TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

In most cases in which a person pleads guilty to a tax-related crime in federal district court, the U.S. Attorney’s Office will require him to agree that the district court can order the payment of restitution to the IRS for the years for which he pleads guilty plus any years constituting relevant conduct. Following conviction for a tax-related crime in federal district court, the court can order restitution as a condition of probation or of supervised release.  The amount of restitution will often be substantial.  In addition, following the criminal case, the IRS can issue a notice of deficiency asserting additional tax liabilities for the same years, plus fraud and/or accuracy penalties and interest.   The good news is that the taxpayer can do an offer in compromise of the additional taxes, penalties and interest assessed by the IRS.  The Tax Court in Rebuck v. Commissioner,  T.C. Memo 2016-3, reminded taxpayers of the bad news: to do so, they need to pay the full amount of restitution, which cannot be compromised.

The taxpayer in Rebuck was indicted along with a number of co-defendants of conspiring to defraud the United States by marketing foreign and domestic trusts that falsely claimed that they would help taxpayers legally avoid paying federal income tax, in violation of 18 U.S.C. §371.  Rebuck was convicted of one count of conspiracy.  At sentencing, the district court ordered Rebuck to pay restitution to the IRS of $16,399,199 jointly and severally with his co-defendants.

After his conviction, Rebuck filed income tax returns with the IRS for 1999, 2000, 2001 and 2002.  The IRS assessed the tax shown due on the returns together with penalties and interest.  Because Rebuck neither paid his tax liabilities for 1999 – 2002 nor entered into an installment agreement for those years, the IRS issued a Final Notice/Notice of Intent to Levy under IRC §6330.  Rebuck’s attorney filed a timely request for a Collection Due Process (CDP) hearing.  His attorney submitted an offer in compromise to the Settlement Officer assigned the CDP case.  The offer encompassed Rebuck’s income tax liabilities for 1996-2002 plus promoter penalties that had been assessed against him.  The Settlement Officer concluded that an OIC could only be considered if Rebuck agreed to pay the entire amount of restitution owed the IRS.  Rebuck appealed the determination to the Tax Court, which held that the IRS did not abuse its discretion in rejecting the OIC.

In so holding, the Tax Court stated that under the Internal Revenue Manual, part 5.1.5.24.5, an OIC may not be considered from a taxpayer who owes criminal restitution to the IRS unless the offer proposes an amount that is no less than the full amount of restitution owed. The “refusal to consider petitioner’s OIC unless it met the IRM requirement that criminal restitution be satisfied as part of an OIC does not constitute an abuse of discretion.  Indeed, it appears reasonable for the Commissioner to decline an OIC made by a taxpayer who has committed a crime related to Federal tax but who fails to satisfy a restitution order by a District Court in the criminal case.”   Previously, in Isley v. Commissioner, 141 TC 349 (2013), the Court held that under §7122 and Treas. Reg. §301.7122–1(d)(2), the IRS could not unilaterally accept an offer involving tax years that had been referred for prosecution to the Department of Justice, even where the taxpayer’s offer is submitted post-conviction.

Rubeck and Isley both involve restitution orders entered before 2010.  In 2010, Congress added §6401(a)(4) to the Internal Revenue Code, which requires the IRS to assess and collect the amount of restitution ordered in a criminal case for failure to pay any tax imposed under Title 26 in the same manner as if such amount were a tax. This section allows the IRS to use its administrative collection tools to collect the amount of the restitution order issued by the federal district court.

In addition, §6201(a)(4)(C) restricted a defendant’s ability to challenge an IRS assessment of restitution ordered by a district court in a criminal case.  Under §6213(b)(5), a restitution-based assessment is not subject to deficiency procedures. Additionally, under §6501(c)(11), a restitution-based assessment can be made at any time.

In Notice 2013-12, IRS Chief Counsel determined that court-ordered criminal restitution may only be modified or reduced by the district court in the limited circumstances set out in 18 U.S.C. §3664(o)(1). Thus, if the IRS determines that the amount of restitution ordered exceeds the amount of tax actually owed, the IRS cannot reduce the amount of restitution assessed. Similarly, if the taxpayer has a net operating loss in a subsequent year that would reduce the tax owed, it does not affect the taxpayer’s obligation to pay restitution in the amount ordered by the court.

