By Anthony Diosdi
The most common forms of indirect methods of proving criminal tax evasion is the net worth plus non deductible expenditures method and the bank deposit method. These methods can be used in a single year; different methods can be used in different years in the same case; any of these methods can be combined with specific item proof or be made to stand on its own. To adequately prepare for an Internal Revenue Service (“IRS”) criminal tax evasion investigation, or to prepare properly for a criminal trial which will employ one of these methods, a criminal tax attorney must have a working knowledge of the varieties of circumstantial proof that can be gathered by an IRS special agent, the manner in which such evidence can be structured to prove the ultimate tax deficiency, and the weakness and strengths of such reconstructions of alleged financial facts.
The indirect methods of proof used by the IRS in a criminal tax evasion case are not accounting methods. Instead, they are organized statements of alleged facts capable of supporting an inference of what an individual’s tax liability was in a given year or years. They begin as corroborate evidence of specific items of proof. For example, in a nontax case, a prosecutor might offer testimony to prove that a man robbed a store of $100,000; to corroborate the fact that the defendant was the individual who committed the robbery, he might also offer evidence that the day after the robbery, the defendant, who was unemployed at the time, deposited $90,000 into his bank account. If such proof survives an objection as to relevancy, two things have occurred: first the prosecutor has demonstrated a fact from which the jury can infer that what was deposited was the proceeds of the robbery in question; second, and more importantly, the prosecution has shifted the burden of coming forward with the evidence to the defendant. While the jury might be receptive to another explanation for the source of the deposited funds, if no explanation is in fact offered, it will presume that no other explanation but robbery is available. The reason for this presumption is obvious. An unemployed man who receives $90,000 is bound to know where it came from, whether it was a loan, an insurance payment, an inheritance, or robbery. Once such evidence is introduced, the defendant “remains silent at his peril.”
This example illustrates the power and the problems of the direct method of proof. These methods involve the proof of certain financial facts which can support competing inferences but which will not support competing inferences if the defendant, who is in a position to explain the transaction, fails to do so. In perhaps no other area of the criminal law are insufficient inferences permitted to establish a prima facie case requiring the defendant to come forward with proof. Other explanations of the sources of funds are often available in indirect methods cases, but unless they are offered and proved, the defendant may be convicted of a tax crime.
General Theory of Indirect Methods to Establish Tax Evasion
The indirect methods of proof began as corroborative evidence in specific item cases, just as the deposit of funds the day after a robbery may be corroborative of the depositor’s participation in the robbery. As this type of proof gained in formality, completeness and judicial approval, the corroboration became the primary proof. Specific item evidence, which in large measure depends on the initial availability of the taxpayer’s books and the testimony of sometimes reluctant witnesses, was not always available. The defendant subject of the IRS criminal investigation could refuse to supply his books, under a Fifth Amendment claim; the defendant could also claim his books had been destroyed in a calamity; or the defendant could claim that he never kept any books. The alternative was to produce only corroborative evidence using one or more of the indirect methods. Such proof was approved by the United States Supreme Court because “to require more or more meticulous proof…that there were unreported profits from an elaborately concealed illegal business, would be tantamount to holding that skillful concealment was an invincible barrier to proof.” See Jelaza v. United States, 179 F.2d 202 (4th Cir. 1950).
These methods are aptly described as indirect because they are an elevation of corroborative facts to primary proof as a result of a feeling of necessity. All of these methods look at taxable transactions in an indirect way; that is, they look to the other end of taxable transactions, to what the taxpayer under criminal investigation did with the money he earned. These methods recognize the astuteness of the viewpoint of the IRS, which usually selects its victims by drawing a conclusion from a simple observable fact: an ordinary person living in the San Francisco Bay Area survive in this part of the country earning only $30,000 annually, unless he is deeply in debt or has rich parents.
