Enjoining Pyramiding Taxpayers

Over the past 10-15 years, the Department of Justice Tax Division has become much more aggressive about bringing injunction actions against taxpayers who fail to pay their employment taxes over an extended period of time. The IRS calls the repeated failure to pay employment taxes “pyramiding” and views this as one of the most serious types of bad tax behavior, following such other types of bad behavior as evasion and tax shelter promotion. While the IRS has a long history of prosecuting tax evasion and a pretty solid record of getting legislation to root out and aggressively pursuing tax shelter promoters, it has suffered for a long time with the issue of how to stop pyramiding. We are adding some material on injunctions to Chapter 14 of Saltzman and Book, IRS Practice and Procedure which led us to pay more careful attention to the recent cases coming out on this issue. As you will see from the discussion below, the rules governing the enjoining of taxpayers from continuing a business have not been uniformly developed and applied.

The most recent former Acting Assistant Attorney General in charge of the Tax Division, Caroline Ciraolo, made it one of her signature enforcement efforts to prosecute and/or enjoin taxpayers who engaged in pyramiding. Some of the DOJ press releases on this effort provide a flavor for what they have done in this area: general discussion; injunction in Texas; injunction in Pennsylvania; injunction in Iowa; and injunction in New York. Prosecution has long been a desired effort by the folks in collection at the IRS, and I am sure they were delighted with this effort. The civil action that parallels prosecution for failure to pay employment taxes is an injunction action. Like prosecution, this is a labor intensive effort both on the part of the IRS and DOJ. A pair of cases this summer tell some of the story of the effort to root out pyramiding through suits to enjoin the taxpayers engaged in the activity. Usually, these types of suits are coupled with other actions such as reducing the liability to judgment and foreclosing the tax lien on some property.

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Under the general authority granted by Section 7402(a), the Service can bring an injunction action in certain circumstances in order to stop a taxpayer from taking or continuing certain actions. The Service uses its injunctive authority, and this is authority that it uses sparingly, to seek to stop taxpayers from pyramiding employment taxes in circumstances in which the taxpayer has demonstrated a long term pattern of failing to pay employment taxes. Courts have not provided clear guidance on exactly what the Service must show in order to obtain injunctive relief. Because granting injunctive relief will generally result in the taxpayer losing the right to engage in business, courts carefully look at the request. While seeking criminal prosecution against the responsible officer(s) of a business that has a long history of pyramiding employment taxes provides an alternative to seeking injunctive relief to stop a business from operating and continuing to pyramid, each type of relief places a high burden of proof on the Service as well as a high cost in time and effort.

In United States v. Padron, the court granted injunctive relief in a decision entered in May, 2017. In the Padron case, the Service brought suit against both the individual responsible for running the business and the business itself. The defendants did not vigorously defend the action. The business defaulted and the individual agreed to enter into a consent judgment that included the injunction. Nonetheless, the court saw the need to carefully review the case in order to determine if injunctive action was appropriate including whether the claim of the Service for injunctive relief had merit. The court found the claim for injunctive relief had merit only after looking at the standard it should apply, and noting that the 5th Circuit had not ruled on the issue.

The court stated that the issue of what constitutes a sufficient basis for a permanent injunction under Section 7402(a) has created a split in authority among the courts that have addressed it. Some courts require the Service to show the traditional factors for use of the equitable remedy of injunction. As we discuss in more detail in the Saltzman chapter, the majority of courts permit an injunction under Section 7402(a) if the government shows “that an injunction is appropriate for the enforcement of the internal revenue laws, without reference to the traditional equitable factors.” Having determined that it had a sufficient basis for entering a permanent injunction against the business, the court had little trouble finding that it had a basis for entering one against the individual responsible officer of the business.

Reflecting the split of authority on the issue, in US v Moore, the district court in New Jersey reached the opposite conclusion, a case in which the taxpayer did not contest the imposition of an injunction. The Service sought a default judgment, including an injunction against a taxpayer running a dental practice. The principal of the business failed to pay employment taxes over a 20-year period. The Service clearly proved the long term failure to pay; however, the court found that it must determine if “this relief is necessary and proper ‘in light of the public interest involved.’” Similar to the court in the Padron case, the court in the Moore case found no controlling circuit authority and looked for authority from the other district courts in its circuit.