Not only may a taxpayer not compromise an order to pay restitution to the IRS, restitution may not be discharged in bankruptcy, since under 11 U.S.C. §523(a)(13) a debt is not dischargeable that is “for any payment of an order of restitution issued under title 18, United States Code.” And since a criminal restitution order is part of a federal judgment, it is enforceable beyond the ten-year period during which tax assessments are normally enforceable.

If you represent a defendant in a criminal tax case, you must take steps early on to ensure that any amount of restitution ordered by the court does not exceed the amount of tax actually owed, since, once the court enters a restitution order, the amount of restitution cannot be challenged in any other proceeding, cannot be compromised, is not dischargeable in bankruptcy, and is enforceable for longer than normal tax assessments. And as the Tax Court reminds us in Rebuck, if the taxpayer owes restitution to the IRS, he cannot compromise other tax liabilities unless he agrees to pay an amount that is no less than the total amount owed as restitution.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz 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) and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com

The IRS recently gave unexpected Chanukah and Christmas presents to tax cheats and other assorted ne’er do wells. The present came from an unexpected source, Criminal Investigation (CI), in the form of CI’s 2015 Annual Report, released at the beginning of December, in time for holiday shopping.

All you need to know about the current state of CI is contained in the opening paragraph of the message of CI Chief Richard Weber: “We began the year facing deep cuts in our budget. Having hired only 45 agents in the last three years, attrition was catching up to us and our staffing levels hit their lowest levels since the 1970’s. We finally came to realize that fewer agents and staff really do mean fewer cases.”  Fewer special agents, fewer cases, fewer tax cheats brought to justice.  I guess less is NOT more.

Most of the remainder of the report is an attempt to make a silk purse out of a sow’s ear, with feel good stores about successful prosecutions and initiatives, many with CI’s “partners” in other law enforcement agencies. While CI has had accomplishments with the diminished resources at its disposal, the dire condition of criminal tax enforcement is revealed in the statistics contained in the report.  The number of special agents and professional staff is the lowest since the early 1970s and has fallen by almost one-third in 10 years.

Per capita, CI now has approximately 1 special agent for every 137,000 people living in the United States. That is probably a level that has not been seen since prior to World War II.  Elmer Irey, the first chief of CI and the man who brought Al Capone to justice, must be spinning in his grave.

The report lists CI’s priorities as:

• Identity Theft Fraud
• Abusive Return Preparer Fraud & Questionable Refund Fraud
• International Tax Fraud
• Fraud Referral Program
• Political/Public Corruption
• Organized Crime Drug Enforcement Task Force (OCDETF)
• Bank Secrecy Act and Suspicious Activity Report (SAR) Review Teams
• Asset Forfeiture
• Voluntary Disclosure Program
• Counterterrorism and Sovereign Citizens
• In each of these categories the number of investigations initiated and cases referred for prosecution has declined over the last three years. The total numbers of investigations initiated and prosecutions recommended in 2013, 2014, and 2015 were:

CI’s top priority is identity theft fraud, i.e. criminal gangs who steal taxpayer’s identification numbers, electronically file false returns and obtain refunds. This crime affects hundreds of thousands of taxpayers and costs the U.S. Treasury billions of dollars in illegally obtained refunds each year.  Investigations initiated and prosecutions commenced between 2013 and 2015 were:

General tax fraud is traditionally CI’s bread and butter. It is the investigation and prosecution of tax fraud committed by people who are engaged in legitimate businesses.  Like other priority areas of CI, investigations and prosecutions declined in this area:

And next we come to a program that has been widely touted by CI and the Department of Justice as a top priority: the investigation and prosecution of taxpayers who cheat the government out of employment withholding tax.  Here to, investigations initiated and prosecutions referred are down:

CI has a well-deserved reputation as the being the best financial crimes investigation agency in the world. Its special agents were well-trained, highly-motivated and CI has an unmatched level of success in obtaining convictions:  the conviction rate for federal tax prosecutions has never fallen below 90%.  CI has always been a key to ensuring voluntary compliance.  It has also been instrumental in the prosecution of drug trafficers, health care fraud, money laundering and the financing of terrorist organizations, among other things. With budget cuts and attrition, its ability to fulfill its mandate will only suffer, much to the relief of tax cheats and other perpetrators of financial crimes.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz 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)  and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com

