August 23, 2018
Articles
Law360
By Matthew D. Lee

Two weeks ago federal prosecutors announced criminal tax charges against the owners of five Chicago-area restaurants as part of an ongoing federal investigation into the underreporting of gross receipts using sales suppression software. The charges allege that the defendants willfully avoided paying the full amount of federal taxes by reporting gross receipts that were substantially lower than the true amounts. This case appears to be the largest and perhaps most significant federal criminal case to date against businesses that use sale suppression techniques to conceal revenue from tax authorities.

Commonly called “zappers,” sales suppression software programs run on a point-of-sale computers or cash registers and are used to secretly delete some or all cash transactions. 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. An article published by BNA last year reported that tax-zapping software costs states $21 billion in taxes annually and that 30 percent of the electronic cash registers, or point-of-sale systems, in the United States have a zapper installed.

To date, state attorneys general and revenue departments have taken the lead in cracking down on businesses that use sales suppression techniques. In the last two years, state authorities in Washington, Minnesota, Michigan, Illinois and Connecticut have successfully prosecuted criminal cases against businesses and their owners — primarily in the restaurant industry. Washington’s attorney general has been particularly aggressive in this area, filing earlier this year what he called the largest sales suppression case in the state’s history and two years ago what he called the “first-of-its-kind” zapper prosecution. In addition, numerous states have also passed laws outlawing the use of zappers and other types of sales suppression devices.

The Internal Revenue Service has been conspicuously absent from efforts to prosecute businesses and their owners for use of zappers, leading many to wonder whether the IRS would ever play a role or leave the anti-zapper efforts to the states. The only notable federal case to date involved John Yin, a salesman for a company that sold sales suppression software who was charged in December 2016. Yin sold zapper software to businesses in the Seattle area from at least 2009 through mid-2015. He pleaded guilty to assisting in the widespread distribution of zappers to dozens of customers in and around Seattle over the course of several years, and was eventually sentenced to 18 months in prison. While we expected a wave of federal prosecutions to follow the Yin case, that has not yet materialized (at least not publicly).

The federal charges in Chicago are the first federal charges in a zapper case since the Yin case. Five separate, and for the most part unrelated, business owners were charged in what was described as a “federal investigation targeting underreporting of gross receipts.” It appears that the federal investigation may have been prompted by a prior state case against one of the defendants. In August 2017, Illinois Attorney General Lisa Madigan announced charges against Sandra Sanchez, owner of Cesar’s Restaurant in Chicago. In that case, Sanchez was charged with theft and tax evasion for defrauding the state out of more than $100,000 by using a sales suppression device to underreport more than $1 million in sales to the Illinois Department of Revenue. The Attorney General alleged that between January 2012 and October 2015, Sanchez used a zapper to falsify electronic sales records to avoid paying the full amount of sales and use taxes to the state each month. The Sanchez prosecution was the first zapper case prosecuted in Illinois, following the state’s enactment of anti-zapper legislation in 2013. The press release announcing the charges noted that IRS criminal investigators assisted in the investigation. The Illinois Attorney General has not issued any subsequent press releases regarding this case, so it is not clear whether Sanchez has pleaded guilty or will be proceeding to trial or is cooperating with investigators.

Sandra Sanchez was one of the five individuals charged federally in Chicago two weeks ago. And the press release announcing the charges noted that she was charged by information, not by indictment, indicating that she has likely agreed to plead guilty. Also charged at the same time was Israel Sanchez, owner of a restaurant called Cesar’s on Broadway. Like Sandra Sanchez, Israel Sanchez was charged by information, indicating that he too is likely to plead guilty.

Given the prior state charges filed against Sandra Sanchez, and the apparent forthcoming federal guilty pleas by both Sandra Sanchez and Israel Sanchez, it may well be the case that one or both of these individuals are cooperating and assisting state and federal investigators with their zapper investigation. Indeed, last week’s Justice Department press release indicates that the federal investigation is ongoing and therefore may be more broadly focused than the five individuals charged. Indeed, the special agent-in-charge of the IRS Criminal Investigation Division in Chicago warned that these charges are just tip of the iceberg, and that cash-intensive businesses using zappers are at risk: “This is only the beginning. I want to warn those restaurants, gas stations, convenience stores and other establishments that are currently using or thinking of using sales suppression software, that we are on to you and your methods.”

