Confusion in the Court of Appeals About the Indirect Method of Proof (10/10/11)

In both criminal and civil cases, the Government sometimes uses what is called an indirect method of proof to show that a taxpayer owes additional tax. A direct method, for example, uses the return as filed and proves omitted income or improperly claimed deductions or credits. The indirect methods essentially reconstruct the taxpayer's tax picture (income, deductions, credits, taxable income) without using the return as the starting point. I explain the general theory of the use of the method in my book as follows:

In many cases, the Government may not be able to assemble proof of a tax due and owing from direct methods of proof. In those cases, the Government has developed indirect methodologies that circumstantially prove tax due and owing. The key cases blessing these indirect methodologies have arisen in the guilt determination phase in tax evasion cases where tax due and owing is an element of the offense or in parallel civil cases. These methodologies are also used also in the sentencing phase, although I am aware of no important case opinions arising from sentencing phase determinations.

All indirect methodologies are based on logic – from the facts proven can the further inference be made that there is a tax due and owing. It is the force of that logic – and that force alone – that permits the use of these methods. And, for conviction, the force of the logic must persuade beyond a reasonable doubt.

For use of an indirect method, the Government should establish that a direct method is either not available or not reliable under the circumstances. For example, the Government should show why the taxpayer’s books and records are not available (taxpayer lost or destroyed them) or, if available, are not reliable (substantial provable irregularities). The indirect methodology itself may be sufficient to show that -- for example, large cash flows not reflected on the books and records establishes that they are unreliable. The Government must also establish either a “likely source” for the unreported income or that it has reasonably negated nontaxable sources of income.

Finally, I provide here only a summary of the principal indirect methods. These methods which are heavily fact dependent can be complex in their application. A good and substantially more detailed discussion of these indirect methods is contained in the CTM.

There are various ways in which the indirect methodologies attempt the reconstruction. The more commonly encountered indirect methodologies go by such labels as the "Net Worth Method" and the "Bank Deposits / Cash Expenditures Method"

In United States v. Khanu,  662 F.3d 1226 (D.C. Cir. 2011), here, the Government used an indirect methodology described as the "cash method of proof." A principal element of the proof as presented by the Government at trial was cash of $1.9 million the Government seized pursuant to executing a search warrant at Khanu's home. At trial, the Government identified another $300,000 which, if it were considered alone, would have still produced tax due and owing, a key element of the tax evasion crime with which Khanu was charged. But, the Government insisted at trial, over Khanu's objection, that the $1,9 million seized be included in computing the tax due and owing amount presented to the jury.

Khanu's objection was that the $1,9 million was not his cash but rather the cash of his two corporations which he was merely safeguarding in his safe at home. As noted, the indirect methods rely upon force of logic for their legitimacy; force of logic precludes taxing the taxpayer with respect to cash not belonging to the taxpayer. Of course, where the taxpayer has skimmed off proceeds from his own corporation in a cash intensive business (usually by omitting the cash from the books of the corporation so that it never gets on the corporate return and then failing to report the cash on his individual return), the taxpayer has evaded two levels of taxation. The focus in Khanu was at the individual level. The Government's argument was that Khanu had skimmed the cash and was taxable on it.

On appeal, Khanu's first problem, of course, was that determining whether Khanu had income from the cash turns upon what Khanu's intent was with respect to his possession of the cash (did he really intend to return it to the corporations, so that he might have income only if he did not so intend?) and that is uniquely a jury question.  Khanu's second problem is that a general verdict of guilt does not indicate whether the inclusion of the $1.9 million in cash was critical to the jury's general verdict of guilt (presumably on the element of tax due and owing). In this case, there was an additional $300,000 of cash from which the jury could have found the key tax due and owing element, but as the dissent notes it is by no means certain that, without the $1.9 million in issue in the case, the jury would have found that key element of the crime.

Now returning to first problem, given the general verdict, one could just presume that the jury resolved the factual issue against the taxpayer -- i.e., the jury could have found that the cash was the taxpayer's cash and not his corporations' cash. And indeed, the sacrosanct way that our system deals with such general verdicts would require that we indulge the presumpiton that the jury did properly find that fact. So, on appeal, Khanu had to relinquish any practical hope of prevailing on an argument that the jury had wrongly determined that the $1.9 million was his cash and thus taxable.

Khanu raised a more subtle nuance -- a legal argument -- as to why he could not be taxed on that $1.9 million. The key additional facts readers need for understanding of Khanu's argument are: (i) the source of the cash clearly was the operations of the corporations; and (ii) after it was seized in 2003, it was effectively returned in 2003 to the corporations by applying it against the corporations' tax liability. (The latter fact is not as crisply stated as I would prefer, but the discussions assume the truth of the statement; apparently the logic was that by 2003 Khanu had signed an affidavit claiming the cash was the corporations' and disclaiming any personal interest in the cash and later applying it to the corporations' tax.) Based on these facts, Khanu raised a legal argument based on the landmark James case, James v. United States, 366 U.S. 213, 220 (1961). 

