Introduction

Time Magazine, in its March 5, 1984 issue, had on its front cover the following: “That Monster Deficit: America’s Economic Black Hole”. The article is support of the headline state in part: “…the sheer size of the budget gap is almost beyond comprehension. In it’s weekly newspaper, the American Bankers Association tried to put the $180 billion deficit into perspective by calculating that in order to spend a billion dollars, a shopper would have to use up one hundred dollars a minute for nineteen years. The President has used a similar metaphor. In a speech unveiling his economic program soon after he took office, Reagan dramatized his concern about the national debt, then approaching one trillion, by noting that it would take a stack of one thousand dollars bills sixty-seven miles high to equal that total.

When he brought out his new budget this month, Reagan failed to mention that his deficit would push the debt to $1.8 trillion by next year and raise his stack of one thousand dollar bills to more than one hundred twenty miles.” To this dilemma, you must add the dilemma of the Internal Revenue Service in fighting a long frustrating battle with respect to tax shelters. Tax shelter cases represent approximately one billion dollars in tax liabilities and now make up more than a third of the Tax Court’s total caseload. Furthermore, the IRS estimates roughly that the Treasury loses annually approximately 3.6 billion dollars in revenue from the so-called “abusive” tax shelters.

This circumstance in the economy of the United States resulted in some recent legislation which added to the Internal Revenue Code in 1981 the Economic Recovery Tax Act (ERTA) and in 1983 the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). The 1981 legislation imposed certain stiff penalties aimed at relieving the compliance ills. These new penalties dealt with (1) substantial understatements of tax liability, (2) aiding and abetting understatements, (3) abusive tax shelters, and (4) frivolous returns.

Recently, the Commissioner of the Internal Revenue Service announced a “coordinated filed attack to prevent tax abuse before it can occur”. To assist in preventing so-called tax shelter abuse, the Commissioner pointed to at least two Sections of the Internal Revenue Code, put in place by TEFRA, namely Code Section 6700, relating to the promoter penalty, and Code Section 7408, pertaining to enjoining a promoter from further involvement in a shelter activity. The Service also created a new weapon. This new weapon is a pre-filing notice, in letter form, sent to investors in the so-called “abusive” tax shelter, notifying them that, if they claim certain deductions or credits or other benefits associated with the shelter on their federal tax returns, their returns will be subjected to examination and the tax benefits claimed will be disallowed.

The Problem

The problem that the Service and taxpayers face is one where inflation and a growing level of personal income has resulted in taxpayers seeking to maximize the benefits granted by Congress in the Internal Revenue Code. The Service disagrees with the taxpayer’s aggressive use of tax benefit provisions which result in reducing the amount of revenue flowing into the Treasury.

The result has been, in many instances, abusive tax shelters, which typically do not result in any economic benefit and have been created solely to evade taxes, with little or no expectation of positive financial income. However, there are, and the Service concedes, legitimate investments which yield appropriate tax benefits as granted by the Internal Revenue Code. Therefore, the problem that results is how to identify those tax shelters which are “abusive”; and what to do about such shelters once identified.

The Attack

Approximately ten years ago, the Service initiated a coordinated program emanating out of the national office to examine potentially abusive oil and gas industry schemes. Thereafter, the program was expanded to cover other “so-called tax shelters,” primarily in the areas of real estate, movies, and farming. Following up on this attack, the Service was able to gain legislation pertaining to “at risk”. This legislation turned out to be Section 465 of the Internal Revenue Code as added by the Tax Reform Act of 1976. Subsequently, the Service was able to add additional provisions through ERTA, such as the penalty for over-valuation, and an increased negligence penalty under Section 6653.

To give the Service more punch, Congress enacted certain provisions as part of TEFRA, which materially aids the Service in its attempt to curb abusive tax shelters. The two most important new weapons in the arsenal of the IRS are Section 6700 and 7408. Section 6700 provides for a new civil penalty to be assessed against persons who promote abusive tax shelters. This penalty is aimed at the promoter. It became effective on September 4, 1982. In essence, the penalty provides as follows: in addition to other penalties provided by law, the penalty is equal to the greater of $1,000.00 or 10% of the gross income to be derived from the activity. If the amount to be derived cannot be ascertained, the Service may assess the penalty according to the current value of the portion of such gross income that can be determined.