Even though it quoted language stating that the standard included the totality of the circumstances such as the reasonable likelihood that the taxpayer would violate federal tax laws again, the court in Moore found that “applying that standard, the injunction sought by the United States is overbroad and premature. It would force a shutdown of Dr. Moore’s dental practice and stop him from practicing dentistry entirely until the tax liabilities are paid. Such a harsh result is not only unprecedented but also premature given that no efforts or supplemental proceedings have been taken to satisfy this judgment.” At the same time it sought the injunction, the Service obtained a judgment against Mr. Moore for his failure to pay taxes over a substantial period.

While the Service has the ability to obtain an injunction, the Moore case shows that courts have split in a fairly significant manner on the appropriateness of this remedy or the proof that the Service must provide in order to obtain an injunction. The Moore case involves a very long period of non-payment and high amounts of non-payment. Much of the non-payment of employment taxes no doubt got credited to Mr. Moore when he filed his own individual tax return each year. I proposed in a law review article many years ago that responsible officers should not get withholding credit on their own returns when the business does not pay over the withheld taxes to the IRS. Mr. Moore seems like a poster child for that recommendation. Though the district court in Moore was concerned that he would not be able to repay the taxes if he can no longer practice dentistry, I do not think the injunction prohibits him from practicing dentistry as an employee of another dentist. It just seeks to keep him from running his own business and not paying his taxes. The facts in his case convince me that he should be an employee and not a business owner.

Court Rejects Government Efforts to Award Disgorgement in Preparer Injunction Case

Keith, Stephen and I have recently discussed a number of issues spinning from preparer misconduct, including the government attempting to use the Code’s broad injunction powers to shut down preparers who are gaming the system. Keith and I have also discussed a somewhat newer trend, with the government seeking the equitable remedy of disgorgement to force illicit preparers to give back some or all of the proceeds of their crooked return prep business. US v Mesadieu, a case from earlier this year out of a district court Florida, shows that there are limits on the government’s use of disgorgement as a remedy, at least in terms of its establishing the amount of disgorgement that the government may be entitled to receive. It also raises some questions about the remedy, and in particular whether the Mesadieu opinion might throw some roadblocks in these types of cases.

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The case arose from the government’s seeking injunctive relief stemming from preparer Douglas Mesadieu, who had set up offices in Georgia, Florida and Texas, using eight entities that prepared around thirteen thousand returns in a three-year period. The allegations included that Mesadieu and others affiliated with Mesadieu and the entities goosed income and created deductions to place clients in position to receive the EITC (similar to what Carl Smith discussed in The Often Topsy-turvy World of EITC Litigation where at times the amount of the credit exceeds any income or SE tax liability):

The Government’s evidence shows that one of the ways Mesadieu’s companies’ manipulate the EITC is to create fake businesses to list on the taxpayer’s Schedule C, such as a transport services business, hair salon, or barber shop. Other times, the taxpayer’s Schedule C claims losses for a business but did not list a business name

Another tactic is to claim false unreimbursed employee expenses on a Schedule A. For example, expenses for non-deductible commuter miles or other business-related expenses for unreimbursed meals or uniforms would be claimed.

The schemes involved more than the EITC, as the government alleged that “[a]nother often-used strategy is to claim false charitable donations or education credits that the taxpayer testified he or she did not actually pay and did not tell the tax return preparer that the amounts were paid.”

While the court issued an order granting the government’s expansive injunction request, it ruled against the government on disgorgement. Mesadieu had two main arguments when it came to the disgorgement issue: 1) the court did not have power to order disgorgement in cases arising from return preparer injunction proceedings and 2) even if it did the government did not establish how much should be disgorged.

Is Disgorgement an Appropriate Remedy?

Mesadieu argued initially that the court should not have the power to compel disgorgement. In response to a previous motion, the district court held that courts had wide power under Section 7402(a) to order a disgorgement of a preparer’s ill-gotten gains. That section gives federal district courts jurisdiction “to make and issue in civil actions, writs and orders of injunction, and of ne exeat republica, orders appointing receivers, and such other orders and processes, and to render such judgments and decrees as may be necessary or appropriate for the enforcement of the internal revenue laws.” The statute also states that the remedies listed in Section 7402(a) “are in addition to and not exclusive of any and all other remedies of the United States in such courts or otherwise to enforce such laws.”

