By Anthony Diosdi
The specific item method of proving an underpayment of tax is a direct method of proving one or more tax laws were violated. Actually, the specific item method is nothing more than the ordinary method used by revenue agents in making routine civil audits. An Internal Revenue Service (“IRS”) civil revenue agent will review the taxpayer’s return, analyze the income sources, personal and business deductions and exemptions reported in the various schedules. He will then analyze the original, underlying records which purport to substantiate those figures. Finally, he will determine whether all the transactions reflected in the underlying records have been properly accounted, described and handled in the return and whether the deductions taken are valid under the law and/or fully substantiated by the taxpayer’s records. The final adjustments to taxable income will be itemized, e.g., “disallowed deductions from Schedule C; “increase in interest income,” etc; and the resulting tax deficiency will be calculated. This process is a specific method of determining an underpayment of tax.
If an IRS criminal special agent, using an identical process, comes up with an underpayment of tax, he has proven one of the essential elements of the crime of tax evasion under Internal Revenue Code Section 7201, namely, a tax deficiency. Under Internal Revenue Code Section 7201, a defendant may be charged with tax evasion, if the IRS proves that: 1) the defendant committed an affirmative act to defeat or evade tax; 2) there is a material amount of tax due and owing; and 3) the defendant acted willfully.
Even if no tax additional tax liability results from the adjustment of false items in the return, as for example when the false item will only reduce the amount of a claimed net operating loss, the special agent will have proven one of the essential elements of subscribing a false and fraudulent return under Internal Revenue Code Section 7206(1), namly, a material misstatement in the return, signed under penalty of perjury. Under Internal Revenue Code Section 7206(1), any person who willfully signs and files any return, statement, or other documents containing a declaration that is under the penalties of perjury, and that he does not believe to be true and correct as to every matter, is guilty of a felony. The elements of Section 7206(1) are: 1) the return, statement or other document contained false information with respect to a material matter; 2) the defendant made and signed a return, statement or other document that contained a written declaration that it was being signed subject to the penalties of perjury; 3) the defendant did not believe that the material matter was true and correct; and 4) the defendant acted willfully. If the special agent can then prove that the tax deficiency or the false item was the result of “willfulness,” he has made out a tax fraud case.
The difference between the special agent’s and the revenue agent’s specific method is in the area of concentration. The revenue agent, who is principally interested in the assessment of taxes, will ordinarily be content to move on to other items when he has adjusted the return to reflect a failure to substantiate a deduction or include income. The special agent, however, has only scratched the surface when he finds an omission of income or an exaggerated or wholly false deduction. He will want to trace the item from its origin, through the taxpayer’s books and records, to the actual preparation of the return. A taxpayer cannot simply tell him to “adjust it” or “include it.”
This concentration of the special agent is the reason why all of the elements of a tax crime, i.e., willfulness, falsity, and a tax deficiency, tend to be proven by the proof of the tax deficiency itself in specific items in criminal tax cases. When a specific item, say the omission of cash receipts by a dentist, is being proved, the special agent will start with the actual cash payments by the patients, trace the cash payments from the receptionist who received them, through the office procedure in recording them for tax purposes, through the bookkeeping entries made, or omitted, through the person who either received the cash or deposited it or put in safe in the dentist’s office, through the records given or not given to the tax preparer who prepared the tax return, until he arrives at the final conference between the tax preparer and the taxpayer reviewing the final draft before signing.
If, in the course of such proof, it becomes apparent that ordinary records were not maintained, or unusual instructions were given by the defendant to his office employees, or vital records were not given to his tax preparer, criminal willfulness can easily be demonstrated by the special agent. Specific item proof is invariably the most compelling kind of proof in a criminal tax case because it ties willfulness directly to the disputed transaction, each fortifying and proving the other. United States v. Lehman, 468 F.2d 93 (7th Cir), cert. denied, 409 U.S. 967 (1972), is an example of the concentration of special agents in contrast to an audit by a revenue agent. In this case, the defendant was a dentist who received a notice of an IRS audit. He had just read a “do-it-yourself” article in a dental journal that recommended the self-handling of interviews with IRS agents without the participation of attorneys. To the dentist’s surprise, when the revenue agent arrived, he was accompanied by a special agent. The special agent told the dentist that he wanted to see his cash receipt journal and a “drawer of patient ledger cards.” When some of the patient ledger records did not correspond with the entries in the cash receipts journal, the dentist “became very nervous.” The special agent then “propounded a series of questions directed at uncovering possible reasons for the nonreporting.” When it was discovered that each patient card that was marked with an “X” in the upper right hand corner was not recorded in the journal, “Dr. Lehman told the agents not to pull any more cards and asked if he could lie down on a couch in a recovery room.” While he was lying down, the special agent came into the recovery room and continued to question him. Finally “after asking what would happen to him, his family, and business, Dr. Lehman confessed that he had not been recording all his patient receipts.” This case demonstrates two things: Do not mistake a special agent for a revenue agent and do not handle your own audits. Dr. Lehman was ultimately sentenced to three years in prison.
The Importance of a Defendant’s Books and Records
The most powerful specific item case is made with the taxpayer’s books and records in the hands of the special agent. Bookkeeping is more important than accounting in tax fraud cases because the manner of bookkeeping relates to the recording rather than the interpretation of transactions. Bookkeeping will show falsity, concealment, design, omission, and intention as to the taxable events themselves. On the other hand, it will show defenses such as negligence, mistake, innocent omission, lack of design or pattern, reliance on others, etc. The defendant’s books and records are most important when they are in the defendant’s hands and not in the hands of the special agent.
