I offer the following comments principally to DOJ Tax's comments urging that unclaimed deductions and credits not be considered for the tax loss determination. Here are some key excerpts from the DOJ Tax letter that should set the stage for persons generally familiar with the issue:
"Tax loss" under the Guidelines is distinct from a tax deficiency in a civil tax case or an order of restitution. Tax loss, by definition, should address the entirety of the harm intended by the defendant, including for example the harm caused by concealment through omitting certain deductions. It is only through civil enforcement that the government should be charged with determining the correct tax liability, and restitution serves merely as an aid in the collection of that liability.
The Tax Division, along with the sentencing courts, has extensive experience in considering claims concerning uncharged expenses in Guidelines calculations. As demonstrated by several examples included below, any attempt to determine whether and when to allow a deduction that the defendant did not report on an original tax return will require inappropriate speculation, and may implicate complex tax issues and result in unjust anomalies. At a minimum, it will turn routine sentencing hearings into tax mini-trials. Further, in civil tax enforcement, the taxpayer bears the burden of claiming and substantiating deductions, and the IRS's determinations are accorded a presumption of correctness - fundamental principles that are not incorporated into Options 1 or 3. Either of these proposed amendments runs the risk of giving convicted tax evaders advantages over taxpayers with honest disputes with the IRS.
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Option 1, which categorically mandates the allowance of all unclaimed deductions that could have been claimed on an honest return, is not the law in any circuit.
- Option 1 provides: "The determination of the tax loss shall account for any credit, deduction, or exemption to which the defendant was entitled, whether or not the defendant claimed the deduction at the time the tax offense was committed."
- Option 2 provides: "The determination of the tax loss shall not account for any credit, deduction, or exemption, unless the defendant was entitled to the credit, deduction, or exemption and claimed the credit, deduction, or exemption at the time the tax offense was committed."
As the Commission recognizes, Option 2 is the majority view and reflects the law in six of the eight circuit courts of appeal that have considered the issue. [String cites omitted]
- Option 3 provides: "The determination of the tax loss shall not account for any unclaimed credit, deduction, or exemption, unless the defendant demonstrates by contemporaneous documentation that the defendant was entitled to the credit, deduction, or exemption."
Option 3 resembles, but is different from, the approaches adopted by the Second and Tenth Circuits. [Citations omitted.]DOJ Tax promotes Option 2 - no consideration of unclaimed deductions and credits in computing the tax loss for sentencing. As I have noted before, this could mean that a person is sentenced based upon a tax loss that simply is not a real tax loss. It is a notional tax loss created by disallowing the defendant unclaimed tax deductions and credits.
As I have also said before, the courts buying into that result -- I think, a harsh one -- justify it because, by not claiming the deductions and credits the taxpayer is otherwise entitled to -- he did not intend those tax benefits and thus it is proper to consider only the fraudulent tax benefits he did claim. There is certainly an argument to be made for that position based on the wording of the current guidelines. But the issue now presented is whether that wording should be changed in order to reflect a better result.
DOJ Tax complains that it will be difficult to make the determinations at sentencing as to whether the taxpayer is entitled to the deductions and credits. This rings hollow to me. Those types of issues are resolved in sentencing hearings all the time and need be made only in rather broad strokes anyway. Even if the sentencing court were charged to make the determination, the proceeding would not turn into the Tax Court to do so.
Moreover, over 90% of tax cases are resolved by plea, and overwhelmingly the plea will come only if the prosecutor and the defendant-taxpayer agree upon the tax loss numbers in reaching the plea agreement. The Court will not be slowed down by that exercise. And, even where there is no plea, I suspect that prosecutors and the convicted defendants will be able to agree upon the tax loss numbers (including unclaimed deductions and credits) in most of the cases.
DOJ Tax laments that there will be some disconnect between the civil tax system in which the taxpayer must prove by a preponderance of the evidence the amount of deductions and credits and the sentencing system where the prosecutor would be required to prove the amount of tax loss (including the proper amount of unclaimed deductions and credits). If that is a concern, it seems to me that the solution is to provide that generally, unclaimed deductions and credits will not be considered unless the taxpayer establishes them by a preponderance of the evidence. (This is Option 3, except that the taxpayer must prove by a preponderance, which, as most trial lawyers know rarely determines the outcome of the finding to which it could apply.)
Other submissions to the Commission were as follows:
Edward F. Cronin
Division Counsel and Associate Chief Counsel, Criminal Tax
Internal Revenue Service
Recommends Option 2.
