Significant Changes to Partnership Tax Audits Coming in 2018

David J. Moise and Jill E. Misener

In less than six months, on January 1, 2018, the new centralized partnership audit rules enacted by Congress as part of the Bipartisan Budget Act of 2015 (“BBA”) will go into effect. The new rules were drafted in response to the proliferation of business entities that are taxed as partnerships (such as LLCs), and the perceived difficulty in being able to both effectively audit these entities and to assess and collect tax from the individual parties as appropriate.

The BBA creates a new partnership audit regime that significantly changes the procedures for partnership audits under the Tax Equity and Fiscal Responsibility Act (“TEFRA”) and the special rules for Electing Large Partnerships (“ELP”). Under the new rules, tax adjustments resulting from partnership examinations will generally be assessed at the partnership level rather than the individual partner level. This enables the IRS to collect tax due on partnership adjustments at the entity level, effectively imposing an entity level tax on partnerships. Previously, under TEFRA, adjustments to partnership items were determined in a single proceeding at the partnership level, but then flowed through to partners pursuant to a complex set of rules requiring significant IRS time and effort. The new rules are intended to simplify the complexity of the current partnership audit rules, and increase the ability of the IRS to examine partnerships, particularly large and tiered partnerships. Continue reading

IRS Criminal Investigation Division Announces New Priorities

Carlos F. Ortiz, Bridget M. Briggs, and Jeffrey M. Rosenfeld

At the ABA Section of Taxation’s 2017 May Meeting, Erick Martinez, the IRS Criminal Investigation Division’s Director of Field Operations – Northern Area, provided insight into the Division’s current priorities and strategies. Mr. Martinez indicated that the Division is concentrating on nationally coordinated investigations in conjunction with the Justice Department Tax Division and the IRS Large Business and International Division, such as cases involving renewable fuel credits.

The Criminal Investigation Division is also increasing its focus on data-driven cases such as beneficial owner cases, given the plethora of information resulting from the Swiss bank program and offshore voluntary disclosure programs. Mr. Martinez further noted an increased emphasis on cybercrime with two new cybercrime units in Los Angeles and Washington investigating failure to report income earned through the use of technology.

Tax Court Provides Extra Time for Snow Day

On June 2, 2016, the United States Tax Court issued Guralnik v. Commissioner denying a Motion to Dismiss for Lack of Jurisdiction the Internal Revenue Service (IRS) filed on the ground that the taxpayer’s petition was not timely filed.[1] As these motions are typically granted or denied by the court through a simple order, it seemed strange that the court would issue a division opinion, which is generally reserved for cases involving an issue of first impression or an important legal issue or principle. The court, however, used this case as a means to change precedent related to the date on which a petition must be filed in Tax Court to be considered timely. Continue reading

Chicago Restaurant Tax Case Highlights Broad DOJ Authority

May 25, 2016

Law360

The U.S. Department of Justice’s filing of criminal charges against a Chicago restaurant owner who failed to pay state sales tax demonstrates the perils business owners face if they underreport their gross receipts to avoid paying sales tax. Hu Xiaojun, who owns and operates nine restaurants in the Chicago area, was charged with federal wire fraud and money laundering offenses arising from his failure to pay Illinois sales tax on nearly $10 million in cash transactions occurring at his restaurants over a four-year period.[1] On May 16, 2016, Xiaojun pleaded guilty to one count of wire fraud and one count of money laundering. He faces a prison sentence of 41 to 51 months, and must pay restitution of over $1 million to the Illinois Department of Revenue as well as forfeit an additional amount as punishment for his misconduct. Sentencing is scheduled for Aug. 22, 2016.

The Offense Conduct

According to the publicly filed guilty plea agreement, between January 2010 and September 2014, Xiaojun failed to pay sales tax on transactions in which customers paid cash. To conceal cash sales, he instructed restaurant managers and employees to provide him with daily summaries of restaurant sales, which he would in turn alter to conceal cash sales. Xiaojun and others would destroy the daily summary reports and cash transactions receipts, replacing them with incorrect reports that omitted the bulk of each restaurant’s cash sales. To hide cash sales from the state tax authorities, the defendant instructed employees to withhold cash generated from the restaurants from the corporate bank accounts to avoid creating financial records for those cash sales. The defendant instead used the cash to pay restaurant employees and suppliers without recording those expenses in the corporate books and records. The defendant also deposited a portion of the cash into his personal bank account, which he then used to pay personal expenses.

During the 2010 to 2014 time period, the defendant instructed others to submit fraudulent sales figures to the Illinois Department of Revenue on monthly sales tax returns. Each month, the defendant directed his employees to provide false sales figures to his accountants, who in turn provided those figures to the state. In all, the defendant underreported his sales to the state by nearly $10 million, resulting in his underpayment of sales taxes by more than $1.1 million.