An IRS criminal investigator will ignore the receipt of income and look at how a taxpayer under investigation lives, what he deposits in his bank account, what assets he buys, and what expenses he pays. The IRS special agent will systematically structure this evidence with the aid of one of the indirect methods, and come to a conclusion as to what an individual would have to earn to make such deposits, acquire such assets, and pay such expenses. The IRS special agent will also attempt to gather evidence that will exclude the possibility that the individual being investigated financed his lifestyle by going into debt or with the help of rich parents or by any other “explanations.” If the investigator can exclude explanations other than taxable income, the agent can reconstrued the taxpayer’s taxable income, if not with geometric logic, at least with what passes in the courts as prima facie proof necessary to obtain a conviction for tax evasion and/or the filing of false tax returns. .
Prerequisites to the Use of Indirect Methods
Because the indirect methods were approved, at least partially, out of the necessity of finding a means of proving a taxpayer’s guilty when he refused to come forward with the direct evidence of his taxable transactions, several early court cases came to the logical conclusion that the IRS and/or the Department of Justice was obligated to show that the direct evidence was in fact unavailable, incomplete, or unreliable. If, for example, the taxpayer did not come forward with his books and records, it was thought that the IRS should first demonstrate the inadequacy of these records before resorting to the indirect methods, which were concededly approximations.
This argument was put to rest in Holland v. United States, 319 U.S. 503 (1943), where the United States Supreme Court decided that the IRS could prove the inadequacy of the taxpayer’s books by the indirect method itself. If the net-worth proof indicated a substantial tax liability not disclosed to the IRS, that was proof that the taxpayer’s books were incompetent in the first place. This decision has been followed to the point that if the taxpayer has what appears to be a perfect set of books, the IRS could ignore them and recompute his tax liability for criminal purposes in any manner elects (as long the IRS can establish a willful attempt to avoid paying taxes).
This does not mean, however, that the books and records are irrelevant. From the IRS’s point of view, the books and records may demonstrate willfulness by various specific-item proofs, or they may demonstrate a likely source for the understated income through the books. On the other hand, the defendant can use a good set of books to demonstrate that he properly reported his income. The defendant can also use an inaccurate set of books to demonstrate the actual source of the net-worth increases and that the errors in the books were the product of negligence on the part of others or himself. What the defendant’s books and records show will invariably be important in a criminal tax case.
The “Substantial Understatement” Requirement
The indirect methods of proof are recognized by the courts as “approximations.” Their imprecision is permitted by the courts because their nature is not exact. There are many alleged safeguards protecting the use of these methods. One such general safeguards was thought to be the “substantial understatement” requirement. The theory was that if the IRS’s proof was by nature imprecise, the defendant would be protected if the IRS had to prove a substantial deficiency.
There have been very few cases in which the courts have done more than refer to this concept while affirming a conviction. Nevertheless, this is a practical limitation on the Service, because it selects cases for indictment based on a judgment that a reasonable probability of conviction exists in the district court. A small understatement proven by an indirect method is not likely to have such a probability of success for two reasons: first, various unexpected and unknown adjustments may be made by the defense which will reduce the small understatement to a point where no jury will convict; second, the indirect methods, because they do not portray specific transactions and specific conduct, must often rely on the size, pattern, and continuity of the understatement to establish willfulness. The smaller the deficiency, the weaker is the proof of willfulness.
The Net-Worth Plus-Non Deductible Expenditures Method
Our analysis of the net-worth method plus non deductible expenditures method will begin with the landmark case of Holland v. United States. The net worth plus nondeductible expenditures method was defined in Holland as follows:
In a typical net worth prosecution the IRS, having concluded that the taxpayer’s records are inadequate as a basis for determining income tax liability, attempts to establish an “opening net worth” or total net value of the taxpayer’s assets at the beginning of a given year. If then proves increases in the taxpayer’s net worth for each succeeding year during the period under examination and calculates the difference between the adjusted net values of the taxpayer’s assets at the beginning and end of each of the years involved. The taxpayer’s nondeductible expenditures, including living expenses, are added to these increases, and if the resulting figure for any year is substantially greater than the taxable income reported by the taxpayer for that year, the Government claims the exces represents unreported taxable income.