James was resolved by plurality opinion, with the other opinions agreeing on certain points from which a majority could be fashioned. The key proposition for which James is often cited (after analysis of all opinions in the case) is that uncertainty in the tax law precludes legal prosecution. I have discussed variations of that theme before here. But, the plurality decision also discussed in dictum a situation where an embezzler returns embezzled funds to the victim thus eliminating the tax (certainly if accomplished in the same year). For this proposition, the Khanu majority opinion cites: 

See James v. United States, 366 U.S. 213, 220 (1961) (dictum) ("if, when, and to the extent that the victim recovers back the misappropriated funds, there is of course a reduction in the embezzler's income'"); Gilbert v. Comm'r, 552 F.2d 478, 481 (2d Cir. 1977) ("if [an embezzler] repays the money during the same taxable year, he will not be taxed"); Han v. Comm'r, 83 T.C.M. 1824, 2002 WL 1298745, at *23 (2002) ("Funds over which a taxpayer has obtained dominion and control, lawfully or unlawfully, are not taxable to him to the extent they are repaid before year end"); Mais v. Comm'r, 51 T.C. 494 (1968) (funds seized from embezzler by police not taxable to him in the year repaid).

The majority cryptically dismisses Khanu's argument as "confused as well as confusing." The majority's reasoning for that conclusion is, in my mind, as confused and confusing as the majority imagines Khanu's argument to be. So, I turn to the dissenting opinion which I find neither confused nor confusing and which found Khanu's argument neither confused nor confusing. So, rather confuse the the dissent straightforward analysis, I just quote it here (footnote omitted).

I accept the majority's statement of the underlying facts respecting the $1.9 million. Briefly, government agents discovered the $1.9 million in cash in Khanu's possession during the relevant tax year. Khanu identified the money as that of his corporation, disavowed ownership, paid the money over to the IRS in settlement of corporate tax obligations, and did not possess it at the end of the tax year. Unlike the majority, I cannot, however, conclude that those facts support the inclusion of the $1.9 million in the computation of the deficiency element of tax evasion. Unlike the majority, I find appellant's argument on this point neither confusing nor confused, nor do I find the distinction between "'permitting the inclusion' of evidence and a conventional argument against 'admission' of the same," elusive. Maj. Op. at 10.

To me, the distinction is plain. Appellant does not contend that the evidence was not admissible for some purpose, only that the $1.9 million amount could not be included in the expert witness's computation upon which the deficiency element of tax evasion was based. It would seem reasonable, indeed commonplace, to assume that use of a cash method or other circumstantial evidence method of establishing deficiency would always involve accounting which would include cash flow and cash amounts that would pass through the expert witness's computations but not be included in the final deficiency at the conclusion of those computations. Any nontaxable source of cash to the taxpayer would certainly enter the expert witness's computation, but such amount would not be included at the end. For example, it would not be error for the court to admit evidence of a taxpayer's bank account swelling by $100,000 due to a nontaxable gift, and yet it would be error for the same court to permit the expert witness to testify to the jury that that $100,000 was included in the shortage upon which the expert witness bases his conclusion of reported income deficiency. Just so here.

Unlike the majority, I share appellant's understanding of the appropriate standard of review. Certainly, admissibility of evidence is generally reviewed for abuse of discretion, see United States v. Warren, 42 F.3d 647, 655 (D.C. Cir. 1994). However, the tax consequences of a particular transaction would seem to be a rather pure question of law which we would review de novo for legal error.

Finally, I do not accept the majority's description of this argument as "late raised." Khanu filed his "motion to exclude $1.9 million from government's calculations . . ." on August 3, 2009. The district court entered its denial of that motion on October 14, 2009. Both of these occurred before the commencement of the trial. In this court, the first point argued by appellant in his opening brief is that "the $1.9 million was, as a matter of law, not taxable income to Mr. Khanu." I see no sense in which the argument is late raised. Therefore, concluding that the standard of review is for legal error, the remaining question is whether it was in fact error. It was.

In the court below, and before us, appellant has consistently contended that the $1.9 million could not be included in the computation of his cash expenditures, as it was held by him only in safekeeping for the corporations. The government argued at trial, and argues on appeal, that it was a factual issue for the jury to resolve as to whether he was in fact holding the cash for the corporations, or had taken it for his personal use. If the $1.9 million was properly included in the accountant's computation, the government contends, then it was for the jury to decide whether it was cash he held and expended upon its seizure, or cash he held for the corporation which was not includable. The difficulty with the government's case is that it should not have been included in his unreported income under either circumstance.