In calculating the penalty for the amounts still to be derived, the IRS may look only to unrealized amounts that may be reasonably expected to be realized. For the penalty to apply, reliance by the purchaser is not required. Nor is under-reporting of tax a prerequisite. Instead, the offering materials alone can form a legitimate basis for assessing the penalty.

Who is subject to the penalty? Persons subject to the penalty include those who organize or assist in organizing, or who participate in the sale of, an abusive tax shelter. Two types of conduct can lead to such a determination: false or fraudulent statements. The penalty will be imposed on any person who, in connection with the organization of sale of any interest to an entity, an investment plan or arrangement, or any other plan or arrangement makes or furnishes a statement that he/she knows or has reason to know is false or fraudulent as to a material matter with respect to any tax benefit available through participation in the investment. The other ground is based upon gross valuation overstatements.

An individual can also be rendered liable for the penalty if, in connection with the organization or sale of an arrangement, he makes or furnishes a gross valuation overstatement as to any material matter. A matter is considered material if the investor places considerable significance on it in deciding whether to invest in the arrangement. A gross valuation statement is a statement of the value of property or services.

If the value is directly related to the amount of any income tax deduction or credit available to an investor by reason of his participation in the arrangement, the stated value must, however, exceed 200% of the correct value. Nevertheless, if there is a showing that there was a reasonable basis for the valuation in that it was made in good faith, the IRS may waive all or part of the penalty that is attributable to the gross valuation overstatement.

In addition to the Section 6700 penalty, there is coupled another provision found at Section 7408 that allows a civil action to be brought at the request of the Treasury, seeking to prohibit a promoter of an abusive tax shelter from further involvement in the identified promotion, or in any other abusive shelter activity. Injunctive relieve may be granted against any person found to be engaging in conduct subject to the promoter penalty where an injunction is appropriate to prevent further violations.

Present Shock

The Service will no longer wait until the tax benefits are claimed on filed returns. Instead, it has begun an immediate battle on the promoter and investors prior to filing tax returns. Here is how present shock becomes reality. First, the Service identifies what it considers an abusive shelter. It happens in this manner. A coordinator responsible for gathering information on shelters has been designated in each IRS district.

This coordinator will rely primarily on leads obtained from federal, state and local information agencies, other IRS investigations, and magazines and newspapers to identify tax shelter promotions. Furthermore, it will also seek assistance from lawyers, accountants, and other tax professionals who may be aware of any abusive tax shelter promotions.

Once a potential tax shelter has been identified, a committee in each district will review the attributes of that potential abusive shelter to determine whether in fact there is a likelihood of abusive practices. This committee consists of representatives of the district counsel, the criminal investigation division and the examination division. The committee’s review will focus on past activities of the promoter, the type of shelter under consideration, the size of the promotion, the amount of the tax deductions, and other tax benefits claimed.

Furthermore, it will also consider the degree of regional and national impact of such a shelter on the tax revenue. In addition, substantive, specific issues will be considered and any other factors that will be relevant in determining whether or not a particular shelter is abusive. If after this review, the committee determines that the promotion possibly involves tax abuses, the activity will be referred to a revenue agent for an examination under Section 6700. Moreover, a district counsel attorney will be assigned to aid the revenue agent in examining the particular shelter.

Once an investment has been so identified, the Service will notify the promoter that the shelter is the subject of an investigation that may lead to the imposition of the promoter penalty or the issuance of art injunction prohibiting further promotion of the shelter. In addition, the promoter will also be notified that the Service is considering sending a pre-filing notification letter to each investor.

The IRS agent will then request a list of documents, books and records, that the promoter must produce within ten days or be faced with issuance of a summons. If after examination of the records, a decision is made that the shelter is abusive, the promoter will have an opportunity to try to convince the Service that an action under Section 6700 or 7408 is inappropriate. At this meeting, the promoter will present whatever evidence is available to persuade the IRS that no action is warranted.

As part of the timing, the Service has a strict schedule and will not normally deviate from its administrative procedural level of examination. After the meeting with the promoter, the Service will consider on the basis of the agent’s and the attorney’s recommendations, whether or not to assert the Section 6700 penalty or whether to apply for injunctive relief against the promoter under Section 7408. If a pre-filing notice is to be issued to each investor, the district director must personally approve such a notice.

