Diverting Corporate Earnings - Constructive Dividends or Wages / Salary (9/17/11)

One of the common ways of cheating on taxes is to divert corporate earnings from a C corporation to an entity that is off the IRS's radar screen. The diversions may be of the income which never hits the corporation's books and thus is not reported as income on its tax returns; they may also occur after the income is recorded with the diversion achieved by making payments from the corporation for goods or services which are deducted.  When the transactions thereafter get on the IRS's radar screen, the issue is whether the diversion was an underpayment of tax at the corporate level. 

In a wholly owned corporation, particularly a personal service corporation providing professional services, the corporate income arises from the personal services of the sole shareholder. In such a case, the corporation could easily pay the shareholder wages or salary of the entire net income before payment of compensation. (I refer to this as wages, as did the Court in the case I discuss below.) There would certainly be no unreasonable compensation issue. But, by paying the amount as wages, although fixing the tax issue at the corporate level, the income still is taxed at the shareholder level and the corporation has to withhold, payover and provide a W-2 for an easy IRS match at the shareholder level. By diverting that amount via  either diverting the income or through falsely deductible payments to a shareholder designated entity which does not pay tax, the tax cost at both the corporate and the shareholder levels are avoided (at least until caught). When caught, of course, in order to minimum the tax avoided, the corporation and the shareholder may try to claim that the diversion payments were really wages to the sole shareholder rather than dividends thereby eliminating the corporate level tax. Sometimes, when caught, the shareholder will cause the corporation to amend its returns making that claim.
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First Sentencing in Offshore Case that Went to Trial

Maricio Cohen Assor and Leon Cohen-Levy, previously blogged here, were sentenced yesterday. I include below links to the SD FL USAO press release and some articles, but here are the bullet points I found interesting:

1. Each was convicted of one count of conspiracy (Klein conspiracy) under 18 USC 371 and 2 counts of filing false tax returns under 26 USC 7212.  The maximum permissible sentence for those counts of conviction was 11 years each.

2. Each received 10 years incarceration (mitigated only if they qualify for the rather minimal good time benefit).

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Fifth Circuit on the Nature of 7206(1), Commonly Called Tax Perjury

In United States v. Bishop, 629 F.3 462 (5th Cir. 2010), the Fifth Circuit affirmed the defendant's conviction for 3 counts of tax perjury (Section 7206(1)). The panel rejected the defendant's arguments that (1) her trial violated the Sixth Amendment right to speedy trial, (2) that "the trial court violated her constitutional right to present a complete defense by preventing her from arguing that her case was a 'perjury case' rather than a 'tax case;'" and (3) the trial court erred in denying her motion for new trial based on ineffective assistance of counsel.

The Fifth Circuit's panel decision, authored by Judge Garza, addresses the first and the third issues well. Those issues are not unique to criminal tax trials, so I refer the interested reader to the opinion. I address here the third issue -- dealing with the 'perjury case' issue.

For context, section 7206(1) defines the crime as:

Any person who willfully makes and subscribes any return, statement, or other document, which contains or is verified by a written declaration that it is made under the penalties of perjury, and which he does not believe to be true and correct as to every material matter

The panel first sets up the issue as being subject to "plain error" review. Turning to the merits of the defendant's argument under the plain error review standard, the panel says (discussion quoted in full, with parallel citations omitted):

Bishop's allegation of error stems from the district court's ruling preventing her attorney from asking IRS Special Agent Robert Whalen whether this case was "basically a perjury case." The Government objected to the question, and the court sustained the objection, observing, "This is a tax case." Bishop then moved on in her cross-examination. Her counsel took no steps to inform the district court that barring the question potentially violated Bishop's constitutional rights or to clarify the nature of the defense she was pursuing. Her argument on appeal, therefore, must be reviewed for plain error. To establish plain error, Bishop must demonstrate: (1) there was an error; (2) the error is "plain"; and (3) the error affected her substantial rights, was prejudicial and affected the outcome of the district court proceeding. United States v. Olano, 507 U.S. 725, 731-32 (1993). We will correct a plain error only if the error "seriously affects the fairness, integrity or public reputation of judicial proceedings." Id. at 736.

