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The U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) announced today that its aggressive efforts to combat money laundering in the luxury real estate market have been extended for an additional six months. Confirming his agency’s concerns about illicit funds flowing through the U.S. real estate industry, FinCEN Acting Director Jamal El-Hindi said today that this initiative is “producing valuable data that is assisting law enforcement and is serving to inform our future efforts to address money laundering in the real estate sector.” Today’s announcement means that temporary measures requiring U.S. title insurance companies to identify the natural persons behind shell companies used to pay all-cash to high-end residential real estate in six major metropolitan areas – known as “Geographic Targeting Orders” (GTOs) –remain in place for six more months.

Background Regarding Geographic Targeting Orders

A GTO is an administrative order issued by the director of FinCEN requiring all domestic financial institutions or nonfinancial trades or businesses that exist within a geographic area to report on transactions any greater than a specified value. Authorized by the Bank Secrecy Act, GTOs were originally only permitted by law to last for 60 days, but that limitation was extended by the USA Patriot Act to 180 days. Historically, FinCEN’s issuance of a GTO was not publicized, and generally only those businesses served with a copy of a particular GTO were aware of its existence.

Over the course of the last three years, FinCEN — the primary agency of the U.S. government focused on anti-money laundering compliance and enforcement — has aggressively exercised its GTO authority frequently throughout the United States in areas of money laundering concern. Recent, publicly announced GTOs have focused on shipments of cash across the border in California and Texas, the fashion district of Los Angeles, exporters of electronics in South Florida, and check cashing businesses in South Florida. In each of these examples, FinCEN publicly announced the issuance of the GTO and its terms, and expressed concern that the industries or regions in question were vulnerable to money laundering.

Prior Efforts to Prevent Money Laundering in Real Estate Transactions

For several years, FinCEN has sought to ensure financial transparency and combat illegality in the real estate market. In February 2015, The New York Times published a series of articles focused on the use of shell companies to purchase high-value real estate in New York City. In a November 2015 speech, FinCEN’s then-director disclosed that through analysis of Bank Secrecy Act reporting and other information, FinCEN has observed the frequent use of shell companies by international corrupt politicians, drug traffickers and other criminals to purchase luxury residential real estate in cash. In particular, FinCEN uncovered fund transfers in the form of wire transfers originating from banks in offshore havens at which accounts have been established in the name of the shell companies. The perpetrator will typically direct an individual involved in the settlement and the closing in the U.S. to place the deed to the property in the name of the shell company, thereby obscuring the identity of the owner of the property.

The Bank Secrecy Act established anti-money laundering obligations for financial institutions, including institutions involved in real estate transactions. By including these businesses in the definition of “financial institution,” Congress recognized the potential money laundering and financial crime risks in the real estate industry. In the USA Patriot Act, Congress mandated that FinCEN issue regulations requiring financial institutions to adopt AML programs with minimum requirements, or establish exemptions, as appropriate. Since that time, FinCEN has implemented AML requirements for certain real estate businesses or established exemptions for others consistent with the Bank Secrecy Act.

The Original Manhattan and Miami-Dade Real Estate GTOs

Approximately one year ago, FinCEN issued what were believed to be the first-ever GTOs focused on real estate transactions. Effective March 1, 2016, these GTOs required certain title insurance companies to identify the natural persons behind companies used to pay all cash for luxury residential real properties located in the borough of Manhattan and Miami-Dade County. All-cash transactions exceeding $3 million in Manhattan, or exceeding $1 million in Miami-Dade County, were to be reported to FinCEN with an identification of the “beneficial owner” behind the transaction.

The enhanced reporting required by the GTOs applied to “covered transactions,” which were defined as transactions in which (1) a legal entity (2) purchases residential real estate either in the borough of Manhattan or Miami-Dade County (3) for a total purchase price of excess of $3 million (Manhattan) or $1 million (Miami-Dade) (4) without a bank loan or other similar form of external financing and (5) using, at least in part, currency or a cashier’s check, certified check, traveler’s check, or money order. “Legal entity” was defined as a corporation, limited liability company, partnership or other similar business entity, whether domestic or foreign.

If a title insurance company is engaged in a transaction that meets all of the requirements for a “covered transaction,” it was required to report said transaction to FinCEN within 30 days of the closing using a designated form entitled “FinCEN Form 8300.” On the Form 8300, the title insurance company must identify (1) the purchaser; (2) the purchaser’s representative, if any; and (3) the beneficial owner, which is defined as each natural person who, directly or indirectly, owns 25 percent or more of the equity interests of the purchaser. The title insurance company must obtain and copy the driver’s license, passport, or other similar identification for each beneficial owner.

Expansion of GTOs to Six Other Major Metropolitan Areas

On the eve of the expiration of the original Manhattan and Miami-Dade GTOs in August 2016, FinCEN announced a significant expansion of its efforts to combat money laundering in real estate transactions with the issuance of six more GTOs. Effective on August 28, 2016, those GTOs covered the following geographic areas: (1) all boroughs of New York City; (2) Miami-Dade County and the two counties immediately north (Broward and Palm Beach); (3) Los Angeles County, California; (4) three counties comprising part of the San Francisco area (San Francisco, San Mateo, and Santa Clara counties); (5) San Diego County, California; and (6) the county that includes San Antonio, Texas (Bexar County). The monetary thresholds for each geographic area varied.[1]

Beyond expanding their geographic reach, the six new GTOs contained two significant changes from the original Manhattan and Miami-Dade GTOs. First, the earlier GTOs defined “cash” transactions to include money orders, cashier’s checks, certified checks, and traveler’s checks. The newly-issued GTOs also applied to personal and business checks, thereby expanding the types of transactions that will be subject to enhanced reporting. Notably, however, none of the GTOs apply to real estate transactions conducted solely using wire transfers, an area that FinCEN currently lacks authority to regulate. Critics of the real estate GTOs pointed out that money launderers could exploit this gap in the regulatory scheme by using wire transfers from offshore banks to finance their luxury real estate purchases. Second, the new GTOs applied to all U.S. title insurance companies, instead of the few title companies originally selected.

