Sentencing Tax Loss, Unfiled Returns and Deductions

I write today about two recent cases, one which held that, for civil tax purposes, a taxpayer who fails to file is not entitled to claim his or her itemized deductions in a civil tax proceeding and the other applying the same rule in a criminal case at sentencing in calculating the tax loss. See Jahn v. Commissioner, 2010 U.S. App. LEXIS 17525 (3d Cir. 2010) (unpublished opinion); and United States v. Kellar, 2010 U.S. App. LEXIS 19129 (5th Cir. 2010) (unpublished), respectively. I made some revisions to my book and include the following revised section on calculating the tax loss in an failure to file case (footnotes omitted).

Consider the application of this rule [permitting estimates of the tax loss for the tax loss calculation] where the tax offense is failure to file rather a fraudulent return omitting income or misstating claimed deductions or credits. If the defendant originally filed a fraudulent return without claiming otherwise available deductions or credits, I suppose that some sense of fairness could support denying the deductions or credits since the tax loss the defendant intended was not affected by the unclaimed deductions. But, if the defendant filed no return, is he or she to be further punished in the sentencing phase by rigid estimates simply because he or she did not claim the deductions? I can certainly make a distinction between the two circumstances.

In a recent case [United States v. Delfino, 510 F.3d 468 (4th Cir. 2007), cert. denied ___ U.S. ___, 129 S.Ct. 41 (2008)], the Fourth Circuit held that a defendant can be denied deductions after failing to file. It is important to note that the appeal involved a conviction for tax evasion, not for failure to file. As I noted earlier in this text, tax evasion convictions where the taxpayer has failed to file are rare. The Court reasoned:

• The Court adopted the reasoning in Chavin [United Stats v. Chavin, 316 F.3d 666, 677-679 (7th Cir. 2002)] that the tax loss is the intended tax loss rather than the actual tax loss. This appears to be semantics in a failure to file case – although this was an evasion conviction the taxpayer had never quantified under oath the deductions to which he was entitled. In other words, there is a point of reference for making the calculation as to “intent” with a filed return that point of reference does not exist for a return that is not filed.

• In the final analysis, the Court seems to have simply punted on the issue rather than require sentencing courts to compute tax liabilities with more detail. The Court thus concluded its discussion.

The Delfinos chose not to file their income tax returns. They also chose not to cooperate with the initial IRS audit, at which time they could have claimed deductions to which they were entitled. By doing so, they forfeited the opportunity to claim these deductions. Were the district court now to attempt to reconstruct the Delfinos' income tax returns post hoc, it would be forced to speculate as to what deductions they would have claimed and what deductions would have been allowed. This would place the court in a position of considering the many “hypothetical ways” that the Delfinos could have completed their tax returns. Chavin, 316 F.3d at 678. The law simply does not require the district court to engage in this speculation, nor does it entitle the Delfinos to the benefit of deductions they might have claimed now that they stand convicted of tax evasion.

Making judgment calls about a more accurate computation of taxes is not dissimilar to what sentencing courts do all the time with financial crimes that involved a great deal more uncertainty than tax computations. Taxes are not that complex – indeed, even with their complexity, Congress still imposes upon the ordinary citizen the responsibility of filling them out with such assistance as may be needed. The sentencing process is more than vigorous enough to assist in generating a good tax number for sentencing purposes. Federal judges are up to this task.

What troubles me most about this rhetoric is that it seems to offer license to sentencing courts for sloppy thinking in this key component of the sentencing decision. And, it leaves open the door for sentencing to turn upon taxes that the taxpayer does not owe.

Perhaps a more solid ground to deny some deductions – specifically itemized deductions when the taxpayer fails to file a return is the Code requirement that itemized deductions be claimed on the return. If there is no return, then technically the taxpayer – the defendant in the sentencing proceeding – is not entitled to claim itemized deductions that he or she almost certainly would have elected had he or she filed a return. Section 83(e); Jahn applies this in a civil case. All other things being equal, one might surmise that this rule would apply in a criminal failure to file case in the tax loss calculation, denying the defendant the benefit of the itemized deductions which could have substantially lowered his tax liability and resulting guideline range. Where this is a potential problem (it won’t be if the itemized deductions are not sufficiently large to reduce the base offense level), a defendant might consider filing the return immediately upon the conviction. One problem is that the filing of the return might then be used as an admission in the event the case is subsequently remanded for another trial. Moreover, since the return must be true complete and accurate, the defendant may not want to file if he or she is aware of facts that produce tax liabilities that are in excess of the tax loss determined by the Government and submitted to the Probation Officer and the Court. Think it through before you file.

Finally, one additional strategy to get the Probation Officer or the Court to consider itemized deductions in a failure to file situation is to stress that the sentencing tax loss is in the “intended” tax loss. Certainly, it is unreasonable to believe that a taxpayer cheating by failing to file his or her tax returns intended to cheat on an amount that would not have been due had he or she filed his or her tax return and claimed, lawfully, the itemized deductions. Worth a try.

