Thursday, April 4, 2013

Bad Acts Evidence Must be Relevant and Not Prejudicial (4/4/13)

In Nagy v. United States, 2013 U.S. App. LEXIS 6333 (4th Cir. 2013), here, an unpublished opinion, Robert J. Nagy, a CPA, who rendered tax advice to a promoter of an allegedly abusive tax shelter.  The IRS asserted the Section 6700 penalty, here, against Nagy for his role in the allegedly fraudulent tax shelter.  Nagy partially paid the 15% of the assessment under the special Flora mitigation rule and sued for refund.  Section 6703(c).  The liability issue was tried to a jury.  The jury ruled against Nagy.  On appeal, Nagy raised several arguments.  The one that gained traction -- and hence warranted reversal for new trial -- was Nagy's claim that the trial court had erred prejudicially in admitting evidence of his failure to file some of his personal income tax returns in the years in which he participated in the tax shelter.

The following is a reasonable summary of the Section 6700 penalty (United States v. Benson, 561 F.3d 718, 721-722 (7th Cir. 2009)):
Section 6700 imposes a penalty on any person who (1) organizes (or assists in the organization of) any plan or arrangement, or participates (directly or indirectly) in the sale of any interest in an entity or plan or arrangement, and (2) in connection with such organization or sale, makes or furnishes a statement with respect to the allowability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit by reason of holding an interest in the entity or participating in the plan or arrangement (3) which the person knows or has reason to know is false or fraudulent (4) as to any material matter. 26 U.S.C.
The ultimate holding in Nagy was that Nagy's failure to file personal tax returns was not relevant to the issue of his liability under Section 6700.  Generally, trials should include only evidence that is relevant to the issue being tried.  That general truism is necessary to keep trials in proper bounds and to prevent prejudice that might arise from irrelevant matters.  So, according to the Fourth Circuit in Nagy, the prosecutors could never articulate a persuasive reason that the failure to file income tax returns was relevant to the Section 6700 issue.

But, simply because irrelevant evidence creeps into a trial -- almost all trials have some irrelevant  evidence -- does not mean that the result was affected or affected prejudicially.  Reversal is warranted only if the irrelevant matter is prejudicial.