Implications of FinCEN’s Renewal of the Six Real Estate GTOs

Today’s action by FinCEN to extend the six real estate GTOs for an additional six months is not surprising and confirms that FinCEN remains concerned about the risk of money laundering when individuals attempt to purchase high-end real estate in all-cash deals through limited liability companies or similar structures. In a press release issued today, FinCEN revealed that approximately 30 percent of the transactions covered by the GTOs involved a beneficial owner or purchaser representative that is also the subject of a previously-filed “suspicious activity report,” thereby corroborating FinCEN’s long-expressed concerns about the use of shell companies to buy luxury real estate in all-cash deals.

Title insurance companies handling transactions occurring in the six geographic regions covered by the latest GTOs, and their employees and agents, must be familiar with the obligations imposed by these latest GTOs. Title insurance companies should have training programs in place so that they are prepared to address these ongoing compliance obligations. Companies that fail to comply with the reporting and record-keeping requirements of these GTOs, and their employees, may face civil or criminal penalties.

It will be interesting to see whether FinCEN will make permanent the temporary measures imposed by these GTOs through regulations. With a new administration in place committed to rolling back regulations, it is entirely possible that the GTOs may eventually expire without further regulatory action. On the other hand, the GTOs appear to have produced valuable information for law enforcement, and that result may prompt FinCEN to implement these anti-money laundering measures on a permanent basis.

[1] The New York thresholds are as follows: the Borough of Manhattan – $3,000,000; the Borough of Brooklyn – $1,500,000; the Borough of Queens – $1,500,000; the Borough of Bronx – $1,500,000; and the Borough of Staten Island – $1,500,000. The Florida thresholds are as follows: Miami-Dade County – $1,000,000; Broward County – $1,000,000; Palm Beach County – $1,000,000. The California thresholds are as follows: San Diego County – $2,000,000; Los Angeles County – $2,000,000; San Francisco County – $2,000,000; San Mateo County – $2,000,000; Santa Clara County – $2,000,000. The Texas threshold is as follows: Bexar County – $500,000.

2000px-Seal_of_the_United_States_Department_of_Justice_svgOriginally published by the International Enforcement Law Reporter (Feb. 10, 2017)

By Matthew D. Lee[1]

On December 29, 2016, the Justice Department’s Tax Division announced that it had reached final resolutions with the remaining “Category 3 and 4” Swiss banks that had enrolled in the Swiss Bank Program.[2] Originally unveiled in August 2013, the Swiss Bank Program provided a path for Swiss banks to resolve their potential criminal exposure under U.S. tax laws, and to cooperate in the Justice Department’s ongoing investigations of the use of foreign bank accounts by U.S. taxpayers to commit tax evasion. The Swiss Bank Program also provided a mechanism for those Swiss banks that were not engaged in wrongful acts but nonetheless wanted a resolution of their status. Originally viewed with skepticism by some critics, the Swiss Bank Program ultimately proved to be an overwhelming success, with 80 “Category 2” banks resolving their potential liability under U.S. law and paying nearly $1.4 billion in penalties. As the program now enters its “legacy” phase, Justice Department prosecutors and Internal Revenue Agents are working closely with all banks in the program to pursue leads around the globe to further additional investigations of foreign financial institutions, professionals, and individual U.S. taxpayers for offshore tax evasion.

Background Regarding the Swiss Bank Program

The Swiss Bank Program, unveiled on August 29, 2013, provided a path for Swiss banks to resolve potential criminal liabilities in the United States. Swiss banks eligible to enter the program were required to advise the Justice Department no later than December 31, 2013, that they had reason to believe that they had committed tax-related criminal offenses in connection with undeclared U.S.-related accounts. Banks already under criminal investigation related to their Swiss-banking activities and all individuals were expressly excluded from the program.

Under the program’s terms, participating banks were required to: make a complete disclosure of their cross-border activities; provide detailed information on an account-by-account basis for accounts in which U.S. taxpayers have a direct or indirect interest; cooperate in treaty requests for account information; provide detailed information as to other banks that transferred funds into secret accounts or that accepted funds when secret accounts were closed; agree to close accounts of accountholders who fail to come into compliance with U.S. reporting obligations; and pay appropriate penalties.

Any Swiss bank meeting all of the above requirements was eligible for a non-prosecution agreement, ensuring that it would not be subject to criminal prosecution in the United States.

Categories of Swiss Banks

The Swiss Bank Program established four categories of Swiss financial institutions based upon their perceived liability for potential violations of U.S. laws. “Category 1” included Swiss banks already under investigation when the program was announced; such institutions were not eligible to participate in the program. Banks in this category included UBS AG, Credit Suisse AG, Wegelin & Co., and Zurcher Kantonalbank, among others.

“Category 2” was reserved for banks that advised the Justice Department by December 31, 2013, that they had reason to believe that they had committed tax-related criminal offenses in connection with undeclared U.S. related accounts. To obtain a non-prosecution agreement, Category 2 banks were required to make a complete disclosure of their cross-border activities, provide detailed information on accounts in which U.S. taxpayers have a direct or indirect interest, cooperate in treaty requests for account information, provide detailed information as to other banks that transferred funds into hidden accounts or that accepted funds when those secret accounts were closed, and cooperate in any related criminal and civil proceedings for the life of those proceedings. Category 2 banks were also required to pay financial penalties based upon the number of U.S.-related accounts they serviced.

