Can your tax client (or you) go to jail?

EXECUTIVE SUMMARY

* Federal Sentencing Guidelines, declared unconstitutional in 2005, are now merely advisory, not mandatory.

* There are a number of steps CPAs or tax advisers can take to protect both their clients and themselves against possible prosecution.

* If a client faces actual criminal investigation, the CPA should recommend that the client retain an attorney with experience in criminal matters.

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This two-part article highlights the most common substantive and procedural issues a CPA needs to know about crimes under the Internal Revenue Code. Part I, in the April 2006 issue, described the basic elements and consequences of these crimes. Part II, below, discusses current Federal criminal procedure and sentencing rules, and steps CPAs can take to protect against criminal investigation or prosecution.

Overview of Criminal Procedure

When considering the possibility of a criminal prosecution against a client or even a CPA, it is helpful to understand, at least on a rudimentary level, the process leading to a criminal conviction. For example, under Sec. 6531, the statute of limitations for tax evasion, failing to file or pay, filing false or fraudulent returns or other documents, and assisting in filing false returns, generally is six years from when the offense was committed. When a false return is involved, the six-year period starts on the later of the date the return was filed or its due date. (61)

Constitutionality of Federal Sentencing Guidelines

Criminal cases can be resolved through a trial or plea agreement. In either situation, a defendant convicted of tax crimes is likely to be affected by the Federal Sentencing Guidelines (Guidelines). (62) The Guidelines provide a range of punishment, which generally depends on a defendant's past criminal history and, in tax cases, the loss involved in the scheme.

The Guidelines were declared unconstitutional in Booker, (63) a 2005 Supreme Court decision. In the case, a fractured Court majority pointed to the Sixth Amendment right to a jury trial, meaning that the statutory maximum sentence must be based solely on facts as reflected in a jury's verdict or admitted to by a defendant. The Court found this requirement was violated by the Guidelines' scheme under which a defendant's punishment can be enhanced for "relevant conduct." In Booker, the defendant was convicted at trial of possessing 92.5 grams of cocaine base, commonly referred to as "crack." However, his punishment was enhanced under the Guidelines, due to a post-trial sentencing proceeding conducted without a jury, during which the trial judge found Booker had actually possessed far more crack and also had obstructed justice. This mandated a sentence of 360 months to life. However, based on the jury's verdict alone Booker faced a term of between 210 and 262 months in prison. (64)

The effect of Booker remains unclear. In its ruling, the Supreme Court found the Guidelines would satisfy Constitutional requirements if they were merely advisory, rather than mandatory in nature. As a result, the majority deleted the statutory language requiring judges to follow the Guidelines. It ruled that sentencing courts should consider the Guidelines' ranges, but also take into account other factors when determining punishments to be meted out to defendants. (65)

Discussions have erupted in Congress and elsewhere about a legislative fix that would reinstate a system to reduce judicial discretion and disparity in sentencing across the country. (66) It is not clear whether any Congressional action will ever result however.

Application of Guidelines

Even though they are now advisory only, the Guidelines continue to be relevant to taxpayers facing potential criminal action.

Example: A taxpayer with no prior criminal history was convicted after a trial of tax evasion, based on a scheme that caused a tax loss of $45,000. According to Sec. 7201, evasion is punishable by a fine of up to $100,000, a maximum of five years in prison or both. However, the Sentencing Guidelines result would be 15 to 21 months, (67) plus a fine that also would be determined per the Guidelines' Calculations. (68)

The result could be further reduced in some cases, depending on the facts. For example, under Section 3E1.1 of the Guidelines, in pleading guilty to a crime, defendants are generally entitled to a reduction in the severity of their sentence because they have "accepted responsibility" for their criminal actions. (69) Whatever the result, under Booker the sentencing judge now must consider the Guidelines' calculation along with "other statutory concerns" including deterrence, protection of the public and restitution. (70)

What Should a CPA Do?

Whether a criminal matter is a certainty or only a possibility, accountants can take a variety of steps and measures to assist their client, which will enable them to fulfill their own professional responsibilities and avoid malpractice.