Three other individuals were charged in Chicago last week: Shuli Zhao, owner of Katy’s Dumpling House in Westmont; Chun Xu Zhang, owner of Sushi City in Downers Grove; and Quan Shun Chen, owner of Hunan Spring in Evanston. It is not clear from the press release and charging documents whether these three individuals are related to each other or if they are related to the other two individuals charged, Sandra Sanchez and Israel Sanchez. Unlike the Sanchezes, these three business owners were charged by indictments, indicating that they are contesting the charges and are not pleading guilty.

The Chicago cases appear to be the most significant federal criminal case alleging use of tax zapper technology to date. As noted, for the past several years, state authorities have been taking a lead role in investigating and prosecuting businesses that use sale suppression technology. The Chicago cases are significant not only because they represent the first federal charges against business owners in many years (as opposed to the Yin case, which involved a zapper salesman) but also because they appear to be part of a larger investigation of Chicago-area businesses that use zappers. With guilty pleas expected from two of the individuals charged, at least one of those individuals likely cooperating, and the investigation ongoing, we anticipate seeing more federal charges arising out of this likely widening-probe.

Reprinted with permission from Law360. (c) 2018 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

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Our colleagues Matthew S. Adams and Jana Volante Walshak have authored a client alert about the Supreme Court’s recent decision in Carpenter v. United States, where the court held that cellphone location records deserve heightened protection, once again expanding the Fourth Amendment protections afforded to certain modern digital communications. And in doing so, the unusual five-justice majority led by Chief Justice Roberts has suggested a roadmap for white-collar defense lawyers to follow when strategizing their approaches to other high-tech cases. You can read their alert here.

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Four states have filed suit in U.S. District Court for the Southern District of New York, challenging the constitutionality of the new $10,000 cap on the federal tax deduction for state and local taxes, or SALT, enacted as part of the federal Tax Cuts and Jobs Act in 2017. The lawsuit is the latest effort by states to invalidate the SALT cap. It follows legislative workarounds enacted by New York and New Jersey, granting taxpayers in those states credits against state taxes for making contributions to state-created funds. The Internal Revenue Service has for its part responded by warning taxpayers that the federal law controls the characterization of deductions for federal income tax purposes and that taxpayers who utilize the state law workarounds do so at their peril. While this latest effort to challenge the SALT cap places the legality of the provision before the courts, the long-term fate of the SALT cap is more likely to be decided by the political, rather than the judicial, process.

The SALT Cap

Enacted in 2017, the TCJA was touted as the most significant tax reform legislation in three decades. Among its provisions is a $10,000 annual limitation on the deduction for state and local tax, which includes state and local income taxes, local real estate taxes and state sales taxes. Previously, there was no monetary limitation for an individual taxpayer’s SALT deduction. The new limitation is more detrimental to individuals in high tax states, such as California and New York. The average SALT deduction in California was around $18,500, while the average deduction in New York was around $22,000. The SALT limitation imposed by the TCJA applies to taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026.

State Efforts to Work Around the SALT Cap

Some states are attempting to work around the SALT limitation using creative legislative solutions. Earlier this year, New York Gov. Andrew Cuomo signed into law a new state-operated charitable contribution fund to accept donations for the purposes of improving health care and public education in New York state. Taxpayers who itemize deductions may claim these charitable contributions as deductions on their federal and state tax returns. Any taxpayer making a donation may also claim a state tax credit equal to 85 percent of the donation amount for the tax year after the donation is made. Taxpayers may also make qualified contributions to certain not-for-profit organizations for specified purposes. The law also authorizes local governments and school districts to establish charitable gift reserve funds and to offer real property tax credits to incentivize contributions to these new local charitable funds.

