8th Circuit Strikes Down Restrictions on Internet and Computer Use Special Conditions for Convicted Tax Evader

August 3, 2016 by 1 Comment

The Department of Justice goes about the business of prosecuting tax defiers as one of its principal activities. I suspect that there is a long list of possible targets. A recent tax evasion case out of the 8th Circuit, US v West, caught my attention. In West, the court struck down conditions of supervised release relating to computer and internet use that the government sought to impose to limit a tax defier from spreading his ideas after his 51 month jail sentence ended.

I will describe the case and the court’s reason for its failing to allow those conditions below.

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West was a computer technician. West informed his employer that he was exempt from taxes and withholding and his employer complied with West’s request to withhold nothing. West deposited his pay into corporate bank accounts he formed to assist in concealing his income. IRS eventually contacted his employer and served a levy. West resigned as an employee and set up an LLC that performed services for his former employer as an independent contractor, continuing to receive funds free of withholding.

In addition to not paying taxes or fling tax returns, West actively spread his tax ideas to others. The opinion notes that he “proselytized his beliefs in an e-book self-published and sold through Amazon.com, entitled Are You a Taxpayer? Really? Prove It! In addition, the presentence investigation report (PSIR) identified West as “the owner/manager of several websites and/or online blogs which promote his fraudulent tax scheme and contain non-taxpayer propaganda, among other information.”

West was indicted and convicted on three counts of evasion for the years 2007 2008 and 2009. He was sentenced to fifty-one months’ imprisonment and three years’ supervised release. The government requested and the district court granted the following conditions associated with the supervised release:

  • The defendant shall not engage in the creation of or establish any new websites, and he is required to remove any websites, past or present, which are currently active. (Condition 13)
  • The defendant is prohibited from using or possessing any computer(s) (including any handheld computing device, any electronic device capable of connecting to any online service, or any data storage media) without the prior written approval of the U.S. Probation Officer. This includes, but is not limited to, computers at public libraries, Internet cafes, or the defendant’s place of employment or education. Furthermore, he shall consent to the search of his computer for content related to criminal activity, at the request of his probation officer. (Condition 14)

West appealed the special conditions of supervised release, claiming that they were an abuse of discretion and violated his First Amendment rights. (he also appealed an evidentiary issue, which I skip).

Background on Special Conditions

The court set out the context for the district court’s imposition of the special conditions as well as the appellate court’s review of conditions that the trial court imposed:

The district court’s broad discretion to impose special conditions if they comport with the strictures of 18 U.S.C. § 3583(d) that the condition is: (1) reasonably related to the nature and circumstances of the offense, the history and characteristics of the defendant, adequate deterrence, public protection, and the needs of the defendant; (2) involves no greater deprivation of liberty than reasonably necessary for the sentencing purposes of adequate deterrence, public protection, and the needs of the defendant; and (3) is consistent with applicable policy statements by the United States Sentencing Commission.

The opinion describes the appellate court’s review of the district court’s imposition of special conditions is based on an abuse of discretion though also noted that a closer review than generally associated with abuse of discretion accompanies conditions that may impinge on constitutional rights.

The 8th Circuit first addressed the condition that prohibited West’s creation of any new websites. West argued that it was overbroad and also violated his First Amendment rights, though he conceded that if the condition were restricted to not setting up websites that related to disseminating tax advice it might be legitimate. The government argued that it was not overbroad and consistent with 18 USC 3583(d) and that the speech was commercial speech not within First Amendment protection.

In resolving this in favor of West, the 8th Circuit noted that most of the cases where such a condition has been imposed relate to those convicted of criminal sex offenses. After going through the cases in the sex offense context, the opinion concluded that the restriction imposed on West was too broad, even assuming that the government’s “questionable” position that he was only engaged in commercial speech. It noted that given that West did engage and assist others in violating tax laws “there may be a plainly legitimate sweep of restrictions the district court could have placed on West’s ability to promote his ideas through the Internet.”

Despite the possible legitimate restrictions, the 8th Circuit noted that the district court’s special condition “prohibits West from creating and maintaining any website irrespective of its content.” It noted the importance of the web and the reluctance to impose such a broad restriction on the right to speech:

Although West misused his access to the Internet, websites present an important mode of communicative and commercial intercourse in our society through which West can exercise his right to speak. Because “[t]his court is ‘particularly reluctant to uphold sweeping restrictions on important constitutional rights,’ … such [absolute] bans are disfavored.” Bender, 566 F.3d at 753 (quoting Crume, 422 F.3d at 733). We agree with West that Special Condition #13 deprives him of a greater amount of liberty than necessary to achieve the sentencing purposes.

The 8th Circuit similarly struck down the condition limiting his use or possession of any computer without Probation Officer approval. First, it noted that while there were no individualized findings that West used a computer to promote tax evasion schemes, “[t]his likely can be inferred from his Internet activity. The use of a computer could also arguably be inferred from West’s two-level enhancement for sophisticated means in the creation of multiple accounts for different businesses and complex transactions made between them in an effort to conceal income.”

