Is the Spies Element for Evasion (i) Tax Deficiency or (ii) the Criminal Tax Number? (9/17/13)

In United States v. Ervin, 2013 U.S. App. LEXIS 7917 (11th Cir. 2013), here, an unreported per curiam decision, the court of appeals confirmed the defendant's convictions for (i) conspiracy to commit tax evasion (note that it was an offense conspiracy and not the ubiquitous defraud / Klein conspiracy and (ii) tax evasion.  In affirming, the court rejected the defendant's various arguments.  I address here only one -- that "his convictions for tax evasion were unsupported by the evidence and the law."  (Of course, logically, if his conviction for evasion fell, his convictions for conspiracy might also fall, but the court of appeals did not reach that point.)

On the  sufficiency issue, the Court of Appeals first noted the elements of tax evasion:  "(1) willfulness; (2) existence of a tax deficiency; and (3) an affirmative act constituting an evasion or attempted evasion of the tax."  I have highlighted the bone I want to pick.

The court then focused upon whether there was a "tax deficiency."  I think the Court of Appeals was sloppy in stating that element.  The issue is not whether there is a tax deficiency (although even the Supreme Court screws that up as well, see Boulware v. United States, 552 U.S. 421 (2008).  Rather, the issue is whether there is criminal tax due and owing, the actual element of the crime since Spies v. United States, 317 U.S. 492 (1943).  I have just written a draft article for the Villanova symposium here where I address the difference between a deficiency and the tax due and owing element for tax evasion.  The guts of the reasoning is that "tax deficiency" is a term of art that is used in the Code to describe the civil tax liability less taxes paid.  See Section 6211(a), here, stating the "the term 'deficiency' means  * * *."  All tax practitioners know what a deficiency is.  Fewer tax but all criminal tax practitioners know that the criminal number, which is the Spies tax due and owing element for evasion is not necessarily the deficiency; indeed the Spies tax due and owing element can be substantially less than the civil tax deficiency and even less than the tax loss number used for sentencing.  I offer two illustrations from the article:

The tax due that the Government will use to support a tax evasion prosecution is not necessarily the unpaid civil tax due.  To illustrate, assume that, for civil tax purposes, the taxpayer had $100,000 income that he or she failed to report.  Assume that the tax liability on that omitted income is $35,000.  The $100,000 omitted income consists of two items -- $50,000 of embezzlement income which the taxpayer knew was taxable and chose not to report and $50,000 of personal injury income which the Government is satisfied that the taxpayer thought or could have reasonably thought was excludable under § 104 but which for technical reasons is not properly excludable under that section.  In calculating the tax evaded as an element of tax evasion, the Government will compute the tax only on the $50,000 of embezzlement income and will not include the $50,000 of personal injury income.  So, let’s say the tax on $50,000 of embezzlement income is $17,500.  The criminal tax number for establishing tax due and owing in a criminal case is $17,500.  The Government must prove that number beyond a reasonable doubt.

And, I use a more detailed example to dig down into the subleties:

The indictment alleges that the taxpayer evaded $100,000.  That means that the prosecutors believe they can prove beyond a reasonable doubt that the taxpayer evaded $100,000.  The taxpayer is convicted on that basis.  Suppose, however, that the Government can prove by a preponderance of the evidence that the taxpayer really evaded $200,000 but did not allege the additional $100,000 in the indictment because it did not believe that it could prove that additional amount beyond a reasonable doubt.  Further, suppose that the taxpayer’s real unpaid civil tax liability for the year is $300,000, with the additional $100,000 representing items for which the Government cannot prove evasion at all under any standard of proof.  You will note that there are 3 concepts to the overall unpaid civil tax liability – in the order presented they are: (i) the “criminal number” of $100,000 used for purposes of charging and convicting; (ii) the sentencing tax loss number of $200,000, consisting of the criminal number of $100,000 and the $100,000 evaded that is proved by a preponderance of the evidence; and (iii) the residual tax of $100,000 not related to tax evasion for any criminal purpose (i.e., it solely affects civil tax liability).  The three components in the aggregate represent the civil tax liability (or deficiency), whereas only the first two are relevant to the criminal process.

OK, now let's go to what the Court of Appeals said in Ervin that was sloppy and may indicate that the Court reached the incorrect result or sloppily achieved the correct result.