Stated in more mathematical terms, the formula may be described thus: 1) an increase in net worth, plus 2) nondeductible disbursements, minus 3) nontaxable receipts, equals 4) taxable income before exemptions.
The Opening Net-Worth Determination
The accuracy and completeness of the opening net worth are vital to the defense in a tax evasion case. This is because any asset not included in the opening net worth that is dissipated in the indicated years will reduce the tax liability for those years. The opening net worth is an assertion that the items included are the defendant’s only assets and liabilities. Courts typically insist that the opening net worth be proven with “reasonable certainty,” because it purports to present the defendant’s entire financial history to that point. As a result, it is no easy task to reconstruct exact payments made on assets held for years, or to find all of the assets a taxpayer has acquired and still owns over a course of potentially many years.
However, some techniques of proof available to the IRS in supporting its opening net worth presentation at least make it difficult for a defendant to dispute it. First, the IRS is not obligated to make the opening net worth year immediately prior to the first year under indictment. The starting point may be much earlier than the first indictment year, provided such date is not too remote from the years in question. This permits the IRS to start from a year of particular convenience, for example the year the defendant declared bankruptcy or filed a detailed net-worth statement with a bank or, worst of all, with the IRS. Even if the bankruptcy petition or the net-worth statements were materially wrong, the defendant’s admissions of assets and liabilities is sufficient to make a prima facie case of a tax evasion case forcing the defendant to begin his defense by admitting he lied previously about his financial affairs.
The IRS special agent, in making a solid opening net worth, will attempt to obtain statements from the defendant about his assets, check other visible assets through bank records, country real estate records, inheritance, gift tax records, and the defendant’s books and records. The special agent will then attempt to firm up the marshalled assets with admissions from the defendant, net worth statements filed by the defendant, and other records purported to account for the defendant’s assets and liabilities.
The importance of a defendant’s statements cannot be minimized. This is because the starting point is often established simply by asking the defendant if he had any large sums of cash on hand, securities, or other non visible assets. If he says no, the IRS can take him at his word and compute the starting point from his visible assets. If, on the other hand, the individual being investigated by the IRS claims a large cash hoard, accounts receivable, stocks, securities, or loans, the special agent can ask where the assets or debtors are located. If the defendant refuses to tell the IRS, declines to permit inspection of the assets, or tells the special agents of a location that is difficult for them to verify, the IRS may disregard these claims and credit him with little or no such assets. The theory is that the defendant’s refusal to permit the agents to verify his claims, or to help them to do so, has sufficient earmarks of fabrication to present a question for the jury and to permit the jury to infer not only that the taxpayer’s claim of specific assets on hand was false, but that in fact there were no assets on hand other than the visible ones. See Prosecutions for Attempts to Evade Income Tax: A Discordant View of a Procedural Hybrid, 76 Yale L.J. 1 (1966).
The Opening Net-Worth and Invisible Assets, i.e., Cash on Hand
Because of the quality of agents’ training and the availability of records from third parties, the IRS can usually do a fairly good job in accounting for visible assets. However, it is almost impossible to prove invisible assets directly, particularly cash on hand. Because of this difficulty, the “cash hoard” defense is a method to attack the net worth case. The IRS has faced this argument so many times that it has developed regular patterns of proof to dispute it. These “proofs” suggest that a cash hoard did not exist or put the taxpayer in a position that he can no longer claim that one existed. The following sources of proof are taken from Section 324.4(2) Handbook for Special Agents:
1) Written or oral admissions of the taxpayer to the investigating officers concerning his net worth.
2) Failure by the defendant to file tax returns for years prior to indictment.
3) Tax returns filed by the taxpayer for years prior to prosecution years reflecting income reported that is inconsistent with existence of a cash hoard.
