DC Circuit Discusses Cost / Benefit Analysis for Tax Evasion (11/9/09)

I have re-read an earlier case that I think may be interesting to readers of this blog. The case is Mayer Brown LLP v. IRS, 562 F.3d 1190 (D.C. Cir. 2009), here.

The issue in the case was whether the Mayer Brown ("Mayer Brown") could use FOIA to get information about settlement practices for LILO transactions. (I should note parenthetically that Mayer Brown scored a major, if perhaps temporary, victory on a LILO transaction in Consolidated Edison Company of New York v. United States, 2009 U.S. Claims LEXIS 335 (10/21/09).) The IRS asserted that FOIA exemption 7(E) applied because the information risked circumvention of the law. The statute for the exemption says the exemption applies if " disclosure could reasonably be expected to risk circumvention of the law."

The Court concluded that this is broad language covering not only the risk of future violations but the risk of evading punishment after a violation. In the balance of this email, I quote extensively from the court's analysis because it discusses the types of cost / benefit analysis that taxpayers may enter in deciding whether to commit a tax crime (or just an egregious civil tax violation of law) or continue to cover one up.

B. 

Tax evasion (like many crimes, to varying degrees) involves a cost-benefit analysis on the part of the law-breaker. Information about acceptable settlement ranges quite clearly affects the cost-benefit analysis of potential evaders because it informs their economic calculus. Some potential evaders, upon learning the range of settlement percentages, may decide that the range is low enough to make evasion an appealing gamble. In this way, disclosure of the information can create an incentive for increased evasion. For example, suppose hypothetically the requested information revealed that the IRS's acceptable settlement range goes as low as 35% of the amount due, and a potential evader expects to gain a greater sum through an illegal tax scheme. Equipped with this information, the potential evader might decide the risk of a 35% settlement is low enough to gamble and violate the tax laws. 

Similar reasoning applies to other categories of information at issue. Litigation hazards may include types of illegal tax shelters the IRS does not have the resources to pursue, situations which make witnesses unsympathetic or hard to find, or practical complications for investigating certain types of schemes. A potential evader who is made aware of the IRS's perceived litigation hazards will know how to best structure an evasion so as to avoid the maximum enforcement efforts of the IRS. Knowing how to evade in a way the IRS deems more difficult to detect or prosecute also enters into the cost-benefit analysis of a potential evader; a person with such knowledge may feel emboldened because she believes she can execute a scheme the IRS will be loathe to prosecute.Mayer Brown points out that Congress prohibited LILO transactions in 2004. Because, they argue, the 2004 statute will effectively eliminate all LILO arrangements, disclosure presents no danger. Of course, this argument ignores the limitless ingenuity of lawyers and accountants when it comes to tax shelters. Returning to the example above, if a potential evader knows that the IRS's acceptable settlement range goes as low as 35% for LILO arrangements, she might infer that a similar range would apply to a slightly different tax model. The LILO settlement ranges could be used as a baseline or a reference point for analogous schemes. Indeed, the IRS has estimated the existence of "almost 400 SILO transactions" (an arrangement very similar to LILOs) representing "claimed tax deductions in excess of 35 billion dollars" as evidence of the potential use of LILO settlement information for other schemes. J.A. at 140. The information about settlement ranges for LILO transactions may enter into the cost-benefit analysis for other tax shelters and, in some cases, could convince potential evaders that a questionable scheme is worth the risk. 

