Tax evasion.

AuthorBalakrishna, Rajeev
PositionTenth Survey of White Collar Crime
  1. IRC Section 7201

    Violations of the United States Internal Revenue Code ("IRC") are prosecuted under an array of criminal tax statutes.(1) The "capstone of [this] system of sanctions"(2) is the felony provision of 26 U.S.C. [sections] 7201, which provides for a maximum penalty of $100,000, a prison term of five years for a willful attempt to defeat any tax obligation, or both.(3)

    1. Elements of the Offense

      In order to prove a section 7201 offense, the government must prove three elements: (1) the existence of a tax deficiency; (2) an affirmative act constituting an evasion or attempted evasion of the tax; and (3) willfulness.(4) The government bears the burden of proving each element beyond a reasonable doubt.(5) Once a prima facie case is established, however, the burden shifts to the taxpayer, and "the taxpayer `remains quiet at his peril.'"(6)

      1. Existence of a Tax Deficiency

        Generally, for a defendant to be convicted under section 7201, the amount of tax deficiency must be "substantial."(7) The term "substantial" refers to the "amount of the tax evaded" and not to the amount of income unreported.(8)

        The existence of a deficiency may be shown by the use of either direct or circumstantial evidence. The "specific item method," a direct evidence method, is the most accurate means of proving a deficiency. According to this method, the taxpayer's books and records are used as direct proof of taxable transactions.(9) However, "[p]roof of unreported taxable income by direct means is extremely difficult and often impossible."(10)

        Therefore, to, establish the existence of unreported taxable income, the government usually relies on three methods of obtaining circumstantial evidence: net worth, cash expenditures, and bank deposits.(11) These circumstantial methods do not require the government to prove either the exact amount of the deficiency(12) or its source.(13) The government may choose to prosecute under any single theory of proof or a combination method, including a combination of circumstantial and direct proofs.(14)

        The "net worth" theory of proof is the most common method used by the government to establish tax evasion. In it,

        the Government, having concluded that the taxpayer's records are inadequate as a basis for determining income tax liability, attempts to establish an "opening net worth" or total net value of the taxpayer's assets at the beginning of a given year. It then proves increases in the taxpayer's net worth for each succeeding year during the period under examination and calculates the difference between the adjusted net values of the taxpayer's assets at the beginning and end of each of the years involved. The taxpayer's nondeductible expenditures, including living expenses, are added to these increases, and if the resulting figure for any year is substantially greater than the taxable income reported by the taxpayer for that year, the Government claims the excess represents unreported taxable income.(15)

        It is essential that the government's analysis establish the taxpayer's opening net worth with "reasonable certainty,"(16) although it is not necessary to establish with certainty the opening net worth for each of the subsequent years under investigation.(17) The government must also demonstrate that it has conducted a thorough investigation and has negated reasonable alternative sources of nontaxable income.(18) Clear charges and formal instructions outlining the range of permissible inferences both for and against the accused are required.(19)

        The "cash expenditures" method is a "simple variant of the `net worth method'"(20) and requires a showing that the taxpayer's expenditures were derived from taxable income which exceeded the taxpayer's reported income.(21) The government must demonstrate either a "likely source of the allegedly unreported income or that it has negated all reasonably possible nontaxable sources of income."(22) Unlike the net worth method, the cash expenditures method does not require preparation of a formal net worth statement for the period under investigation.(23) Similar jury instructions are required for both the net worth and the cash expenditures methods.(24)

        Finally, under the "bank deposits" method, all non-taxable deposits and amounts deposited in prior years are excluded from the analysis of whether there is a tax deficiency for the year of the tax return being investigated.(25) "`[T]he jury is entitled to infer that the difference between the balance of deposited items and reported income constitutes unreported income.'"(26) As with the cash expenditures method, the government need not prepare a formal net worth statement(27) but must demonstrate that it conducted a full investigation into sources of income.(28) Formal jury instructions on the scope of proper inferences are required.(29)