The emphasized statutory language in Section 7402(a) is what courts have relied on in allowing the government to seek disgorgement in preparer scheme cases. While not every type of federal case inherently implicates disgorgement powers, in upholding the right to order disgorgement in injunction cases against preparers the Mesadieu opinion distinguishes other statutes that are more narrowly drawn or which do not involve the public interest associated with revenue laws. The opinion discusses generally how 7402(a) “encompasses a broad range of powers necessary to compel compliance with the tax laws.” United States v. Ernst & Whinney, 735 F.2d 1296, 1300 (11th Cir. 1984). It also relies on cases that had specifically blessed disgorgement as an appropriate remedy under Section 7402(a) in similar circumstances.

How Much Disgorgement?

While the court found that it could order disgorgement, it held against the government, finding that the government failed to establish how much disgorgement was appropriate. Here is how it got there. The government argued first that all of Mesadieu and his related entities’ gross receipts should be disgorged or in the alternative, disgorgement would be based on the fees that related to an estimated percentage of the non-compliant returns. The amount that should be disgorged depends on the extent of the fraudulent activity; i.e., how much of the return preparation proceeds was attributable to the misconduct. To establish the misconduct, the government put on an expert, an IRS Senior Research Analyst, who problematically looked at returns from only one year and in one location:

To establish the amount of disgorgement, the Government relied on a random sampling of tax returns prepared by Mesadieu’s companies. In total, for all years of tax preparation, Mesadieu’s companies prepared around 13,000 tax returns. However, the random sample that the Government presented at trial consisted of only 230 tax returns prepared in Houston, Texas for the tax year 2012. The overall pool of tax returns from which the 230 were selected was approximately 3,600. Despite that 230 tax returns were selected for the random sample, only 115 taxpayers were interviewed regarding their tax returns to determine whether the information on the tax return was fraudulent. Those customers interviewed were not put under oath. From this, the Government’s expert testified that the percentage of “non-compliant” tax returns–meaning, a taxpayer underreports his taxes due–was 82.6%. Additionally, it is possible that as many as 25% of the tax returns were “compliant,” or correctly reported.

As an initial matter the court discussed the standard to determine the amount of disgorgement, emphasizing that the plaintiff only need “produce a reasonable approximation of the defendant’s ill-gotten gains.” Once the estimate is shown, the defendant has the burden to show that the plaintiff’s estimate was not reasonable. However if there are shoddy records and the estimation cannot be shown and “the exact amount of illicit gains cannot be accomplished without incurring inordinate expense,’ a court may set disgorgement at the ‘more readily measurable proceeds received from the unlawful transactions.'” (citations omitted).

The court emphasized that there must be a “relationship between the amount of disgorgement and the amount of ill-gotten gain,” and a district court may not order disgorgement of an amount obtained without wrongdoing or obtained during a period where there is no record evidence of fraud. (citing to C.F.T.C. v. Sidoti, 178 F.3d 1132, 1138 (11th Cir. 1999)). Given that the expert testified that some of the returns were compliant, the opinion rejected the government’s argument that all of the receipts were subject to disgorgement, distinguishing cases where courts ordered all of the proceeds to be disgorged:

[T]hese cases are distinguishable because they involve an entire fraud. In those cases, either all of the defendant’s conduct was fraudulent or the defendant’s illegitimate activity is indecipherable from his legitimate activity. See, S.E.C. v. Lauer, 478 F. App’x 550, 557 (11th Cir. 2012)…In contrast, in the present case, Mesadieu’s tax preparation stores did not always prepare taxes fraudulently.

The opinion notes that while Section 7402(a) is broad, a “court’s power to order disgorgement is not unlimited.” The opinion describes and distinguishes  cases where all the proceeds were disgorged (like FTC cases involving phony claims in telemarketing and infomercials) where courts have struggled to distinguish legitimate gains from illegitimate gains, or cases where the facts make it impractical to distinguish between legitimate and illegitimate activity. The opinion emphasizes that its disgorgement power “extends only to the amount the defendant profited from his wrongdoing….Any additional sum is impermissible as it would constitute a penalty.”