Section 2503(b) of the Internal Revenue Code provides the annual exclusion, which excludes from taxable gifts the first $10,000 (adjusted for inflation) of “present interest” gifts. The current annual exclusion amount is $14,000. Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968) supplies the rule for present interest gifts in trust. In order to have a present interest in a gift held in a trust, the beneficiary must have an unconditional right to withdraw upon demand. The IRS expressed its agreement with Crummey in Rev. Rul. 73-405.  In Estate of Cristofani v. Comm’r, 97 T.C. 74 (1991), the Tax Court adopted the reasoning in Crummey, finding that the proper focus of the present interest test analysis is not the likelihood that beneficiaries would actually receive enjoyment of the property, but the legal right of the beneficiaries to demand payment from the trustee. The IRS acquiesced to the result in Cristofani, noting that although it will not contest annual gift tax exclusions for Crummey powers where the trust instrument gives the power holders bona fide unrestricted legal right to demand immediate possession and enjoyment of trust income corpus, it will deny Crummey exclusions where the withdrawal rights are not in substance what they purport to be in form.

In Mikel v. Comm’r, T.C. Memo 2015-64, the IRS challenged donor-grantors claims of the annual exclusion for gifts contributed to a trust where the trust granted each beneficiary (many of whom were under 18 years of age) the right to withdraw trust principal (the Crummey provision), but also contained an in terrorem (“no contest”) clause, which provided the following:

“In the event a beneficiary of the Trust directly or indirectly institute, conduct or in any manner whatever take part in or aid in any proceeding to oppose the distribution of the Trust Estate, or files any action in a court of law, or challenges any distribution set forth in this Trust in any court, arbitration panel or any other manner, then in such event the provision herein made for such beneficiary shall thereupon be revoked and such beneficiary shall be excluded from any participation in the Trust Estate.”

Each petitioner made gifts of $1,631,000 to a family trust, reported the gifts on gift tax returns and claimed annual exclusions pursuant to Section 2503(b) of $720,000. Petitioners computed their $720,000 annual exclusion amounts by multiplying $12,000 (the annual exclusion for the taxable year) by the number of beneficiaries to the trust (60). The trust also contained a provision requiring notification to all beneficiaries that the trust received property as to which the beneficiary had a demand right. Such notification must occur within a reasonable time after the contribution of property subject to a demand right. The trust complied with the notification provision after petitioners made their gifts. The trust directed mandatory distributions in response to withdrawal demands and empowered trustees to make discretionary distributions during the term of the trust for “health, education, maintenance or support” (“HEMS” provision).

The trust also provided if any disputes arose regarding the proper interpretation of the declaration the dispute shall be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith (a “beth din”). The beth din was directed to enforce the provisions of the declaration of trust and give any party the rights he is entitled to under New York law.

The IRS conceded that the trust provided each beneficiary with an unconditional right to withdraw (via the Crummey provision), but argued that regardless of the Crummey provision, the beneficiaries did not receive a present interest in property because the beneficiaries “would be reluctant” to enforce their rights in state court as a result of the no contest clause and the beth din requirement. Respondent further argued that beneficiaries’ withdrawal rights were “illusory.” Significantly, the IRS challenged the provision because the drafters did not make it clear that the in terrorem provision did not apply to the right to demand.

In finding for Petitioners, the Tax Court noted the beth din was directed to enforce the declaration of trust and give any party all rights he is entitled to under New York law. As a result, “a beneficiary would suffer no adverse consequences from submitting his claim to a beth din.” The Tax Court also noted Respondent’s concession that the beneficiaries have a state court remedy, and that the no contest clause was meant to discourage legal actions seeking to challenge the trustees discretionary (not mandatory) distributions. Therefore, the Tax Court reasoned, a suit to honor a timely withdrawal demand would not trigger the application of the no contest clause.

Since the trustee did not have discretion to deny a timely made withdrawal demand, the in terrorem provision did not apply to the demand right. Thus, the right to judicially enforce it was not illusory. Because the beneficiaries had an unconditional right to withdraw, they had present interest in the trust.