“Category 3” was designed for banks that established, with the assistance of an independent internal investigation of their cross-border business, that they did not commit tax or monetary transaction-related offenses and had an effective compliance program in place. Category 3 banks were required to provide the Justice Department with an independent written report that identified witnesses interviewed and a summary of each witness’s statements, files reviewed, and factual findings and conclusions. In addition, Category 3 banks were required to appear before the Justice Department and respond to any questions related to the report or their cross-border business, and to close accounts of accountholders who failed to come into compliance with U.S. reporting obligations. Upon satisfying these requirements, Category 3 banks were entitled to receive a non-target letter.

“Category 4” was reserved for Swiss banks that were able to demonstrate that they met certain criteria for deemed-compliance under the Foreign Account Tax Compliance Act (FATCA), a U.S. anti-tax evasion law enacted in 2010. Category 4 banks also were eligible for a non-target letter.

Category 1 Bank Resolutions

To date, a number of “Category 1” banks have reached resolutions of their potential criminal exposure under the U.S. tax laws with the Justice Department. The largest Swiss bank, UBS AG, entered into what was then considered a landmark deferred prosecution agreement in February 2009, agreeing to pay nearly $800 million, revamp its cross-border business, and hand over the identities of certain U.S. clients. The second largest Swiss bank, Credit Suisse, pleaded guilty in federal court to conspiracy to defraud the United States and paid $2.6 billion, the largest fine ever imposed in a criminal tax case. Other notable Category 1 banks which have reached resolutions with the U.S. include Wegelin Bank (Switzerland), Bank Leumi (Israel), and Bank Julius Baer (Switzerland). To date, a total of eight Category 1 financial institutions have resolved their criminal exposure under U.S. law, and several others remain under criminal investigation at this time.

Category 2 Resolutions

Between March 2015 and January 2016, the Justice Department executed non-prosecution agreements with 80 Category 2 banks and collected more than $1.36 billion in penalties. The Justice Department also signed a non-prosecution agreement with Finacor, a Swiss asset management firm, reflecting what the Justice Department described in a press release as its “willingness to reach fair and appropriate resolutions with entities that come forward in a timely manner, disclose all relevant information regarding their illegal activities and cooperate fully and completely, including naming the individuals engaged in criminal conduct.”[3]

Category 3 and 4 Resolutions

The Justice Department’s announcement in late December revealed that between July and December 2016, four banks and one bank cooperative satisfied the requirements of Category 3, making them eligible for non-target letters. No banks qualified under Category 4 of the program. The Justice Department did not announce the names of any of the qualifying Category 3 banks, nor did it release the names of the banks which failed to qualify as Category 4 institutions. Earlier this year Swiss bank Thurgauer Kantonalbank announced that it had received a non-target letter from the Justice Department, thus qualifying as a Category 3 institution.[4] The identities of the remaining Category 3 banks have not yet been made public.

Reflections on the Swiss Bank Program as it Enters “Legacy” Phase

The Swiss Bank Program has been an unqualified success for the U.S. government’s aggressive campaign to crack down on offshore tax evasion. Never before had the Justice Department offered what is essentially a tax evasion “amnesty” program to an entire country’s financial industry, leading some critics to initially question whether any Swiss banks would come forward given the historical secrecy that enveloped that sector. Those critics have been resoundingly proven wrong, given the overwhelming demonstration of interest in the program by Swiss banks and the significant amount of information that the program has generated for the Justice Department and Internal Revenue Service.

The Justice Department’s announcement of final resolutions with Category 3 and 4 banks does not, however, mark the conclusion of the Swiss Bank Program. Instead, the program is now enters what Justice Department calls its “legacy phase,” pursuant to which all participating Swiss banks are cooperating with ongoing civil and criminal investigations in the United States. The Swiss Bank Program is undoubtedly affording U.S. prosecutors and IRS agents a wealth of leads that they will use to “follow the money” around the globe in a continued effort to hold financial institutions, advisors, and account holders liable if they engage in evasion of U.S. tax laws. At the same time, the resolution of the Swiss Bank Program further ratchets up the pressure on non-compliant taxpayers, as the price of admission to the Offshore Voluntary Disclosure Program (OVDP) has dramatically increased for those who maintained secret accounts at any of the Swiss banks that have now resolved their potential liabilities with the U.S.

Given the tremendous success of the Swiss Bank Program, it remains to be seen whether the Justice Department will offer a similar program to banks in other countries or regions. Regardless of whether a formal program akin to the Swiss Bank Program is announced, financial institutions around the globe would be well-advised to take affirmative steps to attempt to resolve any potential exposure they may have under U.S. criminal laws. The Justice Department has long said that it would entertain voluntary disclosures of potential criminal activity from any bank, and that such self-corrective action – assuming it is timely and constitutes a full and complete disclosure – would be viewed favorably by the government officials in determining whether criminal prosecution is warranted.

[1]      Matthew D. Lee is a partner at Fox Rothschild LLP in Philadelphia and a member of his firm’s White-Collar Compliance and Defense practice group. A former U.S. Department of Justice trial attorney, Mr. Lee is the author of The Foreign Account Tax Compliance Act Answer Book 2016 (Practising Law Institute).

[2]     See Department of Justice Press Release, “Justice Department Reaches Final Resolutions Under Swiss Bank Program” (Dec. 29, 2016).

[3]     See Department of Justice Press Release, “Swiss Asset Management Firm Finacor SA Reaches Resolution with Justice Department” (Oct. 6, 2015).

[4]     See https://www.tkb.ch/tkb/medien/medienmitteilungen.htm?go1CDIccbRxIYVr4qeDJyxIIAoxlk7CxJxlD (last visited Feb. 1, 2017).

