Tax Litigation Update: Ninth Circuit Decision Provides Significant Support for Taxpayers Seeking to Discharge Tax Debt in Bankruptcy

October 20th, 2014

On September 15, 2014, the United States Court of Appeals for the Ninth Circuit issued a landmark decision strongly favoring debtors seeking to discharge tax debt in bankruptcy.

The case, Hawkins v. Franchise Tax Board (In Re Hawkins), involved a taxpayer, Trip Hawkins, seeking to discharge roughly 19 million dollars in a Chapter 11 bankruptcy.  The Government objected to the discharge under 11 U.S.C. § 523(a)(1)(C), which precludes the discharge of a tax debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”  The Government, which prevailed at the bankruptcy court and district court levels, argued that Hawkins’ level of spending while his tax debt remained outstanding constituted a willful attempt to evade or defeat his tax liability.

Overruling the bankruptcy court and district court decisions below, the Ninth Circuit held that in order for a tax debt to be precluded from discharge due to a willful attempt to evade or defeat the tax, the Government must establish that the debtor had the specific intent to evade payment of tax; mere overspending on other items while the tax debt remained outstanding, if the overspending did not occur with the specific intent of avoiding payment of tax, is insufficient to rise to requisite level of willfulness.

Background

Hawkins’ background created a less than sympathetic picture, which may have had some effect on the lower courts’ decisions to bar discharge.  Hawkins was a graduate of Harvard and Stanford who had been among the first employees of Apple Computers and later served as CEO (and significant stockholder) of Electronic Arts (EA), the noted video game manufacturer.  Hawkins’ wealth grew to about $100 million.  In 1990, EA created a wholly owned subsidiary called 3DO for the purpose of developing and marketing video games and game consoles, and Hawkins was put in charge of 3DO.  Thereafter, Hawkins sold a large amount of his EA stock and used the proceeds to invest in 3DO.  By selling his EA stock, Hawkins generated significant capital gains.  In order to offset his capital gains liability, Hawkins invested in several tax shelters offered by KPMG.  The IRS challenged the tax shelters in 2001 and disallowed the losses Hawkins had taken to offset his capital gains, resulting in millions of dollars of liability for Hawkins.  At the same time, 3DO’s business was stuttering, further compounding Hawkins’ financial situation.  In a 2003 state court filing seeking to reduce his child support obligations, Hawkins acknowledged that he owed $25 million to the United States in back federal income taxes.  All the while, even after recognizing the severity of his tax debt, Hawkins had enjoyed an expensive lifestyle, spending somewhere between $500,000 and $2.5 million more than what he earned on personal expenses in the 33 months between January 2004 and September 2006 when the bankruptcy petition was filed.

Hawkins did make some efforts to reduce his tax liability; he sold his house in July 2006 and paid all of the net proceeds, $6.5 million, toward his tax debt.  Hawkins also proposed an Offer in Compromise of $8 million in an effort settle the liability, but the IRS rejected the offer.  In September 2006, Hawkins filed for Chapter 11 protection, primarily in an attempt to rid himself of his tax debt.  Shortly after filing, Hawkins sold a vacation house for $3.5 million and paid the proceeds to the IRS.  The IRS also received a distribution of $3.4 million in Hawkins’ Chapter 11 plan.  Nevertheless, millions of dollars of tax debt remained outstanding and the United States objected to the discharge of the tax debt on the basis that Hawkins willfully attempted to evade or defeat his tax liability, again arguing that Hawkins’ extravagant spending evidenced his willfulness.

The United States prevailed on this argument at both the Bankruptcy Court and District Court levels, and Hawkins appealed to the Ninth Circuit.

Governing Law

The Bankruptcy Code generally permits a discharge of all pre-petition liabilities of a debtor, unless discharge is specifically precluded by the Bankruptcy Code.  Discharging income tax debt is possible, but doing so requires the debtor to overcome several hurdles.  In addition to meeting several timing requirements contained in § 523(a)(1)(A)-(B) (for instance, the tax at issue must have been based on a return due at least three years before the petition date and the return must have been timely filed and filed more than two years prior to the petition date), the debtor’s return must not be fraudulent and the debtor must not have willfully attempted to evade or defeat the tax at issue.

In many cases, the timing and non-fraudulent return requirements are clearly satisfied, and the outcome of the dischargeability determination hinges solely on whether the debtor willfully attempted to evade or defeat the tax at issue.  Courts are in near universal agreement that the phrase “willfully attempted in any manner to evade or defeat such tax” contains two elements the Government must prove: a conduct requirement and a mental state requirement.  The conduct requirement means that the Government must prove that the debtor engaged in some act or omission in an attempt to evade or defeat the tax.  The Government must also prove that the debtor committed the act or omission willfully.

The Hawkins case dealt solely with the mental state requirement, more specifically the mental state required by the statute’s use of the word “willfull” in order to preclude discharge.  A majority of Courts, including the Eleventh Circuit, have adopted a test which requires the Government to show that the debtor (1) had a duty to pay taxes under the law; (2) knew that he had such a duty; and (3) voluntarily and intentionally violated that duty.  These courts have not expressly required the Government to establish that a debtor had a specific, fraudulent intent to evade or defeat the tax.

In reversing the bankruptcy court and district court in Hawkins, the Ninth Circuit set forth a more restrictive, debtor-friendly interpretation of willfulness.  Specifically, the Court held that “we conclude that declaring a tax debt dischargeable under 11 U.S.C. § 523(a)(1)(C) on the basis that the debtor ‘willfully attempted in any manner to evade or defeat such tax’ requires showing of a specific intent to evade the tax.  Therefore, a mere showing of spending in excess of income is not sufficient to establish the required intent to evade tax; the government must establish that the debtor took action the actions with the specific intent of evading taxes.”  In other words, to the Ninth Circuit, overspending alone will not rise to willfulness unless the debtor overspent with the specific intent of avoiding payment of his tax liability.

In reaching this conclusion, the Ninth Circuit focused on purpose of the Bankruptcy Code and the textual structure of § 523(a)(1)(C).  First, the Ninth Circuit emphasized the fact that federal bankruptcy law was designed to provide debtors with a fresh start, which in turn compels a strict, rather than expansive, interpretation of “willfulness.”  For support, the Ninth Circuit cited Kawaauhau v. Geiger, 523 U.S. 57 (1998), in which the Supreme Court held that, under § 523(a)(6) of the Bankruptcy Code, which precludes discharge of debts arising out of a willful and malicious injury, the party seeking to preclude discharge must establish an intent to injure, not just an intentional act that leads to injury.

The Ninth Circuit also relied on the text of § 523(a)(1)(C) in requiring a higher standard of willfulness.  The Ninth Circuit held that by grouping willfulness with the filing of a fraudulent return in a separate subsection, rather than the more banal timing requirements of § 523(a)(1)(A)-(B), Congress had evidenced its intent to require a showing of bad purpose on the part of the debtor for the Government to establish willfulness.

The Court also found support for its ruling in the Internal Revenue Code.  Specifically, the Court highlighted the fact that the language of § 523(a)(1)(C) is nearly identical to that found in IRC § 7201, which makes it a felony to “willfully attempt in any manner to evade or defeat any tax.”  Courts interpreting § 7201 have required the Government to prove that the taxpayer voluntarily and intentionally violated a known legal duty.  See Cheek v. United States, 498 U.S. 201 (1992).  This, “almost invariably,” will “involve deceit or fraud upon the Government, achieved by concealing tax liability or misleading the Government as to the extent of the liability.”  Kawashima v. Holder, 132 S. Ct. 1166, 1175, 1177 (2012).  In following this rationale, the Ninth Circuit rejected reasoning of other Circuit Courts facing this question which have relied upon portions of the Internal Revenue Code dealing with civil willfulness (such as IRC § 6672).  Generally speaking, civil willfulness requires the Government to establish intentional conduct, but not a bad faith purpose, while criminal willfulness requires a bad faith purpose.

