Government agents investigating tax offenses often work within well-defined parameters including the time period (i.e., frequently a six-year range) for an investigation without fully assessing the origins of financial transactions that contribute to an ultimate tax loss. This concept of “remaining in the box” can cause the tax loss attributable to fraud to be overstated, thereby contributing to an inflated “guideline sentence” for an individual defendant convicted of tax offense(s).
Forensic accountants are routinely engaged to assist in the calculation of lost profits and economic damages in various types of litigation. One such engagement is assisting attorneys in calculating and/or reviewing calculations of tax loss attributable to alleged fraud committed by a defendant. These tax loss calculations are relevant when a court is determining the length of sentence for a defendant in criminal tax litigation.
Income tax returns represent the end result of a process involving a myriad of transactions, persons and documents. Our role is understanding this process, and in some cases reverse- engineering the process, to extract critical pieces of information that have swayed the outcome of an IRS investigation.
In many loss analyses, accountants have wide latitude in determining the method appropriate to calculate damages incurred. However, Part 2T1.1 of the US Sentencing Guidelines Manual provides certain parameters for calculating tax loss for the purpose of determining the “guideline range” of sentence for the tax crime defendant(s).
This article provides an accountant’s perspective of an engagement to assist in criminal tax or other matters in which a guideline sentence is based upon some measure of financial loss. The authors of this article are not attorneys. This article is not intended to provide legal guidance.
At this writing, federal sentencing guidelines have been in place for approximately 30 years, having been implemented in the late 1980s. An objective of the guidelines is to achieve perceived consistency between sentences for specific offenses. Throughout their history, the sentencing guidelines have been challenged and revised to the point of becoming advisory, rather than mandatory. Loss ranges relevant to sentencing levels have been adjusted for economic conditions (i.e., inflation) and changing views on sentencing. That said, attention must be given to where an alleged loss is positioned within a “range.” The feasibility of effectively moving a loss from one range to another should be considered.
Calculation of Losses
For criminal tax matters, accountants operate within the context of the Internal Revenue Code and its attendant rules and regulations. Additionally, accountants must be mindful of distinctions between willful violations and negligent violations. This requires the accountant to consider causal factors that may be minimized in other types of loss analyses. This mental framework/approach is potentially relevant to any IRS investigation as the agents may attempt to include negligent omissions as part of the tax loss. This is a facts-and-circumstances analysis which, as illustrated below, may necessitate consideration of factors outside the identified years of investigation.
Part 2T1.1 paragraph C (1) of the sentencing guidelines define tax loss as “the total amount of loss that was the object of the offenses (i.e., the loss that would have resulted had the offenses been successfully completed).” If the amount of the tax loss is uncertain, the accompanying application notes allow the courts to make a reasonable estimate of the tax loss based on the available facts. So, if the only facts presented to the court are those “within the box,” the court can potentially decide on a reasonable estimate that is not a true representation of the underlying financial transactions.
Case Example I: IRS initiated an audit and determined that a physician had underreported credit card sales processed through a merchant account (credit card payments) for a three-year period. The matter was referred to the Criminal Investigation Division (CID), which launched an investigation. The CID agent interviewed the doctor’s long-time accountant and tax return preparer. When interviewed, the accountant disavowed knowledge of the merchant account, stating the physician failed to disclose to him the existence of the account. The CID investigation identified in excess of $300,000 of unreported income.
Looking back further, we determined that the tax return preparer had included interest income from the merchant account on tax returns in prior years, seemingly contradicting his statement to the IRS that the existence of the account had been concealed.
The accounting records also indicated the doctor was routinely making capital contributions to the practice throughout the years investigated by the IRS. Ultimately, we were able to establish to the satisfaction of CID that the tax return preparer misclassified transfers from the merchant account to the operating account as non-revenue capital contributions rather than patient revenue.
In this instance, the successful defense against criminal tax violations was based upon understanding the process from inception through the years questioned by the IRS. The proposed tax loss related to the merchant account were finalized on the civil, not criminal, side of the IRS.
Case Example II: IRS initiated a CID investigation of a small business owner for a five-year time period. CID compared the deposits to all known business accounts to the gross receipts reported on the business tax returns, and determined that the business owner had understated gross receipts by more than $2.2 million, for an estimated $616,000 tax loss.
The question is whether the understatement constitutes an appropriate base from which to calculate a tax loss. In many instances, the answer is no, especially in a small business environment with less formal accounting procedures. Not surprisingly, the comparison of reported gross receipts to bank account deposits did not fully address the situation.
Inspection of available business records, including supporting documentation for the tax returns, established that in addition to gross receipts being understated, 80 percent of the expense line items were also understated. We analyzed the bank deposits, included transfers between accounts, and detailed the additional expense items to present a more accurate view of the defendant’s taxable income for the relevant periods.
Our analysis demonstrated to the satisfaction of CID that the actual unreported income was approximately $700,000 and the tax loss was approximately $235,000—significantly lower than the original amounts presented by CID.
As forensic accountants, we are expected to go beyond the mathematical process and thoroughly assess a situation by taking into consideration the how, where, what, why and who, which requires thinking “outside the box.”
Therefore, it is imperative that these calculations be prepared with the utmost accuracy and understanding of the fraud perpetrated. Merely calculating the difference between the value of assets or net worth does not result in actual or intended loss suffered due to fraudulent offenses. In fact, such calculations may include mistakes, such as double counting of the amount of loss or impact on the victims. This results in erroneous calculations and sentences that could have an adverse impact on the sentences of the individual(s).
Jonathan T. Marks, CPA, CFF, CITP, CGMA, CFE, is a partner a leader of the global fraud and forensic investigations and compliance practice at Baker Tilly. Baker Tilly is a top national accounting and advisory firm.
John D. Bullock, CPA, CVA, is a director at Marcum.
Article originally appeared in the Legal Intelligencer and has been modified.