Bishop's argument hinges on a misreading of our discussion of § 7206(1) in State v. Adams, 314 F. App'x 633, 638 (5th Cir. 2009). In that case, we stressed, in obiter dicta, that a § 7206(1) false return case is "a perjury case," unlike, for example, a tax evasion or failure to file case. We interpret those remarks simply to distinguish a charge under § 7206(1) from other types of tax-related charges. We did not hold, nor would it make sense to hold, that false return cases are not "tax cases." n1 Regardless, even if Bishop's characterization of Adams were accurate, she could not show that the district court's ruling affected the outcome of its proceedings, as is required for a reversal based on plain error. The court's lone ruling on her questioning of Whalen did not prospectively prevent her from emphasizing the elements of the Government's case that she considered weakest. Moreover, we see no reason to think that the jury's verdict would have been any different even if she had emphasized those points in the manner she says she would have preferred. Reversal on this point is not warranted.
FOOTNOTE
n1 In fact, later in the opinion, we made clear that Adams was a "tax case." 314 F. App'x at 652 (referring to another case as "also a tax case").

I am not sure exactly what the defendant's attorney hoped to gain strategically by classifying the Section 7206(1) charges as a perjury case.  I do think that counsel was properly entitled to ask that question and argue the point, though.  In my judgment, that is a fair characterization of the Section 7206(1) crime.  Although not admitting that point, the panel rejects the argument under the plain error standard because (i) defendant's counsel 's failed to press the point and (ii) the context, in the panel's mind, showed that error (if there were one) did not influence the jury's verdict.

Perhaps readers can address the issue of whether the defendant was prejudiced by the failure to characterize the case as a perjury case.

Picky, Picky - Tax Perjury is Not Tax Evasion / Fraud

I write just to note that the Third Circuit made a mistake that I hope my students do not make. In United States v. Riley, ___ F.3d ___ (3d Cir. 2010), 2010 U.S. App. LEXIS 19310 (3d Cir. 2010) the defendant was convicted of three counts of tax perjury under Section 7206(1). It is elementary that tax perjury is not tax evasion (or tax fraud as it is sometimes called), which requires a key additional element of tax due and owing. In its opinion, the Third Circuit refers to the tax perjury counts of conviction as "tax fraud" and "tax evasion."

The error does not appear to have affected the opinion. The court reversed on the honest services conviction based on Skilling, but otherwise sustained the convictions.

Willfulness -- Amended Returns and Bank Accounts That Are Not Hidden -- and Materiality

In United States v. Shellef, 2010 732 F.Supp.2d 42 (ED NY 2010), decided 8/5/10, the Court denied Shellef's motion for a motions for acquittal and retrial. This trial was actually his second, the first having been reversed on appeal because of improper joinder issues. United States v. Shellef, 507 F.3d 82 (2d Cir. 2007). After convictions on various counts on the second trial, Shellef moved for acquittal and retrial. The key counts of conviction were for the defraud / Klein conspiracy with respect to excise taxes on certain chemicals, tax perjury (7206(1)) for the 1999 income tax return for a Shellef company, wire fraud with respect to the chemical trading relating to payment of excise taxes, and money laundering. I discuss here only the tax perjury count.

Shellef asserted that the Government had not proved willfulness sufficient that a reasonable jury could have found guilt beyond a reasonable doubt. The hurdle he had to clear -- insurmountable it turns out -- was that the evidence showed that he had not reported "$782,781 in income, which represented the proceeds of his domestic sales of" the chemical subject to the excise tax. The court concluded that
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A Lesson on the Crime-Fraud Exception to Attorney-Client Privilege

On November 20, the Fourth Circuit entered an unpublished decision in United States v. Under Seal & John Doe, 2009 U.S. App. LEXIS 25523 (4th Cir. 2009). The issue was whether the district court properly applied the crime fraud exception to the attorney client privilege, thus permitting the Government to subpoena an attorney's files. The attorney is referred to in the opinion as Counsel.

Such holdings are fact driven, and these facts quoted succincntly by the Fourth Circuit suggest the conclusion:

In 1997, the president of the Corporation established another entity in the Isle of Man ("the Isle of Man Entity"). Two of the Corporation's three directors, one of which is the Corporation's president, were directors of a corporation also established in the Isle of Man ("the Isle of Man Corporation"), which is the trustee of the Isle of Man Entity. Between 1997 and 2000, the Corporation transferred $ 22,523,478 of its assets to the Isle of Man Entity. In 2000, the Corporation dissolved after filing Articles of Termination and Articles of Dissolution with the proper state authorities.