The Ninth Circuit also focused on the consequences of imposing a rule providing that living beyond one’s means would lead to the preclusion of tax debt dischargeability.  “Indeed, if simply living beyond one’s means, or paying bills to other creditors prior to bankruptcy, were sufficient to establish a willful attempt to evade taxes, there would be few personal bankruptcies in which taxes would be dischargeable.  Such a rule could create a large ripple effect throughout the bankruptcy system.”

In sum, the Ninth Circuit held that acts that detract from a debtor’s ability to pay the outstanding tax debt will not preclude discharge unless those acts are made with the specific intent of evading tax.  Intending to commit the act (or omission) that detracts from payment of the outstanding tax is not by itself sufficient.

Conflict with Other Circuits?

As stated above, several Circuit Courts of Appeal have read § 523(a)(1)(C) to require the Government to prove that the debtor (1) had a duty to pay taxes under the law; (2) knew he had that duty; and (3) voluntarily and intentionally violated that duty.  Under a broad interpretation, those elements are arguably satisfied if the act of overspending was committed intentionally, but without the specific purpose of avoiding taxation.

From a surface level it appears that the Ninth Circuit’s Hawkins decision creates a Circuit split, because the Ninth Circuit now requires the Government to prove specific intent to establish willfulness while a number of other Circuits have not expressly made that a requirement.  However, as the Court points out in Hawkins, in those other Circuits, living a lifestyle beyond one’s means has always been coupled with some other act or omission designed to evade taxes, such concealing assets, a failure to file returns and pay taxes, and structuring financial transactions to avoid currency reporting requirements.  Prior to Hawkins, no Circuit Court had directly answered the question of whether a taxpayer that files timely, accurate returns and does not engage in acts of deceit but spends beyond his means is willful under § 523(a)(1).  In that regard,Hawkins can be seen as a case of first impression and its reasoning is applicable across the country.

Moreover, it can be argued that the Ninth Circuit’s Hawkins decision expressly said what other Courts have said implicitly, or at least in a less forthright manner: where a bankruptcy debtor has lived beyond his means in the face of an existing tax debt, in order for discharge of the tax debt to be precluded, the Government cannot rely on overspending itself and must establish by a preponderance of the evidence some other act designed to evade taxes.

Effect on Eleventh Circuit Cases

The Eleventh Circuit is among the Circuit Courts that applies the three part test set forth above (the debtor had a legal duty to pay tax, knew of the legal duty, and voluntarily and intentionally violated that duty) in determining whether the mental state requirement of § 523(a)(1) has been satisfied.  Put more succinctly, “a debtor’s tax debts are non-dischargeable if the debtor acted knowingly and deliberately in his efforts to evade his tax liabilities.”  In Re Mitchell, 633 F.3d 1319 (11th Cir. 2011).  Additionally, the Court has stated that “fraudulent intent is not required” in determining willfulness.  In Re Fretz, 244 F.3d 1323 (11th Cir. 2001).

However, the Eleventh Circuit has never held that mere lavish spending in the face of a tax debt is sufficient to bar discharge.  Some evidence of a debtor’s deceit has always been present.  In both Mitchell (failure to file, titling assets in nominee names, reincorporating to avoid garnishment) and Fretz (failure to file), other factors contributed to the determination that the debtor satisfied the willfulness requirement.  Overspending alone was not determinative.  Therefore, Hawkins does not serve as directly contrary authority to the Eleventh Circuit’s approach to determining willfulness, but it does lend significant support to combat any argument the Government may raise in an attempt to establish willfulness based solely on overspending.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax and tax litigation in the Tax Court, the Federal District Courts, and Bankruptcy Courts.  They will continue to monitor developments in the Hawkins case and this area of the law generally. If you have any questions, an attorney can be reached by emailing us at contact@fidjlaw.com or by calling 305.350.5690.

Bitcoin Update: Recent Decision May Provide Roadmap for Calculating Damages Associated with Bitcoin Related Litigation

October 8th, 2014

On September 18, 2014, the United States District Court for the Eastern District of Texas issued its order granting summary judgment in favor of the United States Securities and Exchange Commission (“SEC”) in the case of SEC v. Shavers, Case No. 4:13-00416 (E.D. Tx. September 18, 2014). While at first glance, the decision may appear to be nothing more than another uncontested motion for summary judgment, the decision is important for the bitcoin industry for several reasons. First, the District Court found that investments in bitcoin can constitute “investment contracts” and thus, “securities” under 15 U.S.C. § 77b the Securities Act of 1933. Second, the Court’s analysis in calculating a reasonable approximation of profits in U.S. dollars from the bitcoin based scheme can provide a roadmap for calculating bitcoin related damages in future litigation.

In its Complaint, the SEC alleged that Shavers violated sections 5(a), 5(c), and 17(a) of the Securities Act of 1933 and section 10(b) and Rule 10b-5 of the Exchange Act, codified at 15 U.S.C. § 77(c) related to his running of a bitcoin investment scheme. As described by the District Court in its Order, the SEC alleged that Shavers founded and operated Bitcoin Savings and Trust (“BST”). From at least February 2011 through August 2012, Shavers sold investments in BST falsely promising investors up to 1% interest daily or 7% interest weekly, purportedly based on Shavers’ trading of bitcoin against the U.S. dollar. What made Shavers’ scheme unique is that he solicited and accepted all investments, and paid all purported returns in Bitcoin. Ultimately, Shavers received at least 732,050 bitcoin in investments of which 180,819 bitcoins constituted ill-gotten gains.

In response to the SEC’s Complaint, Shavers filed a Motion to Dismiss arguing that the District Court lacked subject matter jurisdiction because the investments in BST did not constitute securities under the Securities Act of 1933. More specifically, Shavers argued that 1) bitcoin is not money and is not part of anything regulated by the United States; and 2) that because all transactions were solely in bitcoin, no money ever exchanged hands, thus the investments could not constitute investment contracts and there were not “securities” under the act. [15 U.S.C. § 77b defines “security” as “any note, stock, treasury stock, security future, security-based swap, bond . . . [or] investment contract . . . .” In turn, for purposes of the Securities Act of 1933, an “investment contract” is any contract, transaction, or scheme whereby: 1) a person invests money; 2) in a common enterprise; and 3) is led to expect profits solely from the efforts of the promoter or a third party. See SEC v. W.J. Howey & Co., 328 U.S. 293, 298-299 (1946).]

In denying Shavers Motion to Dismiss and rejecting his arguments, the District Court noted:

It is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses. The only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the U.S. dollar, Euro, Yen, and Yuan. Therefore, Bitcoin is a currency or form of money, and investors wishing to invest in [BST] provided an investment of money.

Thus, because bitcoin was used as money, the investments in BST constituted an investment of money and as such, an investment contract under the Securities Act of 1933. Therefore, the District Court found that the investments sold by Shaver constituted “securities” under the Securities Act of 1933. A copy of the District Court’s Order denying Shaver’s Motion to Dismiss can read here.