That computer usage in furtherance of the tax offense was insufficient to justify the broad ban on computer usage:

But if these activities comprise the full extent of findings justifying the ban on computers, then clearly the restriction is broader than necessary, as computers may be used in myriad ways not related to promoting tax evasion online or concealing funds. We are convinced the district court could have crafted a narrower restriction that would have adequately achieved the sentencing purposes of deterrence and public protection without hindering West in continuing his career as a computer technician

Parting Thoughts

Peter Hardy, a partner at Ballard Spahr, former federal prosecutor for over a decade and expert on criminal tax law, offers some interesting thoughts on the opinion.  Peter notes that it is “good to see a court put some teeth into the substantive limits of Section 3583(d) (“no greater deprivation of liberty than reasonably necessary . . . “), particularly given the deferential standard on appeal.” In addition, Peter believes that “the court appropriately distinguishes the cases involving child pornography.  Putting aside the general exception to the Constitution for drug and child porn offenses (I am joking, sort of), in those cases the electronic transmissions/images are themselves contraband – i.e., it’s actually illegal to possess any electronic device containing the images.  Perhaps a similar distinction could be made as well with cases involving hacking, in which it is literally impossible to commit the crime without using an electronic device.”

Peter offers more on why he thinks the 8th Circuit’s approach was correct:

I am sure that the defendant’s websites were obnoxious, but his use of the Internet to facilitate his offenses (and there was no doubt an aspect of opinion and advocacy in his anti-tax railings) hardly distinguishes him from other federal felons.  Most fraud offenses – as the use of the wire fraud statute can attest – are facilitated one way or another through the Internet or e-mail, given the ubiquity of that form of communication.  Even drug schemes are often facilitated through texting.   However, you don’t really see courts prohibiting the average fraudster (health care fraud/securities fraud/consumer fraud/mortgage fraud/whatever) or drug dealer from using computers.  I am not raising an Equal Protection point so much as noting that such prohibitions don’t happen in other cases because I think it is implicitly understood that such a prohibition would be overkill.  Here, the district court just seemed to be annoyed with the content of the defendant’s beliefs, and reacting on that basis.

Peter’s thoughts are sensible. I understand the frustration that judges must feel when confronted with cases such as this. Yet, sharing a vacation house with teenagers this week where the internet is spotty brings home how important computer and internet usage is to everyday life. Today’s technology obviously facilitates a greater spreading of ideas; that carries heavy risk when the ideas are bad and encourage others to likewise break the law. Yet this opinion I think rightfully limits broad restrictions on computer usage for general tax evasion offenses.

UPDATE: 8/4 For a discussion of the part of the opinion I did not discuss, West’s argument that the trial court erred in not allowing to present his Cheek defense properly, see Jack Townsend’s Federal Tax Crimes post here

Filed Under: Criminal Penalties Tagged With:

Zukerman Case Raises Issues Regarding Crime Fraud Exception to Attorney Client Privilege

June 17, 2016 by 1 Comment

We welcome back guest blogger Peter Hardy.  Peter is a partner at Ballard Spahr in Philadelphia and an adjunct professor at Villanova Law School.  Peter, a former Assistant United States Attorney in Philadelphia and a former trial attorney with the Tax Division of the Department of Justice in Washington, D.C., has a practice that focuses on white collar criminal issues and the civil fallout.  Today, he examines the indictment involving a tax fraud case in which the government sought to turn the target’s attorney into a witness and how the government’s actions here should inform your actions in working with clients.  Keith

A recent indictment returned against a high-profile investor for alleged tax fraud has highlighted the potential perils for counsel posed by the crime-fraud exception to the attorney-client privilege and the attorney work product doctrine.  In this case, the crime-fraud exception was invoked successfully by the government to obtain otherwise privileged communications between the defendant and his lawyers during an IRS audit.  This evidence had real-world consequences because the disclosed communications resulted in both additional allegations of criminality and an effort by the government to suggest that counsel might be conflicted out of defending their client during the criminal case filed in the wake of the audit.  This case reminds tax practitioners – and any lawyer representing a client before a government agency – that the real-world protections surrounding legal privilege may be more fragile than anticipated.

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The indictment against Morris Zukerman, unsealed on May 23, 2016, charges him with one count of tax evasion (26 U.S.C. § 7201), one count of wire fraud (18 U.S.C. § 1343), and one count of obstructing the IRS (26 U.S.C. § 7212(a)).  The indictment is lengthy and complex and will be summarized here only.  According to the press release issued by the Office of the U.S. Attorney’s Office for the Southern District of New York, Mr. Zukerman is a business person who owns companies involved in energy investments and who engaged in multi-year tax fraud schemes in which he evaded over $45 million in taxes. More specifically, the government has alleged in part that Mr. Zukerman “evaded tens of millions of dollars of corporate income taxes arising out of $130 million sale of an oil company; he prepared personal tax returns for himself and family members that claimed millions of false deductions; [and] he evaded employment taxes based on personal employees[.].  . . . [W]hen the IRS auditors examined his returns, Zukerman allegedly schemed to defraud and obstruct the IRS auditors who were examining his false tax returns.”