Prior to the Corporation's dissolution and continuing thereafter, the Internal Revenue Service (IRS) conducted an audit of the Corporation. During the audit, the Corporation's president [*3] told the IRS that the transfers from the Corporation to the Isle of Man Entity were made pursuant to opinion letters from several law firms that these transfers were legal. One such letter, which was written by Counsel, was provided to the IRS. Counsel's letter stated that a qualified United States charitable corporation can legally make a grant to a charitable organization in another country so long as the funds are used for charitable purposes. The IRS audit of the Corporation concluded with a finding of "no issue raised."

[I hope you see from just the quoted cryptic summary that something is rotten.]

Back to the case, a grand jury investigation started, and a grand jury subpoena issued. After some sparring and an earlier appeal and remand, the district court held that the Government had established the applicability of the crime fraud exception. The district court based its holding on the ground that the U.S. charitable corporation's return was incorrect, thus potentially violating § 7206(1), in showing no relationship between the U.S. charitable corporation and the Isle of Man charitable corporation.

Counsel appealed, asserting that the statement on the U.S. corporation's return was technically correct, thus, a la Pirro, avoiding the shoals of § 7206(1), because the question only asked about relationship between the U.S. corporation and an individual. (There was of course an individual or individuals behind the lifeless and breathless, wholly fictional (from a legal perspective) Isle of Man corporation, but let's not get hung up on such technicalities.)

The Fourth Circuit summarized the exception and the showings required to invoke it:

The invocation of the crime-fraud exception requires a prima facie showing that "(1) the client was engaged in or planning a criminal or fraudulent scheme when he sought the advice of counsel to further the scheme, and (2) the documents containing the privileged materials bear a close relationship to the client's existing or future scheme to commit a crime or fraud." In re Grand Jury Proceedings # 5, 401 F.3d at 251 (citations omitted). A party invoking the crime-fraud exception can satisfy the first prong of this test by making a prima facie showing of evidence, which, if accepted by the trier of fact, establishes the elements of an ongoing or prospective violation of the law. Id. The second prong of this test is satisfied with a showing of a close relationship between the withheld communications and the alleged violation. Id. Once a sufficient showing has been made, the attorney-client privilege ceases to protect any of the communications related to the alleged violation. In re Grand Jury Subpoena, 419 F.3d 329, 345 (5th Cir. 2005) (citing In re Sealed Case, 676 F.2d 793, 812 n.74, 219 U.S. App. D.C. 195 (D.C. Cir. 1982)).

The Fourth Circuit then reviewed the district court's application of the exception, gliding past the district court's invocation of the potential for violating § 7206(1) and moving to what it perceived was more solid ground in a potential defraud / Klein conspiracy violation under 18 U.S.C. § 371. The court said:

In its ex parte submission, the Government has provided the court with prima facie evidence that the Corporation, its principals and the Isle of Man Entity had an agreement to defraud the United States Government in contravention of § 371. The Government's submission provides prima facie evidence that the Corporation and the Isle of Man Entity entered an agreement to defraud the United States both by concealing the ultimate disposition of the Corporation's funds through the transfer of assets overseas and by using the Corporation's tax-exempt status to circumvent the collection of taxes on the profits of individuals. Such a purpose falls directly within the confines of § 371. The transfer of $ 22,523,478 to the Isle of Man Entity would be an overt act in furtherance of this purpose.

The Fourth Circuit then closed or tightened the noose by holding that the close relationship to that potential violation had been shown.

Things do not look good for the attorney.

Get in Line Brother #26 - Another Plea to Encourage the Reticent and Risky

The Government posted another notch in its publicity belt yesterday which it went public with the squeeze it put on another hapless UBS depositor and thereby, it hopes, to squeeze the masses to come forward. The DOJ Tax announcement of the plea is here. I have received a copy of the plea agreement but have not yet posted it on the web. I may do that later or, hopefully, when someone else does, I will link to it. I offer here just a few brief comments on the plea agreement in the Cittadini plea. I will probably add to this and refine or revise it (particularly if errors are called to my attention).

1. The Plea Count. Cittadani pled to violation of 26 U.S.C. § 7206(1), often referred to as tax perjury. This means, in effect, that Cittadani admitted that he will told a material lie on the tax return with respect to his reporting and nonreporting regarding the UBS account.