The cornerstone of the Service’s attack on tax shelters is Revenue Procedure 83-78, I.R.B. 1983-43,44. This revenue procedure, in addition to outlining the various steps, as previously discussed, at the administrative level, in determining whether or not a Section 6700 penalty should be imposed and whether a Section 7408 injunction proceeding should be commenced, also gives authority to the Service to issue a pie-filing notification letter.

This is the most unique aspect of the new battle of the IRS against targeted tax shelter promotions. Under this approach, pre-filing letters are sent to investors in a targeted tax shelter. This notice advises such taxpayers that an IRS review of the promotion has indicated that it has generated certain tax benefits which the Service does not believe are allowable.

Further, the notice points out that the return is subject to review by examination and that if the tax benefits are claimed, they will be disallowed and possibly the negligence penalty, or other penalties, such as overvaluation, and substantial understatement penalties will be asserted.

Furthermore, this revenue procedure allows notification letters to be issued to investors who have already filed, advising them that they may file amended returns. Even if an amended return is filed, the Service may assert the appropriate penalties, based upon the taxpayer’s position on the original return. Among the factors the IRS will consider in deciding whether to issue pie-filing notices in a particular case include, among others, whether the shelter involves an overvaluation of assets, false or fraudulent statements, or the aberrational use of a technical position.

Future Shock

Once a shelter has been identified, examined, and the Service has made its recommendation, the Department of Justice becomes involved. Presently, the Department of Justice has pledged its full support to the IRS and has created a special litigation unit to work exclusively on promoter penalty and injunction cases and related summons activity.

The Tax Division becomes involved when an examination of a promotion is concluded and there is a determination to seek an injunction under Section 7408. However, the Tax Division can be consulted earlier when a promoter has indicated a willingness to negotiate a consent decree. The Division’s Special Tax Shelter Unit handles any related summons enforcement actions that arise in connection with the Section 6700 penalty.

In addition, the Tax Division, at its discretion, will offer a conference to permit the promoter in appropriate cases to negotiate a consent decree, but will not grant a conference merely to duplicate the conference held at the IRS district level. Entering a consent decree will not always require a promoter to admit allegations of tax abuse, but it will involve an agreement to refrain from or to take specific actions. A promoter, or his or her or its representative, should be aware that consent decrees could be fashioned in the following manner:

1. An agreement to pay a specified amount of the promoter penalty (often immediate payment of the entire amount and not to deduct such payment on income tax returns);
2. An agreement to refrain from specified types of conduct and also from the type of conduct generally prohibited by Code Section 6700;
3. An agreement to give the IRS advance notice of any future tax shelter offerings, accompanied by copies of the offering materials;
4. An agreement to provide a list of investors to the IRS containing names, addresses, and Social Security numbers; and

1. Standard procedural safeguards:
2. An admission of the Court’s jurisdiction and consent to venue,
3. b. A waiver of the findings of fact and conclusions of law,
4. c. A waiver of the right of appeal from the entry of decree,
5. A waiver of the right to file for a refund of the penalty.

In addition to the injunction proceedings, a promoter could possibly be subjected to criminal prosecution. The Justice Department has indicated that an injunction action will not prejudice its review and recommendation for future criminal prosecution, should one be appropriate.

Therefore, during the injunction litigation, the Justice Department will refrain, as a general policy, from even discussing any potential aspects of the conduct upon which the injunction is based. Consequently, the combination of the Internal Revenue Service and the Department of Justice polices may subject a promoter to a full range of civil penalties, injunction proceedings, as well as the future shock of criminal tax prosecution.

What Can Be Done?

In an early reported case, Mid-South Music Corporation, in the Tennessee District Court, 83-2 U.S.T.C. 9710(1983), the taxpayer failed in its initial attempt to prevent the IRS from issuing a pre-filing notification letter. However, the IRS did not succeed in obtaining an injunction. (Presently, the case is on appeal 2). The current effort by the Service and the Department of Justice requires that each practitioner be fully aware of the continuing and shifting sands in the Government’s battle against “abusive tax shelters”.