The wire fraud charge to which the defendant pleaded guilty is based upon his sending of an email containing false sales figures for the month of May 2014. The money laundering charge to which the defendant pleaded guilty is based upon a series of financial transactions that he conducted using proceeds of his scheme to defraud the Illinois Department of Revenue. Specifically, the defendant deposited over $72,000 in cash into his personal bank account, which he knew consisted of funds derived from cash sales at his restaurants that were concealed from the state tax authorities. The defendant thereafter withdrew $60,000 from that account and purchased an official bank check, which he then deposited into a different business account. The defendant used the funds in that second bank account to purchase a restaurant and equipment, which he subsequently operated.

Analysis 

At first glance, the facts of United States v. Xiaojun read like a typical criminal tax case and include the all-too-common attributes of tax fraud in the restaurant industry: the concealment of cash sales and the use of diverted cash to pay employees, purveyors and personal expenses of the restaurant’s owners. Indeed, the Justice Department’s website is replete with press releases announcing criminal tax charges against restaurant owners who engaged in conduct similar to that of Xiaojun, mostly commonly filing of false income tax returns in violation of 26 U.S.C. § 7206 or tax evasion in violation of 26 U.S.C. § 7201.

For example, in United States v. Happy Asker, the owner of a chain of pizza restaurants in the Detroit area engaged in what the government called “a systematic and pervasive tax fraud scheme to defraud the IRS” by substantially underreporting gross sales and payroll amounts on corporate income tax returns and employment tax returns filed for nearly 60 restaurant locations.[2] Over a three-year period, the defendant and his co-conspirators diverted for personal use more than $6.1 million in cash gross receipts and failed to report approximately $3.84 million of gross income and pay approximately $2.39 million in payroll taxes. A portion of the unreported income was shared among the defendant and most of his franchise owners, in a weekly cash “profit split.” As a result of this conduct, the defendant was charged with, and later convicted of, typical Title 26 offenses: filing false personal income tax returns, aiding and assisting in the filing of false corporate income and employment tax returns for several pizza restaurants, and obstructing and impeding the administration of the Internal Revenue Code.

In another fairly typical case, United States v. Ramon S. Arias, the defendant owned numerous Little Caesars pizza franchises in Alabama, Georgia and Louisiana. In a written plea agreement, the defendant admitted that between 2010 and 2013, he “skimmed” hundreds of thousands of dollars of cash from his restaurants and concealed these cash receipts from his accountant. As a result, the S corporation tax returns underreported gross receipts from the restaurants, and those omissions flowed through to the defendant’s personal income tax returns. The defendant pleaded guilty to one count of filing a false 2013 personal income tax return in violation of 26 U.S.C. § 7206(1) and agreed to pay restitution to the Internal Revenue Service for the years 2010 through 2013.[3]

What makes United States v. Xiaojun notable is that the Justice Department chose not to assert a single federal tax charge against the defendant. Based upon admissions in his plea agreement, the defendant presumably failed to report as taxable income the concealed cash receipts, thereby likely exposing him to multiple federal income tax charges during the five tax years at issue (2010 through 2014). In addition, the defendant’s payment of his employees in cash presumably could have led to employment tax-related charges. But instead of charging Title 26 offenses, the government transformed this garden-variety criminal tax case into a wire fraud and money laundering case by focusing on the defendant’s failure to pay state sales taxes.

Tax Division Directive No. 128

The government’s case against Xiaojun appears to be premised upon a relatively obscure Justice Department policy entitled Tax Directive No. 128, “Charging Mail Fraud, Wire Fraud or Bank Fraud Alone or as Predicate Offenses in Cases Involving Tax Administration.” This directive provides federal prosecutors with significantly expanded authority to use the mail and wire fraud statutes to charge additional crimes, and seek correspondingly increased penalties, in tax-related cases. Under a preceding policy, prosecutors were generally not permitted to use the fraud statutes where the use of the mails or wires was only incidental to a violation arising under the Internal Revenue laws.

Under Tax Directive No. 128, prosecutors may now use mail and wire fraud offenses and, more importantly, state tax violations where the mails or wire communication facilities are used, to transform cases that traditionally would be prosecuted under the tax laws into fraud and money laundering prosecutions. By charging mail and wire fraud in tax cases, the government can significantly change the charging and plea bargaining process. The mere threat of a mail fraud or money laundering charge may well cause targets of government investigations to plead guilty more willingly, and to agree to cooperate against other targets, than would have been likely under the prior policy where the charges were likely limited to federal tax offenses absent exceptional circumstances. In addition, the ability to include mail or wire fraud charges in a tax-related case provides prosecutors with an additional tool not previously available in traditional tax cases — the ability to seek forfeiture of the proceeds of the fraudulent scheme.