The opinion then turned to the government’s alternative argument that an estimated percentage of non-compliant returns should provide the basis for disgorgement:

As the Court has determined that a disgorgement award of gross receipts is not a reasonable approximation, the Court must next consider the Government’s argument that the estimated percentage of non-compliant tax returns from the Texas sample is a sound methodology for separating illegal proceeds from legal ones. Under this method, the Government asks the Court to utilize the confidence interval of the non-compliant tax returns (73%-91.7%) to calculate Mesadieu’s companies’ illegal proceeds. To clarify, the Government urges the Court to use this percentage derived solely from the Texas sample of 2012 tax returns and apply it to the total gross profits of Mesadieu’s companies from its operations in all three states and for tax years 2013, 2014, and 2015.

Mesadieu argued that the government’s alternative approach was unreasonable because it essentially extrapolated from returns prepared in Texas and only looked at one year and failed to take into account the entire operations. The opinion agreed that reliance on such a limited sample was not reasonable:

The Court finds it is unreasonable to approximate the total disgorgement award in this case based on a sample limited to one tax year and one geographical area. Utilizing a random sample from a pool of only 3,600 tax returns to make a conclusion about 13,000 tax returns is not reasonable. There are approximately 9,400 tax returns that were inevitably not capable of selection. The Government’s sample provides no information as to the percentage of non-compliant tax returns in other years or in other states. The Government’s expert testified only as to the soundness of the sample methodology for the pool of 3,600 tax returns from which the sample was selected. Importantly, the Government’s expert testified that the sample data provides no information on whether the compliance rate from that sample is the same in other years. Accordingly, the Court finds that this sample is not generalizable to the universe of 13,000 tax returns.

Parting Thoughts

 The Mesadieu opinion does not throw up an impossible burden for the government, as the government should have pulled most of the returns prepared by this business and should have had the ability to get pretty specific. While the opinion also notes a technical foot fault in that the government did not join the specific entities that Mesadieu controlled and questioned whether it could have ordered disgorgement with respect to the fees that those entities received, that too is remediable in future cases. If in the future the government dots the i’s and crosses the t’s in proving a reasonable approximation of returns with phony deductions and credits and properly joins all parties, what is the value of the disgorgement to the government?

Keith discussed the government’s use of its injunction and disgorgement powers in Return Preparer Shenanigans and expressed some skepticism that both remedies were likely to be effective, comparing them to “trying to pull up individual dandelions instead of putting down a fertilizer that kills them and prohibits growth. Aside from having to pull them up one by one, you invariably do not get the roots so it pops back up before long.” Likewise, Keith said he would be “surprised if the return preparation fees are sitting around in a bank account just waiting to be disgorged.”

If Keith’s skepticism is correct, I am not sure why the government would pursue disgorgement as a remedy though I have previously discussed in Restitution Based Assessment and Bad Tax Return Preparers: An Uneasy Mix why the government may have difficulties in pursuing restitution in these types of cases, perhaps thus making disgorgement more attractive. Alternatively, it could go the route of preparer penalties, assessable without deficiency procedures and then subject to administrative collection. Any result that ties in the preparer misconduct to dollars, however, suffers from the same “you cannot get blood from a stone” problem that Keith flagged.

In any event, the tax system is still plagued with preparers (and taxpayers) who view the tax system as an unwatched cookie jar. DOJ is emphasizing its injunction tools as part of its efforts to root out schemes and scams and it will likely try to use some means to impose a monetary cost on the preparers. I suspect we will see more of these cases and perhaps gain some more insight on calculating the amount of disgorgment when preparers such as Mesadieu have many thousands of returns spread across entities and multiple states.

DOJ Cracking Down on Preparers Using its Injunction Powers and Requiring Preparer to Disgorge Illicit Profits

The government has lots of tools at its disposal when it comes to going after the effects of crooked preparers. Last week I wrote about how the fraud of a preparer can have consequences for the taxpayer and indefinitely extend a taxpayer’s SOL on assessment.   DOJ often goes after the illicit preparer as well, sometimes using its vast civil remedies, including injunctions, as Keith discussed in Return Preparer Shenanigans.

This past month the DOJ has been busy releasing information trumpeting its efforts to get civil injunctions against prepares as well as requiring those preparers to disgorge their profits. Preparers that submit returns with phony refundable credits seem to be getting a great deal of attention.