For the purposes of this discussion, we will concentrate only on the alleged obstruction of the audit. Again, the government’s press release asserts as follows:

In seeking to obstruct and defraud the IRS during an audit of one of ZUKERMAN’s companies, ZUKERMAN utilized two attorneys from a law firm in Washington, D.C., to convey a false factual narrative to an IRS Appeals officer, who was undertaking a review of ZUKERMAN’s challenge to an adverse determination made by an IRS auditor during the corporate audit.  Pursuant to a “crime-fraud” ruling by the United States District Court for the Southern District of New York, and affirmed by the Second Circuit Court of Appeals, ZUKERMAN’s companies were required to disclose to the grand jury all of the communications between ZUKERMAN and the two attorneys that led to the submission to the IRS of the false factual narrative.

 

It is somewhat remarkable that the government saw fit to include the last sentence in the press release. The first sentence quoted above would have sufficed to describe the offense alleged in the indictment. For whatever reason, the government also wanted to announce publically the process underlying the grand jury investigation – which was irrelevant to whether or not prior obstruction had occurred during the audit – and make clear that, through successful invocation of the “crime fraud” exception to the attorney-client privilege, the government had obtained records regarding the defendant’s communications with his lawyers. Perhaps this language was intended as a pointed message to defense counsel; perhaps it was intended to set the stage for the government’s effort to raise potential conflict issues involving the defendant’s counsel in the criminal case – who were the same lawyers who had represented him in the audit.

After the return of the indictment, the government filed a letter with the district court, requesting a hearing on whether or not the defendant’s counsel could remain in the case. To be clear, there has been no suggestion that counsel engaged in misconduct. Rather, the government stated that there was a potential conflict created by the Mr. Zukerman proceeding to trial with his defense counsel, who “are potential witnesses as a result of the defendant’s use of those attorneys to convey false information to the Internal Revenue Service during a civil audit – offense conduct that is . . . described at length in the Superseding Indictment[.]” Although the government indicated that it thought that potential conflicts could be waived by the defendant, a hearing was necessary to establish knowing and intelligent waiver by the defendant of those potential conflicts. Ultimately, the district court determined that defense counsel could remain in the case because Mr. Zukerman provided the required waiver and because it is anticipated that Mr. Zukerman will not go to trial, but rather may resolve the case through a guilty plea.

Scenarios like the above case highlight the fact that lawyers who represent clients in tax audits – or in any sort of administrative investigation or inquiry – can become potential witnesses if the government later decides that misrepresentations occurred during the audit or inquiry.  Further, the same lawyer can be perceived as a helpful witness by either the client or the government: as a witness in support of a reliance on counsel defense, or as a witness for the government to undermine such a defense or even provide affirmative evidence of criminal intent, if, for example, counsel received less than full and accurate information from the client when providing the advice at issue, or if the client received advice and then acted to the contrary.

Thus, the prosecutorial interest in the potential opportunities afforded by the crime-fraud exception – both tactical and evidentiary – is not surprising. However, there is also a real risk that the crime-fraud exception can be abused, intentionally or otherwise, as we will now discuss.

To invoke successfully the crime-fraud exception to obtain otherwise privileged attorney-client communications, the government must make a prima facie showing that (a) the client was committing or intending to commit a crime; and (b) the attorney-client communications were in furtherance of the alleged ongoing crime.  The government’s prima facie burden is relatively light, and it does not require the government to prove that a crime in fact occurred, or that the intended crime was accomplished.  Rather, courts generally hold that the standard is merely one of “reasonable cause”; that is, the government only has to make a showing of reasonable cause to believe that the attorney’s services were misused in furtherance of an ongoing criminal scheme.  The exception can apply even if the attorney is innocent and entirely unaware that the client is engaged in or planning a crime.  As a matter of process, the district court reviewing the government’s application – which will be filed under seal – may make its decision in camera, based upon information supplied ex parte by the government.  The court does not have to base its decision on evidence independent of the communications between the attorney and the client.

This evidentiary threshold is low.  Further, the usual procedure attendant to decisions regarding the crime-fraud exception, which almost always occur during grand jury investigations, virtually ensures that the details and merits underlying most decisions – sometimes based on ex parte government submissions – will never see the light of day.  Moreover, district courts overseeing grand jury investigations are, generally speaking, extremely reluctant to potentially interfere with the evidence gathering function of the grand jury, which historically has received very wide berth.  Of course, the course of almost every grand jury investigation is a function of the choices and subjective beliefs of the particular federal prosecutor directing the investigation, rather than the grand jurors themselves.  This confluence of factors means that, as a practical matter, it will be a very rare case indeed – perhaps no case – in which a district court or a magistrate court concludes on the basis of a limited and non-public hearing that it will put some brakes the grand jury’s fact-finding function because the government has failed to show (sometimes through an ex parte submission) that, after accepting its view of the case, there is at the very least “reasonable cause” to believe or suspect that legal advice was misused in the furtherance of some alleged ongoing offense, and that the most prudent course is to order otherwise privilege communications to be divulged.  In part, the reasoning for allowing privilege to be pierced may go:  if criminal charges are actually ever filed, it ultimately will be up to the jury to sort out whether or not an actual crime was committed.  Such reasoning may be explicit, or it may be an unconscious consideration rooted in the very human proclivity to perform an act when ultimate responsibility can be attributed to others.