Mayer Brown urges this Court to adopt an extremely narrow interpretation of the exemption, arguing the IRS has a high burden to specifically prove how the law will be circumvented.
We are aware the language of FOIA's exemptions "must be narrowly construed." Dep't of Air Force v. Rose, 425 U.S. 352, 361, 96 S. Ct. 1592, 48 L. Ed. 2d 11 (1976). But broad language -- even when construed narrowly -- is still broad language. Although some FOIA exemptions set a high standard, see, e.g., 5 U.S.C. § 552(b)(6) (requiring the agency to show "a clearly unwarranted invasion of personal privacy"), the text of exemption 7(E) is much broader. In matters of statutory construction, the text is our primary guide. See Sierra Club v. EPA, 536 F.3d 673, 679, 383 U.S. App. D.C. 109 (D.C. Cir. 2008). Rather than requiring a highly specific burden of showing how the law will be circumvented, exemption 7(E) only requires that the IRS "demonstrate[] logically how the release of [the requested] information might create a risk of circumvention of the law." PHE, Inc. v. DOJ, 299 U.S. App. D.C. 223, 983 F.2d 248, 251 (D.C. Cir. 1993). The IRS has logically shown how a risk of circumvention might result; Mayer Brown's desire for an even narrower reading is simply not supported by the text. 

In addition to potential future violators who may be encouraged to evade, those who have already evaded the tax laws (either through questionable lease transactions or other conduct) may use the information when deciding whether to come forward -- a different but equally rational cost-benefit analysis, factoring in the degree of risk, the likelihood of enforcement, and other factors. If a tax cheat knows the IRS's acceptable settlement ranges, and if her liability is substantial, she might decide the ranges are so high that it is better to remain in hiding. If the consequences of confession seem especially harsh, a past evader may feel every effort must be undertaken to cover up the violation. If her efforts actually impede investigation or prosecution, not only has she circumvented the law by avoiding the legally prescribed consequences of her evasion, but she has also violated an additional law by obstructing justice. See, e.g., 18 U.S.C. § 1503 (prohibiting attempts "to influence, obstruct, or impede, the due administration of justice"). The information about settlement goals, litigation hazards, and settlement ranges is just another factor in an evader's cost-benefit calculation about whether to cooperate.
Mayer Brown insists the term "circumvention of the law" applies only to future conduct. Thus, a disclosure that merely inhibits expiation for past conduct -- a circumvention which has already occurred -- does not implicate exemption 7(E). But even if we accept Mayer Brown's premise that exemption 7(E) is solely forward-looking, there is a logical flaw in its argument. Information that encourages a past violator to remain in hiding affects that violator's decisions in the future. The fact that a tax evader has circumvented the law in the past does not mean she cannot also circumvent the law in the future by avoiding the legally proscribed consequences of her actions. The decision to evade the legal consequences of the initial violation is not just made once; it is a decision that is made anew when there is additional information. If the disclosed information reveals severe costs in coming forward, it may influence future conduct, satisfying even Mayer Brown's assumption that the exemption is only forward-looking. 

C. 

The consequences of a contrary interpretation of exemption 7(E) highlight the problem. In this case, companies using LILO schemes would love to have information about the IRS's objectives of settlement, assessment of litigation hazards, and acceptable ranges for settlement. Why? Because this information would inform their cost-benefit analysis about the advantages of evading the law. Constructing a phony tax shelter may only be worthwhile if the IRS's acceptable settlement range is below 80% of the tax liability. Once armed with (hypothetical) information that the IRS's acceptable settlements are between 60% and 75%, a questionable tax scheme becomes viable. Even a failure may be a win. And, once also armed with information about which cases the IRS does not like to litigate, the illegal tax shelter can be designed to minimize the chances of litigation or the likelihood of sanctions.\ 

In other analogous contexts, similar information could be sought. Everyone seeking to minimize tax liability -- not just LILO users -- would love to have all of the IRS's guidelines for all other schemes to learn when the agency is likely to seek enforcement versus when the agency views the specific context as too difficult to litigate because of concerns about lack of agency resources for certain types of cases, unsympathetic witnesses, or complicated investigation requirements. Once equipped with information about settlement guidelines for all tax evasion schemes, particularly crafty evaders could plan their behavior to maximize the litigation hazards for the IRS and evade tax laws when, based on the settlement ranges, it was economically beneficial for them to do so.