4) Low earnings for years prior to prosecution years as shown by records of former employers.
5) Net worth as established by books and records of the taxpayer.
6) Certificates of Assessments and Payments showing tax assessed for years prior to the prosecution period. With this information and tables showing tax rates and the amount allowed for exemptions and dependents, it may be possible to calculate income reported by a taxpayer for the years in question.
7) Financial statements presented for credit or other purposes at a time prior to or during the prosecution period. Banks, loan companies, and IRS (offer in compromises) are some of the better sources from which to obtain this type of documentation.
8) Bankruptcies prior to the prosecution periods.
9) Loss of business because of financial reasons.
Net Worth Defenses
Because of the open ended quality of the net worth proof and its supporting evidence of current income, a criminal defense lawyer cannot merely sit back and take intellectual swings at the proof. This is because for better or worse, a substantial number of federal court cases have shifted the burden of coming forward with evidence to the defense in all but the most inadequate of net worth cases. Below are some potential net worth defenses:
Prior Accumulated Funds
The prior accumulated defense is based upon failure to include all of the defendant’s assets in the opening net worth, coupled with additional proof that the prior accumulated funds were spent or converted into other assets in the indictment year. At the very least, the defendant will have to supply an explanation for his creation of the cash fund, particularly if he otherwise used banks in a normal way. However, the defense must find someone, the more independent the better, who knows of the defendant’s accumulated funds and the witness must be prepared to testify clearly regarding his or her knowledge of the accumulated funds.
Nontaxable Sources for the Net-Worth Increase
It is not uncommon for an individual’s lifestyle to substantially expand as a result of nontaxable sources of income, such as inheritance, gifts, loans, or untaxed portions of capital gains. Nontaxable sources of income is a defense to net worth proof. However, it will not be enough to merely assert such a source, or even to assert the assertion by the defendant’s testimony. Because of the wide latitude the courts have approved for the Government’s presentation of its case, failure to account for such sources will ordinarily not preclude the Government from getting its case to the jury and obtaining a conviction. A nontaxable source or sources defense will usually have to be presented by the defense if the sources can be particularized and the use of the source funds traced, and the IRS’s net-worth computation can be redone in light of this evidence.
If the source evidence is based almost exclusively on the testimony of interested witnesses, the testimony will have to be substantiated. Often the defense will claim loans from close family members which were made without observable formalities such as a note, interest, security, and regular repayment. The most important supporting evidence for such testimony is the existence of a source for the lender’s funds. How was it paid” Was there a check to the taxpayer or a check to cash? Did the lender have sufficient available funds to make the loan at the time claimed? Did any other independent witnesses observe the making of the loan? A gift will ordinarily run into the same difficulties of proof and must be substantiated, or it will be vulnerable to prosecution cross-examination or jury disbelief. .
The Technical Tax Defense
It is important to understand the net-worth method in order to effectively attack it. As soon as it appears that the IRS will use a net-worth method, the defense should evaluate the IRS’s position for mathematical mistakes, accounting errors, the differences between criminal omissions and technical adjustments.
Improper Allocation of Income Between Taxable Years
An implicit assumption of the net worth method is that assets are a measure of taxable income in the year in which they come to light. This can affect a substantially improper allocation of income among years if the IRS is incorrect in fixing the entire increase in net worth to the date of acquisition. The object of such adjustments is not to escape conviction for one year by completely reducing the tax liability in that year. In almost all net worth cases involve multiple years. Thus, what is taken out of one year will be added to another year. It is of little comfort to the defendant to escape one year’s liability if he is convicted in another year for the same offense. Such a defense, however, can be of advantage in establishing other defenses. If the defense is attacking the IRS’s proof of willfulness, which in net worth cases often consists of little more than proof of substantial, continuous, and patterned understatements for a period of years, allocations and adjustments can destroy the pattern and the continuity. Allocation adjustments may be able to shift into a particular tax year income of such a substantial nature as to make proof of a likely source impossible. Or such adjustments may shift income into one or two years where the resulting tax deficiency can be tied to one or two sizable transactions, and the defense of negligence, mistake, or reliance can be effectively presented as to those transactions.