The Tax Court noted that the no contest clause was poorly drafted and devoted significant analysis to whether the no contest clause should be read narrowly. In finding for Petitioners, the Tax Court concluded a Crummey provision existed, beneficiaries’ “literally” had state court enforceable rights, and “the [no contest] provision, properly construed, would not deter beneficiaries from pursuing judicial relief.” Accordingly, although the IRS will have difficulty challenging the application of the annual exclusion to gifts to Crummey trusts, practitioners should carefully and clearly draft other trust provisions so that the Court is not in a position to consider whether other terms of the trust create present interest test issues.

KRISTA HARTWELL – For more information please contact Krista Hartwell at Hartwell@taxlitigator.com or 310.281.3200. Ms. Hartwell is a tax lawyer at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com.

Section 481 provides that where a taxpayer’s taxable income for a tax year is computed under a method of accounting different from that previously used, an adjustment will be made to prevent amounts from being duplicated or omitted solely by reason of the change in accounting method.[i]  Section 481 applies regardless of whether the change in accounting method is initiated by the taxpayer or by the IRS, and regardless of whether the prior accounting method was a correct or incorrect method of accounting.

If the requirements of Section 481 are met, the section allows an adjustment for amounts that would have been reported in prior years if the new method of accounting had been consistently used, even if adjustments for those earlier years are otherwise barred by the statute of limitations.  As a result, it is important to have an understanding of what changes are considered to be a change in accounting method, and what changes do not fall under Section 481.

Definition of a Change in Accounting Method.  Section 481 and the regulations thereunder do not include a definition of “accounting method” or explain what constitutes a change in an accounting method—the terms are defined only by reference to Section 446 (“General rule for methods of accounting”).[ii]  Section 481 applies to a change in a taxpayer’s over-all method of accounting for gross income or deductions, such as a change from the cash method of accounting to the accrual method of accounting, as well as to any change in the “treatment of a material item.”[iii]  The regulations define “material item” as “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.”[iv]

Section 481 Applies Only to Changes in Timing.  Any change that does not relate to the proper time for the inclusion of an item in income or the proper time for the taking of a deduction is not a change in accounting method under Section 481.  Treasury Regulation Section 1.446-1(e)(2)(ii)(b) provides that a change in accounting method does not include any “adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction.”[v]    The test that courts generally use to determine whether an adjustment involves the timing of an item of income or deduction is whether the change permanently distorts the taxpayer’s lifetime taxable income (that is, the taxpayer’s cumulative taxable income for all taxable periods of its existence).[vi]

The regulation provides two examples to illustrate this rule: (1) corrections of items that are deducted as interest or salary, but that are in fact payments of dividends, are not changes in method of accounting; and (2) corrections of items that are deducted as business expenses, but that are in fact personal expenses, are not changes in method of accounting.[vii]  In both instances, a corporation’s overall taxable income is permanently changed as a result of the disallowed deductions—the changes disallow the deduction instead of merely deferring the deduction.

For example, in Pelton & Gunther P.C., TC Memo 1999-339, the Tax Court held that Section 481 was not applicable where the IRS determined that a law firm’s practice of deducting litigation expenses that it advanced on behalf of clients was erroneous, recharacterizing those amounts instead as non-deductible loans.  The Tax Court concluded that it was not a timing question even though the law firm had been including the reimbursed amounts into income in the year the reimbursements were received, because the IRS determined that the item was not deductible ab initio, finding that the petitioner’s payments of litigation costs were non-deductible loans to its clients.  Because the deductions were disallowed entirely, the Tax Court determined there was not a change in method of accounting.

However, in Humphrey, Farrington & McClain, TC Memo 2013-23, another Tax Court case involving advanced litigation expenses, the Tax Court found there to be a change in accounting method where the IRS had disallowed an ordinary and necessary business deduction for such expenses but instead allowed a bad debt deduction for the unreimbursed expenses in a later tax year, because the amount of the net deduction was the same under both the taxpayer’s treatment of the expenses and under the IRS’ treatment of the expenses.

