition of lesser penalties is expected to be exceptional. Where the facts and the

law support the assertion of a civil fraud or willful FBAR penalty, a taxpayer must present convincing evidence to justify why the civil fraud penalty should not be imposed.

  1. Penalties for the failure to file information returns will not be automatically imposed. Examiner discretion will take into account the application of other penalties (such as civil fraud penalty and willful FBAR penalty) and resolve the examination by agreement.

vii. Penalties relating to excise taxes, employment taxes, estate and gift tax, etc. will be handled based upon the facts and circumstances with examiners coordinating with appropriate subject matter experts.

viii. Taxpayers retain the right to request an appeal with the Office of Appeals.

  1. d) The Service will provide procedures for civil examiners to request revocation of preliminary acceptance when taxpayers fail to cooperate with civil disposition of cases.
  2. e) All impacted IRM sections will be updated within two years of the date of this memorandum.

The original OVDP was criticized by National Taxpayer Advocate Nina Olsen for its “one-size-fits all” cookie-cutter approach that treated taxpayers who made honest mistakes the same as those who acted willfully.  As Ms. Olsen noted in a recent NTA Blog, “the IRS’s initial failure to design programs for benign actors probably eroded trust for the IRS, posing risks to voluntary compliance.”  The new voluntary disclosure program, with its emphasis on fraud penalties and FBAR willful penalties, is designed for those taxpayers Ms. Olsen would designate as truly bad actors.

While the IRS will update its IRM sections impacted by the new guidelines, the basics of its voluntary disclosure practice will remain in place: a) the disclosure must be truthful, complete and timely, b) the taxpayer must cooperate with the IRS to determine his or her correct tax liability, c) the taxpayer must pay or makes good faith arrangements to pay in full any tax, interest and penalties owed, and d) voluntary disclosure does not apply if the taxpayer had income from illegal sources.  And, as in the past, a voluntary disclosure will not immunize a taxpayer from criminal prosecution, although the IRS will probably not recommend criminal prosecution where the taxpayer complies with the program.

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez, P.C., former Chair of the Taxation Section, California Lawyers’ Association, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He 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

The Treasury Inspector General for Tax Administration (“TIGTA”) is always on the lookout for the IRS’s flaws.  They hit the agency with both barrels last month, finding in consecutive audit reports that: (1) the IRS effectively ignores currency transaction reports (“CTRs”) in IRS civil cases; and, (2) even when civil auditors use bank-filed CTRs and suspicious activity reports (“SARs”) to identify possible tax cheats, most criminal referrals wither on the IRS-Criminal Investigations vine.

Under the Bank Secrecy Act (“BSA”), banks and other financial institutions are legally obligated to report cash transactions exceeding $10,000 in CTRs.  These same institutions are also required to file – in secret, without telling the taxpayer – SARs when the institutions identify suspicious patterns or activity, such as unusual cash transactions or repeated deposits of $9,900.  Avoiding the CTR reporting by always depositing less than $10,000 is itself a crime (structuring), but the reporting is also to try to detect illegal-source income and terrorist financing.  The CTRs and SARs are filed with another arm of the Treasury Department, the Financial Crimes Enforcement Network (“FinCEN”), but the IRS’s civil auditors and criminal investigators can access CTRs and SARs.

One might think that using SARs to identify viable civil audit targets and criminal investigations is like fishing with dynamite: a bank has already told the government that something looks fishy about the taxpayer.  The problem is the number of SARs filed: more than 2 million in 2017.   https://www.fincen.gov/reports/sar-stats.  The number of CTRs presumably is much higher, so the IRS has struggled with ensuring that CTR and SAR data is integrated with other tax data.

TIGTA warned the IRS in 2010 that it was missing the boat regarding using CTRs to identify tax non-filers.  The IRS pledged to do better, and TIGTA conducted a progress checked in eight years later.  In its September 21, 2018 report, https://www.treasury.gov/tigta/auditreports/2018reports/201830076fr.pdf, TIGTA noted little improvement.