Moreover, the specific matter in issue here was not just irrelevant evidence but a particular genre of suspect irrelevant evidence.  The evidence in question was his failure to file income tax returns, conduct which constitutes so-called "bad acts."  Bad acts, often crimes, are recognized as having a particular propensity to affect prejudicially the outcome of a case.  Hence, strict rules apply to its use.  At the threshold, as noted, all evidence should be relevant and that was a problem in this case.  And, bad acts have to run traps under FRE Rules 404(b), here, and 403, here.  Here is the Nagy Court's discussion of these Rules in the context of Nagy's case:
Rule 404(b) prohibits the admission of evidence of "a crime, wrong, or other act . . . to prove a person's character in order to show that on a particular occasion the person acted in accordance with the character." Fed. R. Evid. 404(b)(1). Such evidence may be admissible, however, to show, among other things, "knowledge" and "absence of mistake." Id. 404(b)(2). Evidence is  admissible under Rule 404(b) only when that evidence is "(1) relevant to an issue other than character; (2) necessary; and (3) reliable." United States v. DeLeon, 678 F.3d 317, 330 (4th Cir. 2012) (internal quotation marks omitted). Nagy argued to the district court that the evidence of his failure to meet personal tax obligations was not relevant to the determination of liability under § 6700 and served no purpose other than to cast Nagy's character in a negative light. The government argues that the evidence of Nagy's failure to timely file and pay his taxes in certain years during which he was advising Derivium was relevant to show an absence of mistake in his tax advice. Yet the government does not explain, or even attempt to explain, how this evidence was relevant to Nagy's state of mind in the rendering of opinions on the 90% Loans. 
The government presented no evidence linking Nagy's failure to file or pay certain personal taxes to his work for Derivium. Nothing in the record connects Nagy's failure to timely file or pay his personal taxes to any knowing act of fraud or fraudulent intent in giving tax advice to Derivium. There simply is no record evidence linking the two. Indeed, Nagy argues that his failure to file or pay his personal taxes was related to severe family medical situations and his lack of assets: acts which would subject Nagy to, at most, negligent failure to file or pay penalties under § 6651. 
The government contends that the evidence of Nagy's failure to timely file or pay his personal taxes was relevant to Nagy's state of mind at the time he was rendering tax advice to Derivium. But the government completely fails, as noted above, to make any remote connection between Nagy's failure to timely file and pay his own taxes and his provision of tax advice to Derivium. Nagy was not a Derivium principal or customer, and the record contains no evidence that his personal tax returns depended in any way upon the Derivium scheme. 
In short, we are at a loss to see any relevance for Rule 404(b) purposes for the admission of Nagy's personal tax information other than "to prove [Nagy]'s character in order to show that on a particular occasion [Nagy] acted in accordance with the character." See Fed. R. Evid. 404(b). While Rule 404(b) is a rule of evidentiary inclusion, United States v. Smith, 441 F.3d 254, 262 (4th Cir. 2006) ("This court has recognized that Rule 404(b) is primarily a rule of inclusion, not exclusion."), any evidence must satisfy the threshold of relevance to an issue other than character that we find lacking here. 
Moreover, for Rule 403 purposes, the admission of Nagy's personal tax information was highly prejudicial and quite likely to influence the jury against him. Had the personal tax information had some semblance of relevance (which proper evidence in some other case may well show), a different balancing for prejudice purposes would be required. But in the absence of relevance, we conclude that the district court abused its discretion to admit Nagy's personal tax information into evidence, particularly as it bears all the indicia of garden-variety "bad acts" evidence with no other purpose than to emotionally inflame the jury against the defendant. 
Further, we conclude that the admission of Nagy's personal tax information was not a harmless error. Under harmless error analysis, we will not reverse if we can "say, with fair assurance, after pondering all that happened without stripping the erroneous action from the whole, that the judgment was not substantially swayed by the error." Kotteakos v. United States, 328 U.S. 750, 765 (1946).  Nagy presented a cognizable defense as to his state of mind for the knowledge purposes of § 6700 that would have permitted a reasonable jury to have rendered a verdict in his favor. The prejudicial effect on the jury of the personal tax information about Nagy, however, and the possibility that it swayed their judgment in their consideration of this case, cannot be ignored. As the error was not harmless, the liability verdict must be vacated.
In leading up to the foregoing discussion, the Court did acknowledge but did not decide a predicate issue of whether the prosecutors' use of the failure to file evidence was improper use of tax return information under Section 6103, here, which generally mandates that tax return information cannot be disclosed outside the IRS (and even inside the IRS only for purposes of tax administration).  There are myriad exceptions, the one involved here is provided in Section 6103(h)(4).  That subsection provides in part relevant:
(4) Disclosure in judicial and administrative tax proceedings.  A return or return information may be disclosed in a Federal or State judicial or administrative proceeding pertaining to tax administration, but only—    (A) if the taxpayer is a party to the proceeding, or the proceeding arose out of, or in connection with, determining the taxpayer’s civil or criminal liability, or the collection of such civil liability, in respect of any tax imposed under this title;
    (B) if the treatment of an item reflected on such return is directly related to the resolution of an issue in the proceeding;
    (C) if such return or return information directly relates to a transactional relationship between a person who is a party to the proceeding and the taxpayer which directly affects the resolution of an     issue in the proceeding; or
    (D) to the extent required by order of a court pursuant to section 3500 of title 18, United States Code, or rule 16 of the Federal Rules of Criminal Procedure, such court being authorized in the issuance of such order to give due consideration to congressional policy favoring the confidentiality of returns and return information as set forth in this title.
The Court said:
Nagy first contends that I.R.C. § 6103(h)(4) did not authorize the disclosure of Nagy's personal income tax return information as evidence in the § 6700 penalty case. While § 6103(h)(4)(A) was clearly satisfied (Nagy was a party to the § 6700 proceeding), the applicability of subsections (B) and (C) is much more problematic. But we will assume, without deciding, that the § 6103(h)(4) restrictions can be applied disjunctively. See Mallas v. United States, 993 F.2d 1111, 1118, 1121-22 (4th Cir. 1993) (applying § 6103(h)(4) disjunctively); see also Rice v. United States, 166 F.3d 1088, 1092 (10th Cir. 1999) (holding that § 6103(h)(4) allows the disclosure of a person's tax return information when that taxpayer "is a party to the proceedings"); Tavery v. United States, 32 F.3d 1423, 1430 (10th Cir. 1994) ("The exceptions in § 6103 are stated in the disjunctive."). 
Even if § 6103 does not bar the evidence at issue, however, that conclusion does not resolve the underlying evidentiary issue. The § 6103(h)(4) exceptions operate only as a gatekeeper device that allows the disclosure of taxpayer information in certain situations. If a § 6103(h)(4) exception applies, that determination removes only the statutory disclosure barrier; it does not resolve the independent evidentiary determinations of relevance or prejudice.


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