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COURT OF APPEALS REJECTS IRS AUDIT PROCEDURES USED IN TAX RETURN PREPARER FRAUD CASE
Posted by: Mark Horwitz
November 14, 2008

One priority of the Internal Revenue Service is the criminal prosecution of tax return preparers who it believes have fraudulently prepared tax returns. Investigation into tax return preparers involves the IRS contacting many, if not all, of the tax return preparer's customers and auditing their tax returns.

In addition to various civil penalties and fines, which the IRS can impose upon a tax return preparer for failing to follow various specific rules, the U.S. Justice Department can prosecute a tax return preparer for preparing or presenting false or fraudulent tax returns on behalf of the tax return preparer's clients.

The case of U.S. v. Schroeder, 536 F.3d 746 (7th Cir. 2008) involved the prosecution of a tax return preparer under 26 U.S.C. § 7206(2). This statute makes it a crime for anyone who willfully aides or assists in, or counsels or advises the preparation or presentation of a U.S. tax return, which is fraudulent or false as to material matters, whether or not the falsity is done with knowledge or consent of the taxpayer. Each false return constitutes a separate crime and is punishable by a maximum of three years in prison, and a $100,000 fine if the defendant is a person, and a $500,000 fine if the defendant is a corporation.

Mr. Schroeder had a tax return preparation business which he operated out of his home. He was indicted and charged with 21 counts of tax preparer fraud. Schroeder pled guilty to one count of tax preparer fraud, and in the plea agreement admitted that the false tax returns resulted in a loss to the United States Treasury of at least $161,000.

At the sentencing the government contended that the tax loss was $428,000. The additional tax loss over the amount in the plea agreement significantly increased Schroeder's potential sentence.

The IRS determined the tax loss by conducting a civil audit of the defendant's clients. The audits were conducted to determine the correct tax liability. Written requests were sent to Schroeder's clients asking them to provide proper documentation to substantiate deductions. During the audit, any customer who did not respond or who did not provide proper documentation to substantiate deductions, had their taxes adjusted by disallowing the deductions.

The purpose of the audit of Schroeder's customers was not to determine who was responsible for the improper deductions, i.e. Schroeder or his clients, but rather to determine the total amount of the loss incurred by taking improper deductions. Mr. Schroeder's attorney objected to utilizing this audit technique because it did not establish that the underpayment of tax was due to Schroeder's conduct. The government argued that the audit revealed deductions that were not properly substantiated. This was the basis of Schroeder's crime.

In determining the amount of loss for sentencing purposes, the government is required to prove the loss by a preponderance of the evidence, and not beyond a reasonable doubt, as is required to determine guilt. In addition, the court is allowed to accept evidence that would not be admissible in a trial.

Schroeder was originally sentenced to 42 months incarceration. This sentence was obviously improper since the maximum that Schroeder could face for the one count was 36 months. Somehow, the judge, prosecutor, and, defense attorney failed to recognize this obvious mistake. Schroeder appealed and both the defense and government acknowledged that the sentence was illegal and asked the appellate court to remand for re-sentencing. That remand occurred, and at the re-sentencing the defense attacked the method of computing the tax loss. Before allowing the defense counsel to make his presentation, the judge stated that he was accepting the amount of the tax loss as computed. The appeals court said that such conduct by the trial court denied the defendant his right to due process since the hearing was not fair.

The Court of Appeals rejected the use of this civil audit to attribute criminal liability for the tax loss. The major flaw of the audit was that the audit did not purport to attribute responsibility for the improper deductions, but rather whether the deductions could be substantiated.

The Court, in rejecting the use of the audit to determine tax loss in the criminal case stated the following:

The government contends that the civil audit is circumstantial evidence of Schroeder's culpability for the additional tax loss amount, pointing out that almost all of the taxpayers who were audited told IRS agents that they could not provide documentation supporting the itemized deductions claimed on their tax returns. The government also notes that the inaccurate deductions on the audited returns were of the same type that Schroeder admitted to having falsified. But these facts do not make it more likely that the overstated deductions were due to Schroeder's criminal conduct than to a mistake or fraud on the part of his taxpayer clients. The district court treated the underpayments that were detected in the audit as frauds attributable to Schroeder without conducting any analysis as to what evidence proved that Schroeder's unlawful conduct caused the underpayments.

Schroeder at 755.

The government utilizes correspondence audits and sampling techniques to determine the amount of loss that it attributes to a tax return preparer. Often this involves not even a correspondence audit of all of the customers, but rather a sampling of customers. Such evidence raises due process concerns. As shown in this case, the purpose, as well as the message of the audit, must be fair. Therefore, the audit must be analyzed in detail.

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