When it is conducting BSA examination under Title 31, not the Title 26 tax code, the IRS can’t use the BSA exam as a pretext to do a tax examination.  However, if the BSA examination happens to reveal a possible tax violation, the BSA group refers the matter to IRS civil auditors in the Small Business/Self-Employed Division.  TIGTA wanted to find out what happened with the 3,000 or so referrals between 2015 and 2018.  TIGTA’s findings:

  • First, for most of the period, the IRS didn’t bother establishing procedures to process the referrals. In an organization so wedded to process, this caused referrals to fall into the expected bureaucratic black hole.  No one knew how long it was taking to process the referrals, and no tracking means no consequences for delay.  In the overworked IRS, this pushes the referrals to the bottom of the work pile.  Some referrals sat for three years between receipt and forwarding for possible audit.
    • The IRS agreed in response to TIGTA’s findings that it should start tracking BSA referrals, not surprisingly.
  • Second, one third of IRS auditors didn’t review CTRs before issuing no-change determinations, even when doing so would have revealed more than $100,000 of currency transactions.
    • The IRS disagreed with the percentage of missed CTRs but agreed with TIGTA’s recommendation to update the Internal Revenue Manual to emphasize that auditors should consult CTR information.

 

In the second report, issued three days later, TIGTA took the IRS to task for the terrible return-on-investment demonstrated in BSA cases, which included cases involving Forms 8300 (essentially CTRs for businesses, not banks).  https://www.treasury.gov/tigta/auditreports/2018reports/201830071fr.pdf

 

Given that its budget has been cut to – and even into – the bone, the IRS tries to get the most bang for its criminal enforcement buck.  If that’s true, the IRS should pull the rip cord on its BSA enforcement efforts and move the resources to more-lucrative cases.

The title of TIGTA’s report says it all: “The IRS’s Bank Secrecy Act Program has Minimal Impact on Compliance.”  Why did it reach that conclusion?

  • Referrals from the IRS back to FinCEN for Title 31 (BSA) penalty cases go through long delays and don’t seem to change BSA compliance;
  • The BSA program spent nearly $100 million to assess (let alone collect) approximately $40 million (an abysmal rate, given that spending on tax assessments is always a good deal for taxpayers), in part because the IRS lets many violations slide and just issues warning letters instead of penalties because FinCEN and not the IRS has exclusive penalties authority;
  • Those tasked with BSA compliance called their efforts “a waste of time” because the IRS didn’t track whether anyone complied with the IRS’s warning letters, and the frequency of repeat offenders who suffered no consequences, was stark evidence of this fact;
  • The few (about 5 cases per year) referrals to IRS-CI for BSA prosecutions were mostly declined by IRS-CI, showing they don’t prioritize these cases; and
  • The IRS continues to separate virtual currency from BSA work, when it should be integrated with other Title 31 BSA work, and it only opened about 10% of a small number of virtual currency cases were even assigned to a BSA examiner (the upshot being that virtual currency violations remain nearly untouched by the IRS).

The upshot of the report is that it appears no person at the IRS has taken responsibility to ensure that the BSA program gets results.  Therefore, there have been no consequences for failure, no rewards for success, and no incentives for efficiency.  The lack of leadership equals lack of focus and results.

Will the new IRS Commissioner kill the BSA program in the name of directing scarce resources to higher-impact cases, or improve it as recommended by TIGTA?  It’s too early to tell.  Having both prosecuted legal-source structuring and, more recently, having represented targets of legal-source BSA investigations, I am of two minds as to the best outcome for the IRS and taxpayers.  The IRS has a lot of priorities and needs to direct its resources to get the most bang for the buck, but BSA violations can be the tip of an important iceberg of criminal activity and the IRS will never know how deep the criminal conduct goes without investigating.

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 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 (Streamlined Procedures and otherwise).

 

When a partnership wants to sell real property it sometimes has a problem: some of the partners want to cash out while others want to do a like-kind exchange and remain invested in real property.  The “drop and swap” transaction was designed to address this problem.  Prior to the sale, the partnership distributes, in exchange for their partnership interests, tenancy-in-common (TIC) interests to partners who want to do a like-kind exchange.  At the close of escrow, the partners will get cash distributed to them.  The former partners will do a like-kind exchange through a qualified intermediary.  To ensure that those partners who want to do a like-kind exchange do not prolong or disrupt a sale by not agreeing to terms the partnership finds acceptable, these transactions are normally structured so that the TIC interests are distributed after the partnership and the buyer have entered into a contract.

For several years, the Franchise Tax Board has scrutinized “drop and swap” transactions and, in late 2016, in In re Giurbino, a non-precedential decision, the Board of Equalization upheld the FTB’s determinations that such a transaction did not qualify as a like-kind exchange and that the taxpayers were liable for an accuracy penalty.