New Jersey soon followed suit, with Gov. Phil Murphy signing into law a measure allowing municipalities, counties and school districts to establish charitable funds where taxpayers can donate in return for a property tax credit. In return for donations, taxpayers would receive credits on their property tax bill of up to 90 percent of the donation. Taxpayers would then be able to claim their donation as a charitable deduction on their federal income tax return.

Efforts to work around the SALT cap are also underway in California. The California Senate has passed a bill that would allow taxpayers a credit against their state income tax for contributions to the newly created California Excellence Fund. A similar bill is pending in the California Assembly.

IRS Warns Taxpayers Regarding Efforts to Bypass SALT Cap

Earlier this year, the Internal Revenue Service notified taxpayers that it will soon be issuing regulations addressing the deductibility of state and local tax payments for federal income tax purposes. At the same time, the IRS reminded taxpayers that federal law controls the characterization of payments for federal income tax purposes regardless of the characterization of the payments under state law. These forthcoming regulations will be targeted at the state-level work-arounds described above.

The IRS said that the regulations, to be issued in the near future, will help taxpayers understand the relationship between federal charitable contribution deductions and the new statutory limitation on the deduction of state and local taxes. The IRS also warned that it is continuing to monitor other state legislative proposals being considered to ensure that federal law controls the characterization of deductions for federal income tax filings.

Is the SALT Cap Unconstitutional?

The latest effort by the states to challenge the SALT cap is the lawsuit filed by states New York, New Jersey, Connecticut and Maryland. The suit names as defendants the Secretary of the Treasury, the Acting Commissioner of Internal Revenue, the Internal Revenue Service and the United States of America. The states allege that the SALT cap violates numerous provisions of the U.S. Constitution, including the 10th Amendment, the 16th Amendment and Article I, Section 8.

According to a press release issued by Gov. Cuomo, the SALT cap was enacted to target New York and similarly situated states, interferes with states’ rights to make their own fiscal decisions and will disproportionately harm taxpayers in these states. An analysis by the New York State Department of Taxation and Finance shows that the cap will increase New Yorkers’ federal taxes by $14.3 billion in 2018 alone and an additional $121 billion between 2019 and 2025. A press release issued by Connecticut Gov. Dannel Malloy similarly said that Connecticut taxpayers will lose an estimated $10.3 billion in SALT deductions in 2018 and see an increase in federal income tax liability of approximately $2.8 billion in 2018.

The states’ lawsuit challenging the SALT cap asserts three causes of action arising under the U.S. Constitution. The first alleges that by capping the amount of the SALT deduction, the federal government has impermissibly interfered with the states’ sovereign authority to determine their own fiscal authority, thereby violating the 10th Amendment. In their second cause of action, the states allege the federal government has exceeded its powers under the 16th Amendment by failing to provide for a deduction for all, or a significant portion of, state and local taxes. Finally, the states allege a violation of Article I, Section 8, which provides Congress with the “[p]ower to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States.” Specifically, the states contend that the SALT cap interferes with their sovereign authority to determine their own taxation and fiscal policies by “coercing the Plaintiff States into lowering their taxes and cutting the services those taxes support.”

The U.S. Department of Justice is expected to vigorously defend the SALT cap as a legitimate exercise of the federal government’s taxing power. The Justice Department will no doubt point out that the newly enacted SALT cap was not specifically targeted at the four plaintiff-states; rather, the cap applies uniformly throughout all of the states, even though it may have disproportionate impact in states with high property taxes. In addition, SALT cap defenders will note that although state and local taxes have been deductible since the creation of the federal income tax code in 1913, Congress has many times modified the scope of the allowable SALT deduction, including in the Tax Reform Act of 1986 and, most recently, in 2005. Finally, the Justice Department will surely rely upon the federal government’s constitutionally imbued and well-settled powers to tax and spend as set forth in Article 1, Section 8 Constitution in defending the SALT limitation.

While a federal judge will ultimately have to decide whether the states’ lawsuit has merit, the long-term viability of the SALT deduction cap will likely be determined by the political process instead. The outcome of the November mid-term elections will dictate which political party controls Congress. If the Democrats succeed in wresting back control of the House, expect to see legislation introduced to undo much of the TCJA, including the SALT cap deduction. If, on the other hand, the Republicans maintain their current majority in the House, the SALT cap will likely remain on the books, with its fate to be eventually determined by the courts — most likely an appellate court and potentially the Supreme Court of the United States.

