An Attorney, A CPA and Confidentiality

Do you have privacy protection if you tell me something as your CPA?

Your first thought might be yes, as your CPA might be the financial doppelganger to an attorney.

Then again, the answer might be no, as your CPA is not in fact an attorney – unless he/she is one of those rare birds that pairs-up a JD/CPA.

What got me thinking along these lines is the recent case US v Galloway.

Let’s travel to 2006. The IRS notifies Galloway that his 2003 return has been pulled for audit.

Audit starts.

In the middle of the audit Galloway’s CPA fires him. Why? Galloway did not pay his fees.

In 2008 Galloway gets sent to CID (Criminal Investigation Division), the part of the IRS that carries badges and guns.

As a heads-up: you NEVER want to deal with CID. It is one thing to argue with regular IRS, appeal penalties, stretch out a payment plan and so on. All that crowd wants is your money. CID investigates criminal conduct and they have a different goal: to put you in jail.

CID agents went to his business offices in Bakersfield, California. Upon their approach, a man in the office locked the door and called the police.

The CID agents also called the police and informed them there were two plain clothed and armed federal agents waiting for them to arrive.

The man stepped out of the building and provided them with the name of an attorney. The CID agents cleared out before the police arrived.

Nothing. Suspicious. There.

Since that visit went so well, CID next issued a summons for production of documents to the former CPA.

The CPA met with them, explained his relationship with Galloway and answered questions on how he prepared Galloway’s 2003 return. No great surprise: Galloway had forwarded QuickBooks information; the CPA asked a few questions, massaged a few numbers and produced a tax return. Happens in a thousand CPA offices every day.

There was a smidgeon of a problem, though.

Remember that the CPA had started the Galloway audit. As part of the audit, Galloway had provided him more paperwork, including additional and replacement QuickBooks runs. No big deal - usually.

What was unusual was that the new QuickBooks runs did not match-up to the earlier run the CPA used for the tax return.  

Galloway was charged with four counts of attempting to evade tax.

What to do?

Galloway sought to suppress all evidence obtained from his prior CPA. Why? Code Section 7609. The AICPA Code of Professional Conduct. Equitable authority. Applebee’s 2 for $20 menu.

You get it: kitchen sink. Galloway was throwing everything he had.

And this brings us to the Couch case from 1973. It was a Supreme Court case, so it is big-time precedent.

Couch owned a restaurant. At issue was unreported income. Cash. Pocket. Wink. You understand.

The IRS issued a subpoena to Couch’s accountant for books, records, bank statements, cancelled checks, deposit ticket copies, Sunday newspaper coupons and unexpired S&H green stamps.

Couch said: hold up. She had provided all that stuff to her accountant, so subpoenaing her accountant rather than her personally was nonetheless a violation of her Fifth Amendment right against self-incrimination.

I like her argument.

Ultimately – as Captain Picard would say – her argument was futile.

The Court was short and swift: Couch had no “legitimate expectation of privacy” upon providing information to a third-party with the goal of processing, straining and compressing that same information onto a government tax return.

Back to Galloway.

As you can see, he was taking a low-probability swing on a high-and-tight fastball.

He struck out. He could not make enough separation between his situation and Couch to avoid the precedent.

How do tax CPAs handle situations like Galloway in practice?

First of all: interaction with CID is rare. One can have a long career and never see the criminal side of the IRS.  

I have run into CID once or twice over 30+ years, most recently in connection with a fraudulent tax preparer in northern Kentucky. I also recently (enough) represented a client whose file was submitted by Exam to CID, but CID rejected the matter. The client was eye-rollingly negligent, but Exam hyperventilated (I thought then and now) and started seeing intent where only stupidity abounded.  

Anyway, here is what the CPA should recommend:

(1) Have the client hire an attorney

(2) Have the attorney hire the CPA

Under this arrangement, the CPA works for the attorney. He/she is protected under the attorney’s confidentiality privilege and cannot be compelled to testify unless the attorney releases him/her. The attorney will not – of course -  do any such thing.

This set-up is called a “Kovel,” by the way. Not surprisingly, it refers to a case by the same name.

What did Galloway’s accountant do wrong?