SSTSs

A CPA who suspects a tax client of any criminal activity in connection with filing returns, reporting income, paying taxes, etc., needs to consult and carefully consider the guidance offered in the Statements on Standards for Tax Services (SSTSs), available through the AICPA website. (71) These statements, which are mandatory, apply to all members of the AICPA and can be the basis for professional discipline by the Institute, including loss of membership. In addition, the courts, the IRS and state accountancy boards all have been influenced by the SSTSs or their predecessors, the Statements on Responsibilities in Tax Practice. (72) This means that even tax practitioners who are not AICPA members may be subject to standards similar to those found in the SSTSs. For example, the regulations issued under Sec. 6694 are similar to the language of SSTS No. 1, "Tax Return Positions." Sec. 6694 penalizes income tax preparers when an understatement of tax or refund claim is due to a position that has no realistic possibility of being sustained on the merits.

All of the SSTSs are important and must be consulted as an authority by CPAs who are involved in a tax matter that could turn criminal. The Exhibit on p. 283 summarizes the SSTSs. For example, SSTS No. 4, "Use of Estimates" permits estimates in tax returns if obtaining the precise data is impractical and the estimates are reasonable based on known facts and circumstances. (73) If this standard is met, a CPA who used fraudulent taxpayer-provided estimates would not be convicted of aiding and assisting in the filing of a false return, under Sec. 7206(2). To convict under this section, the government must show willfulness, which involves proving a defendant acted knowingly. (74) When an estimate is reasonable, CPAs would presumably not have had the knowledge required to support a conviction.

SSTS No. 1--"Tax Return Positions"

A CPA who satisfies SSTS No. 1 and can document such compliance will not be treated as having acted willfully for prosecution purposes. SSTS No. 1 prohibits AICPA members from recommending a tax return position unless they have a good-faith belief that the position has a realistic possibility of being sustained on the merits. (75) This means the CPA must have a good-faith belief the position is supported by existing law or a good-faith argument for the extension, modification or reversal of such law. (76) The belief can be based on reasonable interpretations of the statute at issue, pronouncements generated by applicable taxing authority, well-reasoned treatises or articles (77) and also other reference tools commonly used by tax advisers and preparers. (78)

A member may recommend a tax return position that does not meet the realistic possibility standard, as long as the position is not frivolous and the CPA advises the taxpayer to make adequate disclosure. (79) Again, this should be sufficient to preclude a finding of willfulness. (80) A frivolous position is "one that is knowingly advanced in bad faith and is patently improper." (81) The SSTS requires CPAs, when appropriate, to advise tax-payers of potential penalties that may apply to a position, and the opportunity, if any, to avoid those penalties through disclosure. (82) Positions are not to be adopted based on the audit selection process or for bargaining purposes. (83)

SSTS No. 3--"Certain Procedural Aspects of Preparing Returns"

Clients and employers supply information that CPAs use in preparing tax returns or other tax documents. When the information is fraudulent, the supplier may face criminal responsibility, as Leona Helmsley can attest to. (84) However, under the SSTSs, AICPA members are permitted to rely in good faith on information provided by a taxpayer or third parties, although this reliance cannot be blind. Members cannot ignore the implications of the information they received and they must make reasonable inquiries when the facts appear incorrect, incomplete or inconsistent, either on their face or due to other information known to the CPA. (85) When a condition calls in to question the tax treatment of an item (e.g., whether records substantiate a deduction), members should determine whether the condition has been met. (86)

Withdrawal

The possibility that CPAs may need to withdraw from a specific engagement or terminate their professional relationship with a client is recognized in SSTSs No. 6 and No. 7. These statements address the treatment of errors. Under SSTS No. 6, (87) AICPA members who become aware of an error on a previous return or of a failure to file a required return should inform the taxpayer promptly and recommend corrective measures. They are under no duty to disclose the information to the government and cannot do so without the taxpayer's consent, unless required by law. (88) If the taxpayer does not take corrective action, CPAs should consider whether to continue preparing the return, and also whether to continue the relationship. (89) The situation may create a conflict of interest between members and their clients, as potential violations of confidentiality, tax law or privilege may arise. Under such circumstances, CPAs should consult their own legal counsel. (90)