Seal_of_the_United_States_Tax_Court_svgOn January 30, 2017, Judge Goeke of the United States Tax Court issued an opinion rejecting a taxpayer’s asserted reasonable cause defense for failure to file Forms 5471, which are entitled “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” See Flume v. Commissioner, T.C. Memo. 2017-21. At issue in the case was whether the taxpayer, a U.S. citizen residing in Mexico, was liable for penalties for failing to declare his ownership interests in two foreign corporations for tax years 2001 through 2009. The Court’s opinion is one of the few cases to address the meaning of “reasonable cause” in the context of Forms 5471, and by following established case law on reasonable cause in other penalty contexts, it establishes a high bar for any taxpayer seeking penalty relief in the Form 5471 context, especially if the taxpayer was less than forthcoming with their return preparer.

Form 5471 Reporting Obligations

IRC § 6038(a)(1) imposes information reporting requirements on any U.S. person who “controls” a foreign corporation. A person controls a foreign corporation if he or she owns, or constructively owns, stock that is more than 50 percent of the total combined voting power of all classes of voting stock or owns more than 50 percent of the total value of shares of all classes of stock. Id. § 6038(e)(2). A U.S. person must furnish, with respect to any foreign corporation which that person controls, information that the Secretary of the Treasury “may prescribe.” Id. § 6038(a)(1). Form 5471 is used to satisfy the § 6038 reporting requirements, and must be filed with the U.S. person’s timely-filed federal income tax return. Treas. Reg. § 1.6038-2(i).

IRC § 6046 requires information reporting by each U.S. citizen or resident who is at any time an officer or director of a foreign corporation, where more than 10 percent (by vote or value) of stock is owned by a U.S. person. Id. § 6046(a)(1)(A). The stock ownership threshold is met if a U.S. person owns 10 percent or more of the total value of the foreign corporation’s stock or 10 percent or more of the total combined voting power of all classes of stock with voting rights, id. § 6046(a)(2), and attribution rules apply to stock held by family members. Id. § 6046(c). A U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement is required to provide certain information with respect to the foreign corporation. Treas. Reg. § 1.6046-1(c)(1)(ii)(c). Form 5471 is used to satisfy the § 6046 reporting requirements, and must be filed with the U.S. person’s timely-filed federal income tax return. Treas. Reg. § 1.6046-1(j)(1).

When a taxpayer, who was required to do so, fails to complete and file Form 5471 on time, a fixed penalty of $10,000 per foreign corporation per annual accounting period is imposed. IRC §§ 6038(b)(1), 6679. If any failure to provide the required information continues for more than 90 days after the day on which IRS mails notice of the failure to the U.S. person, the person shall pay an additional penalty of $10,000 for each 30-day period, or fraction thereof, during which the failure continues. The “continuation” penalty may not, however, exceed $50,000. Id. § 6038(b)(2), 6046(f), 6679(a).

Form 5471 and its accompanying instructions set forth four categories of persons required to file the form. A category 2 filer is a U.S. person who is an officer or director of a foreign corporation in which a U.S. person owns at least 10 percent of the company’s shares by vote or value. See IRC § 6046(a)(1)(A). A category 3 filer is a U.S. person who acquires, or disposes of, 10 percent or more of stock in a foreign corporation. See id. § 6046(a)(1)(B). A category 4 filer is a U.S. person who “controls” a foreign corporation by owning more than 50 percent of the stock of the foreign corporation (by vote or value). See id. § 6038(a)(1), (e). A category 5 filer is a U.S. person who is a U.S. shareholder of a “controlled foreign corporation,” which is defined as a foreign corporation in which U.S. shareholders own more than 50 percent of the company’s stock (by vote or value).

To avoid penalties for failure to file Form 5471, a taxpayer must make an affirmative showing that the failure to furnish the appropriate information with his or her return was due to “reasonable cause.” IRC § 6038(c)(4)(B); 6679(a)(1).

The Court’s Analysis of “Reasonable Cause”

In Flume, the IRS assessed initial and continuation penalties against the taxpayer based upon his failure to file Forms 5471 to declare his ownership interests in a Mexican corporation and a Belizean international business company. In response, the taxpayer asserted a commonly-heard defense for non-filing of Forms 5471: his return preparer did not advise him that he was required to do so.

In evaluating the taxpayer’s assertion of “reasonable cause,” the Court began by noting that there are no regulations defining “reasonable cause” within the specific context of IRC § 6038. The Court further noted the few cases addressing this issue have followed the Supreme Court’s definition of reasonable cause as articulated in United States v. Boyle, 469 U.S. 241, 246 (1985). See Congdon v. United States, No. 4:09-CV-289, 2011 WL 3880524, at *2 (E.D. Tex. Aug. 11, 2011); In re Wyly, 552 B.R. 338, 442 (Bankr. N.D. Tex. 2016). In Boyle, the Supreme Court held to establish reasonable cause, the taxpayer must demonstrate that he exercised ordinary business care and prudence but nevertheless was unable to file within the prescribed time. Boyle, 469 U.S. at 246.

The Court next observed that similar rules apply with respect to the civil penalties imposed under IRC § 6679 for failure to file information required under IRC § 6046. Sec. 6679(a)(1); Treas. Reg. § 301.6679-1(a). If a taxpayer exercises ordinary business care and prudence and is nevertheless unable to obtain and provide the required information, a failure to file will be considered to be due to reasonable cause. Treas. Reg. § 301.6679-1(a)(3).