The Court of Appeals first addressed the alleged tax deficiency element of tax evasion.  Here is the entire reasoning and holding:

The economic-substance, or sham-transaction doctrine, provides that a transaction ceases to merit tax respect when it has no economic effect other than the creation of tax benefits. United Parcel Serv. of Am. v. Comm'r of Internal Revenue, 254 F.3d 1014, 1018 (11th Cir. 2001). Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motivation is tax avoidance. Id. The kind of economic effects required to entitle a transaction to respect in taxation include the creation of genuine obligations enforceable by an unrelated party. Id. Under the sham-transaction doctrine, courts should look at the substance of a transaction rather than just its form. Kirchman v. Comm'r of Internal Revenue, 862 F.2d 1486, 1491 (11th Cir. 1989). Although a taxpayer may structure a transaction to minimize his tax liability, the transaction must nevertheless have economic substance. See id. 

* * * *\ 

Viewing the evidence in the light most favorable to the government, evidence was sufficient to establish each of the required elements of § 7201. See Miranda, 666 F.3d at 1282; Kaiser, 893 F.2d at 1305. As to whether the evidence established a tax deficiency, Ervin's argument on appeal is meritless because, under the sham-transaction doctrine, the jury was permitted to disregard the trusts as separate legal entities based on evidence that the trusts lacked economic substance. See United Parcel Serv. of Am., 254 F.3d at 1018. At trial, evidence showed that Ervin set up trusts with trustees who did not understand their duties, who did not perform any trustee duties, and who did not know the names of the trust properties or beneficiaries. Specifically, (1) Jack Rudy never performed any trustee duties, he did not understand the nature of a trust, and he did not know the names of the trust properties; (2) Jeff Hargett did not know the name of the trust, when the trust was created, or the names of the beneficiaries; (3) Malone never performed any duties as a trustee other than signing the trust documents and paying state property taxes once; and (4) Milissa Scott Hargett did not know what it meant to serve as a trustee or the names of the trusts or beneficiaries. Additionally, Mary Catherine Spann, another trustee, never agreed to be a trustee. 

However, Tyson, the IRS investigator, testified that the names of these individuals, designated as trustees for various trust properties, appeared on the warranty deeds for the sales of those properties. Further, she testified that the proceeds from the sales were deposited into Southern Realty's bank account and, the Ervins, who owned and managed Southern Realty, used those proceeds for their personal benefit. This evidence supported a determination that Ervin established trusts that lacked economic substance, and thus, those trusts should be disregarded for income tax purposes. See id. On appeal, Ervin alleges that he followed the terms of the relevant trust documents and that the government ignored his right to structure transactions for the purpose of minimizing his tax liabilities. Regardless, Ervin's income from the sales of the trust properties could still be considered as taxable personal income because he has not established that the trusts had economic substance. See Kirchman, 862 F.2d at 1491. Specifically, Ervin has not identified any evidence suggesting that the trusts involved any genuine obligations enforceable by an unrelated party. See United Parcel Serv. of Am., 254 F.3d at 1018.

[Discussion of the willfulness element omitted, except to note that Evin clamed that he was a "sovereign Christian prince" not recognizing his liability to the U.S. and therefore not willful.]

The guts of the Court of Appeals' finding of a "deficiency" is based on two civil tax liability cases -- UPS and Kirchman.  The Court seemed to conflate the civil tax concepts of economic substance and sham-transaction, but did not cite any criminal cases where courts addressed the applicability of those concepts to criminal cases.  Of course, those civil tax cases are relevant to the issue of whether there was a tax deficiency -- i.e., the civil tax liability less the tax paid -- which is what the Court of Appeals said it was determining.  But, as noted that is not necessarily the issue in a criminal tax case.  The issue is whether the criminal tax liability is less than the tax paid -- the criminal tax number.  The court does not acknowledge, much less struggle, with the issue of whether the criminal tax number exceeded the tax paid.  Maybe it intended that by using the term tax deficiency as a proxy for the criminal number (just as perhaps the Supreme Court intended that different concept when it used the term tax deficiency).  But we don't know, do we?

I would recommend that DOJ Tax do what it can to expunge the use of the term tax deficiency if what it really means is the Spies tax due element or even if it means tax loss for sentencing (which  also is not the same as the term deficiency means).

Also, I have ranted before about the use of imprecise civil liability concepts like economic substance and sham transaction.  See the blogs here.  I am not saying that economic substance and sham transaction concepts should never be used in tax cases, but that should be done only with careful differentiation between those transactions which in which there is no economic substance or the transactions are shams for civil purposes.  Most of the cases where DOJ trots out those concepts in civil cases -- UPS and Kirchman included -- could not have supported a criminal prosecution (or at least no one apparently conceived that they could.  Now there are some civil cases where the transactions are so thin that a civil case could proceed, with care.