SSTS No. 7 (91) offers similar guidance when a member becomes aware of an error in the course of an administrative proceeding. The term "administrative proceeding" expressly excludes criminal matters. The statement recognizes that special issues may arise when a CPA is retained by an attorney rather than by the taxpayer to assist in the lawyer's legal representation. Under both statements, an error is defined as a position, omission or accounting method that fails to meet the standards of SSTS No. 1 and can include positions no longer meeting the standard due to retroactive changes in the law. (92) Errors do not include items that have an insignificant effect on a taxpayer's liability. (93)

The SSTSs do not dictate withdrawal in instances when a member suspects a client or employer of committing tax crimes. However, even if withdrawing is not mandatory, the CPA needs to decide very carefully whether to continue a professional relationship. In most cases, the chances of obtaining a criminal conviction against the CPA would be remote. (94) Still, even a criminal prosecution could have an enormous impact on a CPA's reputation and practice. Plus, there is the potential for civil liability if a CPA firm also provides audit services. Warning signs of criminal intent could include a client's failure to turn over material information, and also the use of unorthodox accounting practices.

Documentation

The potential criminal prosecution of clients regrettably underscores the need for CPAs to keep good records. Not surprisingly, taxpayers may react to criminal allegations by Naming their CPAs, claiming, for example, that the CPA failed to take into account information the client provided or prepared the tax return improperly. This was the case in Mounkes, (95) when the taxpayer testified that he did not recall being advised by his CPA to separate business and personal accounts. The taxpayer's strategy backfired; he was convicted despite his efforts, and his punishment was increased under the Guidelines. In part, this was due to the court's finding that Mounkes' testimony about his CPA was false. (96)

Mounkes exemplifies the importance of good recordkeeping. At the very least, a CPA's files should reflect what advice was given, when it was given and why it was given (meaning the authority supporting the CPA's opinion), as well as information the client supplied, as it relates to the specific advice rendered. When CPAs issue an opinion that reflects the results of tax planning, their files should document compliance with Interpretation No. 1-2, "Tax Planning" of SSTS No. 1. That means the files should contain a summary of the facts and an assessment of the reasonableness of any assumptions or representations. The file also should show how the relevant tax authorities were applied and it should include consideration of the business purpose or economic substance of the transaction, if relevant to its tax consequences. Finally, the CPA's records should document the conclusion that was reached. (97) Oral communication with a client regarding the results of tax planning is permissible. (98) However, advice regarding complex, significant or unusual transactions should be written. (99)

Checking IRS Calculations

CPAs whose client has been targeted for criminal prosecution can provide an important service by checking IRS calculations. For example, in a failure-to-pay case, if they can show that the IRS determination was inaccurate and no additional tax was due, the client cannot be convicted under Sec. 7203. Even when CPAs can only reduce, but not eliminate, the tax deficiency, their clients have still received a valuable service because, under the Guidelines, the severity of the sentence generally depends on the amount of tax dollars involved. (100) In other words, a taxpayer who has evaded a large amount of taxes might receive a stiffer sentence than someone convicted of evasion on a much lesser sum, depending on how a sentencing judge weighs the Guidelines with other factors to be considered under Booker. (101)

Legal Counsel

If a client facing criminal investigation asks a CPA for help, the CPA should recommend an attorney with experience in criminal tax matters. This is consistent with both SSTSs No. 6 and No. 7, which relate to errors in the context of return preparation and administrative proceedings, respectively. (102) It is important that this be done promptly, so that neither the client nor the CPA makes any strategic missteps. This could happen, for example, when clients consent to an IRS interview and wind up voluntarily making damaging statements in response to questions that they could have refused to answer, based on the Fifth Amendment right against self-incrimination.