2. Origin of the Account. The seed monies for the accounts was originally received from his family in Argentina and deposited in the UBS account in 1991.

3. Use of Entities to Disguise. In 2001, he created a Hong Kong Corporation to avoid QI requirements, with advice and assistance of Hansruedi Schumaker. The HK corp named Swiss lawyers A.M.R. and Matthias Walter Rickenbach as First Directors.

4. Enablers.

a. Identities. Identifies other Swiss enablers by name where they are already indicted (Shoemaker and Rickenbach) and by initials where not indicted (yet).

b. U.S. Activity. Meetings with one of the enablers were held in the U.S.

5. Relevant Conduct. It is unclear when the UBS account was closed or whether, if closed, the funds went into another offshore account or elsewhere offshore in order to hide from the IRS. The agreement is just silent, perhaps in order to channel the sentencing (i.e., as noted below, the agreement stipulates that the tax loss relevant to sentencing is limited to the years 2001 through 2003). The trend in these cases is certainly to cut off the opening date for relevant conduct consideration, but the truth really is that years prior to that opening cutoff date is relevant conduct. And, of course, a sweeter deal can be achieved if there is an ending date cutoff as there is here. The Government wants pleas and will get its pound of flesh (as well as the perceived needed publicity) by offering goodies to coax out pleas with enough there to permit a significant sentence if that is the sentencing judge's wish. (I should note, however, that he agrees to a single 50% penalty for the FBAR violations for the years 2001 through 2008, certainly suggesting that there was relevant conduct in years after 2003.)

6. Sentencing Factors.

a. Tax Loss (including all relevant conduct): "the tax loss associated with the accounts at UBS that were disclosed to the Government pursuant to the Deferred Prosecution Agreement with UBS, and of which the defendant was the beneficial owner for the tax years 2001 through 2003.” See my comments above.

b. Sophisticated means. A no-brainer.

c. Acceptance of responsibility. A no-brainer.

7. Cooperation.

a. 5K1. Requires cooperation with a possibility of 5K1

b. No Deception. The plea contains this apparently targeted paragraph:

Defendant understands that the United States will tolerate no deception from him. If, in the estimation of the United States Attorney or the United States Department of Justice Tax Division, information or testimony provided from the date of the Plea Agreement proves to be untruthful or incomplete in any way, regardless of whether the untruthfulness helps or hurts the United States' case, the United States may consider that Defendant has breached this Plea Agreement.

c. Use of Information During Cooperation. Not a strange paragraph, but apparently a concern:

d. The parties agree that information provided by Defendant in connection with this Plea Agreement shall not be used to determine Defendant's sentence, except to the extent permitted by USSG § IB1.8.

USSG 1B1.8 provides that information divulged pursuant to plea cooperation agreements contains the usual suspects designed to make the cooperation more effective, but also contains the following exceptions permitting the Government to disclosure: "(5) in determining whether, or to what extent, a downward departure from the guidelines is warranted pursuant to a government motion under §5K1.1 (Substantial Assistance to Authorities)."

d. Cooperation and Rule 6(e). The agreement does not contain an express waiver of Rule 6(e) as seen in other plea agreements but does contain the following:

The defendant further agrees that any evidence, including statements and documents, provided to the United States by the defendant pursuant to a Proffer Agreement, without any limitations, can be utilized by the United States in its civil examination, determination, assessment, and collection of income taxes related to his income tax returns and any related corporate/entity tax returns, or any other civil proceeding.

It is unclear precisely when the proffer(s) occurred, but if they occurrred pre-indictment, I think they have the Rule 6(e) problem that, I am sure, they would prefer to avoid. (I have previously commented on this here.) Certainly, the IRS can get that evidence from him, assuming they formulate the right requests and asks the right questions (based on information independent of the grand jury investigation), but I think it is highly suspect for the "United States" to turn over that information so imbued with the grand jury investigation which was the only investigation DOJ can conduct in a tax case.