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For example, last week the DOJ press release Federal Court Bars Florida Man from Preparing Tax Returns for Others and Enters $1 Million Disgorgement Judgment discusses how a district court in Florida entered an injunction and disgorgement order stemming from the facts as alleged below:

In September 2014, the United States filed a civil injunction complaint against Pierre-Louis alleging that he and his employees prepared fraudulent tax returns for customers.  The complaint alleged that return preparers in Pierre-Louis’s business targeted primarily low- to moderate-income customers with deceptive and misleading advertisements; prepared and filed fraudulent tax returns to increase their customers’ refunds; and profited through unconscionable, exorbitant and often undisclosed fees—all at the expense of their customers and the U.S. Treasury.  According to the complaint, Pierre-Louis and his employees prepared federal tax returns on which they falsely claimed earned income and education credits, reported improper filing statuses, concocted phony businesses, claimed bogus income and expenses related to the non-existent businesses and fabricated job-related expenses.  The complaint also named Jehoakim Victor and Lauri Rodriguez, allegedly former managers at Pierre-Louis’s tax preparation stores, as defendants.  In February 2015, the court permanently enjoined Victor and Rodriguez from preparing tax returns for others and from owning or operating a tax return preparation business.  Victor and Rodriguez agreed to entry of the injunction without admitting the allegations in the complaint.

The order itself is interesting and details just how far-reaching the government’s powers reach under those provisions, enjoining the preparer from preparing or assisting in preparing returns for others and essentially prohibiting him from having any commercial activity related to the preparation of tax returns, including getting a PTIN or EFIN.

The order also requires the preparer to turn over the identities of all people whose returns were prepared by the defendant and his related businesses, all the employees of the defendant and the related entities and also prohibits the defendant from selling any customer list. That customer list can lead to the issue I discussed last week, as it is likely that the IRS will systematically go after those individuals whose returns were prepared by this preparer.

In addition to the injunction, the order requires the defendant to cough up $1 million as a “for the disgorgement of the proceeds that Kerny Pierre-Louis received for the preparation of tax returns making or reporting false or fraudulent claims, deductions, credits, income, expenses, or other information resulting in the understatement of taxes.”

I have not focused much on the government’s use of general disgorgement powers to go after preparers. Disgorgement is an equitable remedy that has its roots in undoing enrichment rather than punishing and is meant to force the preparer to return profits from the improper activity. That disgorgement is not punitive may have significant consequences as to the deductibility of any such payments, as discussed in this McGuire Woods blog post discussing how the IRS in Field Service Advice opined that a Food and Drug Administration disgorgement order was not a non deductible fine or penalty under Section 162(f).

I have seen a number of disgorgement orders in return preparer cases recently and I suspect that they are now part and parcel of the government’s tool kit.

Some Observations

I am in DC this week attending a summit that the Commissioner has convened on the Earned Income Tax Credit. I have been interested in the EITC, and its administration, for years, starting with my time as a director of a low income taxpayer clinic.  I saw early on in my time as director claimants who used a return preparer that was either incompetent or unscrupulous, or both. Assigning blame between claimants or preparers and getting at the root cause of the source of the incorrect claim is a tricky business, and there have been very few meaningful qualitative studies that identify the extent of demand (claimant) or supply (preparer) driven noncompliance. As I have written previously, there is an interesting and complex relationship between preparers and claimants, and government efforts both before the fact (though regulation and oversight, including due diligence) and after the fact (including injunctions and preparer penalties, both civil and criminal) attempt to change the dynamics in that relationship.

In the blog and in other articles I have written about the various ways that the government has sough to change this dynamic. I am working on a longer paper that looks at compliance issues in some more detail. Most of what Congress has done in this area over the past decade has been to increase penalties and allow IRS to detect and unwind erroneous credits through the use of a more automatic reportable error that dispenses with traditional deficiency procedures(though IRS wants even more of that power). I am interested in learning from others at the summit, as this is a problem that is in need of solutions from many differing perspectives, not just increasing penalties and removing barriers to assessment.

UPDATE 7/1 After initially posting I learned that IRS last month has issued a CCA that held that certain disgorgement payments made to the Securities and Exchange Commission for violating the Foreign Corrupt Practices Act were not deductible. There is a lot of commentary on that substantive issue. For example, see Lawrence Hill from Shearman in the FCPA Report.