Section 481 Does Not Apply to Mathematical and Posting Errors.  The regulations specify that a change in accounting method does not include a correction of a mathematical or posting error.[viii]  In Korn Industries, Inc. v. United States, 532 F.2d 1352 (Ct. Cl. 1976), the Court of Claims considered whether a taxpayer’s omission of three items of inventory in prior years was a “change in method of accounting” when those errors were corrected in a subsequent year.  The taxpayer’s income tax return for the tax year at issue reported a beginning inventories amount that was greater than the company’s closing inventories amount for the prior year, as a result of including the value of these additional amounts in inventory.  The taxpayer had conceded that the error resulted in an understatement in the year of the omission, so the only issue was whether an adjustment for those prior years was barred by the statute of limitations.  The IRS argued that the adjustment in the taxpayer’s beginning inventory was a “change in method of accounting” necessitating an adjustment under Section 481, but the Court of Claims held there to be no change in method of accounting.  Even though the change affected a balance sheet item in the current tax year, the court held that the taxpayer did not change its method of accounting because the taxpayer had simply made an error analogous to a mathematical or posting error—there was no change to the taxpayer’s method of valuing inventories.

Section 481 Does Not Apply to a Change Caused by a Change in the Underlying Facts.  There is no change in accounting method if the change in treatment of an item results from a change in the underlying facts.[ix]  For example, a change in the tax year that a taxpayer accrues a liability for a vacation pay plan is not a change in the method of accounting if the change results from a change the company made in the type of vacation pay plan.[x]  Similarly, in an IRS National Office Technical Advice Memorandum dated June 3, 2010, the IRS concluded that a change in the treatment of a loss from an entity from active to passive pursuant to Section 469 is not a change in a method of accounting for purposes of Sections 446(e) and 481(a).[xi]  In the Technical Advice Memorandum, the IRS states: “We do not believe that a determination of whether a taxpayer materially participates in an activity is a method of accounting.”[xii]

It is important to keep these concepts in mind during the course of an audit, as the IRS may take the position that an adjustment affecting the timing of an item of income or deduction triggers the application of Section 481, giving rise to an adjustment for the item not only in the year under audit, but also for each prior year relating to the item.  Having an understanding of what is and is not an accounting method change will assist practitioners in evaluating any potential Section 481 issue.  In addition to the above concepts, the detailed regulations in Section 1.446-1(e) provide specific rules and illustrate several examples of how the Section 481 rules apply to various situations.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue domestic civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. She has considerable expertise in handling matters arising from the U.S. government’s ongoing civil and criminal tax enforcement efforts, including various methods of participating in a timely voluntary disclosure to minimize potential exposure to civil tax penalties and avoiding a criminal tax prosecution referral. Additional information is available at http://www.taxlitigator.com.

[i] IRC § 481(a).

[ii] Treas. Reg. § 1.481-1(a)(1) (“For rules relating to changes in methods of accounting, see section 446(e) and paragraph (e) of § 1.446-1.”).

[iii] Treas. Reg. § 1.481-1(a)(1); 1.446-1(e)(2)(ii)(a).

[iv] Treas. Reg. § 1.446-1(e)(2)(ii)(a).

[v] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[vi] See, e.g., Schuster’s Express, Inc. v. Commissioner, 66 TC 588 (1976).

[vii] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[viii] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[ix] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[x] See Treas. Reg. § 1.446-1(e)(2)(iii) Examples (3) & (4).

[xi] TAM 201035016, June 3, 2010.

[xii] Id.

ABA 2015 National Institute on Criminal Tax Fraud and Tax Controversy, December 9-11, Encore Hotel, Las Vegas.

We are closing in on a full house for the ABA 2015 National Institute on Criminal Tax Fraud and Tax Controversy, December 9-11, Encore Hotel, Las Vegas, Nevada.  If you are interested in attending and have not yet registered, please do so as soon as possible.

Many members of the judiciary (Tax Court and District Court) and senior government representatives (IRS, DoJ TAX, Office of the U.S. Attorney – Tax Division, etc.) are confirmed for this year! Our primary Institute meeting rooms (accommodating 330 and 175 attendees, respectively) will again be located next to each other. There are numerous opportunities to meet your government and private practitioner colleagues and to get re-acquainted with old friends in an open, friendly setting! 

Also, please remember that the ABA 2015 National Institute Criminal Tax Fraud and Tax Controversy, December 9-11, Encore Hotel, Las Vegas is BUSINESS CASUAL.  