7th Circuit Says Attorneys Fees Do Not Mitigate Sentence

In United States v. Presbitero, ___ F.3d ___ (7th Cir. 2009) (decision here), the Seventh Circuit sustained convictions for two counts of filing false tax returns under § 7206(1) (tax perjury) and one count of Klein / defraud conspiracy under 18 U.S.C. § 371. The district judge tossed the conspiracy convictions on a motion for acquittal, finding that the Government had no evidence tending to show that one of the two alleged conspirators had joined the conspiracy to impair or impeded the IRS. Since it takes two to tango for conspiracy, the judgment of acquittal for that defendant meant that the conspiracy conviction of the other defendant (who had clearly engaged in conduct to impair or impede) must be dismissed also. (That defendant, of course, might have been but was not charged with the obstruction counterpart, § 7212.) The defendants appealed their convictions on the two tax perjury counts and the Government appealed the acquittal on the Klein conspiracy count. The parties also appealed the district judge's sentencing decisions.

The case appears pretty much garden variety for criminal tax cases. I point out here only a few points I thought were interesting:

1. § 7206(1) (tax perjury) does not have as an element that there be any tax loss to the Government. This is a standard holding, and just barely worth commenting on except as a reminder to students.

2. In a variation of the holding, the court said: "it is not a defense to a charge of willfully and knowingly filing a fraudulent tax return that the amount fraudulently deducted could have been deducted for some other reason." citing United States v. Helmsley, 941 F.2d 71, 92-93 (2d Cir. 1991) among others.

3. The court reversed the district court's acquittals on the conspiracy charge, thus reinstating the jury's convictions. The court of appeals recounted more than ample evidence of actions by both defendants to impair or impede the IRS through deceitful means to support the jury's verdict. "That is, from the evidence before it, the jury could have concluded that Velasquez knew that at least one purpose of the agreement to make up the six subcontractors was to reduce PDC's tax liability on false pretenses." Merely that they co-conspirators may have had some other goal (deceiving others) did not detract from their goal to impair or impede the IRS through deceitful means. (For other blogs on the lie as the critical component of tax crimes, click here.)

4. The court of appeals reversed for resentencing because of its reversal noted in #3 and the affect it might have on sentencing enhancements.. In so doing, the court of appeals addressed the notion that attorneys fees might be a factor mitigating the sentence. As suggested in the quote below, it was not clear what weight, if any, the sentencing judge placed on the attorneys fees, but he did comment on them. The background is that the Government had brought earlier nontax charges against one of the defendants for ERISA and mail frud charges upon which he had been acquitted. He had incurred large attorneys fees in that proceeding, and then the Government indicted again in this tax case where he also incurred large attorneys fees. The court said, perhaps gratuitously:

To aid everyone during the resentencing, we also take note of the government's arguments that the district court took impermissible factors into account when it sentenced Presbitero to a below-guidelines sentence. For one, the district court commented on the amount of money Presbitero paid in attorney's fees, stating at the sentencing hearing that Presbitero had spent "probably a good part of his savings defending against charges brought by the Government. That's a long time to be fighting the government. Almost ten years. And a huge amount of stress that's involved with that, and expense." Presbitero maintains that the district court did not actually rely on the amount of attorney's fees incurred when it decided which sentence to impose. Instead, he says, the comments we quoted were just observations that did not factor into his sentence.

It is not clear to us from the record whether the comments regarding attorney's fees and the resulting stress were simply asides at the hearing or whether they factored into the imprisonment term decision. In an opinion issued after Presbitero's sentencing hearing, we explained that the fact "that a defendant spends heavily on lawyers is not a mitigating factor. It would not only encourage overspending; it would be double counting, since the pricier the lawyer that a defendant hires, the less likely he is to be convicted and given a long sentence." United States v. Sriram, 482 F.3d 956, 961 (7th Cir. 2007), vacated on other grounds, 128 S. Ct. 1134 (2008). So the district court on remand should not consider high attorney's fees as a mitigating factor. And while we certainly recognize the emotional and financial tolls of an investigation, indictment, and trial, the resulting stress is not in and of itself an appropriate reason to lower Presbitero's sentence. See Sriram, 482 F.3d at 961 (protracted prosecution not a reason to lower sentence).

Putting on my economic animal hat (as criminal lawyers certainly do in striking the fee arrangements), I find the idea intriguing that, but for the court's rejection of this notion, defense lawyers might have both a success clause for more attorneys fees for acquittal, and a failure clause for more attorneys fees for conviction; either way it would be win, win for the lawyer.

For those wishing to pursue the issue, the Sriram decision, written by Judge Posner, is here.