By Anthony Diosdi
In previous articles, we discussed various defenses to indirect method cases, such as prior accumulated funds, nontaxable sources of net worth increases, bank deposits, improper allocation of income between taxable years, and accounting defenses. This article will focus on defenses to specific item cases. In these cases, once the Internal Revenue Service (“IRS”) establishes by proof a specific understatement of a tax liability, the question is will criminal liability follow and if so, does the taxpayer at issue have any viable defenses. The IRS has the burden of proof on this question. The IRS must tie the understatement of taxes to the defendant, demonstrating both his knowledge and intent.
Translating this proposition into the language of investigative and administrative stages of a criminal tax case, the IRS special agent must prove, and the agent’s reviewers must find, “a reasonable probability of conviction” of a tax crime before making or approving a criminal recommendation to the United States Attorney.
IRS special agents are jaded. Most have heard just about every excuse from taxpayers. Defenses of reliance on others, negligence, mistake, etc., are so often employed and so easily disproved if untrue, that there is a tendency to note them dutifully and then go out to prove they are untrue. On the other hand, the IRS special agent knows it is his responsibility to find evidence of guilt and that his findings will be thoroughly reviewed. We will now discuss the most common defenses to tax crimes.
Reliance Upon the Advice on Others
Probably the most common defense to a tax crime is reliance on others. The taxpayer has a valid defense to specific questioned tax adjustments if he can demonstrate that he inquired about appropriate treatment of those transactions of a qualified advisor to whom he disclosed all pertinent facts and whose advice he followed. The Handbook for Special Agents formulates this defense as follows:
“Advice of counsel, accountant, or Government agent, if relied upon by the defendant, may be a valid defense to a willful violation. However, if it can be shown that the defendant did not act in good faith upon such advice by not following it, or that he did not fully inform his advisor of all the facts, or that he sought advice from one not qualified to give it, or from one who he had reason to believe was not qualified, the defense is vitiated. An attempt by the defendant to shift responsibility for a fraudulent return to the person who made out the return or kept the books can be met with proof, direct or circumstantial, that the defendant knew or should have known the return was false. Such proof may take the form of testimony by bookkeepers, or other office help about the defendant’s knowledge of the book entries or lack of entries.”
The difficulty with this defense is that it can never be offered hastily. The so-called tax advisor is a vital witness, who will be obligated to admit he gave wrong advice with disastrous results to his client, which is not much in the way of advertising. He may even feel put upon by the taxpayer whose defense will embroil him, unfavorably, with the IRS, if what the taxpayer claims is true.
Before this defense is offered, the defense must interview the tax advisor. Any correspondence between the defendant and the advisor should be gathered, including transmittal letters indicating documents sent to the advisor or returned by him. Workpapers, notes, and memoranda relating to the tax return’s preparation, with specific notations as to where they are located, should be searched for. This defense can never merely be offered; it must be proven completely. The defense of reliance is particularly popular when the taxpayer discovers that the preparer has since died. While it might appear at first that his death was a blessed event for the taxpayer, it is not a very effective defense unless existing documents give some support to the defendant’s claims. Federal courts have approved an instruction that since the alleged advisor was dead, the taxpayer’s testimony concerning advice given “must be received by you with caution and the closest scrutiny and weighed by you in the light of all the testimony and evidence in the case.” See Benetti v. United States, 97 F.2d 263, 267 (9th Cir. 1938).
Whatever position the tax advisor takes, for or against, living or dead, the success of the defense will likely depend on the reasonableness of the advice. Obviously, the advice was wrong, because the defense would not be required if it had been right. But it cannot be wholly absurd advice that one one with common sense could credit, because the jury will either doubt that the advice was given or that it was honestly believed. With that said, it does not hurt if the advice or the advisor is somewhat bizarre, provided the defendant is not an accountant or tax lawyer. The defense of good faith reliance and, even if the defendant receives clearly erroneous advice, the question of whether he believed it or was merely shopping, is for the jury to decide. See Criminal Tax Fraud-Representing The Taxpayers Before Trial, George Crowley and Richard Manning, (1976), Practising Law Institute, New York City.
Shifting the Blame to Others
Tax advisors and tax preparers are not the only so-called potential fall guys. Bookkeepers have come in their share of abuse, as well as office managers, employees, secretaries, spouses and, in one case, a faulty adding machine. This defense is usually tied to a claim of negligence, that a particular employer failed to perform his assigned task and that his failure caused the omission of income, when a bookkeeper fails to debt or credit an appropriate account or an office manager neglects to record patient fees in a daily receipt book used by the accountant in preparing the return. Businesses which require complex booking can often run into difficulties because a lower echelon clerk improperly records original entries which everyone else subsequently relies upon.