The taxpayer claimed that his return preparer failed to advise him that he was required to file Forms 5471 for his foreign corporations. The Court therefore evaluated the taxpayer’s reasonable cause assertion through the legal standards utilized when a taxpayer claims reliance on a professional. To establish reasonable cause through reliance on a tax adviser’s advice, the Court noted that the taxpayer must prove: (i) the adviser was a competent professional with sufficient expertise; (ii) the taxpayer provided necessary and accurate information to the adviser; and (iii) the taxpayer relied in good faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

At trial, the taxpayer testified that he did not inform his return preparer of his interests in the two foreign corporations. The Court thus held the taxpayer failed to satisfy the second prong of the Neonatology prong because he did not provide his preparer with all necessary information. As a result, the taxpayer was barred from reasonably relying on his tax return preparer’s advice and therefore failed to show reasonable cause for his failure to file Forms 5471.

Notably, while the Flume opinion notes that the taxpayer failed to make full disclosure to his return preparer, it does not provide important additional details relevant to evaluating that finding. The opinion does not state whether the preparer affirmatively asked the taxpayer about ownership of foreign corporations, and the taxpayer withheld information in response, or if instead the return preparer did not inquire, and the taxpayer failed to affirmatively volunteer information about his foreign corporations without prompting. There is a significant difference between these two scenarios, particularly in the case of a taxpayer (like Flume) who resides outside of the United States and may not be familiar with the obligation to disclose ownership of foreign corporations.

The Tax Court’s decision in Flume confirms that the interaction between the taxpayer and his or her return preparer is of critical importance in assessing reasonable cause. The opinion seemingly forecloses the ability to assert reasonable cause where the taxpayer fails to advise the return preparer of the existence of foreign corporations. Reasonable cause would only be found where the taxpayer makes full disclosure of the foreign ownership, and the return preparer nonetheless advises that no Forms 5471 are required. Flume does not address how this outcome might change if the preparer failed to inquire of the taxpayer, and the taxpayer is unsophisticated and unaware of the Form 5471 duty to disclose foreign corporation ownership; this scenario may still present an opportunity for reasonable cause relief.

2000px-Seal_of_the_United_States_Department_of_Justice_svgEnsuring that employers collect and pay over to the Internal Revenue Service taxes withheld from their employees’ wages is one of the highest priorities of the Justice Department’s Tax Division. Unpaid employment taxes are a substantial problem for the U.S. government, as amounts withheld from employee wages represent nearly 70 percent of all revenue collected by the IRS. As of June 30, 2016, more than $59.4 billion of federal employment taxes remained unpaid, and employment tax violations represent more than $91 billion of the “Tax Gap,” which represents the difference between the amount of taxes owed to the U.S. Treasury and the amount actually collected. In this context, several recent criminal prosecutions demonstrate the perils businesses, and their officers, face if they fail to carry out their legal duty to remit employment taxes to the IRS.

Background

Employers have a legal responsibility to collect and pay over to the IRS taxes withheld from their employees’ wages. These employment taxes include withheld federal income tax, as well as the employees’ share of social security and Medicare taxes (collectively known as FICA taxes). Employers also have an independent responsibility to pay the employer’s share of FICA taxes. The IRS takes the position that when employers willfully fail to collect, account for, and deposit with the IRS employment tax due, they are stealing from their employees and ultimately, the U.S. Treasury. The IRS also contends that employers who willfully fail to comply with their obligations and unlawfully line their own pockets with amounts withheld are gaining an unfair advantage over their honest competitors.

The Justice Department’s Tax Division pursues civil litigation to enjoin employers who fail to comply with their employment tax obligations and to collect outstanding amounts assessed against entities and responsible persons. In the last two years, in an effort to send a clear message to delinquent employers who treat taxes withheld from employee wages as a personal slush fund or loan that can be put off or ignored entirely, the Justice Department filed 55 injunction complaints in federal courts across the country and obtained 47 permanent injunctions. These injunctions require the timely deposit of employment tax and filing of employment tax returns, prompt notice to the IRS after each deposit, and notice to the IRS if the employer begins operating a new business. In addition, the injunctions preclude employers from assigning property or making payments to other creditors until the company’s employment tax obligations are paid.

The Tax Division also investigations and prosecutes individuals and entities who willfully fail to comply with their employment tax responsibilities, as well as those who aid and assist them in failing to meet those responsibilities. According to former Principal Deputy Assistant Attorney General Caroline D. Ciraolo, “[t]he willful failure to comply with employment tax obligations is a crime – plain and simple. Stealing employee withholdings and failing to pay them over to the U.S. Treasury, gives dishonest employers an unfair advantage over their law-abiding competitors. The department will continue to work with the Internal Revenue Service to prosecute these offenders and level the playing field.”

Recent Employment Tax Criminal Cases

On January 26, 2017, two West Virginia business owners were sentenced to prison for failing to pay over employment taxes. Michael Taylor and his wife, Jeanette Taylor, were sentenced to serve 21 months and 27 months in prison, respectively. According to documents filed with the court, from 2000 through 2010, the Taylors owned and operated a construction business that transported steel and sold gravel and concrete throughout West Virginia and Kentucky. The Taylors changed the name of the business several times, though the operations of the business remained the same. From 1999 to 2004, the business was operated as Taylor Contracting & Taylor Ready-Mix LLC. In 2004, the name changed to Taylor Contracting/Taylor Ready-Mix LLC. In 2010, the name changed a third time to Bluegrass Aggregates. Both Michael Taylor and Jeanette Taylor were responsible for collecting, accounting for, and paying over to the IRS federal income taxes and social security and Medicare taxes that were withheld from the wages of their employees. From July 2007 through 2010, the Taylors withheld over $850,000 from their employees’ paychecks, but instead of paying over the withheld taxes to the IRS, the Taylors used the funds to purchase property and finance their horse farm. The Taylors also failed to pay over $490,000 in employment taxes for their prior business. The total tax loss for the Taylors’ conduct is $1.4 million. In addition to the term of prison imposed, Michael Taylor was ordered to pay $1,440,130 in restitution to the IRS. Jeanette Taylor was ordered to pay $766,273 jointly and severally with Michael Taylor to the IRS.