The whole area is taught with significant consequences to everyone involved. The consequences range from heavy civil penalties to the most severe destruction of a business and criminal prosecution. It is therefore necessary to be familiar with the penalty provisions as added by ERTA and TEFRA, as well as to know how the Service plans to apply Rev. Proc. 83-78, supra. The questions that need to be considered continuously are:

1. What is an “abusive tax shelter”?
2. Is there an authoritative definition on “abusive tax shelters”?
3. What happens if the IRS defines a tax shelter as “abusive”?
4. What to consider in representing promoters, investors or other taxpayers in handling an IRS tax shelter examination.
5. What remedies are available to the taxpayer in combating an IRS examination under TEFRA Sections 6700 and 7408?
6. What remedies are available to the IRS in its effort to shut down a “true” abusive tax shelter?
7. Are any of the remedies illegal under the Constitution and existing laws of the United States?
8. How does the District coordinating committee of the Service operate?
9. Is the taxpayer exposing himself or herself or it to criminal prosecution from the very beginning of its tax shelter examination?
10. How can the IRS prevent abuse in examining a tax shelter?
11. What criteria will be applied to determine whether a case being examined under Sections 6700 and 7408 is criminal?
12. When will such criteria be applied?
13. Are taxpayers’ constitutional rights violated?
14. What remedies are available to the IRS to prevent the claiming of deductions under an abusive tax shelter?
15. What remedies are available to a taxpayer to prevent the IRS from issuing a pre-notification letter in circumstance where one may not be warranted?
16. How does the Department of Justice plan to operate its Special Tax Shelter Unit?
17. Under what circumstance can a taxpayer obtain a conference at the Department of Justice?
18. If such a conference is obtained, will the Department use statements made at that conference to institute other civil proceedings or criminal action?
19. What safeguards are available to the investor, promoter, and other taxpayers in a tax shelter examination?
20. What rights, duties, privileges and powers are available to both the IRS and taxpayers in achieving a fair result with respect to its tax shelter examination and procedures as provided by the provisions of ERTA and TEFRA?

WHITE COLLAR CRIMINAL DEFENSE

Criminal Investigations:

An individual or entity may come under criminal investigation by the IRS or FBI. The agent conducting a criminal financial investigation is a Special Agent assigned to the IRS’ Criminal Investigation Division. The purpose of the investigation is to charge the taxpayer with a crime, be found guilty, go to jail and pay a fine. Civil penalties and additional tax will be sought by the IRS after the criminal investigation has concluded.

TIP: Do not make any statements to the Special Agent. You have the right to remain silent, pursuant to the Fifth Amendment to the United States Constitution. Simply advise the agent you will retain an attorney, who will contact the agent. Sometimes the Criminal Investigator indicates that the case will go “faster” and easier if you cooperate.

However, having the case proceed “faster” and smoother are not cooperate but it should be through a competent attorney knowledgeable in handling IRS Criminal Investigations.

The firm also represents individuals and businesses in grand jury investigations. Such representation may be on behalf of the target subject, a witness, or a custodian of records. There may be many rights and privileges available to the recipient of the subpoena. We have been successful in quashing subpoenas to corporations based on the alter ego theory, even though a corporation ordinarily is not entitled to the constitutional rights available to individu

Criminal Prosecutions

An individual charged with criminal violations of the Federal Criminal Code or the Internal Revenue Code will be prosecuted in a United States District Court. Potential financial-related crimes in which the firm has represented individuals include tax evasion, willfully filing a false tax return, wire fraud, mail fraud, money laundering, violating currency reporting requirements, bank fraud, bankruptcy fraud, telemarketing fraud, counterfeiting and conspiracy to defraud the Government. There are many successful defenses available.

The government can commence a formal prosecution by either an information filed by the United States Attorney or an Indictment filed by the grand jury.

A defendant can move to suppress evidence or dismiss the case on numerous grounds prior to a trial. A defendant is presumed innocent and can exercise this right at a trial. A defendant can also enter into a plea bargain with the prosecution.

Plea negotiations and sentencing issue are extremely complex, and should only be discussed by using qualified legal counsel. There are different plea agreements available under Rule 11, Federal Rules of Criminal Procedure. If a defendant wishes to plead guilty, then as a general rule a plea under 11(e)(1)(C) ensures the most certainty and is binding on the court, if accepted.