Registration and Encore Hotel information is available at: www.shopaba.org/2015criminal.   (If the link doesn’t work, search 32nd Annual National Institute on Criminal Tax Fraud and the ABA site should come up for you). 

Wynn / Encore Hotel, 3131 Las Vegas Boulevard South, Las Vegas, NV 89109

We look forward to seeing you all at the National Institutes next week at the Encore Hotel! If you should have any questions, please feel free to contact Steve Toscher toscher@taxlitigator.com, Dennis Perez perez@taxlitigator.com or Chuck Rettig at rettig@taxlitigator.com . 

On November 23, 2015, the District Court for the Western District of Washington issued its decision in one of the most closely watched summons enforcement cases in recent years: United States v. Microsoft Corp., Case No. C15-00102-RSM.  The case drew attention not only because of the taxpayer involved, Microsoft Corporation, but also because Microsoft challenged the summonses based on the IRS’s unusual action in retaining the law firm of Quinn Emanuel Urquhart & Sullivan “as a private contractor to assist in the IRS’s examination of Microsoft’s 2004 to 2006 tax years.”

Under United States v. Clarke, 134 S.Ct.2361 (2014), a district court is to hold an evidentiary hearing in a summons enforcement case if the taxpayer can point to specific facts from which the court can infer that the summons was issued for an improper purpose.  Based on the Clarke standard, the Court granted Microsoft’s motion for an evidentiary hearing.  The Court held a one-day evidentiary hearing, where Microsoft’s only witness was an IRS agent, Eli Hoory.  The parties then filed extensive briefing on the issue of whether the summonses were issued for an improper purpose.  The Court was “troubled by Quinn Emanuel’s level of involvement in this audit.”   This was, however, insufficient to defeat enforcement of the summons.

The IRS was auditing Microsoft’s income tax returns for 2004 to 2006. The audit has been ongoing since 2007.  It focused on cost-sharing arrangements Microsoft had with subsidiaries in Puerto Rico and Asia.  During the audit, the IRS issued over 200 Information Document Requests to Microsoft and interviewed a number of Microsoft employees informally.

Microsoft agreed to several extensions of the statute of limitations on assessment. In November 2013, Microsoft agreed to extend the statute on more time, to December 31, 2014.  The IRS also sent timelines for completion of the audit to Microsoft that were consistent with the IRS’s “roadmap” for transfer pricing audits.  In early 2014, Microsoft signed the statute extension.

In May 2014, the IRS awarded Quinn Emanuel a $2,185,000 contract to act as a “professional expert witness” to assist the IRS in investigating the cost-sharing arrangement. This marked the first time that the IRS is known to have hired a private civil litigation firm to participate in an income tax audit.  In June 2014, the IRS issued a temporary regulation, without notice and comment, allowing an outside contractor to participate in the summons process.  Among other things, the regulation allowed outside contractors to “receive books, papers, records, or other data summoned by the IRS and take testimony of a person who the IRS has summoned as a witness to provide testimony under oath.” Quinn Emanuel began work under the contract on July 15, 2014.  In August 2014, the IRS informed Microsoft that Quinn Emanuel attorneys would attend previously scheduled consensual interviews of Microsoft personnel.  At the interviews, the Quinn Emanuel attorneys’ role was limited to asking follow-up questions.  The IRS admitted that Quinn Emanuel attorneys reviewed documents and interview transcripts, did an independent assessment of the positions of the IRS and Microsoft with respect to the cost sharing arrangement and commented on the summonses at issue before they were served on Microsoft.  When Microsoft failed to comply with the additional summonses, the Government filed petitions to enforce.

To enforce a summons, the IRS must show that a) the summons was issued for a legitimate purpose, b) that the information sought is relevant to that purpose, c) that the information is not already in the IRS’ possession, and d) that all administrative steps required by the Internal Revenue Code have been followed. Because summons enforcement cases are summary proceedings, this showing is normally made by a declaration from the IRS agent who issued the summons.  If the IRS makes the requisite showing, the district court issues an order to the summoned party to show cause why the summons should not be enforced.  To be entitled to an evidentiary hearing, the taxpayer must allege specific facts that support an inference that the summons was issued in bad faith or for an improper purpose.  To defeat enforcement, however, it is not enough to establish an improper purpose.  The taxpayer must also establish that the summons was not issued for any legitimate purpose.  Thus, if the summons was issued for both an improper and a proper purpose, the court will order the summons enforced.