On January 12, 2017, a Pittsburgh tax attorney was sentenced to four years in prison for failing to remit employment taxes to the IRS. According to court documents and the evidence presented at trial, between 2004 and 2015, Steven Lynch co-owned and operated the Iceoplex at Southpointe, a recreational sports facility located in Washington County, Pennsylvania. Iceoplex included a fitness center, ice rink, soccer court, restaurant and bar. Lynch controlled the finances for these businesses and was responsible for collecting, accounting for, and paying over tax withheld from employee wages, and timely filing quarterly employment tax returns. The jury found that between 2012 through 2015, Lynch failed to timely pay over to the IRS more than $790,000 in taxes withheld from the wages of the employees for these businesses. In addition to the prison term sentence, the Court ordered Lunch to pay $793,145 in restitution to the IRS.

On December 15, 2016, an Iowa businessman was sentenced to 13 months in prison after pleading guilty to failing to pay employment taxes. Darrell Smith was the president and general partner of Energae, which was a minority investor in Permeate Refining LLC., an ethanol-production business in Hopkinton, Iowa. In his position at Energae, Smith had significant control over the finances of Permeate and was responsible for paying over to the IRS employment taxes on behalf of Permeate’s employees. From the first quarter of 2011 through the third quarter of 2012, Smith failed to pay over $502,863. After Smith discovered that a subordinate employee had made some payments to the IRS, Smith stopped that employee from making further payments.

On October 24, 2016, the owner of several Nevada landscaping and rock hauling businesses was sentenced to 10 months in prison for failure to pay over employment taxes. In addition, the company’s bookkeeper was sentenced to five years’ probation with three months home confinement for willful failure to file an employment tax return. According to documents filed with the court, Kyle Archie was the part owner of Reno Rock Inc., GKPA Inc., and D Rockeries Inc. Kyle Archie admitted that he was responsible for the day-to-day operations of the businesses and that from 2003 through 2009, he had a legal duty to collect, truthfully account for, and pay over employment taxes to the IRS. He further admitted that although he collected these taxes from his employees’ wages and held them in trust, he failed to pay them over to the IRS for the third quarter of 2008. Linda Archie, who is Kyle Archie’s mother, worked as the bookkeeper for Reno Rock Inc., GKPA Inc., and D. Rockeries Inc. and was responsible for maintaining the books and records of the companies and filing documents with various government agencies. She admitted that between 2003 and 2009, she failed to file employment tax returns on behalf of these businesses to account for the taxes that were withheld from the employees’ wages. The Court also ordered both Kyle and Linda Archie to pay restitution to the IRS in the amount of $1,235,528.

Conclusion

These criminal cases demonstrate the harsh consequences that employers face if they willfully fail to comply with their legal duty to collect and remit employment taxes. Such cases will not simply be addressed civilly by the IRS with back payment of taxes and penalties by the employer, but instead may be criminally prosecuted and with responsible corporate officers facing prison sentences. This is particularly the case if the withheld taxes are used to pay personal expenses of the business owners and/or to fund luxurious lifestyles. The Justice Department and IRS are especially focused on “pyramiding,” which refers to the common practice of repeatedly filing bankruptcy once a substantial employment tax liability has accrued and opening a new business entity so as to avoid the payment of employment taxes, as occurred in the Taylor case described above. And the “willfulness” legal standard is not particularly difficult for prosecutors to satisfy, as nearly all employers are aware of their obligation to remit taxes withheld from their employees’ paychecks. Employers must take special care to ensure that withheld employment taxes are property remitted to the IRS given the intense focus now being paid to this area by the Justice Department and IRS.

The Internal Revenue Service opened the 2017 tax filing yesterday, announcing that more than 153 million returns are expected to be filed this year. The tax filing deadline for this season is not April 15 – the date universally viewed as “Tax Day” – but is instead Tuesday, April 18, 2017. Taxpayers are afforded three extra filing days this year because April 15 falls on a Saturday, and the next business day (April 17) is a holiday observed only in the District of Columbia. By law, holidays observed in District of Columbia are treated as federal holidays nationwide for purposes of the filing deadline, thereby moving the tax deadline to April 18.

As is typically the case, the opening of the tax filing season was accompanied by several well-publicized enforcement actions by the Justice Department intended to warn potential tax cheats of the perils of filing a false tax return. The enforcement actions target “return preparer fraud,” previously identified as one of the IRS’ “Dirty Dozen Tax Scams for 2016.” According to the IRS, about 60 percent of taxpayers use tax professionals to prepare their returns. While the vast majority of tax professionals provide honest, high-quality service, the IRS is focused on dishonest preparers who perpetrate refund fraud by promising their clients overly large refunds utilizing unscrupulous tactics in preparing tax returns.

In the first action, the Justice Department announced that it had filed a civil lawsuit seeking to shut down a tax return preparer in Broward County, Florida. The suit, filed in federal court in Fort Lauderdale, asks the court to permanently bar the preparer, Billy Philippe, from preparing federal tax returns for others and asks the court to order Philippe to turn over a list of all the tax returns he has prepared since January 1, 2012. In its complaint, the Justice Department alleges that Philippe prepares federal income tax returns for customers that fraudulently overstate the amount of the refunds due by falsely claiming refundable credits, including the Earned Income Tax Credit (EITC) and credits for education expenses. The complaint further alleges that Philippe frequently claims fraudulently inflated wages or self-employment income in order to maximize the amount of EITC a customer claims. The IRS previously penalized Philippe over $24,000 for failure to exercise the due diligence required to claim the EITC for his customers and the failure to properly identify himself as the paid return preparer, according to the complaint. From 2011 to 2015, Philippe prepared at least 899 returns, according to the complaint. The complaint alleges that audits of 44 returns prepared by Philippe in 2014 and 2015 revealed that he claimed credits his customers were not entitled to take and/or understated their correct tax liability by more than $300,000 in the aggregate.