Privilege: Another reason why clients should hire a lawyer is because of the need to protect work done in preparation for a possible trial from having to be disclosed to the IRS. The Federal courts do not recognize a general accountant-client privilege. (103) The privilege created by the IRS Reform Act of 1998 under Sec. 7525(a), for communications between a taxpayer and a "federally-authorized tax practitioner" is not applicable to criminal proceedings. Thus, the work a CPA does to assist a client in preparing for a criminal tax matter can be obtained by the IRS. However, courts have held that the attorney-client privilege applies if the CPA was hired to assist in the lawyer's legal representation of the client. (104) In other words, if a criminal tax investigation is anticipated, the client's attorney--not the client--should hire the CPA who will assist in preparing for the proceedings; all documentation among the parties, including retainer letters, bills, etc., should reflect this arrangement.

Communication with attorney: It is important for a CPA to communicate carefully and precisely with any attorney who is retained by the client. In Bender, (105) a worksheet prepared by the taxpayer's accountant was used as part of the government's proof in a prosecution for tax evasion. The worksheet was surrendered by the taxpayer's lawyer, who thought the document would explain the deficiencies that appeared on the tax return. Presumably, thorough communication between a CPA and the attorney will help to prevent the inadvertent surrender of damaging material that might otherwise be protected from disclosure through privilege or on other grounds.

Conclusion

Although most CPAs are unlikely to have many, if any, clients with tax problems that could lead to criminal punishment, it is still important to be aware of how clients could be prosecuted and which actions could be viewed as criminal. Also, CPAs should know which actions on their own part could lead to criminal prosecutions of the CPA and possible punishment or professional discipline. A CPA whose client is facing criminal tax action can play an important role, such as checking IRS calculations of the tax amount allegedly due. Whether a client or the CPA is facing the criminal justice system, however, it is important to get the advice of an attorney experienced in criminal tax matters before trying to resolve the matter with the IRS.

For more information about this article, contact Ms. Hibschweiler at [e-mail]

(61) Arnold Habig, 390 US 222 (1968).

(62) U.S. Sentencing Commission, Guidelines Manual (November 2005).

(63) Booker, 543 US 220 (2005).

(64) Id.

(65) Id.

(66) See, e.g., Cohen and Fields, "New Sentencing Battle Looms After Court Decision--Lawmakers Move to Regain Control Over Prison Terms; 'Congress has Ample Power,'" Wall St. J. (1/14/05), pg. A1.

(67) U.S. Sentencing Commission, Guidelines Manual, note 62 supra, at Section 2T1.1.

(68) Id., at Chapter 5, Part E.

(69) Id., at Section 3E1.1

(70) Booker, note 63 supra.

(71) Available at www.aicpa.org/download/tax/sstsfinal.pdf. In December 2005, an exposure draft of proposed SSTS No. 9, "Quality Control," was issued. This statement identifies five elements to be included in a tax practice quality control system, including acceptance and continuance of clients and performance of professional services. The Tax Executive Committee set a proposed effective date of June 30, 2007.

(72) See Swails, "New Standards for Tax Practice," Journal of Accountancy (November 2000). Available at www.aicpa.org/pubs/jofa/nov2000/swails.htm.

(73) AICPA, SSTS No. 4, "Use of Estimates."

(74) Peter Pomponio, 429 US 10 (1976).

(75) AICPA, SSTS No. 1, "Tax Return Positions," at par. 2.

(76) Id., at par. 7.

(77) Id.

(78) AICPA Interpretation No. 1-1, "Realistic Possibility Standard," of SSTS No. 1, "Tax Return Positions," at par. 6.

(79) AICPA, SSTS No. 1, note 75 supra, at par. 2.

(80) John L. Cheek, 498 US 192 (1991).

(81) AICPA, SSTS No. 1, note 75 supra, at par. 9.

(82) Id., at par. 2.

(83) Id., at par. 3.

(84) Leona M. Helmsley, 941 F2d 71 (2d Cir. 1991).

(85) AICPA, SSTS No. 3, "Certain Procedural Aspects of Preparing Returns," par. 2. A member should consider information known from the returns of others, if relevant and necessary to prepare a return, unless limited by law or confidentiality rules. Id., at par. 4.