To negotiate a plea agreement, one must be proficient with the United States Sentencing Guidelines. The firm also represents and consults with individuals who come to the firm for the sole purpose of negotiating an appropriate minimum sentence with the government through a plea of guilty.

Collection Process

The IRS, FTB, EDD, and State Board of Equalization have vast powers to collect additional tax, after an assessment has been legally made. Taxes may be due from income tax, employment taxes, sales and use tax, or excise tax. The danger to a taxpayer, whether it is an individual or a business, is the loss of assets and income. Taxpayers may need to complete financial statement forms and provide other private information if they decide to engage in discussions with the taxing authorities in order to resolve their disputes.

After receiving a notice of lien or notice of intent to levy, strict guidelines must be followed within prescribed time limits in which to protest and request an appeals conference. There are many new procedures that provide the taxpayer with the opportunity to seek an appeals conference and proceed to the United States Tax Court even after the collection process has started.

Other areas to be explored are:

(1) Whether the taxpayer may make an Offer in Compromise based on Doubt as to Liability or Doubt as to Collectibility, or

(2) Whether the taxpayer may make a claim for innocent spouse relief?

Civil Damages For Certain Unauthorized Collection Actions – If any officer of employee of the Internal Revenue Service recklessly or intentionally disregards any provision of the Internal Revenue Code, such taxpayer may bring a civil action for damages against the United States in a district court of the United States. The defendant may be liable in an amount equal to the less of $100,000 or the sum of the actual damages and the costs of the action. 26 U.S.C. Section 7433.

It is possible legally to pay less than is owed the IRS or the Franchise Tax Board. The two most common methods of eliminating unpaid assessed taxes are through Offer in Compromise and Bankruptcy. However, both processes are long and complex. To take advantage of IRS or FTB settlement procedures, prescribed time limits must be followed on a timely basis.

CIVIL TAX CONTROVERSIES

In this section, we broadly categorize Civil IRS controversies into two areas: Audit/Examination Process and Civil Tax Litigation. Under Civil Tax Litigation, three possible cases can be dealt with. They are Tax Court Cases, Refund Cases and Collection Cases. These are explained below.

Audit/Examination Process

The IRS sends a notice for an office or field examination/audit. The purpose is to verify income and expenses reported on the tax return. The IRS may seek additional information in writing and orally. The office audit is usually less complex than the field examination. The goal is to collect additional tax, interest and penalties. The tax being examined may be income, employment, excise or other tax.

TIP: Have your records organized for presentation to the IRS. You records should be presented by an attorney or certified public accountant who is competent to handle civil examinations. The problem is to confine the exposure to additional tax, interest and penalties; or in the alternative to obtain a refund. Usually handling the audit by yourself does not produce satisfactory results from the taxpayer’s point of view because the ordinary taxpayer is not aware of all the procedural issues, problems and benefits in dealing with the IRS.

Civil Tax Litigation

Tax Court Cases. A taxpayer individual or entity can challenge the IRS in the Tax Court, within ninety (90) days of receiving a written notice indicating the tax year, amount of additional income tax deficiency and penalties the IRS believes is owed.

Refund Cases. A taxpayer can sue for a refund, if the IRS does not allow a refund claim properly field. A refund suit can be filed in a federal district court, or the United States Federal Claims Court. The procedures are complex and require experienced and knowledgeable representation. This office recently successfully represented a taxpayer in a United States Court of Federal Claims employment tax refund suit. See Consolidated Flooring Service v. United States, 38 Fed.Cl. 450 (1997). For information on independent contractor/employee issues see discussion of cases and 20 common law factors below.

Collection Cases. Collection cases are brought by the IRS against a taxpayer for the additional assessed taxes owed, but unpaid. This type of lawsuit requires immediate legal assistance. Otherwise, the taxpayer may lose his, her or its assets in a summary fashion. A taxpayer may also sue the IRS in a wrongful levy suit if the funds levied upon are not those of the taxpayer. A taxpayer can even obtain an injunction against the IRS. Taxpayer is entitled to certain due process appeal right, but must act within a limed time period.