At the evidentiary hearing, IRS agent Hoory testified that while there was a possibility that the case could end up in Tax Court, the summonses in question, “are supposed to help us get to the right number” just “like in any examination.” He also testified that the case had not been designated for litigation and that, when the summonses were issued, the IRS was “still seeking information to get to the right number.”  Microsoft asserted that the summonses were issued in bad faith or an improper purpose because a) the IRS deceived Microsoft into extending the statute of limitations, b) enforcement of the summonses would allow Quinn Emanuel attorneys to “take testimony” in contravention of Internal Revenue Code §7602, c) t enforcing the summons would allow Quinn Emanuel to impermissibly conduct a tax examination and d) the IRS would use the summonses to prepare the case for litigation rather than to conduct an audit.

Microsoft’s basis for claiming that the IRS deceived it into extending the statute was that at the time it sought the extension, the IRS was considering hiring Quinn Emanuel but did not disclose this fact to Microsoft. As Microsoft admitted, the IRS was not legally required to disclose to Microsoft that it was planning to hire Quinn Emanuel and that the IRS’ “hiding the ball” did not constitute bad faith.  The Court, as a result, found that Microsoft did not establish that the statute extension was for an improper purpose or in bad faith.

The Court also rejected Microsoft’s claim that enforcement of the summonses would allow Quinn Emanuel attorneys to “unlawfully take testimony.” Section 7602 empowers the Secretary to conduct investigations, examine books, papers, records or other data, and to take testimony.  “Secretary” is defined in the Internal Revenue Code as “the Secretary of the Treasury or his delegate.”  Microsoft conceded that Quinn Emanuel attorneys could suggest questions for the IRS to ask, but argued that they could not ask questions.  The IRS countered that asking questions was not “taking testimony” and that nothing in the Internal Revenue Code requires the Secretary to “take testimony”; it just authorizes him to do so.

During argument, Microsoft’s attorneys admitted that the Code did not prohibit Quinn Emanuel from examining books and records, formulating questions to ask witnesses, attending interviews of witnesses and handing the IRS personnel pieces of paper with questions to ask the witnesses. It found that there was nothing in the statute that prohibited the IRS from going one step further and having the contractor ask the questions.  Finding that having Quinn Emanuel attorneys ask questions did not establish bad faith or improper purpose, the Court stated:

“The Court is troubled by Quinn Emanuel’s level of involvement in this audit. The idea that the IRS can ‘farm out’ legal assistance to a private law firm is by no means established by prior practice, and this case may lead to further scrutiny by Congress.  However, Microsoft has failed to convince the Court that §7602, which empowers the Secretary to take certain actions, actually limits the IRS’ ability to delegate the asking of certain questions to contractors like Quinn Emanuel attorneys.”

Because Microsoft failed to establish that the IRS lacked the authority to delegate, the question of whether the temporary regulation was valid was moot and did not have to be addressed.

The Court also found that Quinn Emanuel’s role in the case was not so great that it was performing the “inherently governmental function” of conducting the audit or assessing tax. The facts showed only that Quinn Emanuel was gathering information under the direction of IRS personnel.  Nor was there evidence that the IRS issued the summonses for the sole purpose of preparing a case for Tax Court.  While Quinn Emanuel specializes in civil litigation, there was no evidence that the it was retained for purposes of trying the case in Tax Court or that the summonses were issued to circumvent the Tax Court’s discovery procedures.

The Court concluded that Microsoft failed to meet the “heavy” burden of proof necessary to prevent the enforcement of the summonses in question. The Court therefore ordered the summonses enforced.