Third Circuit Decision in Staudtmauer - Willful Blindness (Conscious Avoidance)

The Third Circuit issued a very interesting opinion yesterday in a tax crimes case. The opinion is United States v. Stadtmauer, 620 F.3d 238 (3rd Cir. 2010). The opinion is 88 pages long and covers several important issues. I plan to discuss the issues in separate blogs, but first I start the Court's introduction to the opinion:

Following a two-month jury trial in the District Court for the District of New Jersey, Richard Stadtmauer was convicted of one count of conspiracy to defraud the United States (in violation of 18 U.S.C. § 371), and nine counts of willfully aiding in the filing of materially false or fraudulent tax returns (in violation of 26 U.S.C. § 7206(2)). On appeal, Stadtmauer raises many challenges to these convictions. We deal principally with the issue Stadtmauer raises last: whether the District Court erred in giving a willful blindness instruction in this case, including whether the Supreme Court's decision in Cheek v. United States, 498 U.S. 192 (1991), forecloses the possibility that willful blindness may satisfy the legal knowledge component of the "willfulness" element of criminal tax offenses. We join our sister circuit courts in concluding that Cheek does not prohibit a willful blindness instruction that applies to a defendant's knowledge of relevant tax law. We reject also Stadtmauer's other claims of error, and thus affirm.

Read more »

Government Fails to Prove Willfulness in FBAR Civil Case

In Williams v. United States (EDVA Civil Action No. 1:09-cv-437, decision dated 9/1/10), the court declined to find willfulness.

The opinion is relatively short, so I won't rehash the opinion. Some significant facts from the case are:

1. "Between 1993 and 2000 Williams deposited more than $7,000,000 in assets in the accounts, earning more than $800,000 in income over that period."

2. During the year in issue (2000, for which the FBAR was due 6/30/01), the Swiss were focusing on the accounts perhaps at the request of the U.S., the Swiss interviewed Williams about the accounts, the Swiss froze the accounts at the request of the U.S. and the U.S. was aware of the accounts (it is not stated whether that request was a tax driven request or some other law enforcement imperative request.) (The timing of some of these events were disputed by the Government, but the district judge would have none of that.)

3. On his 2000 1040, Williams failed to include the income from the accounts and, on Schedule B, failed to check the FBAR question.

4. Williams failed to file the FBAR by June 30, 2001.

5. Williams' lawyers and accountants had advised him of the requirement to file the FBAR.

6. The Government had not proved that Williams willfully failed to file the 2000 FBAR.

7. "On October 15, 2002, Williams disclosed the accounts by filing his income tax return for the tax year 2001."

8. On February 2003, Williams disclosed the accounts pursuant to an earlier version of the offshore voluntary account program (the OVCI program).

9. "On June 12, 2003, Williams pleaded guilty to one count of conspiracy to defraud the United States and to one count of criminal tax evasion in connection with funds held in the Swiss bank accounts during the years 1993 through 2000." (Apparently, Williams' attempt at voluntary disclosure did not work, presumably because the disclosure was not timely.)

10. "On January 18, 2007, Williams filed the TDF 90-22.1 form for all years going back to 1993, including tax year 2000."

The key legal holdings are:

1. The legal review standard is de novo, in which the Government must prove willfulness -- in this context the intent to violate a known legal duty.

2. The maximum penalty for the willful violation then was $100,000.

3. The court found on the facts presented that the Government had not proved that the defendant knew the legal duty in question. The Court reasoned:

In this case, the Government has failed to prove a "willful" violation. The Court finds that the Government's case does not adequately account for the difference between failing and willfully failing to disclose an interest in a foreign bank account. n5  Further, the Government fails to differentiate tax evasion from failing to check the box admitting the existence of a foreign bank account.
n5. It is worth noting that Congress has since amended 31 U.S.C. § 5321 to allow the government to assess a civil penalty for FBAR violations regardless of whether the violation is willful. See 31 U.S.C. § 5321(a)(5), as amended by P.L. 108-357. Further, the statute now provides a "reasonable cause" exception. See 31 U.S.C. § 5321(a)(5)(B)(ii). While the issue of Williams' liability under the statute as amended is not before the Court, the Court notes that Congress found it necessary to expand the coverage of § 5321 to address a class of conduct falling short of the "willful" standard solely accounted for under the old statute. Clearly, simply failing to file a Form TDF 90.22.1 was insufficient to subject an individual to liability for a civil penalty under the old statute.

4. The court was not persuaded, on these facts, that Williams' no answer to the foreign account question on his 2000 1040 Schedule B gave his the requirement knowledge of the legal duty.

5. Moreover, since the accounts were surely known by all, including the U.S. by June 30, 2001, it would make no sense for Williams not to disclose them by filing the FBAR.

6. Williams was not estopped by his evasion guilty plea.

The Government argues that Williams' guilty plea should estop him from arguing that he did not willfully violate § 5314 for the tax year 2000. However, the evidence introduced at trial established that the scope of the facts established by Williams' 2003 guilty plea are not as broad as the Government suggests, and there remains a factual incongruence between those facts necessary to his guilty plea to tax evasion and those establishing a willful violation of § 5314. That Williams intentionally failed to report income in an effort to evade income taxes is a separate matter from whether Williams specifically failed to comply with disclosure requirements contained in § 5314 applicable to the ALQI accounts for the year 2000. As Williams put it in his testimony at trial, "I was prosecuted for failing to disclose income. To the best of my knowledge I wasn't prosecuted for failing to check that box." Tr. at 34.

I think the case illustrates the difficulty the Government will meet in establishing willfulness for the truly draconian FBAR penalty (in its present iteration).  Perhaps this will encourage at least some taxpayers in the current voluntary disclosure initiative to opt out and be subject to the normal FBAR penalty regime.  Assuming that the Government cannot meet the high standard (as illustrated by this case), the penalty costs could be a whole lot less than the program requires.