The Shavers case concluded in the District Court granting the SEC’s unopposed Motion for Summary Judgment. In so deciding, the District Court explained that it enjoyed broad equitable power to order securities law violators to disgorge their ill-gotten gains. However, as Shavers’ scheme solely involved bitcoin, the District Court was tasked with the issue of how to properly determine what constitutes a “reasonable approximation of profits casually connected with the violation.” As noted by the District Court, this task became more difficult in light of the large fluctuations in the exchange rate of bitcoin from the time the Ponzi scheme first started to the ultimate determination of liability. Ultimately, the District Court concluded that a reasonable calculation of disgorgement in U.S. Dollars could be obtained by multiplying the total amount of ill-gotten gains in bitcoin by the average daily price of bitcoin between the time the Ponzi scheme ended and the date of the Court’s ruling. In so calculating, the District Court order Shavers to disgorge $38,638,569. It waits to be seen whether other courts adopt the District Court for the Eastern District of Texas’s logic in calculating bitcoin to U.S. dollar exchanges for judgment purposes in light of bitcoin’s historic volatility. A copy of the District Court’s Order granting summary judgment can be read here.

The Shavers’ decision comes at a time when both federal and state regulators have increasingly turned their attention towards virtual currency. As we have previously reported, New York State has recently proposed a highly detailed regulatory framework for virtual currency businesses. In addition, on August 11, 2014, the Consumer Finance Protection Bureau (“CFPB”) issued a consumer advisory warning customers of the potential risks associated with virtual currencies, including their high volatility and potential use in Ponzi schemes In the same announcement, CFPB announced that it has begun accepting consumer complaints regarding bitcoin transactions and dealings. A copy of our report on CFPB’s announcement can be read here.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of anti-money laundering compliance, administrative law, constitutional law, white collar criminal defense and litigation against the U.S. Department of Justice. If you or your company has a question related to its anti-money laundering compliance obligations, our anti-money laundering attorneys can provide further information. You can reach an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690

Third Circuit decision highlights power of “good faith exception” to the exclusionary rule

October 8th, 2014

We previously discussed the decision of the United States Court of Appeals for the Third Circuit in United States v. Katzin, wherein the Court found that a warrant is required for GPS monitoring and that there was no good-faith exception to the exclusionary rule.  However, on October 1, 2014, the Third Circuit sitting en banc  overruled the decision of the three judge panel and held that although a warrant is required to use a GPS monitor, because the state of the law before the Supreme Court’s 2012 decision in United States v. Jones supported the FBI agent’s action, the exclusionary rule did not apply.

The Good Faith Exception to the Exclusionary Rule

By reversing its earlier decision, the Third Circuit joined the Second, Fifth Seventh, and Ninth Circuits which have also held that the use and installation of a GPS device without a warrant prior to the Supreme Court’s Jones decision did not require the suppression of the evidence because of the “good faith exception” to the exclusionary rule. Consistent with the Supreme Court’s decisions in Knotts and Karo, both of which stand for the proposition that law enforcement searches which are conducted with an objectively reasonable reliance on binding appellate precedent are not subject to the exclusionary rule, the Third Circuit ruled that the FBI agent acted in good faith reliance upon Jones and therefore the good faith exception to the exclusionary rule applied. In other words, even though the agent’s search was subsequently deemed to be unlawful, because at the time of the search he relied in good faith on binding judicial precedent, the evidence obtained as the fruit of that “unlawful” search was nevertheless allowed to be used against the defendant from whom it was obtained.

As explained by the Third Circuit sitting en banc, the recent trend in Supreme Court jurisprudence is to limit the scope and application of the exclusionary rule to those “unusual cases” in which the suppression of illegally obtained evidence may “appreciably deter governmental violations of the Fourth Amendment.” Indeed, as the Third Circuit observed, the cost of suppressing illegally obtained evidence is that evidence of a criminal defendant’s guilt, even though reliable and trustworthy, will not be admitted “thereby ‘suppress[ing] the truth and set[ting] [a] criminal loose in the community without punishment.”

The Ramifications

Law enforcement’s ability to avoid the suppression of evidence has been dramatically expanded. Katzin and similar decisions in other federal courts are incredibly powerful means for law enforcement to circumvent the Fourth Amendment. Thus, in all criminal cases where a defendant attempts to challenge evidence based upon law enforcement’s clear violations of the defendant’s Fourth Amendment rights, one should anticipate the prosecution’s attempt to establish that law enforcement relied in good faith upon some binding appellate precedent, even if that precedent has since been overruled.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience litigating and trying criminal cases both at the state and federal levels including before the United States Courts of Appeal.  You can contact us via email:  contact@fidjlaw.com or via telephone:  305.350.5690.

Bitcoin Regulatory Update: CFPB Issues Consumer Advisory Regarding Virtual Currencies, Begins Accepting Complaints

September 1st, 2014

On August 11, 2014, the Consumer Finance Protection Bureau (“CFBP”) issued a consumer advisory warning customers of the potential risks associated with virtual currencies. A copy of the CFBP press release can be read here.

Created with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, CFPB, which began operations on July 21, 2011, was tasked with the responsibility of regulating both banks and nonbank institutions which offer financial products or services to ensure that these institutions comply with federal consumer financial protection laws. Under the Dodd-Frank act, CFPB is authorized to supervise all banks with more than $10 billion in assets as well as all sizes of nonbank mortgage companies, payday lenders, and private education lenders. Dodd-Frank also grants CFPB the power to regulate nonbank institutions in other consumer financial services markets.

CFPB’s consumer advisory does two things. First, it provides consumers a series of warnings and risks to be considered prior to entering into the virtual currency marketplace. According to CFPB, among the issues that consumers should be aware of prior to entering the virtual currency market include: 1) virtual currency is not a legal tender, not backed by any government, and digital wallets used to store such currency are not FDIC insured; 2) the exchange rate for virtual currency vis-à-vis fiat currency is very volatile and virtual exchanges may also charge additional mark-ups and fees for exchange and wallet services; and 3) digital wallets are the target of cyber-attacks and hackers and loses may not be recoverable.

Second, CFPB announced that consumers who encounter problems with virtual currency services and products can now file a complaint with the agency. As explained by CFPB, after it receives a complaint “[t]he CFPB will send the complaint to the appropriate company, and will work to get a response. If the complaint is about an issue outside the CFPB’s jurisdiction, the CFPB will forward the complaint to the appropriate federal or state regulator.” Such other federal agencies may include the Financial Crimes Enforcement Network, which regulates virtual currency exchanges, the Federal Trade Commission, which regulates unfair and deceptive trade practices, and theSecurities and Exchange Commission. (Copies of recent SEC investor advisories regarding virtual currencies can be read here and here.) The CFBP’s consumer advisory can be read here.

CFPB’s advisory comes in the wake of the recent announcement by New York State of its proposed framework for the regulation of virtual currency businesses. As we previously reported, included in the various proposed consumer protection regulations was the requirement that virtual currency businesses provide “clear and concise disclosures” to its consumers about each of the above mentioned risks. New York’s proposed BitLicense and now CFPB’s advisory are early steps in a growing trend of attempts to regulate the virtual currency industry. As we have also explained, the nature of the virtual currency business raises unique challenges for federal regulators seeking to curtail money laundering and state regulators seeking to protect residents from unfair, deceptive, and unscrupulous business practices. Of course, as more and more agencies seek to regulate the virtual currency service, the more likely it becomes that the resulting regulations are inconsistent with one another, leading to confusion in the industry and stifling growth.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of anti-money laundering compliance, administrative law, constitutional law, white collar criminal defense and litigation against the U.S. Department of Justice. If you or your company has a question related to its anti-money laundering compliance obligations, our anti-money laundering attorneys can provide further information. You can reach an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690

International Tax Compliance Update: Renouncing U.S. Citizenship to Avoid Taxes: Is It Worth It?