By relying upon the authority conferred by Tax Directive No. 128, the government could significantly ratchet up the pressure on the defendant in United States v. Xiaojun. By bringing charges under Title 18 rather than Title 26, the government was able to seek a longer prison sentence: the statutory maximum sentences available for mail fraud and money laundering, 20 years each, are significantly higher than the statutory maximum sentences available for tax fraud or tax evasion, which are three years and five years, respectively. In addition, the United States Sentencing Guidelines for mail fraud and money laundering crimes typically call for longer sentences than those applicable to tax offenses.

Charging mail fraud and money laundering also enabled the government to seek restitution to be paid to the state agency that was defrauded. Had the government only charged federal tax crimes under Title 26, restitution could only have been ordered to the Internal Revenue Service, as occurred in United States v. Asker and United States v. Arias. The government was also able to seek forfeiture of the funds that constitute proceeds of the mail fraud and money laundering offenses, an additional punishment that is not available for tax offenses. As part of his plea agreement, Xiaojun agreed to pay at least $1 million in restitution to the Illinois Department of Revenue and to entry of a forfeiture judgment in an amount to be determined by the court at sentencing. The defendant also agreed as part of his plea agreement to cooperate with the civil tax audit that will inevitably follow his conviction, thereby ensuring that the IRS will be able to assess any tax, interest and penalties that are determined to be due and owing.

United States v. Xiaojun illustrates well how Tax Directive No. 128 provides federal prosecutors with significantly more leeway in charging offenses in what are viewed as traditional tax cases. No longer confined to the criminal offenses enumerated in Title 26, federal prosecutors can significantly increase the pressure on defendants by charging mail fraud and money laundering, seeking longer sentences and extracting substantial financial penalties by requiring defendants to pay both restitution and forfeiture.

Footnotes

[1] See United States v. Hu Xiaojun, No. 16-cr-316 (N.D. Ill.).

[2] See U.S. Department of Justice Press Release, “Happy’s Pizza Founder Convicted of Multi-Million Dollar Tax Fraud Scheme” (Nov. 19, 2014).

[3] See U.S. Department of Justice Press Release, “Owner of Pizza Franchises Pleads Guilty to Submitting False Tax Return That Omitted Income From Skimmed Cash” (May 24, 2016).

“Chicago Restaurant Tax Case Highlights Broad DOJ Authority,” by Matthew D. Lee was published in Law360 on May 25, 2016. Click here to read the article online.

Tax Day Brings Barrage of Criminal Tax Charges and Warnings

With “Tax Day” upon us, the Justice Department’s Tax Division and U.S. Attorney’s Offices around the country have unleashed an avalanche of press releases warning would-be tax cheats of the severe criminal and civil consequences they may face.

From the U.S. Attorney’s Office for the Northern District of Illinois comes a press release entitled “Federal Prosecutions Serve as Reminder to Comply with Tax Obligations as Filing Deadline Approaches” announcing criminal charges against four Chicago-area residents for a variety of alleged income tax frauds.  Two Chicago-area tax preparers were charged with assisting clients in obtaining hundreds of thousands of dollars in fraudulent refunds.  The preparers fraudulently reduced their clients’ tax liabilities by misrepresenting their eligibility to claim tax credits, such as dependent exemptions, education and child credits.  In addition, two individuals were indicted for filing hundreds of fraudulent income tax returns that claimed refunds totaling more than $2.1 million.

The U.S. Attorney’s Office for the Eastern District of California has issued a similar press release entitled “Federal Tax Enforcement Is a Focus of Prosecutions in the First Quarter of 2016.”  This release catalogues five new tax indictments so far in 2016, five convictions so far in 2016, and the sentences handed down in tax cases to date this year.  The press release concludes with this statement:  “More criminal tax investigations are underway.”

