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The criminal tax conviction of a New Jersey couple (the DeMuros) for failure to pay payroll taxes to the IRS was affirmed by the Third Circuit Court of Appeals, United States v. DeMuro (3d Cir. 2012). The willful failure to pay payroll taxes is a violation Internal Revenue Code (IRC) Section 7202, and is punishable by up to five years in prison. Of course the willful failure by a responsible officer to pay trust fund taxes is also a violation of IRC Section 6672, and will result in a trust fund recovery penalty (TFRP) being assessed against the responsible officers. Obviously the criminal tax conviction is much more serious than the assessment of the trust fund recovery penalty.
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The DeMuros failed to pay trust fund taxes for their business of more than $546,000 over 21 calendar quarters from 2002 to 2008, resulting in a 21 count indictment. While that is a lot of money it is easy to see how a failing business could wind up in that situation since it amounts to about $25,000 per quarter, and was spread over a seven year period. A large sum, but not shocking, at least not to tax lawyers, and other tax professionals who see this type of underpayment on a semi-regular basis.

The DeMuros tried to argue that their failure to pay wasn’t willful, but to no avail. The IRS pointed to evidence that during the same time period the DeMuros spent over $5 million dollars from their personal and corporate bank accounts. Apparently several witnesses testified at trial about the DeMuros “luxury vacations, nice homes, and [Mrs. DeMuros] substantial home shopping network expenditures,” and the DeMuros argued on appeal that the admission of this evidence was “prejudicial.” The response from the Third Circuit was: “[w]hile we are sensitive to the effect that evidence of a defendant’s liberal spending habits can have on a jury, particularly in these lean economic times, the evidence admitted in this case, i.e. evidence of vacations, jewelry, cars and parties, was not so inflammatory as to carry a great risk of prejudice.”

Mrs. DeMuro argued at trial that she was not responsible for paying the payroll taxes. The IRS response was to show that that Mrs. DeMuro had the authority to fire employees and signatory authority over corporate bank accounts.

Interestingly the IRS also called as a witness the Enrolled Agent that represented the DeMuros before the IRS with regard to the payroll tax problems. The Enrolled Agent testified that he had reviewed two appeals that the DeMuros had filed, and that in his opinion they were meritless, and therefore should have been withdrawn. Advice which apparently the DeMuros didn’t follow, and the IRS relied on this as evidence of bad faith on the part of the DeMuros.
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Our tax litigation attorneys are often asked whether failing to report income is tax fraud. We explain that there are various “badges of tax fraud,” and a simple omission of income may not be tax fraud. A recent Tax Court case illustrates that when coupled with other badges of tax fraud even a small tax due can result in a 75% civil tax fraud penalty.
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In the case of Porch v. Commissioner (March 2012) Porch underwent a tax audit by the IRS for the years 2005 and 2006. At the audit Mr. Porch produced a Form 1099 and 13 unnumbered invoices which roughly totaled the gross receipts reported on the 2005 tax return. Porch did not provide his bank statements to the auditor at that point even though they had been requested. At the second meeting he furnished some, but not all of the requested bank statements. Ultimately the IRS summonsed the statements from the bank, at which point the auditor figured out that business income had been underreported by about $36,000 and $48,000 for 2005 and 2006, respectively. In addition, it turned out that Porch failed to report the gain on the sale of a house, and capital gains from the sale of securities. The tax due, however, was relatively small; $8,392 and $4,471 for 2005 and 2006, respectively.

In determining that the IRS had proven that Porch had committed tax fraud the Tax Court found the following badges of tax fraud:

• Understated Income
• Inadequate Records
• Implausible or Inconsistent Explanations of Behavior
• Failure to Cooperate with IRS
• Dealing in Cash
• Engaging in a Pattern of Behavior That Indicates an Intent to Mislead

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A few of these badges of tax fraud were the most egregious. When Porch went to the tax audit he attempted to mislead the agent by presenting documentation which suggested the amount reported was accurate when in fact he knew that was not the case. The Tax Court was also not pleased with Porch’s testimony at trial. On their 2005 tax return Porch and his wife reported adjusted gross income of around $11,000, and they deducted a similar amount for mortgage interest and taxes Porch answered in the affirmative when asked if he was the primary breadwinner in his family. Then, however, when asked how they supported themselves on the amounts set forth on the tax return he testified: “I mean it was rough. My wife, my friends, Lomax. You know, people helped me out. I mean, when I couldn’t make ends meet, you know, I prayed about it.” The judge referred to this under the heading of Implausible or Inconsistent Explanations of Behavior.