Practitioners Advisory Group
Recommends Option 2 as follows:
First, the Commission should reject Option 2 because a categorical prohibition on considering previously unclaimed deductions would overstate offense seriousness in many cases and, as a result, produce identical guideline ranges for very different tax offenses;
Second, the Commission should adopt Option 1, which produces the most accurate tax loss amounts by measuring the real impact of a false return, while at the same time giving district courts sufficient discretion to develop and impose, on a case-by-case basis, reasonable proof requirements; and
Third, the Commission should articulate a clear distinction between the consideration of unclaimed deductions when determining an advisory sentencing range, and the use of such deductions to offset loss for the purpose of calculating criminal restitution. In cases where the tax remains unpaid and the court must determine the amount of tax owed for restitution purposes, there should be no limitations on the court’s ability to consider unclaimed deductions for restitution purposes beyond those imposed by the relevant tax code sections and regulations; otherwise, the Sentencing Guidelines could cause unintended and inappropriate assessments of tax owed.Teresa Brantley, Chair
Probation Officers Advisory Group
Recommends Option 2
New York Council of Defense Lawyers
Recommends Option 1, with comments including:
Categorically refusing to consider deductions that are legitimate and substantiated by relevant evidence, though unclaimed, is not endeavoring to accurately calculate tax loss. Such a rule is illogical and undermines the credibility and usefulness of this section, and by extension, the Guidelines generally. It would also tend to result in unfair sentences, because it would treat fundamentally different cases as equivalent under the Guidelines.
A hypothetical example illustrates the issue. Defendant A is employed as a teacher, but he also owns and operates a hot dog stand as a side business. His hot dog stand of course has expenses such as the costs of hot dogs, buns, condiments, as well as wages for an employee who operates the hot dog stand when Defendant A is teaching. Such expenses total $60,000 annually, for which Defendant A keeps detailed records and receipts. Defendant A’s hot dog stand brings in gross revenue of $100,000 annually. He files his tax returns, but reports only his income from his teaching job, omitting the income (and, of course, the expenses) from his hot dog stand.
Defendant B owns and operates a home construction contracting business, but he also does construction consulting on the side for one large company. His consulting business has no appreciable expenses apart from his contracting business. Defendant B’s consulting business brings in gross fee revenue of $100,000.00 annually. He files his tax returns, but reports only the income (and expenses) from his contracting business, omitting his consulting income.
A rule that refuses to consider Defendant A’s clearly applicable deductions for cost of goods sold and wages paid would unjustifiably treat Defendant A and Defendant B the same. Assuming a 30% tax rate, it would calculate the tax loss in both cases as $30,000, even though the actual tax loss in Defendant A’s case is only $12,000. This is the difference in an offense level of 12 and an offense level of 10, which, assuming no criminal history, is the difference between an advisory Guidelines range (10-16 months, in Zone C) that requires imprisonment and one that does not (6-12 months, in Zone B).4There is simply no sound basis for treating these two cases the same way, nor is there a sound basis for considering $30,000 to be the tax loss in Defendant A’s case. Doing so overstates the severity of his crime.
Taking into account legitimate but unclaimed deductions likewise furthers § 2T1.1’s basic goal of better approximating actual loss to the treasury, which is manifest elsewhere in the Notes to § 2T1.1. For example, the Notes provide that unless a more accurate determination of tax loss can be made, a presumptive 28% tax rate is to be applied to gross income in underreporting cases, versus a presumptive 20% rate that is to be applied in failure to file cases. Compare § 2T1.1 (c)(1) Note (A) with § 2T1.1 (c)(2) Note (B). Presumably, this differential in rate is designed as a rough substitute for the impact of common deductions, credits and exemptions – like the standard deduction -- in reducing the amount of tax due in the average non-filing case. That is, the difference in rate is an effort to better approximate the actual tax loss to the treasury.
In addition, there is a very good Tax Notes today article on the subject - Jeremiah Coder, Rethinking Tax Losses for Sentencing Guidelines, 2013 TNT 52-4 (3/18/13). I excerpt portions of the article (excluding of course matters discussed above):
Acting IRS Commissioner Steven Miller submitted a letter urging the commission to vote against using unclaimed deductions when computing tax loss. "Permitting convicted tax offenders to introduce previously unclaimed deductions at sentencing would seriously undermine the public interest in preserving the integrity of the nation's tax system," he said. A sentence based on tax loss "is a critical component of deterrence" and should be "based on the manner in which the defendant willfully chose to file his or her fraudulent tax return," he said.
Miller attached to his letter an IRS Criminal Investigation division memo that similarly concluded that a different approach to tax loss would minimize the seriousness of crimes for sentencing purposes and should be tied to the offense committed, not the amount of tax due. Concealing deductions can be part of the criminal scheme itself, so permitting a defendant to introduce evidence of offsetting items not previously included on the return allows him to "undo the crime," the memo said.
The tax loss question ultimately comes down to different perspectives on how to appropriately measure grounds for punishment. * * * *
If the sentencing commission proceeds with the amendments, it should adopt a deferential standard that gives judges maximum leeway to apply their own discretion in every sentencing. Although not discussed at the hearing, it is essential to understand the practical aspects of the sentencing guidelines. Courts have long balked at applying rigid strictures in the sentencing process. They managed to escape bureaucratic control when the Supreme Court held in Booker v. United States, 514 U.S. 220 (2005), that the guidelines were merely discretionary under the Sixth Amendment. That allows courts to consider the guidelines in conjunction with other sentencing factors in 18 U.S.C. section 3553(a), but ultimately allows the totality of the circumstances to guide them in determining an appropriate sentence.