Holding Funds of Others
If the defense can prove that certain assets included in the net worth computation were not in fact his assets, either because he held the asset only as a nominee, or other individuals contributed to and had a claim on the asset, the net worth computation must be adjusted to reflect only the extent of the defendant’s actual interest. While this adjustment could apply to the defendant and any third party, it usually refers to the defendant and his immediate family.
The Bank Deposit Method
The bank deposit method is an outgrowth of the net worth method and in concepts, procedures, and defenses, it is quite similar. Under the bank deposit method, if a defendant had a business which earned money, if he regularly deposited all of the money earned into a single business checking account and if no other income or funds were deposited into the checking account, then the total deposits in the checking account would equal his gross income. If the gross income per the bank deposits exceeded his gross income, it would be evidence that the difference was unreported gross income. If a special agent then deducted all of the business deductions, personal deductions, and exemptions reported on the return from the gross income per checking account, the resulting figure would be true taxable income, a figure that would necessarily be different from reported taxable income.
The bank deposit method, as used in criminal tax cases, is an attempt to present the above analysis as proof of a tax deficiency. It is often more complex than the above example because there may be more than one account; there may be transfers between accounts; there may be nonbusiness deposits; the nonbusiness deposits may be from a taxable or nontaxable source; there may be business deposits which are washed out by non recorded deductions, such as those arising when a business cashes a check from customers or acts as an accommodating wholesaler for another retailer, etc. The bank deposit method can result in a convincing analysis or be among the most unreliable of all the indirect methods.
The basic elements of the bank deposit method are:
1) that the defendant was engaged in an income-producing business; 2) that he made periodic deposits of funds into bank accounts, and 3) that an adequate investigation of the deposits was made by the investigating agents in order to negate the likelihood that the deposits arose from some nontaxable sources.
The same attacks made on the net-worth method can be made on the bank deposit method concerning prior-accumulated funds. However, a good bank deposit analysis will more clearly show that deposited funds are current income than the net-worth method can. If the amount, size, periodicity and composition of the funds show a practice consistent with ordinary business procedures, it is difficult for the defense to claim that the deposits resulted from prior accumulation funds. This is, however, a double edged sword. Any unusual deposit, made out of time or in such an amount that could not be from business, will support the contention that it derived from prior accumulated funds, that is, if there is some credible proof that prior accumulated funds in fact existed.
An important question exists as to who is the burden of proving the source of an unidentified deposit. It would appear that the IRS may suggest a “likely source” for the deposit to shift the burden of coming forward with the evidence to the defendant. If there is sufficient circumstantial evidence that the defendant had unreported income accounted for by a bank deposit analysis, it will be sufficient to require the defendant to explain its actual origin, if he dares. Or the IRS can demonstrate a reasonable effort to exclude all nontaxable sources. The presumption is that the defendant knows what the source was, and if the IRS can suggest, by one means or another, that the deposits appear to be income, the defendant ought to be obligated to disprove the presumption.
Winning or losing a criminal tax evasion case will depend to a large extent on the actual facts of any particular case. Nevertheless, this is one of the few areas of the criminal law where the most vital and damaging facts are consistently developed from the defendant himself, because he makes statements or delivers records or offers early and weak defenses. Even when the IRS proceeds on an indirect method of proof, the defendant invariably admits or supplies vital links which pull together various inferences, assumptions, presumptions, or guesses into what passes in law as a prima facie case. In any area of the law where proof of guilt is thus typically self-generated, the value of a qualified attorney is inestimable.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony Diosdi focuses a part of his practice on criminal tax enforcement, broad-based civil tax compliance and white collar matters generally. He also advises clients on the IRS voluntary disclosure program, with particular focus on disclosure related to offshore banking accounts.
Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.