The errors allegedly made by an entry level clerk must, of course, be tied to the errors which form the basis of the indictment. A criminal tax attorney must also endeavor to remove the defendant from active supervision or detailed review of the records. The complexity of the bookkeeping system must be demonstrated and described as virtually an independent thing upon whose accuracy the defendant relied.
The Defense of Negligence
Next to reliance on others, negligence is probably the most often used defense in criminal tax cases. In these cases, the defendant confesses to the errors but disputes criminal intent. Given the complexity of modern small business, negligence is often a viable defense. However, the IRS has a very effective means of combating the negligence defense. Most criminal tax indictments involve three, or at least two. While it is clear in law that any number of acts of negligence will not amount to willfulness, it is by no means clear in fact. Willfulness is inferred from objective facts, and while a consistent series of faulty recordings or sloppy booking practices can be argued as negligence, they can also be argued as criminal willfulness. Furthermore, as the errors persist from one year to the next they lose their quality of fortuitous incompetency and take on the aspect of devious design. What might have been excusable neglect in a particular year becomes increasingly difficult to excuse as the defendant continues to ignore the errors or seek any credible assistance in correcting them.
Another difficulty with this defense may be presented by the size of the understatement. A jury may understand how a defendant’s negligence can cause an understatement, but if the understatement is such that any reasonable person would be on notice that something was wrong with the figures he acknowledged by signing the return, a negligence defense may be in trouble. Demonstrating the complexity of the returns, or the confusion of the defendant’s personal as well as business affairs or the fact that the defendant was not living well above the standard of a person reporting what he was in fact reporting are means of reducing the impact of a counter “notice” argument. For the most part, however, a defendant asserting a negligence defense will have to demonstrate how the negligence occurred, how it persisted, and how the defendant could have been ignorant of its effect.
Mistake of Law Defense
A defendant may also defend himself by arguing that he misunderstood the law. “Ignorance of the law is no excuse” is a proposition of law which does not apply when the defendant’s state of mind is an issue in the case, and it is an issue in the criminal tax case. The tax law is so complex that innocent errors are not only possible, but probable. With that said, it is not enough to demonstrate that there was confusion. There must be proof that the defendant’s resolution of the confusion was what he honestly believed was the correct interpretation.
Tax Avoidance vs. Tax Evasion
Judge Learned Hand succinctly summarized the operational tax principle guiding most taxpayers and all tax advisors in his dissent in Commissioner v. Newman, 159 F.2d 848, 851 (2d. Cir), cert. Denied, 331 U.S. 859 (1947)…nobody owes any public duty to pay more than the law demands: taxes are enforced bexactions not voluntary contributions.” Judge Learned Hand also said on another occasion: “anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” See Helvering v. Gregory, 69 F.2d 809, 810 (2d. Cir. 1934), aff’d 293 U.S. 465 (1935). Since the federal income tax became law, taxpayers and their advisors have sought loopholes, lobbied for special tax benefits, exhausted the legal forms of arranging their tax affairs and imaginatively contested every tax statute and regulation in pursuing the barest limit of their public duty.
These efforts are described as “tax avoidance” and are claimed to be legal even if they fail. From a formal point of view they are indisputably legal. A hundred authorities could be summoned to approve, if not praise, them. See Helvering v. Gregory, 293 U.S. 465, 469 (1935). The difficulty is that the proposition must emerge out of the facts and inferences from facts. The facts must establish what the defense has always had great difficulty in establishing clearly, the “intent” of an interested party.
This article will not attempt to draw a firm line between avoidance and evasion. Great scholarly efforts have been made in this direction with little tangible result. See Gutkin and Beck, Tax Avoidance v. Tax Evasion (New York; the Ronald Press Company, 1958). Because of the complexity of the Internal Revenue Code, the imagination of taxpayers, the difficulty in proving intent and the broadness of the criminal tax sanction, it is doubtful whether a truly useful definition of either concept is possible. Whether particular conduct is avoidance or evasion will depend upon the initial point of view of whomever is deciding the question.
This defense, as all the defenses discussed in this article can never be hurriedly presented. The point of view of special agents will likely lean heavily toward an adverse construction of facts; they are inclined to see evasion, not avoidance
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: email@example.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.