To be fair: nothing. Galloway was no longer a client. He was under no obligation to chase Galloway down.

Galloway really should have thought of that before stiffing the CPA for his fee.

Let’s however say Galloway was still a client. 

Folks, at the first hint or whiff of a criminal investigation I am (1) firing you or (2) you are providing me with a Kovel. Those are the only two options.

But it requires the accountant to recognize the danger signs.

Like a combined civil-criminal IRS examination, for example. Those are borderline unfair, as the IRS will pretend there is no criminal side to it. They introduce an unsettling miasma of entrapment, and they require the tax practitioner to realize that he/she is being played.

But that is not what happened with Galloway. CID went to his office, for goodness’ sake.

There was not a lot of subtlety there.

JPMorgan's Nondeductible Madoff Deal

On January 7, 2014, JPMorgan entered into a deferred prosecution agreement with the Justice Department. This is another payment in the ongoing Bernie Madoff saga, and the bank agreed to pay a $1.7 billion settlement as well as $350 million to the Office of the Comptroller of the Currency and $543 million to a court-appointed trustee.

Madoff kept significant balances with JPMorgan.  Banks are the first line of defense against fraud, but JPMorgan never filed suspicious activity reports with regulators, even though there were significant reservations as to when they became suspicious. The bank did not admit any criminal activity in the agreement, but it did allow that it missed red flags from the late 1990s to late 2000s.

What caught my eye was the following text from the following joint release by the Manhattan U.S. Attorney and FBI:
           

… JPMorgan agrees to pay a non-tax deductible penalty of $1.7 billion, in the form of a civil forfeiture, which the Government intends….”

This is unusual language.

The tax code provides a tax deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

And then the tax Code starts taking back. One take back is Section 162(f):

162(f) FINES AND PENALTIES.— No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

Let’s drill down a little bit into the Regulations:

This prohibition applies to any fines paid by a taxpayer because the taxpayer has been convicted of a crime (felony or misdemeanor) in a full criminal proceeding in an appropriate court.   The prohibition also extends to civil fines if the fines are intended by Congress as punitive in nature.

So, if fines are paid pursuant to a criminal case, then the taxpayer is hosed. However, if fines are paid pursuant to a civil case, there is one more step: are the fines punitive in nature?

Attorneys differentiate damages between those that are remedial and those that are punitive. A remedial payment is intended to compensate the government or another party – to “make one whole,” if you will. It is intended to restore what was disturbed, upset or lost, and not intended as penalty or lashing against the payer.

Let’s complicate it bit. There is a court case (Talley Industries Inc v Commissioner) that allows damages to be deductible if they are remedial in intent, even if labeled as a fine or penalty.

EXAMPLE: The NFL fines a player for unnecessary roughness. The NFL can call this a fine, but it is not a fine per Section 162(f) and will be deductible to the player involved.

You are seeing how this is fertile hunting ground for tax lawyers. Unless the payment is pursuant to a criminal case, odds are good that it is deductible.

Now remember that this agreement is Madoff related, and that there are hard feelings about JPMorgan’s involvement with Madoff over the years, and you can see why the Justice Department included the “nondeductible” language in the agreement.

Let’s take this a step further. Under Talley, JPMorgan could deduct the $1.7 billion on its tax return. Remember, it is not a fine or penalty under Sec 162(f) just because somebody somewhere called it as such.

Would JPMorgan be likely to do this?

This is a “deferred prosecution” agreement.  If JPMorgan did deduct the settlement, they might not have an issue with the IRS, but they would likely have a very sizeable issue with the Justice Department.

New Plan for U.S. Expats to Comply With The IRS

There is good tax news for many U.S. expats and dual citizens. Beginning September 1^st, the IRS is starting a new program allowing many expats to catch-up on late tax returns and late FBARs without penalties.

This new program is different from the “Offshore Voluntary Disclosure” programs of the last few years. For one thing, this program is more geared to an average expat. Secondly, and more important to the target audience of the OVD programs, this program does not offer protection from criminal prosecution. That is likely a nonissue to an average expat who has been living and working in a foreign country for several years and has not been trying to hide income or assets from the U.S.

Under this new program, an expat will file 3 years of income tax returns and 6 years of FBARs. This is much better than the 8 years of income tax returns and 8 years of FBARs for OVD program participants.