Reprinted with permission from Law360. (c) 2018 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

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Your company is under investigation. Federal agents show up at your business looking for documents, computer files and other evidence. It’s a critical moment. What should you do?

Matthew D. Lee, a former Justice Department trial attorney and partner in Fox Rothschild’s White-Collar Criminal Defense & Regulatory Compliance Practice, explains your options in Episode Two of his this five-part podcast, “Federal Agents at the Door.” Matt tells you exactly what to expect and how to respond.

In Episode One, Target, Subject or Witness?, Matt provided an overview and explained how your status in a probe should affect your overall response. In this episode, Matt explains what to do when agents arrive at your place of business brandishing a warrant.

If you prefer, download the transcript.

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You’ve seen it on CNN. Scores of agents in matching jackets descend on a business or residence, hauling out boxes of documents, laptops and cell phones. How would you react?

Don’t panic. Matthew D. Lee has every aspect covered in his new five-part podcast: “Federal Agents at the Door.” A former Justice Department trial attorney, and partner in Fox Rothschild’s White-Collar Criminal Defense & Regulatory Compliance Practice, Matt knows what to expect and how to respond.

Episode One: Target, Subject or Witness? Matt provides an overview and explains how your status in a probe should affect your response.

If you prefer, download the transcript.

In its 5-4 decision in South Dakota v. Wayfair, the U.S. Supreme Court gave states the authority to require online retailers to collect state sales taxes even if the retailer has no physical presence in a state. The decision overturned pre-internet era rulings that had prohibited states from forcing online retailers to collect sales taxes unless a retailer had a “physical presence” in a state.

Wayfair will likely increase states’ sales tax revenue. The Supreme Court noted that the physical presence standard may have cost states up to $33 billion in sales tax revenue every year. South Dakota alone estimated that it lost $48 to $58 million yearly. This was a serious problem for states like South Dakota that do not have an income tax.

On the other hand, the decision will drive up costs for small online retailers, and those without the resources to comply with numerous taxing jurisdictions will be hit hard. Members of the House Judiciary Committee issued a statement calling Wayfair a “nightmare for … small online sellers, who will now have to comply with the different tax rates and rules of, and be subject to audits by, over 10,000 taxing jurisdictions across the U.S.”

But Justice Anthony Kennedy, who authored the majority opinion in Wayfair, thought there was “nothing unfair about requiring companies that avail themselves of the states’ benefits to bear an equal share of the burden of tax collection.”

Regardless of the policy arguments, the Wayfair ruling will likely significantly increase compliance costs and state audits for online retailers.

Now online retailers must determine whether the states where they have no physical presence require them to collect and remit sales tax. A state may require an online retailer to collect and remit sales tax based on the revenue the online retailer generates or the number of sales it makes in the state.

Online retailers should bear in mind, however, that states cannot impose collection requirements on an online retailer if it does not have a substantial nexus in the state.

Our colleague Alka Bahal has written an article for the Immigration View blog about a dramatic increase in the number of I-9 audits being conducted by U.S. Immigration and Customs Enforcement. More than 5,200 businesses around the country have been served with I-9 inspection notices since January in a two-phase nationwide operation that appears to be the largest I-9 inspection action ICE has undertaken to date. This latest round of workplace audits on employers clearly indicates that the I-9 inspection is now a top priority in U.S. immigration enforcement policy that targets employers rather than employees via the workplace raids of the past. You can read the article here.

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Our colleague Joseph A. McNelis III has written an excellent article for the In the Weeds blog about a recent statement from the U.S. Attorney in Massachusetts regarding his office’s enforcement priorities surrounding recreational marijuana.  In his statement, U.S. Attorney Andrew Lelling noted that while he cannot “immunize the residents of the Commonwealth from federal marijuana enforcement,” his office’s resources will be focused on (1) unauthorized out-of-state marijuana sales; (2) targeted sales to minors; and (3) organized criminal groups which use illicit drug sales to fund their activities.  You can read the blog post here.