This case underlines the difficulty a taxpayer faces in seeking to prevent enforcement of an IRS administrative summons. Despite the existence of the unprecedented facts that the IRS had contracted with a private litigation law firm to assist in the examination and that it had issued a temporary regulation shortly afterwards to allow contractors to participate in the summons process, this was not enough to show that the summonses did not have a proper purpose or that they were issued in bad faith.  As long as the IRS can establish that a summons was issued during an audit to assist in gathering evidence to determine the taxpayer’s correct tax liability, it will be able to establish a proper purpose.  A taxpayer can nonetheless prevail if he can show that the information sought is privileged, that the IRS has failed to follow all procedures required for issuing and enforcing a summons or that the summons is vague, overbroad or unduly burdensome.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz 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)  and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com

The failure of businesses to collect and pay to the IRS employee withholding taxes (income, and the employee portion of social security and Medicare) has been a major problem since the institution of withholding taxes. The tax does not get paid to the IRS.  At the same time, the employee is credited with having paid the tax.  If the amount credited exceeds the amount of tax owed, the employee gets a refund.  For the IRS and the Tax Division, failing to collect, account for and pay over withholding tax is theft.

Civil vs. Criminal. The IRS and DOJ have, in the past, relied primarily on the civil trust fund recovery penalty, IRC §6672, to ensure that businesses and their owners and managers comply withhold and pay employment tax to the IRS. This is no longer the case.  Since her appointment to the Department of Justice Tax Division, Acting Assistant Attorney General Caroline D. Ciraolo has made the criminal enforcement of employment trust fund tax violations, particularly through IRC §7202, a top priority.  She has emphasized that the Tax Division is working closely with both the criminal and civil functions of the IRS in this area.  The Tax Division has recently updated the provisions of its Criminal Tax Manual on §7202. See http://www.justice.gov/tax/file/781546/download.

While many tax attorneys and accountants are aware of the civil trust fund recovery penalty, IRC §6672, few are aware of its criminal counterpart, §7202. The two sections contain virtually identical descriptions of the elements needed to impose liability:

The Supreme Court in Slodov v. United States, 436 U.S. 238, 247 (1978), noted that the civil penalty and the criminal penalty “were designed to assure compliance by the employer with its obligation to withhold and pay the sums withheld, by subjecting the employer’s officials responsible for the employer’s decisions regarding withholding and payment to civil and criminal penalties for the employer’s delinquency.”

The elements needed to impose civil liability under §6672 are the same as those required to impose criminal liability under §7202:

1. A duty to collect, account for or pay over a tax
2. A failure to collect, account for or pay over a tax
3. Willfulness.

Compare United States v. Gilbert, 266 F.3d 1180 (9^th Cir. 2001) (conviction under §7202) with Purcell v. United States, 1 F.3d 932 (9^th Cir. 1993) (§§6672 refund case).

Willfulness. At one time, the Ninth Circuit held that willfulness for purposes of §7202 required a voluntary and intentional violation of a known legal duty coupled with a bad purpose or evil motive. See United States v. Poll, 521 F. 2^nd 329 (1975).  That is no longer the case.  The willfulness element under both the civil and criminal penalties is the same.  Compare Phillips v. United States, 73 F.3d 939 (9th Cir. 1996) (for purposes of §6672, a responsible person acts willfully if he “knows that withholding taxes are delinquent, and uses corporate funds to pay other expenses, even to meet the payroll out of personal funds he lends the corporation.”) with United States v. Easterday, 564 F.3d 1004, 1005 (9th Cir. 2008) (for purposes of §7202. “if you know that you owe taxes and you do not pay them, you have acted willfully.”).

The reported cases and Tax Division press releases for employment tax prosecutions normally involve businesses that pyramided unpaid payroll taxes over a number of taxable periods. Often, they also involve lavish spending by the defendant during the period the withholding tax was accruing.  But neither pyramiding of payroll taxes nor lavish spending by responsible persons is an element of the offense.  Ninth Circuit cases make clear that lavish spending is not needed to transform a civil trust fund recovery penalty case into a criminal trust fund case.  In Easterday, the Ninth Circuit held that it is no defense that every penny available to the business was used to pay legitimate business expenses.  564 F.3^rd at 1011 (evidence “to show how and why he spent money owed to the IRS to pay other business expenses” had no bearing on liability under §7202 and, thus, was irrelevant).

It is increasingly important for tax professionals to advise their business clients about the need to comply with the withholding tax provisions of the Internal Revenue Code and the civil and criminal consequences of noncompliance. In those instances where a business has been noncompliant, you will need to be sensitive to the potential for criminal prosecution when advising the business’s owners and officers, including whether they should agree to be interviewed by the IRS as part of a civil trust fund recovery penalty investigation.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz 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) and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com