All returns filed under this program will be reviewed by the IRS, but the IRS will divide the returns into two categories:

Low Risk – These will be simple tax returns, defined as expats living and working in foreign countries, paying foreign taxes, having a limited number of investments and owing U.S. tax of less than $1,500 for each year. Low risk taxpayers will get a pass – they will pay taxes and interest but no penalties.

NOTE: When you consider that the expat will receive a foreign tax credit for taxes paid the resident country, it is very possible that there will be NO U.S. tax.

 Higher Risk – These will be more complicated returns with higher incomes, significant economic activity in the U.S., or returns otherwise evidencing sophisticated tax planning. These returns will not qualify for the program and (likely) will be audited by the IRS. This is NOT the way to go if there is any concern about criminal prosecution. However, it MAY BE the way to go if concern over criminal prosecution is minimal. Why? The wildcard is the penalties. Under OVDP a 27.5% penalty is (virtually) automatic. Under this new program the IRS may waive penalties if one presents reasonable cause for noncompliance.

NOTE: This is one of the biggest complaints about the OVD program and its predecessors: the concept of “reasonable cause” does not apply. The IRS consequently will not mitigate OVD penalties. This may have made sense for multimillionaires at UBS, but it does not make sense for many of the expats swept-up by an outsized IRS dragnet.

The IRS has also announced that the new program will allow resolution of certain tax issues with foreign retirement plans. The IRS got itself into a trap by not recognizing certain foreign plans as the equivalent of a U.S. IRA. This created nasty tax problems, since contributions to such plans would not be deductible (under U.S. tax law) and earnings in such plans would not be tax-deferred (under U.S. tax law). You had the bizarre result of a Canadian IRA that was taxable in the U.S.

QUESTION: If your tax preparer had told you that this was the tax result of your Canadian RSSP, would you have believed him/her? Would you have questioned their competency? Sadly, they would have been right.

A Doctor, A Tax, An Offshore Account And A Moral

I was reading Kindred v Commissioner recently. There is not much there of technical interest, but the facts are interesting. Plus it has a moral.

Dr Kindred failed to file tax returns or make tax payments for 2001 and 2002. The IRS prepared substitutes for returns and assessed him $912,529 and $1,184,115 for 2001 and 2002 respectively. The doctor goes to court, but not to argue the amount of tax assessed.

NOTE:   Wow! This guy owes over $2 million to the IRS and is not even arguing the amount.

Dr Kindred had gotten himself involved with the Aegis Business Trust System (Aegis) out of Chicago. Aegis was a bushel of bad apples. They promoted the use of trusts – revocable, offshore - as a way to reduce taxes. The problem is that some trusts are useful and others are useless. Aegis promoted useless trusts. The IRS conducted an undercover investigation (code-named “Operation Trust Me”) which resulted in indictments and convictions for tax fraud conspiracy for the operators of Aegis.

Dr Kindred transferred money offshore to one of these Aegis trusts.

In 2003 the government indicted Aegis and froze their offshore accounts. The government seized all the accounts and kept the money, including Dr Kindred’s money.

Subsequently the doctor is contacted by the IRS, and they want $2-plus million.

The doctor’s money is gone. What is he to do?

He files a case in District Court and then Tax Court, that is what he does. His request is simple. He wants to receive “credit” for his share of the monies that were seized. After all, on the one hand he owes the government money. On the other hand the government took money that belonged to him. Seems reasonable, right?

 The district court dismisses his case. There are several issues, one of which is that the case in district court was a criminal case. No matter what, Dr Kindred was not coming out of district court with a verdict that the monies represented tax payments, mostly because the monies did not represent tax payments. Rather than make tax payments to the IRS he boxed them in an Aegis trust and shipped the monies overseas. Money yes, tax payments no.

He next goes to the Tax Court and makes the same plea. The Tax Court asked the obvious question: we are a court for taxes. We see that you owe taxes. We see that you did not pay taxes. Why are you here?

This is a worst case scenario. The doctor lost the money that he shipped offshore AND he still owes the taxes.

The moral? Wouldn’t it have been easier to just HAVE PAID THE TAXES?