The U.S. Attorney’s Office for the Middle District of Pennsylvania has issued a lengthy press release entitled “U.S. Attorney And IRS Announce Message To Potential Tax Cheats That Tax Crimes Result In Criminal Prosecution And Lengthy Prison Sentences And Fines And Issue a Fraud Notice To Taxpayers.”  This announcement summarizes recent prosecutions of taxpayers for tax evasion and tax fraud and stolen identity refund fraud.  The release concludes with a “Tax Scam Warning” urging taxpayers to exercise caution during tax season to protect themselves against tax scams.  In particular, taxpayers are warned to avoid the following common tax schemes:

•           Identity Theft

•           Phone Scams

•           Phishing

•           Return Preparer Fraud

•           Offshore Tax Avoidance

•           Inflated Refund Claims

•           Fake Charities

•           Falsely Padding Deductions on Returns

•           Excessive Claims for Business Credits

•           Falsifying Income To Claim Credits

•           Abusive Tax Shelters

•           Frivolous Tax Arguments

In Sacramento, California, the U.S. Attorney announced on April 15 that four individuals, including two current IRS employees, were criminally charged in tax cases.  The two IRS employees, who are married to each other, were arrested when they came to work and were charged with aiding others in the preparation of false tax returns and filing false tax returns themselves.  Separately, an individual was charged with two counts of tax evasion for tax years 2009 and 2010.  Finally, an individual was criminally charged with failing to file tax returns for 2009 through 2012.  In addition to these cases, so far in 2016, eight individuals have been indicted, five have been convicted and 14 were sentenced for either submitting false claims for refunds or evading taxes.

In Alaska, the U.S. Attorney’s Office announced that a criminal defense attorney, who operated a law practice in Anchorage, was sentenced to 14 months in prison following his guilty plea in June 2014 to three counts of willful failure to file income tax returns.  The defendant in that case admitted that he failed to file federal income tax returns with the Internal Revenue Service for the years 2006, 2008, and 2009, causing a tax loss to the government of $886,058.  According to a sentencing memorandum filed by the government, the defendant still has not paid the more than $800,000 in income taxes that he owed for the years 2006, 2008 and 2009.  At the same time that he failed to file his tax returns and pay the taxes due, the defendant made personal expenditures for gambling, cars, and property.  The defendant also failed to file timely income tax returns for the years 2000 through 2004, 2007, 2010 and 2011, failed to file employment tax returns during the years 2004 through 2008, and failed to pay employment taxes to the IRS.  According to documents filed with the court, the defendant also submitted a false Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, to the IRS in 2009.  A Form 433-A is used by the IRS to obtain financial information from a taxpayer to determine his ability to pay an outstanding tax liability.  On the Form 433-A, which he signed under the penalties of perjury, the defendant failed to disclose certain retirement assets.  In a press release announcing the sentencing, the Tax Division’s Acting Assistant Attorney General made the following statement:

“This case is a reminder that no one is above the law,” said Acting Assistant Attorney General Ciraolo.  “Indeed, as an attorney who has defended individuals charged with financial crimes, Mr. Stockler was particularly aware of his obligations under the tax laws and the consequences of violating them.  Taxpayers who willfully disregard their legal responsibilities will be held to account.”

In the Northern District of Ohio, the U.S. Attorney announced today that a businessman was charged with four counts of tax evasion, based upon taking improper tax write-offs and not reporting more than $2 million in taxable income. The defendant is alleged to have diverted corporate funds for his own use to benefit his personal lifestyle, such as to construct a waterfront residence, maintain his yacht, and pay for luxury travel. It was further alleged that the defendant falsely described these expenses as business-related, and provided false information to his accountants about the nature of these expenses. The government alleges that the defendant underreported his taxable income by more than $2 million during tax years 2007, 2008, 2009 and 2010, and owes at least an additional $611,000 in taxes for those periods. According to the IRS Special Agent in Charge, “[a]s this tax filling season comes to a close, we are reminded of our collective duty to accurately file and pay our taxes. Those who willfully abscond from this duty will be pursued and brought to justice.”

Finally, as part of its ongoing efforts to combat return preparer fraud, the Justice Department filed a federal court lawsuit today seeking to shut down a tax return preparer in South Florida.  The civil complaint alleges that the preparer prepares income tax returns that fraudulently understate his customers’ tax liabilities by falsely claiming deductions for business expenses his customers never incurred, fraudulently overstating his customers’ claims for refunds by falsely claiming education or fuel tax credits to which his customers are not entitled, or both.  According to the complaint, the Internal Revenue Service IRS audited 340 of the more than 3,132 returns he prepared since 2009 and found that the preparer understated the tax owed on all but five of the 340 returns—a total of more than $1.8 million in understatements.  As a result of these fraudulent activities, many of the preparer’s customers are now liable for significant tax deficiencies, penalties and interest.

All of these announcements should serve as a reminder, and a stern warning, that taxpayers should take care to ensure that their tax returns are accurate, complete, and filed on time.  Each of the cases described above demonstrate that taxpayers who deliberately understate their income, overstate their deductions,  or otherwise file inaccurate tax returns may subject themselves to criminal liability.  Taxpayers who are unable to file on time today should file for an automatic six month extension of the deadline.