Anecdotally, it appears to this writer that, over the years, federal prosecutors have become increasingly willing to pursue otherwise privileged evidence from counsel through the aggressive invocation of the crime-fraud exception.  Several years ago, the perils inherent in this possible trend were noted by the district judge who acquitted Lauren Stevens, a former in-house counsel charged with obstruction of justice during an investigation by the Food and Drug Administration, after finding that the government’s evidence during her trial was insufficient as a matter of law to prove criminal intent.  When explaining the granting of the defendant’s motion for judgment of acquittal, the district court observed that much of the evidence upon which the government relied had been obtained through the crime-fraud exception, and then noted:

There are, of course, profound implications for the free flow of communications between a lawyer and a client when the privilege is abrogated, as it was in this case.

. . . .

With the 20/20 vision of hindsight, and that’s always the place to be in terms of wisdom, the [order requiring the production of legal documents under the crime-fraud exception] was an unfortunate one, because I now have benefitted from a trial in which these documents that were ordered produced were paraded in front of me, and the prosecutors were permitted to forage through confidential files to support an argument for criminality of the conduct of the defendant.

What those records demonstrate to the Court is, first of all, that access should not have been granted to them in the first place. . . .

. . . .

[A] lawyer should never fear prosecution because of advice that he or she has given to a client who consults him or her, and a client should never fear that its confidences will be divulged unless its purpose in consulting the lawyer was for the purpose of committing a crime or a fraud.

United States v. Stevens, No. RWT 10cr0694 (D. Md. May 10, 2011).  These concerns regarding the potential for abuse in the use of the crime-fraud exception, although eloquent, do not appear to have been embraced often in practice since the issuance of the acquittal in the Stevens case.

The decision in the Zukerman case regarding the crime-fraud exception may have been entirely appropriate; this discussion does not purport to address that question on the merits.  Regardless of whether it was right or wrong, however, the case represents yet another cautionary tale about how the attorney-client privilege and work-product doctrine do not always provide the long-lasting protections that one might hope they provide, particularly if your client stumbles later into the cross-hairs of a creative and aggressive prosecutor. Even if counsel is not personally the subject or target of a criminal investigation, receiving a subpoena for records or to testify against one’s client is obviously a situation to be avoided.  Certainly, this cautionary tale applies to lawyers representing clients during tax audits.  However, it also applies more globally to any lawyer – whether acting as outside counsel or in-house counsel – handing an administrative inquiry by the government, including the Securities and Exchange Commission, the Food and Drug Administration, and many other agencies.  Although courts describe the reasonable cause standard as reasonably demanding, the practical realities suggest that whether or not the crime-fraud exception will overcome otherwise privileged communications turns not on a court’s application of the legal standard to the facts, but rather on the discretion and mindset of the particular government attorney and whether or not he or she sees fit to pursue the exception.

Filed Under: Attorney Client Privilege Tagged With:

Between the National Taxpayer Advocate and the Courts: Steering a Middle Course to Define “Willfulness” in Civil Offshore Account Enforcement Cases Part 2

March 24, 2015 by 1 Comment

In Part 2 of their post on offshore compliance issues, Peter Hardy and Carolyn H. Kendall of Post & Schell discuss the standard necessary to prove willfulness for failing to file an FBAR. Les

In our first post yesterday, we discussed United States v. Sturman, in which the Sixth Circuit in 1991 upheld a criminal conviction for a willful failure to file an FBAR, and made clear that the standard for willfulness is an intentional violation of a known legal duty. We also observed that the IRS, in a 2006 Chief Counsel Advisory Memorandum, embraced this same definition of willfulness for the purposes of imposing civil FBAR penalties. In this post, we examine how some court opinions have eroded that willfulness standard in the civil FBAR context, a trend that leads us to agree with the recommendation made by the January 14, 2015 Report of the National Taxpayer Advocate that the willfulness requirement for civil FBAR actions be amended legislatively to reflect that willfulness requires not mere recklessness, but a voluntary and intentional violation of a known legal duty.

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Civil FBAR Case Law: Williams and McBride

In contrast to Sturman, two courts that have considered the scope of willfulness in the civil FBAR context have suggested that failing to answer accurately the question regarding a foreign account on Schedule B can, without more, support a finding of willfulness with respect to a failure to file an FBAR. Further, these courts have stated that willfulness in the civil FBAR context includes mere recklessness, which includes careless disregard. These decisions clearly reflect that the government has disavowed the 2006 IRS memorandum’s embrace of a higher standard for willfulness in the civil FBAR context. Regardless of the exact fact patterns at issue in these cases, they state rules of law that may haunt future, more sympathetic account holders.