August 13th, 2014

As we have reported previously (see here, here, here, and  here) in recent years the United States has intensified its efforts to force United States persons to disclose assets they hold and income they earn abroad. Two prominent examples of these efforts are the United States’ increased focus on imposing penalties and people for failing to file Foreign Bank Account Reports (FBARs), and the passage and impending implementation of the Foreign Account Tax Compliance Act (FATCA), Internal Revenue Code §§ 1471-1474. The primary objective of these efforts is to ensure U.S. citizens and residents are accurately reporting their income and paying the correct tax. U.S. persons who fail to do so face serious consequences, which can include not only additional taxes, but also penalties, interest, fines and even imprisonment.

The United States taxes its citizens on worldwide income, no matter where they live and regardless of how long they have been overseas. Further, the rules for filing income, estate and gift tax returns and for paying estimated tax are generally the same whether the U.S. citizen is living in the U.S. or abroad. In addition to reporting their worldwide income, U.S. citizens must also report on their U.S. tax return whether they have any foreign bank or investment accounts.  As we previously reported, the Bank Secrecy Act requires U.S. persons to file a Form 114, Report of Foreign Bank and Financial Accounts (FBAR), if (1) they have financial interest in, signature authority, or other authority over one or more accounts in a foreign country, and (2) the aggregate value of all foreign financial accounts exceeds $10,000 at any time during the calendar year.

To avoid paying taxes to the U.S. government and the civil and criminal penalties associated with not disclosing foreign income or accounts, many U.S. citizens living abroad consider raising their right hand and reciting an oath renouncing their U.S. citizenship. As we have reported, over the past years there has been a significant surge in the number of Americans renouncing their U.S. citizenship. However, in terms of dollars and cents, this may well be a worse option than paying their taxes and reporting their foreign financial accounts to the IRS.

The expatriation tax provisions under Internal Revenue Code (I.R.C.) §§ 877 and 877A apply to U.S. citizens who have renounced their citizenship and long-term residents (as defined in I.R.C. §877(e)) who have ended their U.S. resident status for federal tax purposes. Different rules apply according to the date of expatriation. For U.S. citizens currently considering expatriation, and those who expatriated after June 16, 2008, the new I.R.C. §877A expatriation rules may apply. These rules apply if (1) their average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($147,000 for 2011, $151,000 for 2012, and $155,000 for 2013), (2) their net worth is $2 million or more on the date of your expatriation or termination of residency, or (3) they fail to certify on Form 8854 that they have complied with all U.S. federal tax obligations for the 5 years preceding the date of their expatriation or termination of residency. If any of these rules apply, you are a “covered expatriate.”

All of the property of a covered expatriate is deemed sold on the day before the expatriation date (i.e. the date the individual relinquishes U.S. citizenship) for its fair market value, and the covered expatriate is required to recognize any gain or loss resulting from the deemed sale. I.R.C. §877A(a). This is known as a “mark-to-market” regime.  To determine the gain or loss from a deemed sale, all gains are taken into account notwithstanding any other provision in the Code. Any loss from the deemed sale is taken into account for the tax year of the deemed sale to the extent otherwise provided in the Code, except that the wash sale rules of I.R.C. §1091 do not apply.
The amount that would otherwise be includible in gross income by reason of the deemed sale rule is reduced (but not to below zero) by $600,000, which amount is to be adjusted for inflation for calendar years after 2008 (the “exclusion amount”). For calendar year 2013, the exclusion amount is $663,000. For other years, refer to the Instructions for Form 8854.
The amount of any gain or loss subsequently realized (i.e., pursuant to the disposition of the property) will be adjusted for gain and loss taken into account under the I.R.C. §877A mark-to-market regime, without regard to the exclusion amount. A taxpayer may elect to defer payment of tax attributable to property deemed sold. (For more detailed information regarding the I.R.C. §877A mark-to-market regime, refer to Notice 2009-85.)
Form 8854, Initial and Annual Expatriation Information Statement, and its Instructions have been revised to permit individuals to meet the new notification and information reporting requirements. The revised Form 8854 and its instructions also address how individuals should certify (in accordance with the new law) that they have met their federal tax obligations for the five preceding taxable years and what constitutes notification to the Department of State or the Department of Homeland Security.

A citizen is treated as relinquishing his or her U.S. citizenship on the earliest of four possible dates: (1) the date the individual renounces his or her U.S. nationality before a diplomatic or consular officer of the United States, provided the renunciation is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State; (2) the date the individual furnishes to the U.S. Department of State a signed statement of voluntary relinquishment of U.S. nationality confirming the performance of an act of expatriation specified in paragraph (1), (2), (3), or (4) of §349(a) of the Immigration and Nationality Act (8 U.S.C. 1481(a)(1)-(4)), provided the voluntary relinquishment is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State; (3) the date the U.S. Department of State issues to the individual a certificate of loss of nationality; or (4) the date a U.S. court cancels a naturalized citizen’s certificate of naturalization.

A long-term resident ceases to be a lawful permanent resident if the individual’s status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws has been revoked or has been administratively or judicially determined to have been abandoned, or if the individual: (1) commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, (2) does not waive the benefits of the treaty applicable to residents of the foreign country, and (3) notifies the IRS of such treatment on Forms 8833 and 8854.
Significantly, an individual does not have to be a high net worth individual to fall under the “covered expatriate” rules. As noted earlier, if any of the I.R.C. §877A rules apply, the individual will be considered a covered expatriate. One of those rules states that a taxpayer who fails to certify, under penalties of perjury, compliance with all U.S. Federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date. This means that if the individual failed to comply with his U.S. federal tax obligations or simply failed to certify that he complied, he will be automatically considered a “covered expatriate” subject to the tax imposed by I.R.C. §877A. Therefore, a close look at the expatriation tax makes evident that raising your right hand to renounce U.S. citizenship may be as costly (if not more) than keeping your U.S. citizenship and paying taxes on your worldwide income like all other U.S. citizens even if you are not considered a wealthy individual. The expatriation tax adds up, potentially to as much as paying income taxes to the IRS will. This raises the question: is paying a significant amount of expatriation tax and giving up one of the most desired citizenships in the world really worth it?

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax and tax litigation.  They will continue to monitor developments in this area of the law. If you have any questions, an attorney can be reached by emailing us at contact@fidjlaw.com or by calling 305.350.5690.

Florida Appeals Court Clarifies Law On Derivative And Direct Shareholder Lawsuits

July 22nd, 2014

On July 9, 2014, Florida’s Third District Court of Appeal issued a landmark opinion in the case of Dinuro Investments, LLC vs. Felisberto Figueira Camacho, et al., 3D13-1242 & 3D13-1246, (July 9, 2014).  In Dinuro, the Court analyzed whether a member of a limited liability company (“LLC”) had standing to commence a lawsuit directly against fellow LLC members.  In reaching its conclusion, the Court synthesized nearly fifty years of inconsistent Florida case law bringing clarity to which actions must be maintained directly and which actions must be brought derivatively.

Direct Claim vs. Derivative Claim

But first, it’s important to understand the basic distinctions between direct and derivative claims.  Generally, a derivative action is “an action in which a stockholder seeks to sustain in his own name a right of action existing in the corporation. The corporation is the real party in interest, the stockholder being only a nominal plaintiff.” James Talcott, Inc., v. McDowell, 148 So. 2d 36, 37 (Fla. 3d DCA 1962). A derivative action “must allege two distinct wrongs: the act whereby the corporation was caused to suffer damage, and a wrongful refusal by the corporation to seek redress for such act.” Id. at 38.  See also Kaplus v. First Cont’l Corp., 711 So. 2d 108, 110 (Fla. 3d DCA 1998) (“In a derivative action, a stockholder seeks to sustain in his or her name, a right of action belonging to the corporation.”).  Both the Florida Business Corporation Act and Florida Revised Limited Liability Company Act contain provisions for derivative actions.  See Fla. Stat. §607.07401 (shareholder derivative actions) and Fla. Stat. §605.0801-605.0806 (member derivative actions).See also Florida Limited Liability Company Act, specifically, Fla. Stat. §608.60, for derivative actions in LLCs formed before January 1, 2014.  However, effective January 1, 2015 all LLCs will be governed by the Revised Limited Liability Company Act. Comparatively, a direct action (a/k/a an “individual action”) is a suit by a shareholder/member to enforce a right of action existing in him, separate and distinct from that sustained by other shareholders/members. Citizens National Bank of St. Petersburg v. Peters, 175 So. 2d 54, 56 (Fla. 2d DCA 1965).