Bookkeeping procedures are also vital in specific item cases. It is standard procedure for special agents, in any criminal tax case, to determine from the defendant’s accountant, bookkeeper, secretary, receptionist and other office employees, how he handled his taxable receipts, what instructions they were given, what records they maintained, how they billed customers, etc. When this information is put together with actual bookkeeping entries, the taxpayer’s vulnerability, if he has any, will emerge.
The defendant cannot effectively prohibit the special agent from obtaining an employee statement because he has no power to prohibit the agent from forcing his employees to make statements under oath about the bookkeeping procedures. Office employees, and for that matter, accountants, have no privilege relationship with the defendant. See Criminal Tax Fraud-Representing The Taxpayers Before Trial, George Crowley and Richard Manning, (1976), Practising Law Institute, New York City.
Types of Specific Item Cases
The most effective way to present the power, problem, and possibilities of specific item cases is by the use of concrete examples. We have selected three typical examples of specific item cases to present in detail.
Criminal Tax Bookkeeping Case
The defendant is a doctor practicing general medicine. He services from 250 to 300 patients a year. The receipts from patients are handled as follows: all payments received by doctor or other office personnel are ultimately given to the bookkeeper-receptionist, who records the payments against an individual patient ledger. After the payments are recorded, payments are deposited in the doctor’s business account at X bank. The doctor removes some of the payments from the journal. At the end of the year, the accountant determines the doctor’s gross receipts by analyzing the journal. A special agent’s investigation begins when the IRS learns that the doctor removed some of the payments received from his journal. The agent reviews the doctor’s return and sees a relatively moderate gross income figure has been reported. He meets with the doctor, gives him Miranda warnings, and asks the doctor’s permission to examine his books and records. Permission is granted. It is a simple matter for the special agent to prove actual receipt of payments received that is not reported in the journal. Willfulness proof also emerges from this proof. The amount of the understatement alone might suggest either direct knowledge or at least notice that all receipts were not reported.
Criminal Tax Cash Transaction Case
The defendant is the chief executive officer of a large manufacturing corporation. Old machine parts, no longer serviceable for the business, are sold to a small contractor who rebuilds them for resale. The taxpayer has an arrangement with the small contractor whereby the contractor pays the corporation by check for some parts and then pays the defendant in cash for the remainder of the parts. Two invoices are prepared by the contractor, one for the goods paid for by check, one for the goods paid for by cash. The defendant submits the check and the check invoice to the corporation’s controller and both are recorded on its books. An audit of the corporation’s return will not disclose any impropriety unless a detailed inventory of old machine parts was maintained and a comparison between the inventory and the contractor’s invoices was made, an unlikely occurrence. The defendant therefore feels absolutely secure and is convinced that as long as he does not become greedy he will be safe.
What the defendant has forgotten, however, are tax problems he has created for the contractor. The contractor cannot afford to lose a cost of goods deduction for the material he buys for cash. He therefore sets up his books in such a way as to provide the maximum substantiation for goods paid with cash. On each occasion that he purchases material from the manufacturing corporation, he draws sequential checks, the first made payable to the corporation, the second made payable to cash with a notation on the stub that it was a payment to the manufacturing plant. He maintains both the cash and the check invoices. He also maintains inventory tally sheets that tie out exactly to the two invoices he maintains. When an examination of his records is madse, he can produce, quite apart from his own testimony, compelling proof that he delivered cash to the chief executive of the corporation.
When a check of the corporation’s books is made, and only the checks and the check invoices are recorded, a specific item case will quickly be made. The mere proof of the specific taxable items will demonstrate willfulness because the taxpayer had knowledge of the transactions (i.e., he received the check, noted its receipt and transferred it to the controller) and he suppressed or concealed information from the controller (i.e., the cash and the cash invoice). The cash transaction has been a consistently used device for evading taxes. Cash transactions may make proof more difficult, but they never make proof impossible.
Potential Overcoming the Specific Item Criminal Tax Case
The defendant is an attorney who handles the affairs of approximately 25 clients. The defendant understates his gross receipts by approximately 40 percent per year. He very carefully spends the understated receipts, aware that living like a person earning $200,000 a year is bound to create suspicion when he reports only $120,000 a year. When the special agents come to visit the lawyer, the defendant not only listens to the Miranda warnings, he embraces them. He turns over none of his books and records, makes no statements, and immediately retains a criminal tax attorney for his defense. An indirect method of proving an underpayment of tax may not be very successful because the defendant has not purchased visible assets or deposited the understated funds.
Does this mean that the special agent cannot build a criminal case against the lawyer? No. From various sources the special agent may be able to develop a substantially complete list of the defendant’s clients. This could be done by examining his office personnel, his accountant, or his tax preparer. The special agent can also view the attorney’s linkedin page which might indicate references or “clients represented.”
Once a reasonable complete list is compiled, the special agent may contact each client and ask for (or summon) all records relating to payments to the defendant, including checks, monthly statements, correspondences relating to the bill or its payment, and reimbursement for expenses. If the defendant reported gross receipts on Schedule C of $200,000, every dollar over $120,000 developed from the third-party investigation is specific item proof of the falsity of the $120,000 figure. However, this defendant is in a far better position in regard to proof of willfulness than the two previous examples. This is because the special agent may not find all of his clients, and every undiscovered client reduces the amount of the total tax deficiency provable. Foley v. United States, 290 F.2d 562 (8th Cir.), cert. Denied, 368 U.S. 888 (1961) provides an example of a divorce lawyer indicted for tax evasion for two years. From the nature of the defendant’s law practice, the IRS had to locate and interview the lawyer’s former clients that paid fees. Some of the clients were deceased and many had moved out of state. Special agents interviewed 113 of the lawyer’s former clients and called them as witnesses at trial. Through their testimony, the government was able to show a substantial underpayment of gross income. The attorney was ultimately sentenced to three years in prison.
Conclusion
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: adiosdi@sftaxcounsel.com.
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.