In the view of our tax litigation attorneys had Porch not been caught in several apparently dishonest statements perhaps he could have avoided the tax fraud penalty.
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Tax fraud penalties were recently upheld against Miguel Robleto of Oregon by the 9th circuit. These were civil tax fraud penalties pursuant to IRC Section 6663, not criminal tax evasion charges under IRC Section 7201. The difference is that although you can wind up paying a lot of money if civil tax fraud penalties are imposed at least you won’t go to jail. In some cases the IRS brings criminal tax evasion charges, and then goes after you for the taxes, plus a civil tax fraud penalty. Although Mr. Robleto probably doesn’t think so he may have been lucky that the IRS didn’t bring criminal tax evasion charges.

The civil tax fraud penalty under IRC Section 6663 is 75% of the tax that is owed. The process of imposing the civil tax fraud penalty is a lengthy one. Generally the first step is a tax audit, sometimes followed by an appeal to the Internal Revenue Service’s Appeals Division. Next the IRS will issue a notice of deficiency, after which the taxpayer may petition the United States Tax Court to decide his case. In order for the Tax Court to uphold the fraud penalty it must find clear and convincing evidence of tax fraud. That’s just what happened in Mr. Robleto’s case.

Mr. Robleto was a small business owner, and under the auspices of the Oregon DMV charged non-English speakers a fee for administering Oregon drivers’ license exams. Although the Tax Court determined, and Mr. Robleto pretty much admitted, that he failed to report over $300,000 spread over four years his excuse was that he had never operated a business before, that he was overwhelmed by all of the customers he had, that he was totally inept in handling the financial aspects of his business, that he couldn’t even pay his utility bills on time, that he had unopened envelopes of cash lying around his home, and that the filing of his incorrect income tax returns was at worst grossly negligent, but not fraudulent.

The Tax Court didn’t buy it. Instead the Tax Court looked at various so-called badges of fraud including inadequate books and records, concealment of ownership of assets, cash transactions and cash hoarding. As the Tax Court so subtly put it:

Dealing in large amounts of cash and not keeping any records thereof often go hand in hand with intentional underreporting of income and taxes. Noteworthy are [Robleto’s] placement of assets in nominee names and [his] lack of cooperation.

Robleto probably wasn’t helped by the fact that he had a safe in his house with almost $200,000 of cash contained in it, or that he had a side business of preparing tax returns. He hired an accountant to prepare his own tax returns, but neglected to tell the accountant about the income from the preparation of the tax returns.
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Last month, while most people were preparing their Christmas lists, Louis Alba, a New York contractor, plead guilty to criminal tax charges of failing to pay over to IRS employment taxes withheld from employee wages in the amount of almost $780,000 over approximately six years. Failure to pay over payroll taxes is considered a felony under Internal Revenue Code (IRC) Section 7202. It is punishable by up to five years in jail, and a fine of up to $250,000.
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In the current economic environment business owners who are strapped for cash sometimes decide to “borrow” from the IRS by not paying the payroll taxes. The theory is that if cash is tight, and the vendors aren’t paid there will be no more merchandise to sell, and therefore the business will go under quickly. The same with the landlord; don’t pay the rent, and one can expect an eviction notice in short order. The IRS on the other hand moves slowly, and the temptation is to believe that if you have another 6 months or so business will turn around, and the IRS can be paid back.