A significant distinction between a derivative and a direct lawsuit is one that ultimately impacts the bottom line.  In a derivative action, all recoveries belong to the corporate entity. In a direct action, all recoveries belong to the individual shareholder/member plaintiff(s). That said, aggrieved shareholders/members typically prefer to initiate direct actions and pocket the recovery. However, as clarified by Dinuro, the bar to initiate a direct lawsuit has now been raised.

The Dinuro Facts

In Dinuro, three equal members of San Remo Homes, LLC (“San Remo”) obtained financing to purchase pieces of real estate through subsidiary entities. Due to a decline in the housing market San Remo was forced to negotiate a loan modification with its lender. A term of the revised loan agreement required the three members to make additional contributions to San Remo. Two members made the contributions, while one member, Dinuro, did not. Further, the two compliant members refused to front Dinuro’s member contribution. Consequently, the loan went into default.

The two compliant members formed a new corporation, SR Acquisitions, LLC, and successfully negotiated a purchase of San Remo’s defaulted loan from the lender. Thereafter, SR Acquisitions, LLC initiated foreclosure proceedings against San Remo, acquired the San Remo properties, and left San Remo with no viable assets. Dinuro initiated a direct member lawsuit against the two other members and the lender alleging a breach of operating agreements, tortious interference, and conspiracy to cause the damage outlined in previous counts.

The Defendants moved to dismiss on several grounds, including Dinuro’s lack of standing.  The trial court granted the motion to dismiss “finding that Dinuro lacked individual standing to bring a direct claim against the other members for this type of harm, and that its claims should have been brought derivatively on behalf of San Remo.”

The Third District Court of Appeal agreed with the trial court and provided a detailed opinion to “provide clarity on a complicated point of law.”

Florida’s New Two-Prong Approach

Pulling from “scholarly literature and case law from around the country,” including Florida, the Dinuro Court stated as follows:

[t]he only way to reconcile nearly fifty years of apparently divergent case law on this point is by holding that an action may be brought directly only if (1) there is a direct harm to the shareholder or member such that the alleged injury does not flow subsequently from an initial harm to the company and(2) there is a special injury to the shareholder or member that is separate and distinct from those sustained by the other shareholders or members.

(Emphasis added).

The Court also identified an exception to the rule stating that a “shareholder or member need not satisfy this two-prong test when there is a separate duty owed by the defendant(s) to the individual plaintiff under contractual or statutory mandates.”

Succinctly, if a plaintiff cannot satisfy the two-prong test (direct harm and special injury) or demonstrate a contractual or statutory exception, the plaintiff will have to bring his or her claims derivatively on behalf of the corporation or company.  Relying on this new approach, the Dinuro Court reached the same conclusion as the trial court, that is, Dinuro’s claims could only be maintained derivatively because it was the entity that was initially injured, not the individual.

The attorneys at Fuerst Ittleman David & Joseph, PL will monitor subsequent application of Dinuro.  Our attorneys have extensive experience in the areas of complex corporate litigation, business litigation, tax, tax litigation, administrative law, regulatory compliance, and white collar criminal defense.  If you have any questions, an attorney can be reached by emailing us at contact@fidjlaw.com or by calling 305.350.5690.

Operation Choke Point Update: Despite Congressional and Industry Criticism, DOJ Will Continue Crackdown On Payday Lending Industry

July 3rd, 2014

Since early 2013, the United States Department of Justice (“DOJ”) has been formally targeting banks and payment processors servicing a wide range of lawfully operating businesses that various federal agencies, including DOJ and the Federal Deposit Insurance Corporation (“FDIC”), consider “high risk,” including nontraditional financial services providers such as payday lenders. The probe, known as “Operation Choke Point,” seeks to eliminate these “high risk” industries by cutting off their access to banking services. More information regarding Operation Choke Point can be read in our previous report here.

Not surprisingly, Operation Choke Point has drawn harsh criticism from both Congress and the financial services community because it has forced banks to terminate relationships with a wide variety of perfectly legitimate merchants. In January of this year, the U.S. House of Representatives Committee on Oversight and Government Reform requested that DOJ produce numerous documents regarding its general policies and procedures involving Operation Choke Point. Based on DOJ’s disclosures, on May 29, 2014, the Committee issued its staff report entitled: “The Department of Justice’s ‘Operation Choke Point’: Illegally Choking Off Legitimate Businesses?.” In its report, the Committee found that the DOJ has taken the position that providing normal banking services to certain merchants, including payday lenders, creates a “reputational risk” sufficient to trigger a federal investigation. The report concluded that as a result of increased pressure by DOJ and federal bank regulators, banks are terminating their relationships with “high risk” merchants in order to avoid heightened scrutiny by the federal government.

The report further questioned DOJ’s authority to implement Operation Choke Point. As explained in the report:

Operation Choke Point is being executed through subpoenas issued under Section 951 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. The intent of Section 951 was to give the Department the tools to pursue civil penalties against entities that commit fraud against banks, not private companies doing legal business. Documents produced to the Committee demonstrate the Department has radically and unjustifiably expanded its Section 951 Authority.

(emphasis in original).

Operation Choke Point has also drawn the ire of the financial services industry. On June 5, 2014, the Community Financial Services Association of America (“CFSA”) filed a lawsuit seeking to end Operation Choke Point alleging that regulatory agencies and the DOJ are “engaged in a concerted campaign to drive [payday lenders] out of business by exerting back-room pressure on banks and other regulated financial institutions to terminate their relationships with payday lenders.” A copy of CFSA’s press release can be read here and the complaint can be read here.  (Our previous report regarding the financial services industry’s criticism of Operation Choke Point can be readhere.)

However despite this criticism, the DOJ has no plans to discontinue the program. Instead, the DOJ argues that Operation Choke Point is necessary to crack down on online payday lenders (and other “high risk” businesses) who attempt to operate in states where payday lending is illegal. According to DOJ, many online payday lenders operate in states where payday lending is prohibited by utilizing third party payment processors that have bank accounts to make direct deductions from borrower’s accounts. (Non-bank or “third party” payment processors provide payment processing services to merchants and other business entities. Typically, payment processors use their own deposit accounts at financial institutions to process such transactions and sometimes establish deposit accounts at the financial institution in the names of their merchant clients.) By using payment processors to process payday loans and debit borrowers’ accounts, online lenders can operate in states where such activity is prohibited. (Our most recent report regarding how effective anti-money laundering compliance programs can help reduce the risk that third party payment processors may be facilitating fraudulent and illegal activity can be read here.)

DOJ also argues that Operation Choke Point has been successful. On April 29, 2014, DOJ announced a settlement with Four Oaks Fincorp. Inc., which was sued as part of Operation Choke Point. According to the Complaint filed by DOJ, Four Oaks permitted a third party payment processor facilitate $2.4 billion in fraudulent and illegal online payday loans through its banking system. As a result, Four Oaks agreed to pay $1.2 million in civil penalties. A copy of the DOJ press release announcing the settlement can be read here.