In the second action, the Justice Department announced that it had successfully convinced a federal judge to shut down an unscrupulous return preparer located in Sterling, Illinois. The court’s order permanently prohibits the preparer, Daria Emma Valdivia, from preparing federal tax returns for others and requires her to turn over to the IRS a list of all persons for whom she prepared federal tax returns since 2012. According to the lawsuit, the preparer routinely prepared tax returns for customers that falsely claimed unqualified individuals as dependents, such as persons who did not live in the United States or a country contiguous to the United States. The complaint also alleged that the preparer also improperly reported her customers’ filing status as “Head of Household” when the customers were ineligible for that status. The complaint further alleged that the preparer continued to engage in this conduct even after the IRS assessed her with $132,000 in penalties for similar misconduct. Finally, the complaint alleged that IRS audits of 65 returns show that the preparer underreported her customers’ tax liabilities on 89 percent (58) of them by more than $285,000 collectively.

Both press releases contain identical warnings to taxpayers to be careful in selecting a return preparer so as to avoid falling prey to a fraudulent return preparer:

The IRS is reminding taxpayers that the 2017 individual income tax return filing season begins today, Jan. 23, 2017, and there is information available on the IRS’s website. Return preparer fraud was one of the IRS’s Dirty Dozen Tax Scams for 2016 and taxpayers seeking a return preparer should remain vigilant. The IRS has some tips on their website for choosing a tax preparer and has launched a free directory of federal tax preparers. In the past decade, the Tax Division has obtained injunctions against hundreds of unscrupulous tax preparers. Information about these cases is available on the Justice Department’s website. An alphabetical listing of persons enjoined from preparing returns and promoting tax schemes can be found on this page. If you believe that one of the enjoined persons or businesses may be violating an injunction, please contact the Tax Division with details.

In a third action, the Justice Department announced that the owner of multiple tax preparation businesses located in Illinois, Kansas, and Missouri was sentenced to 27 months in prison for tax evasion. According to the press release announcing the sentence, the defendant, Semere Tsehaye, owned 20 Instant Tax Service franchise locations between 2005 and 2011, and during certain of those years he substantially unreported his gross receipts by providing his return preparer with fraudulent financial summaries. The defendant underreported his gross receipts by nearly $550,000 in 2010, and by over $1 million in 2011. In addition to a jail sentence, the court required the defendant to pay nearly $300,000 in restitution to the IRS.

It is well-known that the IRS and Justice Department typically increase the frequency of their press releases announcing enforcement activity in the weeks leading up to the filing deadline. In fact, academic research confirms that these agencies issue a disproportionately large number of tax enforcement press releases as “Tax Day” approaches:

Every spring, the federal government appears to deliver an abundance of announcements that describe criminal convictions and civil injunctions involving taxpayers who have been accused of committing tax fraud. Commentators have occasionally suggested that the government announces a large number of tax enforcement actions in close proximity to a critical date in the tax compliance landscape: April 15, “Tax Day.” These claims previously were merely speculative, as they lacked any empirical support. This article fills the empirical void by seeking to answer a straightforward question: When does the government publicize tax enforcement? To conduct our study, we analyzed all 782 press releases issued by the U.S. Department of Justice Tax Division during the seven-year period of 2003 through 2009 in which the agency announced a civil or criminal tax enforcement action against a specific taxpayer identified by name. Our principal finding is that, during those years, the government issued a disproportionately large number of tax enforcement press releases during the weeks immediately prior to Tax Day compared to the rest of the year and that this difference is highly statistically significant. A convincing explanation for this finding is that government officials deliberately use tax enforcement publicity to influence individual taxpayers’ perceptions and knowledge of audit probability, tax penalties, and the government’s tax enforcement efficacy while taxpayers are preparing their annual individual tax returns.

Joshua D. Blank and Daniel Z. Levin, When Is Tax Enforcement Publicized?, 30 Virginia Tax Review 1 (2010).

As “Tax Day 2017” approaches, we can expect similar — and more frequent — announcements intended to deter would-be tax cheats from filing false tax returns.

2000px-Seal_of_the_United_States_Department_of_Justice_svgIn December, the Justice Department announced criminal charges against John Yin, a software salesman who worked for a Canadian company that sells point of sale (POS) software programs that enabled restaurants to underreport their sales, thereby lowering their tax liability.[1] Commonly called “zapper” programs, these revenue suppression software (RSS) programs are used to delete some or all of a restaurant’s cash transactions and then reconcile the books of the business.

The result is that the company’s books appear to be complete and accurate, but are in fact false because they reflect fewer sales than were actually made. State authorities have been trying to combat the use of zappers by cash intensive businesses like restaurants for years, and the Yin case is significant because the government’s investigation revealed that the defendant marketed and sold zapper software throughout the Seattle area to multiple restaurants over the course of several years.

Yin pleaded guilty to a widespread scheme to defraud federal and state tax authorities, resulting in the avoidance of more than $3.4 million in taxes. This case is undoubtedly only the tip of the iceberg, as charges against other defendants will almost certainly result from Yin’s guilty plea.