Williams

In United States v. Williams, the government filed a complaint to recover civil FBAR penalties assessed against the defendant for the year 2000. The defendant had deposited more than $7 million in assets into two Swiss bank accounts from 1993 through 2000, earning more than $800,000 on the deposits, and had failed to disclose these accounts or the income derived therefrom. On his individual income tax returns, Williams checked the relevant box on Schedule B “no,” thereby indicating that he had no foreign accounts. Likewise, Williams indicated on a tax organizer provided to him by his accountant in January 2001, for the purposes of his then-upcoming 2000 tax return, that he did not have a foreign account. However, Williams had retained counsel in the fall of 2000 because Swiss and U.S. authorities had become aware of his Swiss accounts, which were frozen in November 2000 on the day after Williams and his counsel had met with the Swiss authorities to discuss the accounts. Over the course of 2002 and 2003, Williams disclosed these accounts to the IRS, and disclosed them on his 2001 tax return and amended tax returns for 1999 and 2000, as part of his bid to participate in the IRS’s voluntary disclosure program. Williams was not accepted into the program, and he pleaded guilty in June 2003 to tax fraud, on the basis of the funds held in his Swiss accounts from 1993 through 2000. In 2007, he filed FBARs for all years going back to 1993, including for the year 2000.

After a bench trial regarding the basis for the civil FBAR penalties assessed for the 2000 tax year, the district court found that “[d]espite hiring tax lawyers and accountants, Williams had never been advised of the existence of the [FBAR] form prior to June 30, 2001, nor had he ever filed the form in previous years with the Department of Treasury.” The district court also found that Williams had not acted willfully as to his 2000 year FBAR. Specifically, it found that when Williams checked the “no” box on his 2000 personal income tax return indicating that he had no foreign bank accounts, and when he failed to file an FBAR on June 30, 2001, he already knew that the tax authorities were aware of his noncompliance, and he already had begun to meet with Swiss authorities. The district court found that this lack of willfulness was corroborated by Williams’s later disclosures of the accounts to the IRS and his filing of accurate returns. Finally, the district court rejected the government’s claim that Williams’s plea to tax evasion estopped him from arguing that he did not willfully violate his 2000 year FBAR obligation.

The Fourth Circuit, purporting to apply the standard of clear error, reversed the district court’s factual finding that Williams had not acted willfully in a 2012 unpublished opinion. When doing so, the Fourth Circuit also stated that, in the civil context, willfulness includes not just knowing violations, but also reckless ones. Citing Sturman for the proposition that willfulness may be inferred under the willful blindness doctrine, the Fourth Circuit emphasized that Williams had signed his 2000 income tax return, which had put him on notice about the 2000 FBAR filing requirements because of the question on Schedule B regarding foreign bank accounts, which references the FBAR – i.e., Williams should have realized that he had an FBAR filing requirement, but avoided learning about it. The Fourth Circuit also found that Williams’s guilty plea allocution for his tax convictions confirmed that his FBAR violation was willful. However, the Williams opinion contained a dissent, which argued that the record contained sufficient evidence supporting the conclusion of the district court, which had not clearly erred when it found a lack of willfulness. Moreover, the dissent observed that the district court correctly rejected the government’s collateral estoppel argument because Williams never admitted during his guilty plea to failing to file an FBAR, much less failing to do so willfully.

Although Williams involves unusual facts, it implies – because it reversed for clear error the contrary conclusion of the fact finder – that willfully filing a false tax return that does not disclose a foreign account can be inherently synonymous with willfully failing to file the separate FBAR form for the same tax year, at least in a civil penalty case. Although the court also pointed to the inaccurate information Williams provided on his tax organizer as an example of additional conduct meant to conceal, that conduct seems secondary and intrinsic to its immediate consequence – the failure to disclose the account on the tax return. Whether the outcome in Williams was the product of the court’s embrace of the recklessness standard, or was the inevitable product of the court’s interpretation of the willful blindness doctrine, cannot be gleaned from the opinion. Certainly, the court made clear that it viewed the willfulness standard in a civil penalty case as different from the willfulness standard in a criminal case.

McBride

The District of Utah cited Williams when holding in 2012 that the willful filing of signed false income tax return supports a finding of willfulness with respect to failing to file an FBAR. In United States v. McBride, the defendant sought to reduce his tax liabilities arising from his increasingly successful company, and so contacted a financial management firm devoted to tax minimization, Merrill Scott and Associates (MSA). MSA presented McBride with a plan to shift his company’s income to offshore accounts owned by MSA’s foreign entities, over which McBride would have indirect control. MSA also gave McBride a pamphlet setting forth duty as a U.S. taxpayer to report his interest in any foreign account to the government. Pursuant to MSA’s plan, McBride created a transfer pricing scheme whereby the company purchased inventory from a manufacturer at an inflated price and the manufacturer then deposited the overpayment into the offshore accounts that McBride indirectly controlled. During 2000 and 2001, McBride routed roughly $2.7 million through these offshore accounts. McBride failed to inform his preparers of the MSA plan or his interest in the offshore accounts. On his individual income tax returns for both years, he checked “no” on Schedule B and signed the returns. In 2004, the IRS began to investigate McBride; he denied using MSA’s plan or having an interest in the foreign accounts and refused to complete FBARs for 2000 and 2001. Ultimately, the IRS asserted civil penalties against McBride for tax years 2000 and 2001.