 

While DOJ’s stated position is that Operation Choke Point is designed to eliminate online payday lenders operating in states where online lending is illegal, in reality Operation Choke Point has resulted in banks severing ties with payday lenders operating in states where online lending is perfectly legal. In fact, the House Committee’s Report concluded that DOJ is using Operation Choke Point as a tool to target all forms of online lending. As explained in the Report, “Internal memoranda and communications demonstrate that Operation Choke Point was focused on short-term lending, and online lending in particular. Senior officials expressed their belief that its elimination would be a ‘significant accomplishment’ for consumers.”

Fuerst Ittleman David & Joseph, PL will continue to monitor the development of Operation Choke Point. The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of administrative law, anti-money laundering, regulatory compliance, and litigation against the U.S. Department of Justice. If you are a financial institution seeking information regarding the steps your business must take to remain compliant, you can reach an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690.

United States Supreme Court: Warrants are required to search digital data on seized cell phones

July 2nd, 2014

On June 25, 2014, in Riley v. California, a unanimous United States Supreme Court held that the Fourth Amendment requires that police obtain a warrant prior to searching the digital data found on an arrested suspect’s cell phone. The opinion can be read here.

Generally speaking, a warrantless search is unreasonable and a violation of the Fourth Amendment unless it falls within a specific exception to the warrant requirement. At issue in Riley v. California was whether the warrantless search of the digital data of a cell phone is permissible under the long recognized “search incident to arrest” exception to the warrant requirement which generally provides that law enforcement may search an arrestee at the time of his or her arrest.

In a series of decisions, the Supreme Court has explained the bounds of the search incident to arrest exception. In Chimel v. California, 395 U.S. 752 (1969), the Supreme Court held that for a warrantless search incident to arrest to comport with the Fourth Amendment, the search must be limited to the area within the arrestee’s immediate control. The Chimel court made clear that the purposes behind the search incident to arrest exception are twofold: 1) the need to protect officer safety; and 2) the need to prevent the destruction of evidence.

The Supreme Court further explained the search incident to arrest exception in United States v. Robinson, 414 U.S. 218 (1973). In Robinson, the Court held that physical evidence found on a person during a lawful search incident to arrest could itself be searched pursuant to the doctrine announced in Chimel. Finally, in Arizona v. Gant, 556 U.S. 332 (2009), the Court again relied uponChimel in holding that a search incident to arrest permits searches of a car where the arrestee is unsecured and within reaching distance of the passenger compartment, or where it is reasonable to believe that evidence of the crime of arrest might be found in the vehicle.

In declining to extend Robinson and Gant to warrantless searches of digital data of an arrestee’s cell phone, the Court found that neither of the unique and narrow purposes (officer safety and preventing the destruction of evidence) is served by allowing the search of digital data on cell phones. As to officer safety, the Court found that digital data stored on a cell phone cannot itself be used as a weapon to harm an officer. Thus, while warrantless physical inspections of a seized phone are permissible to ensure officer safety, such as a search to ensure that a cell phone is not concealing a weapon which may harm an arresting officer, searches of digital content require a search warrant.

With regard to the destruction of evidence, the Court rejected the Government’s argument that, because remote wiping of information may be possible, officers should be allowed to conduct warrantless searches of digital data. The Court found that the Government’s briefing did not indicate that wiping and encryption were pervasive problems and that other techniques and technologies, such as simply turning the phone off or placing in a radio wave proof bag, could combat those problems.

Although finding that the purposes of Chimel were not satisfied, the Court did recognize that in certain rare circumstances the need for officer safety or the prevention of the destruction of evidence would necessitate the searching of a cell phone. However, the Court found that those rare instances would be governed by the “exigent circumstances” exception, not the search incident to a lawful arrest exception.

The Supreme Court also made clear that due to the vast storage capabilities of modern cell phones, greater privacy interests are implicated when addressing the Fourth Amendment’s warrants requirement as applied to the search of digital data. As explained by the Court, “[t]he search incident to arrest exception rests not only on the heightened government interests at stake in a volatile arrest situation, but also on an arrestee’s reduced privacy interests upon being taken into police custody.” Riley, 573 U.S. ___ (2014) slip op. at 15. However, the Court noted:

The fact that an arrestee has diminished privacy interests does not mean that the Fourth Amendment falls out of the picture entirely. Not every search is acceptable solely because a person is in custody. To the contrary, when privacy-related concerns are weighty enough a search may require a warrant, notwithstanding the diminished expectations of privacy of the arrestee.

Id. at 16 (internal citations and quotations omitted).

The Supreme Court also found that the privacy concerns regarding digital data on cell phones was different than those concerning the contents of physical objects. First, the Court found that modern “smart” cell phones allow users to store various distinct types of information that, when searched in combination, would reveal much more information than any one particular record in isolation. Second, the storage capacity of cell phones allows far broader access to information than previously possible. As explained by the Court, “the sum of an individual’s private life can be reconstructed through a thousand photographs labeled with dates, locations, and descriptions; the same cannot be said of a photograph or two of loved ones tucked into a wallet.” Id. at 18. Finally, the data on cell phones can date back years. Whereas “before cell phones, a search of a person was limited by physical realities and tended as a general matter to constitute only a narrow intrusion on privacy,” today the search of digital data of seized cell phones would be far more exhaustive, revealing, and intrusive. As a result, greater privacy concerns exist.

Of course, the Court’s decision does not mean that law enforcement is somehow foreclosed from searching cell phones. As explained by the Court:

Modern cell phones are not just another technological convenience. With all they contain and all they may reveal, they hold for many Americans the privacies of life. The fact that technology now allows an individual to carry such information in his hand does not make the information any less worthy of the protection for which the Founders fought. Our answer to the question of what police must do before searching a cell phone seized incident to an arrest is accordingly simple – get a warrant.

Id. at 28 (internal citations and quotations omitted)(emphasis added).

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of administrative law, constitutional law, white collar criminal defense and litigating against the U.S. Department of Justice. You can reach an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690.

Tax Litigation Update: Eleventh Circuit Holds Clear and Convincing Evidence Standard Applies to Penalties Imposed under IRC § 6701

June 25th, 2014

The Eleventh Circuit Court of Appeals, which hears appeals from the federal district courts in Florida, Georgia, and Alabama, ruled earlier this month that in order to impose penalties under IRC § 6701, the government bears the burden of proving each element of the statute by clear and convincing evidence.  In so doing, the Eleventh Circuit reversed the holding of the Middle District of Florida that a lower standard, preponderance of the evidence, applies to § 6701.  Moreover, the Eleventh Circuit’s decision was contrary to the Second and Eighth Circuits, which have held that proof by a preponderance of the evidence is the proper standard.  The Eleventh Circuit’s decision also created precedential case law that tax practitioners can potentially use to defend their clients from civil penalties beyond just § 6701.

Background

The case before the Eleventh Circuit, Carlson v. United States, involved a tax return preparer, Frances Carlson, working for two companies doing business as Jackson Hewitt.  Prior to starting this job, Carlson did not have any professional tax return experience.  In this position, Carlson prepared both individual and corporate returns.  In total, Carlson worked for Jackson Hewitt for five years and prepared between 1200 and 1500 tax returns.

In 2006, the owner of the two Jackson Hewitt franchises that employed Carlson was arrested for, among other crimes, money laundering.  The arrest prompted an investigation of the businesses by the IRS.  In its investigation, the IRS determined that approximately 40 of the returns prepared by Carlson during the course of her employment contained unsubstantiated deductions.  The IRS thereafter assessed penalties against Carlson under IRC § 6701(a), which imposes a penalty against any person who:

(1) aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document,

 

(2) knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and

 

(3) knows that such portion (if so used) would result in an understatement of the liability for tax of another person.

