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How the IRS Establishes a Tax Evasion Case

How the IRS Establishes a Tax Evasion Case

The building of a criminal tax evasion against a criminal defendant often takes months or even years. The process of building a tax evasion case often involves a careful examination of a criminal defendant’s finances. This article examines the methods that the IRS uses to build a criminal tax evasion case.

The most common forms of 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 methods of proof used by the IRS in a criminal tax evasion case are typically 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 corroborating 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 $100,000 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 $100,000 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 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.

Indirect Methods to Establish Tax Evasion Case

The crime of tax evasion reads as follows: Any person who willfully attempts in any manner to evade or defeat any tax imposed by the Internal Revenue Code or the payment thereof shall by guilty of a felony. On its face, this is an extremely broad criminal statute, “any person,” “any tax,” and “any manner” of evasion. It is not restricted to the income tax laws; successful prosecutions have involved evasion of the gift tax, estate tax, excise tax, and withholding taxes. It is not restricted to the taxpayer filing his or her income tax returns but has been included under the definition of “any person,” corporate officers evading corporate tax, administrators of estates evading the estate tax, and attorneys, accountants or bookkeepers who assist in evading any taxes. The IRS’s ability to establish a case of tax evasion in large measure depends on its ability to obtain a targeted taxpayer’s records and the testimony of reluctant witnesses. The problem for the IRS is this type of evidence is not always readily available. An individual subject of the IRS criminal investigation may refuse to supply his books, under a Fifth Amendment claim; the individual could also claim his books had been destroyed; or the individual under investigation could claim that he or she never kept any books or records. Since direct methods of proof are not always available in an IRS criminal tax evasion investigation, the IRS may attempt to prove tax evasion by utilizing one or more indirect methods. 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 individual under investigation did with the money that should have been taxed did with the funds.

One way that the IRS establishes tax evasion by indirect evidence is drawing a conclusion from a simple observable fact. For example, in the IRS eye’s, a person living in a large home in an affiliate area of the San Francisco Bay Area and driving a brand new Porsche sports car who earns only $50,000 annually is probably committing tax evasion, unless he or she is deeply in debt or has a wealthy family.

In such a case, 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 or her 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 IRS special agent can reconstrued the taxpayer’s taxable income with what may pass in a federal district court as proof necessary to obtain a conviction for tax evasion.

Prerequisites Utilizing Indirect Methods of Proof

Accusing an individual of serious crime such as tax evasion is controversial. At one time it was believed that the IRSshould demonstrate the inadequacy of a targeted individual’s books and records before indirect methods can be utilized to build a case for tax evasion. This argument was put to rest almost eighty years ago in Holland v. United States, 319 U.S. 503 (1943). In Holland, 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 was not disclosed to the IRS, and the targeted individual’s books and records were incompetent. The Holland decision also means that the IRS can ignore what appears to be a perfect set of books and records and recompute an individual tax liability for purposes of establishing tax evasion. 

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 that an individual intended to evade the payment of taxes. However, a good set of books can demonstrate that an individual under investigation properly attempted to report his or her taxes. Even an inaccurate set of books and records can be utilized by an individual accused of tax evasion to demonstrate the actual source of the net-worth increases and that the errors in the books were the product of negligence rather than criminal willfulness. 
The indirect methods of proof discussed above of establishing the failure to pay taxes for purposes of building a case of tax evasion are “approximations.” Although indirect methods of proof are approximations, such evidence may be admissible in court against a criminal defendant. There are many alleged safeguards protecting the use of these methods. One such general safeguards was thought to be the “substantial understatement” requirement. This means that a small understatement of taxable income cannot be established by “approximations” in a criminal tax evasion case. 

The Net-Worth Plus-Non Deductible Expenditures Method

The next way of indirect proof of tax evasion is under the so-called net-worth plus-non deductible method. Our analysis of the net-worth method plus non deductible expenditures method will begin with the landmark case of Holland v. United States, 121, 132 (1954). 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 targeted individual’s books and records are inadequate as a basis for determining income tax liability, the IRS will attempt to establish an “opening net worth” or total net value of the individual’s assets at the beginning of a given year. If then the IRS proves an increase in the targeted individual’s net worth for each succeeding year during the period under criminal tax examination and calculates the IRS establishes the difference between the adjusted net values of the individual’s assets at the beginning and end of each of the years involved. The individual’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 IRS will claim that the excess represents unreported taxable income. Stated in mathematical terms, the net-worth plus nondeductible expenditure formula may be described as follows: 1) an increase in net worth, plus 2) nondeductible disbursements, minus 3) nontaxable receipts, equals 4) unreported taxable income before exemptions.

The Opening Net-Worth Determination

The accuracy and completeness of the opening net worth discussed above is vital to the defense in a tax evasion case. This is because any asset that the IRS does not include in the opening net worth could reduce the amount of unreported income for purposes of the tax evasion statute. The opening net worth is an assertion by the IRS is an assertion that the items included are the targeted individual’s only assets and liabilities. This is no easy task and as a result, the opening net worth determination by the IRS is often subject to attack by criminal tax attorneys.