After a bench trial, the district court found that McBride’s failure to file FBARs for 2000 and 2001 was willful. As in Williams, the court stated that “willfulness” for civil FBAR enforcement proceedings has the same definition as in other civil contexts: recklessness and willful blindness both constitute civil willfulness, which can be inferred from circumstances, including actions taken to conceal or mislead. However, invoking a recklessness standard hardly seemed necessary to establish liability: according to the court, ample evidence demonstrated that McBride had actual knowledge of his obligation to file an FBAR. The court found that McBride had read the pamphlet from MSA discussing the filing requirement and, more tellingly, he testified that he did not check “yes” on Schedule B “because . . . if you disclose the accounts on the form, then you pay tax on them, so it went against what I set up [MSA] for in the first place.” Despite this seemingly ample evidence of actual knowledge, the court also engaged in an imputed knowledge analysis; it held that because “a taxpayer’s signature on a return is sufficient proof of a taxpayer’s knowledge of the instructions contained in the tax return form,” and because McBride signed the return, which contained instructions concerning the FBAR filing requirement, McBride had imputed knowledge of the FBAR requirement. The court further noted, relying on Sturman, that circumstantial evidence of McBride’s willfulness included his misstatements to, and concealments from, the IRS during their 2004 investigation, which also contradicted his claim that he did not know he had a legal duty to file FBARs.

Finally, the court rejected McBride’s contention that he was not willful because he subjectively believed that he lacked a reportable interest in the foreign accounts based on professional advice. The court held that any belief by McBride that he was not legally required to file an FBAR was “irrelevant” in light of his signing of his tax returns. According to the court, under Lefcourt v. United States, once it is established that a filing was required by law, the only relevant inquiry is whether the failure to file was voluntary rather than accidental. This statement, considered in the abstract, is simply contrary to a definition of willfulness requiring an intentional violation of a legal duty that is subjectively understood by the individual.

Legislative Proposal

The Williams and McBride opinions both reflect that the government has disavowed the more measured position articulated by the IRS in its 2006 Chief Counsel Advisory Memorandum. They also provide ammunition for the government’s anticipated efforts to advance in future civil FBAR cases a lax definition of willfulness which allows for mere recklessness. Further, the McBride court’s reasoning under Lefcourt and the Williams court’s reversal for clear error suggest that simply failing to “check the box” on Schedule B of a tax return regarding a foreign account might cause any failure to file an FBAR to be deemed – at least by the IRS, if not a court – a per se willful failure in a civil case. Given this erosion of the willfulness standard, the suggestion by the National Taxpayer Advocate that the willfulness requirement for civil FBAR actions be amended legislatively to make clear that willfulness requires not just recklessness, but a voluntary and intentional violation of a known legal duty, therefore makes particular sense. As the Report suggests, restoring the integrity of the willfulness standard in civil cases will honor the intent of Congress that the draconian 50% penalty address the problem of bad actors concealing their income. Likewise, clarity regarding the standard for willfulness, and excluding the merely reckless from its net, would accomplish several goals:

  • Imposition of the severe 50% penalty for willfulness would be limited, at least in principle, to those who actually deserve it and to whom it was intended to apply: those individuals who intentionally disregarded a known legal duty, rather than those who merely “should have known better.”
  • Public criticisms of the IRS offshore disclosure programs and related enforcement should be muted. Although case-specific disagreements likely will remain regarding the application of the willfulness standard, it simply will be easier as a matter of principle for the IRS to justify imposing high penalties on intentional law breakers.
  • Excluding recklessness from the definition of willfulness enhances the clarity and fairness of the process of certifying non-willfulness, as required by the current “streamlined” program for offshore accounts. Programs such as the streamlined program, which offer the government the benefits of administrative convenience and maximizing the amount of taxpayers who enter into compliance with the tax system, succeed best when individuals and their advisors feel relatively secure about how the rules are both defined and applied. If willfulness includes recklessness, it is simply harder to predict what conduct eventually may be deemed to be willful. Further, if not checking the box on one’s tax returns to indicate the presence of a foreign account is regarded by the government as synonymous with civil willfulness for the purposes of the FBAR, then the streamlined program becomes almost incoherent, because its benefits and purpose will not be realized except in the most unusual cases.

However, we respectfully disagree with the Report that any legislative or policy change should reflect that the government cannot meet its burden through “circumstantial evidence.” Given the entrenched role of circumstantial evidence in gleaning mental state in both civil and criminal contexts, such line drawing seems unworkable in practice and would contradict basic principles regarding proof of mental state, for which “direct evidence” – to the extent that it is even possible in practice to distinguish direct and indirect evidence – rarely is available. Likewise, we disagree that the government should not have access to the doctrine of willful blindness when attempting to prove mental state. Again, willful blindness – like it or not – is an accepted method of proving mental state. Although the doctrine of willful blindness invites the unfortunate risk that fact finders will inappropriately conflate negligence with actual knowledge or intent, the doctrine itself, properly articulated, demands more than mere recklessness. Indeed, as the Supreme Court made clear in 2011 in Global-Tech Appliances, Inc. v. SEB S.A., willfulness blindness is not a substitute for actual subjective belief, and the doctrine requires that the defendant take deliberate, affirmative actions to avoid learning the critical facts. Deliberate indifference and the existence of known risks, standing alone, will not suffice. Ultimately, a clear definition of willfulness as an intentional violation of a known legal duty will harmonize the civil and criminal law for FBARs; how mental state may be proved should be left to traditional principles of civil and criminal law.