Carlson paid 15 percent of the assessed penalty, filed a claim for refund, which was rejected, and then sued in the district court for a refund.  Prior to trial, the IRS conceded 13 of the 40 penalties (one for each return bearing unsubstantiated deductions), leaving 27 penalties to determine.  At trial, Carlson moved for judgment as a matter of law as to 5 of those penalties because the Government had failed to introduce any evidence that Carlson knew the returns she prepared were incorrect.  The district court denied the motion and all 27 penalties went to the jury.  Carlson then objected to the district court’s jury instruction that the Government’s burden of proof under IRC § 6701 was proof by a preponderance of the evidence rather than by clear and convincing evidence.  The Court overruled the objection and the jury returned a verdict in favor of the government on all of the 27 penalties at issue, resulting in a judgment of $119,173.12 against Carlson.

The Eleventh Circuit’s Reasoning

On appeal, the Eleventh Circuit determined that the district court was incorrect in its jury instruction and in denying Carlson’s motion for judgment as a matter of law.  In reversing the district court on the jury instruction issue, the Eleventh Circuit began by stating that under its longstanding precedent, the Government’s burden for proving fraud in a civil tax case was “clear and convincing evidence.”  Based on this principle, the Eleventh Circuit stated that the pertinent question before it was whether § 6701 requires the Government to prove fraud.  If so, then the proper burden of proof is “clear and convincing evidence.”

In holding that § 6701 does require the Government to prove fraud, the Eleventh Circuit analyzed the text of § 6701(a), particularly subsection (a)(3) which requires the defendant to “know[s] that such portion [of a return or other document] (if so used) would result in an understatement of the liability for tax of another person…”

Section 6701(a)(3) contains the statute’s scienter requirement–the state of mind the defendant must have had to be liable under the statute.  The Eleventh Circuit read § 6701(a)(3) to require actual knowledge by the return preparer that the return the prepare had assisted in the preparation of would deprive the government of tax that is owed to it.  To the Eleventh Circuit, § 6701’s requirement of actual knowledge of the understated tax is akin to “the preparer deceitfully prepar[ing] a return knowing it misrepresented or concealed something that understates the correct tax,” which amounts to “a classic case of fraudulent conduct.”

The Government attempted to argue that the statute could not require a finding of fraud, and therefore could not necessarily require clear proof of a violation by clear and convincing evidence, because the statute does not contain the word “fraud.”  The Court summarily rejected that argument as elevating form over substance—“the lack of the word ‘fraud’ is immaterial if the conduct the government must prove meets the definition of fraud.”

Moreover, the Government itself had previously argued that because § 6701 is an anti-fraud provision, no statute of limitation applied to deficiencies resulting from actions prohibited under § 6701.  Thus, the government was seeking to cabin the characteristics of fraud contained in § 6701 to situations in which only it benefitted.

Creation of a Circuit Split

In holding that § 6701 requires proof by “clear and convincing evidence,” the Eleventh Circuit contradicted the Second Circuit and the Eighth Circuit Courts of Appeal.  In Mattingly v. United States, 924 F.3d 785 (8th Cir. 1991), the Eighth Circuit determined that § 6701 requires proof by a preponderance of the evidence for two reasons (which the Second Circuit followed without much elaboration in Barr v. United States, 67 F.3d 469 (2d Cir. 1995)): first, the Eighth Circuit reasoned that § 6701 does not require proof of fraud (and thus does not require a heightened standard of proof) because it does not refer to the “evasion of tax.” The Eleventh Circuit in Carlson rejected this notion because it could not discern a reason why a reference to evasion of tax in § 6701 was relevant to its analysis of the burden of proof imposed by § 6701.  Moreover, the Eleventh Circuit reasoned, even if it were necessary for the statute to reference tax evasion to implicate a higher standard of proof, § 6701 does reference tax evasion (without explicitly using that phrase) due to its requirement that the return preparer’s knowing violation “result in an understatement of the liability for tax of another person.”

Second, in Mattingly, the Eighth Circuit reasoned that the structure of sections 6700, 6701, 6702, and 6703 suggests the application of a uniform standard of proof.  The Eleventh Circuit dismissed this reasoning on the basis that applying standards of proof based on a statute’s relationship to other statutes could lead to perverse results.  Additionally, even if sections 6700-6703 suggest the need to apply a uniform standard of proof, there is no specified standard of proof for those sections.  Thus, there is nothing specifically requiring a court to impose a preponderance of the evidence standard over a clear and convincing evidence standard in any of those statutes.

Finally, the Eighth Circuit, in justifying the application of a lower standard of proof to § 6701, reasoned that § 6701 was enacted as “another piece in the expansive non-fraud penalty scheme” applicable to taxpayers and tax preparers.  In refusing to follow this rationale, the Eleventh Circuit, drawing on the case of Sansom v. United States, 703 F.Supp. 1505 (N.D. Fla. 1988), identified three penalties applicable to tax preparers, IRC §§ 6694(a), 6694(b), and 6701.  Of those, only § 6701 requires the return preparer to actually know that that the return understates the proper amount of tax, thus suggesting that § 6701 was unique among those three statutes and worthy of a higher standard of proof.

The Fallout

After rejecting the approach taken by the Second and Eighth Circuits and holding that the imposition of penalties under § 6701 required proof by clear and convincing evidence, the Eleventh Circuit further determined that the district court’s application of the incorrect standard of proof was not harmless and required a new trial.

Additionally, the Eleventh Circuit reversed the district court’s decision to deny Carlson’s motion for judgment as a matter of law as to the penalties imposed on five specific returns.  With regard to each of these five penalties, the Government only presented evidence that the taxpayer assisted by Carlson did not substantiate the claimed deductions.  The Government did not present evidence that Carlson actually knew the returns understated the correct tax.

A verdict based on evidence that merely demonstrates that the taxpayers could not substantiate their deductions would have the effect of improperly transferring the burden to Carlson to prove that she did not actually know of the error, as opposed to the Government proving she did know of the error.  Additionally, it would be an impermissible inference by a jury to conclude that Carlson actually knew of the error based solely on the fact that the taxpayer could not substantiate his deduction—the presence of an incorrect deduction does not prove that the return prepare knew the return was inaccurate.

Because the government failed to present any evidence as to Carlson’s knowledge of the inaccurate returns on these five penalties, the Eleventh Circuit held that Carlson’s motion for judgment as a matter of law should have been granted.  The Eleventh Circuit went out of its way to state that it was not deciding what standard of proof should be used to review a district court’s denial of a motion for judgment as a matter of law on § 6701 penalties (as opposed to the context of jury instructions, which it did decide).  Under either the preponderance of the evidence or clear and convincing evidence standards, the government’s failure to introduce any evidence of Carlson’s knowledge required judgment as a matter of law in Carlson’s favor.

The Carlson decision is an important victory for tax return preparers operating in the Eleventh Circuit.  Under a fair reading of the decision, tax return preparers are entitled to rely upon the information supplied to them by the taxpayer, without the fear of being accused they were “willfully blind” to the errors contained in the taxpayer’s claimed deductions.  Additionally, by deciding the question in contravention of the Eighth and Second Circuits, the Eleventh Circuit has created a circuit split, heightening the chances the Supreme Court may ultimately decide the question.

Potential Relevance in Other Contexts

        i.            Willful FBAR Violations

It remains to be seen if the Eleventh Circuit’s articulation of the burden of proof under IRC § 6701 will translate to or be adopted in other areas where the correct burden of proof is less than clear.  A very active area where the burden of proof is less than clear is the imposition of willfulness penalties for failing to file a Report of Foreign Bank Account (“FBAR”).  A non-willful failure to file an FBAR may lead to a penalty of $10,000 per violation, but a willful failure to file an FBAR can lead to a penalty of the greater of $100,000 or 50 percent of the highest balance in the undisclosed account during the given year, so the determination of willfulness or non-willfulness is an important one.