Independent Contractor vs. Employee Classification

Whether a taxpayer’s workers can be classified as independent contractors rather than employees depends on the application of the 20 common law factors, and possibly whether the taxpayer is entitle to relief under Section 530 of the Revenue Act of 1978.

Federal employment taxes include both the employer portion and the employee portion of the tax imposed by the Federal Insurance Contributions Act (FICA), the tax imposed by the Federal Unemployment Tax Act (FUTA), and the collection of income tax at source on wages. The requirement that the reclassification of the worker as an employee is a necessary prerequisite before considering the applicability of Section 530 relief is not always understood.

Section 530 of the Revenue Act of 1978 is a “safe haven” for obtaining independent contractors status. The analysis is a two step process. First, it must be determined under the common law whether the workers are employees of the taxpayer or are independent contractors. Then, if the workers are employees, it must be determined whether the taxpayer is entitled to relief under Section 530. If the workers are independent contractors, Section 530 does not apply.

The court, in In re Rasbury, 91-2 USTC par. 50,454 (Bankr. N.D. Ala. 1991), aff’d., 92-1 USTC par. 50,195 (N.D. Ala. 1992), cited language in a report of the House Committee on Government Operations entitle “Tax Administration Problems Involving Independent Contractors,” H.R. Rep. No. 979, 101 st Cong., 2d Sess. (1990), which stated: “If a company cannot claim protection under one of the safe harbor provisions, then IRS is free to scrutinize the employer’s classification decision against 20 “common law’ factors.”

In Apollo Drywall, Inc. v. United States, 71 A.F.T.R. 2d 93-1689 (W.D. Mich. 1993), the court state, “Disqualification from the safe harbor protections of the act does not, by any stretch of the imagination, automatically direct a finding of employee status; it just means that the workers are not automatically independent contractors. Hence, an analysis of the common-law factors is necessary.”

As an aid to determining whether an individual is an employee under the common law rules, twenty factors have been identified as indicating whether sufficient control is present to establish an employer-employee relationship. See Rev. Rul. 87-41, 1987-1 C.B. 296. See Also United States v, Silk, 331 U.S. 704 (1947

If the workers are determined to be independent contractors, no determination is necessary with respect to Section 530; it simply does not apply because the taxpayer has no liability under subtitle C of Code. However, if the workers are determined to be employees, it must be determined whether relief from employment taxes is available under Section 530. Under Section 530, if for federal employment tax purposes a taxpayer did not treat a worker as an employee for any period, the worker will be deemed not to be an employee for that period, unless the taxpayer had no reasonable basis for not treating the worker as an employee. The applicability of Section 530 becomes an issue only after the worker has been classified as an employee.

In conclusion, an analysis under the 20 common law factors may only be the first step in determining whether workers are classified as independent contractors or employees. This office recently represented a taxpayer in a United States Court of Federal Claims employment tax refund suit. For the Opinion, in which the court determined independent contractor status, see: Consolidated Flooring Services and Monroe Schneider Associates-Texas v. United States, 38 Fed.Cl. 450 (1997).

CRIMINAL TAX CONTROVERSIES

The firm represents individuals, corporations, partnerships and other entities in criminal tax matters involving alleged violations of 26 USC Sections: 7201, 7206(1) and (2), 7212, 7213 and 18 USC Section 371, as being representative of technical criminal violations the IRS would investigate for the purpose of pursuing formal prosecution.

The firm is prepared and is experienced to handle all alleged criminal tax violations pursued by the IRS. The principal of the firm, Martin A. Schainbaum, is a former Assistant United States Attorney and prosecutor of tax cases. Ralph G. Latza has approximately 10 years of experience in defending clients in criminal matters. Please see our White Collar Criminal Defense page for more information.

An IRS criminal tax investigator’s function is to investigate criminal tax violations of the Internal Revenue Code. To accomplish their goal, they usually desire a statement from the subject being investigated. It is in the subject’s best interest not to make a statement, but rather, on contact by the IRS criminal investigator, to seek the advice of an attorney who practices criminal tax defense. A criminal tax violation exposes the subject, not only to a risk of monetary sanctions, but also to imprisonment.

The firm also defends clients accused of white collar crimes, such as mail fraud, wire fraud, money laundering and conspiracy to commit alleged crimes.