Filed Under: Offshore Disclosure Tagged With: ,

Between the National Taxpayer Advocate and the Courts: Steering a Middle Course to Define “Willfulness” in Civil Offshore Account Enforcement Cases Part 1

March 23, 2015 by Leave a Comment

Today we welcome first time guest bloggers Peter D. Hardy and Carolyn H. Kendall who practice in the Internal Investigations & White Collar Defense Practice Group of the law firm of Post & Schell P.C., in Philadelphia, PA.  Peter, a principal in the firm, is the author of a legal treatise entitled Criminal Tax, Money Laundering, and Bank Secrecy Act Litigation (Bloomberg BNA 2010).  He also serves as an adjunct law professor for the Villanova University School of Law Graduate Tax Program, where he co-teaches a class on civil and criminal tax penalties. Carolyn, an associate at the firm, co-authored the 2014 Supplement to Criminal Tax, Money Laundering, and Bank Secrecy Act Litigation. Both conduct internal investigations and defend corporations, officers and other individuals facing criminal and civil investigations.  

They also assist clients in offshore account disclosure and compliance via IRS disclosure programs (OVDP and Streamlined Procedures) which is the subject of today’s blog post. Picking up on a recommendation in the National Taxpayer Advocate’s 2014 Annual Report, they explain in a two part post the change they feel necessary to the willfulness standard applied to the reporting (or failure to report) offshore bank accounts. Today’s post describes the problem and early case law. Tomorrow’s post will explain where the standard veered off course and how to get it back on track with the appropriate legislative change. Keith

The government has pursued for several years a successful enforcement campaign against undisclosed offshore accounts; the definitive opening salvo in this campaign was the deferred prosecution agreement in February 2009 involving Swiss banking giant UBS. In addition to numerous prosecutions of account holders, professionals, and banks, the IRS has reported that over 38,000 U.S. taxpayers to date have self-disclosed their offshore accounts. The reporting form that has driven this enforcement campaign is the Foreign Bank Account Report, or FBAR, an annual report required under the Bank Secrecy Act (BSA) for U.S. taxpayers holding offshore accounts with a value above $10,000 at any point in the year. Underlying the success of the campaign and the number of voluntary disclosures has been the potentially draconian civil penalties associated with failing to file an FBAR: a “willful” failure to file an FBAR, or the “willful” filing of a false FBAR, can produce a civil penalty equal to fifty percent of the entire account balance, for every year of violation. Given a six year statute of limitations, stacked civil penalties could equate to three times the account balance. Thus, although a “willful” FBAR violation can result in criminal penalties, the tail of potentially very severe civil penalties often has wagged the dog of most taxpayers’ very unlikely real world criminal exposure, and has allowed the IRS to dictate some tough terms when outlining its offshore disclosure programs, which permit taxpayers to avoid criminal prosecution and avoid the harsh 50% penalty.

On January 14, 2015, the National Taxpayer Advocate issued a detailed report (“Report”) regarding suggested reforms of the civil FBAR penalty regime. Although the Report contains many good proposals, we focus here on just one, which seems to strike at the heart of the many critiques raised over the years regarding the perceived inequities in the structure and application of the IRS’s various offshore voluntary disclosure (OVD) programs. The OVD programs have netted many people who may have inadvertently failed to file FBARs, and who are not wealthy people with substantial accounts. As the Report explains, uncertainty has compelled some individuals who never committed fraud to resign themselves to significant civil penalties because“[b]enign actors cannot be sure that IRS will not view their FBAR violations as ‘willful,’ and attempt to impose severe penalties. This is because the government has eroded the distinction between willful and non-willful violations.”

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We agree. Court victories by the government in civil FBAR enforcement actions have diluted the willfulness threshold, from the more appropriate standard of an intentional and voluntary violation of a known legal duty, to a standard of mere recklessness. A “recklessness” standard lacks precision and invites severe penalties simply because an individual is presumed – or is concerned about being presumed – to have “known better,” even if he in fact did not know.

The Report therefore wisely proposes that the willfulness requirement for civil FBAR actions be amended legislatively to make clear that willfulness requires not just recklessness, but a voluntary and intentional violation of a known legal duty. In the first part of this two-part post, we describe how, prior to the current offshore enforcement campaign, willfulness in the civil FBAR context was understood to be equivalent to willfulness in the criminal context. In the second part, we describe how recent case law in the civil FBAR context has eroded this definition, and why the Report’s legislative proposal would benefit both taxpayers and the IRS by correcting this apparent trend. As practitioners who assist taxpayers with disclosing their offshore accounts and becoming fully tax compliant, we join with the Report and the public and private comments of many of our colleagues in observing that this erosion of the willfulness standard fails to distinguish adequately between most account holders and true bad actors, and therefore can discourage those who otherwise wish to become fully compliant.