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The States of New York, Connecticut, Maryland, and New Jersey filed a federal court lawsuit this week challenging the constitutionality of the new $10,000 cap on the federal tax deduction for state and local taxes (SALT). The lawsuit, filed in the Southern District of New York, names as defendants the Secretary of the Treasury, the Acting Commissioner of Internal Revenue, the Internal Revenue Service, and the United States of America. The States allege that the SALT deduction cap, enacted as part of 2017 tax reform, violates numerous provisions of the United States Constitution, including the Tenth Amendment, the Sixteenth Amendment, and Article I, Section 8.

According to a press release issued by New York Governor Andrew M. Cuomo, the lawsuit argues that the new SALT cap was enacted to target New York and similarly situated states, that it interferes with states’ rights to make their own fiscal decisions, and that it will disproportionately harm taxpayers in these states. An analysis by the New York State Department of Taxation and Finance shows that the cap will increase New Yorkers’ federal taxes by $14.3 billion in 2018 alone, and an additional $121 billion between 2019 and 2025. A press release issued by Connecticut Governor Dannel P. Malloy similarly estimated that Connecticut taxpayers will lose an estimated $10.3 billion in SALT deductions in 2018, and will increase Connecticut taxpayers’ federal income tax liability by approximately $2.8 billion in 2018.

The SALT deduction cap has been one of the most controversial provisions of the 2017 tax reform legislation.  We previously wrote about efforts by some states, including New York and New Jersey, to pass laws providing for mechanisms to work around the cap. These “workarounds” would allow taxpayers to make payments to specified entities in exchange for a tax credit against state and local taxes owed.  In May, the IRS the Internal Revenue Service notified taxpayers that it would soon be issuing regulations addressing the deductibility of state and local tax payments for federal income tax purposes, and issued a not-so-subtle reminder that federal law controls the characterization of payments for federal income tax purposes regardless of the characterization of the payments under state law.

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Last month we wrote about the Justice Department’s new corporate resolution policy, which is intended to curb the practice of multiple government authorities imposing separate punishments on a corporate defendant for the same underlying conduct. Employing a football metaphor, Deputy Attorney General Rod Rosenstein explained that the intent of the new policy was to prevent “piling on,” which he described as “a player jumping on a pile of other players after the opponent is already tackled.” In the wake of this policy change, we have been carefully following Justice Department announcements of corporate investigations to see how this policy will work in practice.

The Justice Department recently announced resolution of a Foreign Corrupt Practices Act investigation involving a Hong Kong subsidiary of Swiss bank Credit Suisse. The allegations involved the awarding of employment to friends and family of Chinese officials in exchange for banking business. As part of the resolution, the Credit Suisse subsidiary entered into a non-prosecution agreement and agreed to pay a criminal penalty of $47 million. The SEC simultaneously announced that Credit Suisse entered into a settlement agreement covering the same underlying conduct and agreed to pay disgorgement of nearly $25 million with nearly $5 million of prejudgment interest. In an apparent nod to the anti-“piling on” policy, the SEC agreed to refrain from imposing any civil penalty. In fact, the SEC administrative order expressly provides that “[Credit Suisse] acknowledges that the Commission is not imposing a civil penalty based upon the imposition of a $47 million criminal fine as part of Credit Suisse’s settlement with the United States Department of Justice.”

When Rosenstein unveiled this new policy last month, he cited two examples of recent corporate resolutions that he said were consistent with the new anti-“piling on” approach. One of those resolutions, announced in April 2018, is very similar to the Credit Suisse resolution announced last week. In that case, the Justice Department entered into a deferred prosecution agreement in an FCPA investigation of the subsidiary of a global electronics company. The company paid a criminal penalty of $137 million. In a related proceeding, the SEC filed a cease-and-desist order against the company, which required the payment of $143 million in disgorgement for the same conduct. Rosenstein noted that the SEC agreed to forgo the imposition of penalties given the company’s agreement to pay a criminal penalty to the Justice Department.

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