Unfortunately in many cases that doesn’t happen. The IRS doesn’t look on this as borrowing; it views the failure to pay payroll taxes as stealing. Even if criminal tax charges are not brought, so-called responsible officers who fail to pay over corporate payroll taxes can be held personally liable under IRC Section 6671. More and more, however, the IRS is bringing criminal tax fraud charges. For the record persons convicted of tax crimes still must pay the taxes. It’s not one or the other.
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The California State Board of Equalization (BOE or SBE) announced almost one year ago that medical marijuana dispensaries are not exempt from collecting and paying tax attorneys are fielding inquiries from a number of medical marijuana dispensaries who are undergoing sales tax audits by the BOE. The M.O. of the BOE seems to be to stand at a discrete location outside of the clinic, and count the number of people coming in the door per hour. The Board then compares that to the clinic’s records of the number of patients, and if there is any discrepancy it calculates the value of an average “sale,” multiplies that by the number of alleged unrecorded patients per day, and projects that amount over a (generally) three year audit period.

Of course this projection by the SBE is rarely accurate, and fails to take into account a number of reasons that the dispensary’s records don’t match. For example, discrepancies can exist because:
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1. Not everyone who comes into the clinic is a member, or actually fills his prescription 2. The number of patients entering the clinic on the particular day that the BOE is counting may be higher than average because the clinic was having a good day 3. The BOE may be using an inaccurate sale price which results in an overstatement of receipts.

There are many other reasons why the BOE estimates can be inaccurate. Luckily there are many avenues for appeal of a BOE determination. However, an ounce of prevention is worth a pound of cure, and proper tax representation during the initial sales tax audit may prevent problems from arising. Information on sales tax audits and sales tax appeals in general is available on our website, click here to view. Managers of medical marijuana cooperatives and collectives should also be aware that if the BOE determines that sales tax is due and the dispensary fails to pay they could be personally liable pursuant to California Revenue and Taxation Code Section 6829.
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In IRS Notice IR 2012-3 the IRS announced that innocent spouse defenses pursuant to IRC Section 6015(f) will become a little easier. Generally there are three different kinds of innocent spouse defenses, each with its own rules and exceptions. IRS Notice 2012-8, which somewhat confusingly was announced in IRS Notice IR 2012-3, sets out a proposed new Revenue Procedure which will supersede Revenue Procedure (Rev. Proc.) 2003-61. IRS Notice 20012-8 addresses the criteria used in making innocent spouse relief determinations under the equitable relief criteria of Internal Revenue Code Section 6015(f). The IRS Notice covers several topics. It provides for certain streamlined determinations; it creates new guidance on the potential impact of economic hardship, and the weight to be accorded to certain facts in determining equitable innocent spouse relief. Importantly it also expands how the IRS takes into account abuse and financial control by the nonrequesting spouse in deciding whether to grant equitable relief.

The IRS is inviting comments on the forthcoming proposed Revenue Procedure. The comments must be submitted by February 21, 2012.

One important change is that under Rev. Procedure 2003-61, which previously provided guidelines for equitable innocent spouse determinations, lack of economic hardship was treated as a factor which weighed against granting equitable innocent spouse relief. Now if economic hardship exists that is still a factor which weighs in favor of granting innocent spouse relief. However, the lack of economic hardship will no longer be counted against a requesting spouse. Instead it will be treated as neutral.

Another significant change is that the proposed revenue procedure provides that abuse or lack of financial control may mitigate other factors that might weigh against granting equitable relief under IRC Section 6015(f). For example, even though a requesting innocent spouse has knowledge or reason to know of omitted income on a tax return if the nonrequesting spouse abused the requesting spouse or maintained control over the household finances by restricting the requesting spouse’s access to financial information, and, therefore, because of the abuse or financial control the requesting spouse was not able to challenge the treatment of any items on the joint return for fear of the nonrequesting spouse’s retaliation, then that abuse or financial control will result in this factor weighing in favor of relief even if the requesting spouse had knowledge or reason to know of the items giving rise to the understatement or deficiency.

In the end, however, the granting of innocent spouse relief is based upon all of the facts and circumstances. Only by discussing your case with a knowledgeable tax litigation attorney can you determine if you are likely to prevail.
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