9th Circuit Imposes a Sentencing Double Whammy for State Tax Loss Relevant Conduct

In United States v. Yip, ___ F.3d ___ (9th Cir. 2010), decided 1/13/10, the Ninth Circuit held, consistently with most other circuits, that relevant conduct for sentencing purposes includes relevant state tax loss in determining the tax loss for the first step of the tax crimes sentencing calculation. See my prior blog here discussing United States v. McElroy, 587 F.3d 73, 88-89 (1st Cir. 2009). The Ninth Circuit also held that the relevant conduct factored into this tax loss calculation is not concerned with expiration of the statute of limitations for criminal prosecution. Finally, the Ninth Circuit, having just required the state tax relevant conduct to be included in the tax loss, said that the defendant is not entitled to factor in the appropriate federal tax deduction for state taxes. This is the holding I discuss in this blog.

The unclaimed deductions issue may present itself at two stages of a criminal case -- (i) at trial in addressing the tax due and owing element that the Government must prove (see my prior blog here; see also United States v. Helmsley, 941 F.2d 71, 83- 89 (1991), cert denied, 502 U.S. 1091 (1991).); and (ii) at sentencing in determining the offense level under S.G. 2T1.1. The holding in Yip addresses only the second stage. I quote from the opinion so the reader can understand the Ninth Circuit's reasoning (case citations and one footnote omitted):

Relying on the latter clause, the Second Circuit has concluded that, under the amended Guidelines, tax loss should be adjusted for "'legitimate but unclaimed deductions.' " Several other circuits, however, disagree. These sister circuits have offered three reasons to refuse to allow a defendant to reduce tax loss by the amount of unclaimed deductions. First, deductions are not permissible if they are unintentionally created or are unrelated to the tax violation, because such deductions are not part of the "object of the offense" or intended loss. Second, the revisions of Amendment 491 [to the Sentencing Guidlines] were so extensive that the mere fact that the revised § 2T1.1 does not include the former "offsetting adjustments" reference fails to demonstrate that deductions are now permissible. Finally, our sister circuits reject the nebulous and potentially complex exercise of speculating about unclaimed deductions. The Tenth Circuit observed that it does not interpret the Guidelines "as giving taxpayers a second opportunity to claim deductions after having been convicted of tax fraud. . . . Rather, we are merely assessing the tax loss resulting from the manner in which the defendant chose to complete his income tax returns."

We are persuaded by the Fourth, Fifth, Seventh, Tenth, and Eleventh Circuits. The amendment to § 2T1.1's application notes is irrelevant to our analysis. It is true that the notes no longer state that § 2T1.3's alternative minimum standard "may be easier to determine, and should make irrelevant the issue of whether the taxpayer was entitled to offsetting adjustments that he failed to claim." But this sentence was deleted when § 2T1.3 was deleted in its entirety from the Guidelines. As a reference to § 2T1.3 was no longer logical, such a change does not show an intent to allow unclaimed deductions sufficient to undercut our decision in Valentino.

Section 2T1.1 does permit "a more accurate determination" of tax loss than the 28% approximation. A more accurate determination might involve applying a different tax rate or incorporating exemptions and deductions legitimately claimed by the taxpayer on a tax return. But that section does not require a court to speculate about tax deductions that the taxpayer chose not to claim. n3 We hold that § 2T1.1 does not entitle a defendant to reduce the tax loss charged to him by the amount of potentially legitimate, but unclaimed, deductions even if those deductions are related to the offense.

n3 We note, for instance, that a taxpayer is entitled to deduct either state income tax or state sales tax, but not both. 26 U.S.C. § 164(b)(5)(A). Some of the states in our circuit impose both an income tax and a sales tax. Reconstructing a hypothetical federal tax return for a resident of one of these states would require selecting between these potential deductions.

In Defendant's case, he cannot even argue that the state taxes are legitimate, but unclaimed, deductions. The state taxes are not legitimate deductions because he did not pay them. A cash-basis taxpayer may deduct state and local taxes "for the taxable year within which paid." 26 C.F.R. § 1.1641(a). The district court properly refused to reduce the tax loss attributed to Defendant to account for an imputed deduction from his unpaid state taxes.

The court ultimately held that the defendant was not entitled to the deductions because he had not paid the state tax. It is not at all clear that the Ninth Circuit would allow the deductions even for an accrual method taxpayer. In apparent dicta (not necessary because of the "not paid / cash method" final holding), the Court sweeps very broadly on the issue of unclaimed deductions.

I am troubled by the Ninth Circuit's refusal to allow the state tax deduction after it required, properly I think, that the state tax loss be included in the calculation. The purpose of the tax loss calculation is to determine the loss by reference to what the taxpayer would have paid if he had done it right. If the had done it right, the state tax would have been paid (hence failure to pay is properly included in the sentencing tax loss) and the state tax deduction would have been taken in calculating the federal tax loss (hence federal tax would have been less). That should, in my mind, set the appropriate tax loss for sentencing purposes.  But I am not the judge (or judges in this case).

I am also unpersuaded about the perceived difficulty or uncertainty in making the calculation.  We require citizens to make this type of calculation routinely in filing their tax returns.  This is not beyond the capacity of the courts, the Probation Office and counsel for the parties (and their experts) to calculate or make a reasonable estimate of what the effect of these unclaimed deductions should be.