Appellant argues, and I agree, that under the principle of taxation announced by the Supreme Court in James v. United States, 366 U.S. 213 (1961), even if Khanu took the money from the corporations for his personal use — whether that is called embezzling or skimming — it could not under the facts of this case be included in his taxable income. In James, the Court accepted with approval the government's proposition that "'if, when, and to the extent that the victim recovers back the misappropriated funds, there is of course a reduction in the embezzler's income.'" Id. at 220 (quoting the brief of the United States). While the opinion in James is a plurality opinion, neither of the separate opinions questioned the judgment of the plurality on this point. While neither the Supreme Court nor this court has clearly spoken to the question since James, other lower courts have reiterated the Supreme Court's point. In Gilbert v. Commissioner of Internal Revenue, 552 F.2d 478 (2d Cir. 1977), the Second Circuit held that "if [an embezzler] repays the money during the same taxable year, he will not be taxed." Id. at 481 (citing James). Likewise, the Tax Court has followed James. In Han v. Commissioner, 83 T.C.M. 1824 (2002), that court declared, "[f]unds over which a taxpayer has obtained dominion and control, lawfully or unlawfully, are not taxable to him to the extent they are repaid before year end." Id. at 23 (emphasis added).

Very directly on point to the issue before us, in Mais v. Commissioner, 51 T.C. 494 (1968), the Tax Court held that embezzled money turned over "to the New York Police Department for restitution to" the victim would not be "treat[ed] as income" to the embezzler in the year of the embezzlement. Id. at 497. Language of Mais applies perfectly to the case before us. The United States on appeal is unable to dispute the correctness of defendant's interpretation that money gained by embezzlement but repaid during the tax year does not generate tax liability for the embezzler. Citing Mais, the government argues that Khanu should have reported the $1.9 million then deducted it. I am at a loss as to how this would fill in the necessary element of deficiency. The zero income shown by not reporting the $1.9 million is precisely the same as the zero that would be shown by reporting then deducting it. In any event, nothing in James compels the "report then deduct" procedure the government would impose, nor do I see any way in which willful criminal conduct could be found on the part of the defendant for not complying with such an apparently frivolous accounting procedure.

Finally, the government contends, and the majority argues, that if the inclusion of the $1.9 million in the tax accounting was error, it was harmless. Its argument is that because there was other accounting evidence of over $300,000 of unreported income in 2003, on which an additional $75,000 was due in owing, the inclusion of the $1.9 million did not prejudice the defendant. This argument fails for two reasons. First, the potential prejudice from a properly evidenced $300,000 understatement enhanced by a $1.9 million improper inclusion would seem evident. The government went to the trouble of including the $1.9 million in its accounting, defended it against motions to exclude at trial, and argued the $2.2 million figure to the jury. I do not believe we can hold with confidence that this change in the magnitude of evidence by the improper inclusion did not prejudice the minds of the jury. Perhaps equally importantly, if not more so, we cannot know that the jury did not entirely base its guilt verdict on the $1.9 million while disbelieving or being unconvinced as to the smaller figure in the accounting. Nonetheless, the government is correct that the $300,000 was properly in evidence. Therefore, we should not reverse the district court's denial of defendant's motion for judgment of acquittal, but rather should vacate the judgment and remand this count for retrial.

I note again that I would not hold, nor did appellant contend, that the seizure of the $1.9 million could not come into evidence — only that it could not be included as part of the unreported income. It may be that the evidence would go to the intent of the defendant or to his method of operation. It is likely that the $1.9 million could, indeed perhaps should, be part of the accountant's computation as a source of cash, then offset by an expenditure at the time of the seizure and the return to the corporation.

For the reasons set forth above, I dissent from the court's affirmance of the conviction and sentence on Count 4.

Addendum 12/12/11:  The D.C. Circuit revised the opinion on December 9.  The revision is a bit cryptic, but I am not sure it affects the points above.  The revised opinion is here.  The Court explained the revision as follows:

FURTHER ORDERED that the opinion filed October 7, 2011, be amended as follows: 

Slip Op., delete the second sentence of the second full paragraph on p. 11 through the end of the paragraph on p. 12, and insert in lieu thereof: 

We affirm the sentence because the district court made sufficient factual findings at sentencing to support the inclusion of the $1.9 million in the calculation of tax loss notwithstanding Khanu's "repayment" of those funds to his corporations. See U.S.S.G. § 2T1.1(c)(1), (5) ("the tax loss is the total amount of loss that was the object of the offense (i.e., the loss that would have resulted had the offense been successfully completed)" and is "not reduced by any payment of the tax subsequent to the commission of the offense"); see also § 1B1.3(a) & cmt., n.1 (relevant offense conduct for purposes of sentencing is not limited to acts for which defendant is criminally liable and includes "all acts and omissions committed . . . by the defendant . . . that occurred during the commission of the offense, in preparation for that offense, or in the course of attempting to avoid detection or responsibility for that offense").