The case law shows that regardless of what announced test a circuit follows -- whether to allow deductions or not -- judges essentially balance the facts and arrive at their own tax loss conclusion regardless of the guidelines. That was pointed out by commissioners at the public hearing and should help the commission decide what direction to take.
Courts are used to, and well equipped for, applying discretion as necessary in each case. The tax system would be well served by a rule that essentially modifies the first of the commission's options so that judges may consider unclaimed deductions in determining tax loss when it is appropriate and can be done relatively easily.Finally, I would like to make one more comment about the DOJ Tax's presentation in the letter of the Second Circuit's decision in Helmsley . I believe that, if a defendant puts unclaimed deductions and credits in play in the guilt determination phase where a tax loss is relevant (principally in a tax evasion case where a tax due and owing is an element of the crime), the Government will have to disprove the existence of the unclaimed deductions and credits at least if necessary to prove beyond a reasonable doubt that a tax due -- or a significant tax due -- exists. The Government, not surprisingly, does not like that; so, in the letter, the DOJ Tax makes expansive claims for a key authority, the Helmsley Second Circuit decision as follows:
In United States v. Helmsley, 941 F.2d 71 (2d Cir. 1991), the taxpayer attempted to eliminate her tax deficiency by retroactively changing the method of depreciation that she elected when she filed her returns. In that case (which predated the 1993 tax Guidelines amendments), the Second Circuit rejected the taxpayer's revisionism, observing that taxpayers with complicated returns should not be permitted, when caught committing evasion, to manipulate subsequent events in an attempt to cancel an existing tax deficiency. Id. at 86-87. Options 1 and 3, however, would allow convicted defendants to engage in such strategic, after-the-fact elections and characterizations at sentencing.Even if technically correct in terms of the case, it is misleading on an unclaimed deduction case where the taxpayer had unclaimed deductions only by ex post facto changing an election made in filing the return. Here is what I say in my Federal Tax Crimes Book about the Government's more expansive claims (footnotes omitted):
In undertaking this defense, practitioners should be aware that some expansive Government rhetoric might suggest that a defendant cannot use unclaimed deductions or credits to reduce or eliminate the tax due and owing element for tax evasion. The central basis for that claim is a noncontextual reading of the Second Circuit’s decision in Helmsley. There, in filing the returns, the defendant used a method of accounting that deferred depreciation deductions into later years that, under a different method, might have permitted them to be claimed in the years of prosecution. In order to avoid the effect of the Government’s claims of unreported income and unrelated deductions, the defendant sought to use a different, more accelerated method of accounting that might defeat the element of tax due and owing. The Second Circuit noted that the held that the doctrine of election would prevent the change and, in any event, the Commissioner’s consent, which was neither sought nor granted, would be required to change the method of accounting. The Second Circuit did articulate a concern that permitting the change of depreciation method would allow ex post facto opportunity to avoid a tax evasion charge:
The law could hardly be otherwise. If it were, evaders with complicated returns would be allowed to evade taxes on one portion of their return while using a depreciation period that would be the most profitable in the long run if the evasion went undetected. If the evasion were uncovered, then they would need only to recalculate under a shorter depreciation period that would increase deductions for the years in which evasion is charged.
Notice that the Second Circuit limited the concern to the change of accounting method. Under the method of accounting adopted with the original return, there were no unclaimed depreciation deductions. I don’t think that Helmsley is properly read to mean that the defendant cannot assert unclaimed proper deductions to rebut the Government’s proof of a tax due and owing. And, of course, the defense was recognized in Sansone [Sansone v. United States, 380 U.S. 343, 351 (1965)], so I think it is alive and well, the Government rhetoric notwithstanding.As indicated, the Supreme Court in Sansone blessed the use of the unclaimed deduction defense ini the context of resolving a lesser included offense issue. Without getting into the details of the lesser included offense, the issue turned upon whether Section 7201 tax evasion required, in the context of the case, an element that Section 7207 false document did not. In discussing, how the elements might be different, the Supreme Court said (pp. 352-353, emphasis supplied): "if the Government in a § 7201 case charged tax evasion on the grounds that the defendant had understated his tax by understating his gross receipts, and the defendant contended that this was not so, as the misstatement of gross receipts had been offset by an understatement of deductible expenses, the defendant would be entitled to a lesser-included offense charge based on § 7207, there being this relevant disputed issue of fact." That statement, essential to the Court's reasoning, could only make sense in Sansone if the Court were approving the claim of unclaimed expenses in the guilt-finding phase on the tax evasion tax due and owing element.