There is a dearth of judicial precedent regarding the proper burden of proof in determining willfulness in the FBAR context.  In a recent high profile case, United States v. Zwerner, the Southern District of Florida submitted the willfulness question to the jury with the instruction to apply the preponderance of the evidence standard, and the jury found that the taxpayer had willfully failed to meet his FBAR obligations.

While the amount of the penalty to be imposed in the Zwerner case settled before the jury’s verdict could be appealed, some have speculated that had the Eleventh Circuit’s decision inCarlson been released earlier, the taxpayer in Zwerner would have had leverage to seek a more favorable settlement.  This is because under Carlson, the imposition of civil penalties based on fraudulent conduct requires the Government to prove its case by clear and convincing evidence, even where the subject statute does not explicitly reference fraud.  Rather, under Carlson, the key determination was whether the return preparer knew that her actions would result in the understatement of liability for the taxpayer, which the Eleventh Circuit held to be synonymous with fraud.

Willfulness is generally defined as an intentional violation of a known legal duty.  It can be effectively argued that knowingly taking action that would result in an understatement of liability (which the Eleventh Circuit held in Carlson to require proof by clear and convincing evidence) is analogous to an intentional (i.e. knowing) violation of the FBAR requirement.  Hence, establishing willfulness for purposes of applying the higher civil FBAR penalty should require proof by clear and convincing evidence just as proving the elements of a § 6701 violation now (in the Eleventh Circuit at least) requires proof by clear and convincing evidence.

While there are certainly counterarguments as to why the Carlson should not extend to the context of FBARs, the Carlson decision certainly provides a weapon for clever and resourceful tax attorneys to use in defense against civil penalties imposed beyond the scope of IRC § 6701.

     ii.            The Offshore Voluntary Disclosure Program

In a related issue, the IRS recently modified the rules applicable to its Offshore Voluntary Disclosure Program (OVDP).  As we wrote about more extensively here, a key determination regarding what type of voluntary disclosure a taxpayer may make is whether that taxpayer’s past non-compliance (such as failure to file FBARs) was willful or non-willful.  In general, far more lenient treatment is provided to those OVDP filers who successfully establish that their past non-compliance was not willful.

The problem, as more thoroughly explained in our previous blog entry, is that defining “non-willfulness” in the context of the OVDP is extremely difficult.  Under the new OVDP rules, the ultimate arbiter of whether an OVDP filer’s past non-compliance was or was not willful is the IRS—its determinations are final and the methodology it will employ in evaluating willfulness is unknown to both taxpayers and to IRS personnel.

To compound the uncertainty, as the Carlson case demonstrates, not even the Circuit Courts of Appeal are in agreement as to what proof is required to establish certain penalties, such as those imposed under § 6701, that are based on the violator’s knowledge and willfulness, and there appears to be no circuit-level authority regarding the standard of proof for imposing civil, willful FBAR penalties.  The disagreement and lack of guidance from the courts on these points simply exacerbates the uncertainty surrounding how the IRS will evaluate willfulness in the OVDP and leaves potential OVDP filers searching for answers.

The attorneys at Fuerst, Ittleman, David & Joseph have extensive experience litigating tax cases in the Tax Court, Federal District Courts, and the Court of Claims. We will continue to monitor the development of the Carlson case and other issues relating to IRC § 6701, FBAR penalties, and the non-willfulness in the OVDP and we will update this blog with relevant information as often as possible. You can reach an attorney by calling us at 305-350-5690 or emailing us atcontact@fidjlaw.com.

FTC Settlement with Payment Processor Highlights Importance of Anti-Money Laundering Programs for Non-Bank Financial Institutions

On June 11, 2014, the Federal Trade Commission (“FTC”) announced that it had entered into a stipulated permanent injunction with Independent Resources Network Corp., a payment processor, to settle charges that it knowingly assisted and facilitated a telemarking scam that swindled nearly $10 million from unsuspecting consumers. A copy of the FTC’s press release can be read here.

In its most simple terms, payment processors are entities that process credit or debit card transactions between merchants and consumers. As described by FinCEN:

Non-bank, or third party, Payment Processors … provide payment processing services to merchants and other business entities, typically initiating transactions on behalf of merchant clients that do not have a direct relationship with the Payment Processor’s financial institution. Payment Processors use their own deposit accounts at a financial institution to process such transactions and sometimes establish deposit accounts at the financial institution in the names of their merchant clients.

See FinCEN Advisory FIN-2012-A010.

In its Complaint, FTC alleged that Independent Resources either knew or consciously avoided knowing facts about the illegal conduct of a telemarketing scam operated by one of its merchants, Innovative Wealth Builder, Inc. (“IWB”). According to the complaint, IWB operated a phony debt relief scam wherein IWB would cold call its victims explaining how, for a fee, IWB could reduce the interest rates the customers were correctly paying on their outstanding credit card debt. In reality, no such program existed.

As alleged in the complaint, Independent Resources ignored several indicators of potential fraud including: 1) that IWB had an “F” rating with the Better Business Bureau; 2) that IWB was the subject of an investigation by the Florida Attorney General’s Office for unfair and deceptive trade practices; 3) that MasterCard identified IWB as “tier 3” or “high fraud alert” because of the number of fraudulent transactions which were associated with the debt relief company; 4) that IWB was the subject of an FTC investigation for unfair and deceptive trade practices; and 5) from August 2009 until January 2013 (the filing date of the complaint) IWB’s chargeback rate exceeded 40% multiple times despite the average chargeback rate for all other merchants of the payment processor was below 1%. In addition, the complaint alleged that the payment processor assisted IWB in responding to and defeating thousands of chargeback requests and helped structure sales transactions in order to divide fees over multiple transactions.

In an effort to settle the FTC’s allegations of violations of the Telemarketing Sales Rule, Independent Resources entered into a Stipulated Order. As part of the Stipulated Order for Permanent Injunction and Monetary Judgment, the payment processor agreed to pay $1.1 million. In addition, the order prohibits the payment processor from processing payments for any client that sells debt relief products or services. Further, the payment processor cannot process payments from collection agencies, credit card protection services, lead source provides, mortgage loan modifications, or outbound telemarketing without conducting upfront screening and ongoing monitoring.

As the Independent Resources settlement makes clear, in addition to the numerous agencies which regulate the financial services industry, including FinCEN, FDIC, OCC, and the IRS, non-bank financial institutions must also ensure that the business practices of their customers are not false, misleading, or unlawfully deceptive so as to violate the FTCA. The stipulated order and settlement highlights the need for payment processors, and the financial institutions that serve them, to develop, implement, and maintain robust anti-money laundering compliance programs. See generally, 31 U.S.C. § 5318. A properly constructed AML program — even for companies which are not technically required to have one – will be helpful in accomplishing two critical tasks: 1) detecting potential fraud and abuse by merchants, and 2) ensuring that the company is not unwittingly participating in the legal violations of third parties. As we have previously reported with regards to internet gambling, in addition to civil liabilities, third party payment processors face potential criminal prosecution for facilitating violations of federal law. (Our previous reports regarding payment processor liability can be read here and here.)

We will continue to watch for the latest developments. Fuerst Ittleman David & Joseph’s Anti-Money Laundering practice covers a wide range of businesses and legal issues. Our AML practice group has represented a wide array of financial services providers in all aspects of their business. In addition, our attorneys have experience working with regulated industry to ensure that marketing, advertisements, and disclosures are in compliance with applicable FTC law and regulation. For more information regarding the Bank Secrecy Act or if you seek further information regarding the steps which your business must take to become or remain compliant, you can reach an attorney by emailing us at contact@fidjlaw.com or by calling us at 305.350.5690.