The newly-constituted Office of Tax Appeals has done an about face and held for the taxpayer in a drop and swap transaction in Appeal of Mitchell (8/2/2018).  The facts in the case are similar to those in In re Giurbino.  The partnership, Con-Med, owned rental property.  It began negotiations with the lessee, which offered to buy the property for $6 million.  Con-Med and the lessee entered into a contract for the sale of the property.  Because two of the partners, the taxpayer and her mother, wanted to do a 1031 exchange, shortly before the close of escrow Con Med redeemed the taxpayer’s and her mother’s partnership interests and issued grant deeds transferring TIC interests in the property to them.  The partnership, the taxpayer and her mother signed grant deeds transferring their respective partnership interests to the buyer.  The escrow company transferred to a qualified intermediary the taxpayer’s and her mother’s aliquot share of sale proceeds.  Subsequently, replacement property was identified and purchased for the taxpayer and her mother.

The OTA held an evidentiary hearing before a panel of three administrative law judges.  The FTB argued that the transaction did not satisfy the exchange requirement because the partnership rather than the taxpayer sold the property.  It argued substance over form, that the taxpayer was merely a conduit for passing title and that she never had any of the benefits or burdens of ownership.  Finally it argued that the partnership made an anticipatory assignment of income.   The OTA rejected the FTB’s arguments and ruled for the taxpayer.

The two judge majority held that the taxpayer “continuously held” an interest in the property for investment purposes and that she intended to exchange it for like-kind property.  That the taxpayer’s ownership changed from holding through a partnership to direct ownership of a TIC interest was viewed as immaterial.  Since she transferred her interest to a qualified intermediary she met the requirements of §1031.

The majority rejected the substance over form and step transaction arguments on the ground that for a number of years prior to the sale the partners had been discussing a sale that allowed some of the partners to do a like-kind exchange.  A drop and swap was the only way to accommodate the wishes of the partners to either cash out or do a like-kind exchange.

With respect to the conduit argument, the majority held that since the grant deed to the taxpayer was valid on its face and Con Med negotiated on behalf of all its 17 partners, “that only Con Med’s name appears on counteroffers is simply a reflection of the state of the title to the Property at the time.”

In Court Holding, 324 US 331, the Court held that a corporation that  negotiated a sale of property was in substance the seller taxable on the gain even though, prior to the close of the transaction, it had deeded the property to its shareholders, who signed the sales agreement, completed the transaction and reported the gain on their tax returns.  The majority viewed Court Holding as inapplicable since it involved a corporation and was based on its facts.  The case before it did not involve an attempt to avoid taxes, merely to defer them through a 1031 exchange.  The majority also rejected the assignment of income argument on the ground that the partnership, as a pass-through entity, was not taxable on gain from the sale.

The dissent pointed out that the taxpayer was not involved in negotiations, was not mentioned in any of the counteroffers or the signed agreement and the redemption agreement recited that Con Med (not the taxpayer) was under contract to sell the property.  Con Med handled the negotiations and sold the property. Additionally, rents were paid to Con Med during the entire period up to the sale date and Con Med paid all expenses associated with the property, not the taxpayer.  Based on the notarized dates and filing dates, the deeds transferring TIC interests to the taxpayer and her mother were signed and filed one day before the deeds transferring the property to the buyer.

The dissent criticized the majority’s rejection of Court Holding, noting that it had been applied by both federal courts and the Board of Equalization to cases involving 1031 exchanges.  It also pointed out that the facts in Court Holding were more favorable to the taxpayer since the shareholders were the only ones who signed any sales contract whereas here the partnership, not the partner, signed all sales documents.  Thus, the dissent would have found that there was an assignment of income.

The dissent would also have found that in substance the transaction was a sale by the partnership, rejecting the taxpayer’s argument that the partnership negotiated the sale as her agent.  Further, contrary to the majority, there was no evidence that the taxpayer’s mother negotiated a sale on behalf of the taxpayer.  The dissent would have found that the partnership, not the taxpayer, negotiated and sold the property, and, therefore, the transaction was not a like-kind exchange.

The FTB has filed a petition for rehearing, which is currently pending. Because of the petition for rehearing, the opinion has not become final.  Whether the OTA will deny the petition or issue a new opinion remains to be seen.  If the OTA ultimately reaffirms its initial opinion and designates it as precedential, the FTB’s challenges to drop and swap transactions will  finally be over and application of the like kind exchange provisions in California will be consistent with the more liberal federal interpretations.

 

 

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., former Chair of the Taxation Section, California Lawyers’ Association, a former Assistant United States Attorney and a formed Trial Attorney, United States Department of Justice Tax Division.  He 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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