      2. Affirmative Act Constituting Evasion

        The Supreme Court has interpreted the second element of section 7201 offenses to require a positive attempt to evade or defeat any tax rather than merely "passive neglect."(30) Thus, an affirmative act to evade tax must be a commission rather than an omission.(31) The United States Supreme Court stated that the "affirmative act" language should be construed broadly(32) to include filing false returns,(33) keeping a double set of books,(34) making false entries or alterations,(35) making false invoices or documents,(36) destroying books or records,(37) concealing assets or covering up sources of income,(38) and avoiding making records usually kept for transactions or conduct where the likely effect would be to mislead or to conceal.(39)

      3. Willfulness

        To prove willfulness under section 7201, the government must make "a showing of specific wrongful intent to avoid a known legal duty."(40) The government must demonstrate more than carelessness on the part of the defendant,(41) but it does not necessarily need to show bad faith.(42) The defendant's belief regarding the applicability of a legal duty is a question of fact.(43) Consequently, even an objectively unreasonable misunderstanding of the law negates a finding of willfulness if the jury believes it.(44)

        Willfulness is inferred from both the surrounding circumstances and the defendant's affirmative acts of evasion,(45) and "proof of willfulness usually must be accomplished by means of circumstantial evidence."(46) When applied, this inference often leads to a blurring of the distinction between willfulness and affirmative acts.(47)

    2. Defenses

      1. Lack of Deficiency

        The taxpayer may rebut the government's charge by showing that the income received is not taxable.(48) In cases involving circumstantial evidence, the taxpayer may identify errors in the government's analysis to negate a tax deficiency.(49) The taxpayer may also claim deductions and credits which were available but which the taxpayer inadvertently neglected to claim when the return was originally submitted.(50)

      2. Lack of Willfulness

        The taxpayer may avoid conviction under section 7201 if the tax was evaded in a non-willful manner.(51) In 1973, the Supreme Court defined willfulness as the "voluntary, intentional violation of a known legal duty."(52) Mere carelessness is insufficient to demonstrate willfulness.(53) In assessing a lack of willfulness defense, the court will look to the taxpayer's conduct(54) and past record of compliance,(55) as well as the taxpayer's sophistication and level of knowledge.(56) Under the Supreme Court decision in Cheek v. United States,(57) a good faith belief that one is not violating the law negates willfulness, regardless of the objective reasonableness of the belief.(58)

        A taxpayer's mere preoccupation with "pressing matters" will not negate willfulness, however.(59) Similarly, most courts have ruled that a defendant's inability to pay taxes when due is not a valid defense to a finding of willfulness.(60) Courts have also rejected arguments that a formal assessment is a necessary precondition to establishing tax evasion.(61)

      3. Third Party Liability/Reliance

        The taxpayer may seek to shift responsibility for an assessed deficiency to a third party, such as a tax preparer or a lawyer.(62) Reliance on the advice of such third parties is not a complete defense, but does tend to disprove the willfulness element.(63) Finally, the defense of third party liability is not available if the taxpayer did not provide the preparer with all necessary information.(64)

      4. Selective Prosecution

        The defense of selective prosecution is difficult to establish to the extent that "some selectivity in the decision to prosecute" is permissible(65) and the government is allowed to concentrate its resources on the most "flagrant violators" of the tax law.(66) A successful presentation of this defense requires the defendant to show both that others similarly situated were not prosecuted and that the defendant was selected based upon an "impermissible consideration such as race, religion, or an improper desire to prevent [the taxpayer] from exercising his constitutional rights."(67) The defendant bears the burden of establishing evidence sufficient for a prima facie case of selective prosecution;(68) "mere suspicion or surmise" is insufficient.(69)

    3. Investigations

      1. Notice of Criminal Proceedings

        The "Omnibus Taxpayer Bill of Rights"(70) requires the IRS to provide an explanation of the audit process to the taxpayer prior to an initial audit interview, but a proposed Senate amendment requiring the IRS to provide notice that the taxpayer's case has been referred to the Criminal Investigation Division was rejected in conference.(71) Congress has refused to require the IRS to provide the potential defendant with notice of the initiation of criminal proceedings.(72)

      2. Fifth Amendment

        While the IRS is not required to give Miranda warnings in noncustodial interviews,(73) IRS procedures mandate that special agents provide a Miranda type warning.(74) In order to successfully assert Fifth Amendment protection in...

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