The Alleged Offenses

According to the publicly-filed charging document and guilty plea agreement, Yin worked as a salesman for Profitek, a British Columbia company selling POS systems for hospitality and retail industries, from at least 2009 through mid-2015. In addition to its Canadian headquarters, Profitek has offices in China and a growing dealership network across North America.

Profitek designed, marketed, sold, and supported revenue suppression software as an “add-on” to its Profitek point-of-sale software. The RSS functioned only with the Profitek POS software. POS software creates a database of transactions that is used to calculate a business’ tax obligations. RSS is used to modify a business’ POS database for the sole purpose of hiding cash skimming.

When executed, the RSS program deletes all or some of the business’s cash transactions, and then reconciles the books of the business. The result is business records that appear to be complete and accurate but, in fact, are false and fraudulent in that they show less than total income earned.

Yin acknowledged in his guilty plea agreement that he successfully sold the POS software, and assisted in the widespread distribution of the zapper software, to dozens of customers in and around Seattle over the course of several years. The zapper software could only be ordered from a supplier in China, so Yin would put his clients in touch with the Chinese company and facilitate their purchase of the software. Yin also serviced the zapper software once his clients purchased and installed it.

Yin further admitted that his clients’ use of zapper software allowed them to consistently and significantly underpay their various federal, state and local taxes, including business and occupation taxes, Social Security and Medicare taxes and federal income taxes.

The plea agreement states that eight restaurants in the Seattle area were audited by the Washington State Department of Revenue and found to be using Yin’s zapper software. The total amount of state sales and federal income taxes avoided by these establishments during the period 2010 through 2013 were determined as follows:

Restaurant 1 $218,447.75
Restaurant 2 $498,666.75
Restaurant 3 $302,222.25
Restaurant 4 $472,222.25
Restaurant 5 $565,952.75
Restaurant 6 $332,433.00
Restaurant 7 $145,319.75
Restaurant 8 $910,324.50

These amounts do not include unpaid Social Security and Medicare taxes. The grand total of unpaid taxes attributable to zapper software sold by Yin is $3,445,589.00.

Yin entered a guilty plea on Dec. 2, 2016, to two federal charges: (1) wire fraud; and (2) conspiracy to defraud the U.S. government. The wire fraud charge is based upon Yin’s use of email to communicate with the Chinese supplier of the zapper software purchased by many of his clients. The conspiracy charge is based upon Yin’s efforts to facilitate the use of zapper software by his clients for purposes of underreporting taxable income required to be reported on federal income tax returns.

Based upon the agreed-upon tax loss of $3.4 million, at sentencing Yin is facing a potential sentence of 37 to 46 months in prison as calculated by the United States Sentencing Guidelines. As part of his guilty plea, Yin agreed to make full restitution, in the amount of $3,445,589, to the IRS and Washington State. Sentencing is scheduled for Feb. 24, 2017.

The publicly-filed court documents are silent as to whether Yin is cooperating with ongoing federal and state investigations of restaurants suspected of using zapper software. Given the widespread use of such software by Yin’s clients and the substantial jail sentence he is facing, it is reasonable to assume that he is cooperating in order to earn leniency at sentencing. As a result, charges against additional defendants are likely.

State Efforts to Combat Use of Zapper Software

Historically, state law enforcement agencies, not the U.S. Department of Justice or the Internal Revenue Service, have taken the lead in cracking down on the use of revenue suppression software. In early 2016, the attorney general of Washington state filed what he called a “first-of-its-kind” criminal case against a restauranteur, Yu-Ling Wong, for allegedly using sales suppression software to avoid paying nearly $400,000 in state sales tax.[2]

That case, which evidently spawned the federal prosecution of Yin, began as a routine audit by the Washington State Department of Revenue, which trains its auditors to detect the use of revenue suppression software. Auditors noted an unusual change in cash receipts, as compared to the restaurant’s historical cash receipts, determined that the restaurant’s point-of-sale system could not be trusted, and eventually uncovered the use of zapper software provided by Yin.

The case was thereafter referred for criminal prosecution, and state attorney general executed a search warrant at Yin’s residence. During a law enforcement interview conducted during execution of that search warrant, Yin admitted he sold the zapper software in approximately 2007 and trained a purchaser in how to use it.

Many states have passed laws outlawing the use of revenue suppression software, including Washington, Michigan, Florida, Georgia, Utah and West Virginia, and others are considering proposals to enact such laws. And the problem is not just confined to the United States. In a 2013 report entitled “Electronic Sales Suppression: A Threat to Tax Revenues,” the Organisation for Economic Co-operation and Development concluded that revenue suppression software “facilitate[s] tax evasion and result[s] in massive tax loss globally.”

Increasing Federal Attention to Zapper Software?

The Yin case suggests that federal authorities may take a greater interest in prosecuting restaurants and other cash intensive businesses that make use of revenue suppression software. The investigation of Yin and his subsequent guilty plea have opened a window into what appears to be widespread and longtime use of zapper software by restaurants throughout the Seattle area, and additional charges are expected.

The IRS has trained revenue agents to look for evidence that zapper software may be used, and its “Cash Intensive Businesses Audit Techniques Guide” specifically instructs agents to focus on point-of-sale software when auditing restaurants and bars. In addition, increasing vigilance by state auditors of cash intensive businesses will likely spawn additional federal prosecutions just as occurred in the Yin investigation.

Reprinted with permission from Law360. (c) 2017 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

In our previous post, found here, we discussed the IRS Notice designating certain micro-captive transactions as “transactions of interest” required to be disclosed to the IRS by participants and material advisors.  In Notice 2017-08, the IRS extended the deadlines for meeting the reporting requirements set forth in Notice 2016-66.  Interested parties should review both notices and consult with a tax advisor to determine the appropriate filings and deadlines based on their individual situation.