However, some techniques of proof available to the IRS in supporting its opening net worth presentation are difficult to dispute. First, the IRS is not obligated to make the opening net worth year immediately prior to the first year a defendant is under indictment for tax evasion. 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 to it. For example, the IRS may begin with a year the targeted individual declared bankruptcy or filed a detailed net-worth statement with a bank or, worst of all, forwarded financial information to the IRS on a tax return or a financial statement such as an IRS Form 433-A. Even information provided to bankruptcy court, financial institution, or the IRS for a prior year was incorrect for purposes of establishing a tax evasion case, such errors may force a defendant on trial for tax evasion to begin his or her defense by admitting that he or she lied to a bankruptcy court, a financial application to a financial institution, or the IRS. An IRS special agent may also attempt to determine an opening net worth through statements from the targeted individual about his or her assets through bank records, country real estate records, inheritance, and gift tax records and the defendant’s books and records.

Finally, the IRS will attempt to utilize a targeted individual’s own statements against him or her. The importance of a defendant’s statements cannot be minimized. If an IRS auditor or special agent questions an individual being invested for tax evasion and the individual elects at his or her own peril to answer these questions, the defendant’s own words will be used to determine an opening net worth amount. This is because the starting point of a criminal tax evasion investigation is often to ask the defendant if he or she had any large sums of cash on hand, securities, or other non visible assets. If the targeted individual says no, the IRS can take the defendant at his or her word and compute the starting point from the individual’s 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 Opening Net-Worth and Invisible Assets, i.e., Cash on Hand

Because of the quality of IRS special agents’ training and the availability of records from third parties such as financial institutions, the IRS can usually do a fairly good job in accounting for visible assets. With that said, it may be very difficult for an IRS special agent to prove invisible assets directly, such as cash on hand. Because of this difficulty, the “cash hoard” defense in certain cases could be 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 targeted individual in a position that he or she cannot claim this defense. The following sources of proof are taken from the 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.
Because of the open ended quality of the net worth proof and its supporting evidence of current income, the following are potential defenses to the opening net worth determination by the IRS:

Prior Accumulated Funds

The first potential defense to the opening net worth determination is a prior accumulated funds defense.The prior accumulated defense is based upon the IRS’s failure to include all of the targeted individual’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. For this defense to potentially have any traction, the defendant will need to supply a plausible explanation for his creation of the cash fund incorrectly classified by the IRS. 

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 good defense to the IRS opening net worth calculation. 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 prosecution 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 need 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.
Another important defense to the IRS’s net worth determination is a technical tax defense. In order for this defense to work, it is important to understand the net-worth method used by the IRS in order to effectively attack it. A technical tax defense should evaluate the IRS’s position for mathematical mistakes, accounting errors, and the differences between criminal omissions and technical adjustments.

Improper Allocation of Income Between Taxable Years

An implicit assumption typically made by the IRS when applying the net worth method is that assets are a measure of taxable income in the year or years under investigation.
In certain cases, an individual under investigation by the IRS can take the position that the IRS improperly allocated income and assets for purposes of determining the net worth method. The object of taking such a position is not to escape conviction for one year. In almost all net worth cases involve multiple tax years. Thus, what taxable income for tax evasion purposes may be removed from one tax year could potentially be added to another tax year. This would be of little comfort to a targeted individual to escape a tax evasion charge in one year if he or she is convicted of tax evasion in another year. However, reducing or eliminating the allocation of taxable income in one year 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 potentially eliminate an alleged pattern and the continuity. Allocation adjustments may also 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 on a professional more believable.

Holding Funds of Others

Sometimes individuals are accused of tax evasion based on the fact they are holding assets for another individual. In such a case, if the defense can prove that certain assets included in the net worth computation were not in fact a targeted individual’s 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.

The Bank Deposit Method

The IRS often uses the so-called bank deposit method to build a tax evasion case against a targeted individual.Under the bank deposit method, if a defendant had a business which earned money, if he or she 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 or her gross income. If the gross income per the bank deposits exceeded his or her 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 evasion 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 could suggest a “likely source” for the deposit to shift the burden of coming forward with the evidence to the individual under investigation. If there is sufficient circumstantial evidence that the targeted individual had unreported income accounted for by a bank deposit analysis, it will be sufficient to require the defendant to explain its actual origin. If the defendant cannot explain the bank deposit as being from a taxable source, the IRS will assume that the unexplained deposit is evidence of unreported taxable income for purposes of establishing a tax evasion case.

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 or she may make statements or deliver records or offer early and weak defenses. This may invariably result in the IRS being able to pull together various inferences, assumptions, and presumptions which can ultimately result in the IRS successfully building a criminal tax case against a targeted individual. If you are being investigated by the IRS it is extremely important to retain a highly qualified tax attorney to represent you as early as possible.

Anthony Diosdi has more than 20 years of experience representing closely held businesses and individuals in civil and criminal controversy matters. Hei has represented individuals accused of tax evasion and other tax related crimes by the IRS and the United States Attorney both pre and post indictment.

Anthony Diosdi is admitted to the California and Florida bars.

Diosdi & 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.

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