Admittedly, the Report’s legislative proposal is unlikely to attract much Congressional support, given current budget deficits and the presumed desire of legislators to avoid being depicted as protecting offshore account holders. Nonetheless, the legal point remains: if an individual did not act with the intent to violate a known legal duty, then it is difficult to argue why he should be subject to a very draconian, albeit civil, penalty from the perspective of either fairness or the smart use of limited enforcement resources. As the Report states, the enhanced civil penalties for willful conduct were enacted to target bad actors, not to ensnare the inadvertent or negligent. Moreover, and aside from the benefits of attaining consistency between the civil and criminal penalty regimes for willful conduct, the practical reality is that the current IRS “streamlined” program for disclosing offshore accounts, which requires that the taxpayer submit a certificate attesting to his non-willfulness, is complicated by the possibility that the taxpayer is really being asked to assert that he did not act “recklessly,” which is a potentially much murkier claim than asserting that he did not act with fraudulent intent. Indeed, and as we explain, even the IRS used to state that willfulness for the substantial civil FBAR penalties demanded the same heightened showing required for criminal willfulness.

However, and as we note in our second post, we respectfully disagree with the Report that any legislative or policy change should prevent the government from meeting its burden through use of circumstantial evidence or the doctrine of willful blindness. Such proposals would contradict well-settled methods of showing mental state, and would be unworkable in practice.

United States v. Sturman and the IRS’s 2006 Chief Counsel Advisory Memo

If performed “willfully,” failing to file an FBAR, or filing a false FBAR, is a felony violation of the BSA under 31 U.S.C. §§5314 and 5322(a). A “willful” act, for the purposes of Section 5322 – and also for the vast majority of criminal tax offenses – means a voluntary and intentional violation of a known legal duty.

Prior to the government’s relatively recent offshore account enforcement campaign, the federal courts offered scant guidance as to what qualified as a “willful” failure to file an FBAR. In 1991, the Sixth Circuit upheld a criminal conviction for a willful failure to file an FBAR in United States v. Sturman. Defendant Sturman challenged on appeal his convictions for tax fraud and failing to file FBARs pertaining to business proceeds deposited into Swiss bank accounts. He argued in part that the government had failed to establish he was aware of the legal requirement to file FBARs. The Sturman court rejected this claim and upheld the convictions. In so doing, it cited Cheek v. United States, the seminal case regarding willfulness in the criminal tax context, for the propositions that the test for willfulness is a “voluntary, intentional violation of a known legal duty” and that willfulness “may be proven through inference from conduct meant to conceal or mislead sources of income or other financial information.” In upholding the convictions, the Sixth Circuit noted that the defendant had taken multiple steps to conceal his overseas assets from the government apart from his failure to file the FBAR, including concealing his signatory authority, interest in various transactions, and interest in the corporations that were transferring money to the foreign accounts. The Sturman court also noted that the defendant had admitted his “knowledge of and failure to answer” the question on Schedule B of his federal income tax return, which referred taxpayers to a booklet outlining the FBAR reporting requirements. The court found that the evidence of Sturman’s “acts to conceal income and financial information, combined with the defendant’s failure to pursue knowledge of further reporting requirements as suggested on Schedule B[,]”established willfulness.

The analysis in Sturman therefore reflects that an individual’s mere knowledge of and failure to answer correctly the question on Schedule B concerning foreign bank accounts, absent some other affirmative acts of concealment, is insufficient evidence to establish that the individual knew of the FBAR reporting requirement and willfully violated it – at least in a criminal case.

Once, the IRS itself took its cues from Sturman and embraced a more robust definition of willfulness in the civil FBAR context. In an IRS Chief Counsel Advisory Memorandum released on January 20, 2006, the IRS outlined its position on the willfulness requirement for imposing elevated civil penalties under 31 U.S.C. §5321(a)(5)(C) for an FBAR violation. The IRS stated in this 2006 memorandum that there were no cases “in which the issue presented is construing ‘willful’ in the civil penalty context[,]” a statement that was true at the time. The IRS then expressed its view that the willfulness requirement for imposing a Section 5321 civil penalty is identical to the willfulness requirement for criminal penalties under Section 5322 – i.e., a voluntary and intentional violation of a known legal duty – because both sections use the same word: “willful.” The IRS further noted in the 2006 memorandum that willfulness can be inferred where an “entire course of conduct establishes the necessary intent,” and as an example in the context of a criminal FBAR violation cited to Sturman. This reference to Sturman was potentially instructive because, as noted, the defendant’s criminal conviction for failing to file an FBAR in that case rested on additional affirmative acts of concealment beyond merely failing to check the correct box on Schedule B of his income tax return.

In our second and final post, we will discuss how some recent court rulings have relaxed this standard of willfulness in the civil FBAR context, so as to allow for mere recklessness, and how a legislative fix regarding the definition of willfulness would help to inject needed clarity into the “streamlined” program for offshore accounts, and restore overall fairness.

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