(86) Id., at par. 3.

(87) AICPA, SSTS No. 6, "Knowledge of Error: Return Preparation," at par. 3.

(88) Id.

(89) Id. at par. 4. In choosing to complete the return, members must take steps to ensure the error is not repeated.

(90) Id., at par. 6.

(91) AICPA, SSTS No. 7, "Knowledge of Error: Administrative Proceedings," at par. 1.

(92) AICPA, SSTS No. 6, note 87 supra, at par. 1; SSTS No. 7, note 91 supra, at par. 1.

(93) Id.

(94) To prove that a CPA aided or assisted in filing a false tax return, for example, the government would have to prove that he or she acted willfully under Sec. 7206(2), with a specific intent to aid in filing a false document; see Pomponio, note 74 supra.

(95) William L. Mounkes, 204 F3d 1024 (10th Cir. 2000).

(96) Id.

(97) Interpretation No. 1-2, "Tax Planning," of SSTS No. 1, "Tax Return Positions," at par. 6. See Interpretation No. 1-1, note 78 supra, at par. 7, for steps to be taken in determining whether a realistic possibility exists.

(98) AICPA SSTS No. 8, "Form and Content of Advice to Taxpayers," at par. 6.

(99) Id., at par. 7.

(100) U.S. Sentencing Commission, Guidelines Manual, note 62 supra, at Section 2T4.1.

(101) See discussion accompanying notes 63-70 supra.

(102) AICPA SSTS No. 6, note 87 supra, at par. 5; SSTS No. 7, note 91 supra, at par. 5.

(103) Arthur Young and Co., 465 US 805 (1984).

(104) Louis Kovel, 296 F2d 918 (2d Cir. 1961).

(105) Abe Bender, 218 F2d 869 (7th Cir. 1955).

Arlene M. Hibschweiler, Esq., J.D., MBA

Lecturer

University at Buffalo

Buffalo, NY

Exhibit: Statements on Standards for Tax Services (SSTSs)

SSTS No.               Description

No. 1, Tax             Tax return positions are to be recommended
Return                 if an AICPA member has a good-faith belief
Positions              the position has a realistic possibility
                       of being sustained on the merits. A position
                       not meeting this test can still be recommended,
                       provided it is not frivolous and the member
                       recommends appropriate disclosure to the
                       taxpayer. When relevant, taxpayers should be
                       advised of potential penalties and the
                       opportunities to avoid such sanctions through
                       disclosure. Return positions and returns should
                       not rest on assumptions about audit selection
                       or be advanced strictly for bargaining
                       purposes.

No. 2,                 Members are to make a reasonable effort
Answers to             to obtain from a taxpayer information
Questions              necessary to provide appropriate answers to
on Returns             all questions on a tax return.

No. 3, Certain         Members are allowed to rely in good faith
Procedural             on information supplied by the taxpayer or
Aspects of             third parties. Reasonable inquiries are
Preparing              required if the information appears
Returns                incorrect, inconsistent or incomplete.
                       If a condition exists with respect to
                       the treatment of an item, the member
                       should satisfy him or herself that such
                       condition has been met. A member should
                       consider information known from the
                       returns of other taxpayers, if relevant
                       and necessary, but bearing in mind
                       limitations imposed by law or
                       confidentiality rules.

No. 4, Use             When impractical to obtain precise data,
of Estimates           a member is allowed to use the taxpayer's
                       estimates to prepare a tax return, as long
                       as not prohibited by statute or rule. The
                       estimates must be reasonable and should not
                       be presented in such a way as to imply
                       greater accuracy than what exists.

No. 5, Departure       A member is not restricted by an
From a Position        administrative proceeding or court
Previously             decision from recommending a
Concluded in an        different tax position in a
Administrative         later year, unless bound specifically,
Proceeding or Court    as by a formal closing agreement. The
Decision               earlier action should be considered in
                       determining whether the standards of
                       SSTS No. 1 are met.

No. 6, Knowledge       When a member becomes aware of an
of Error: Return       error or failure to file a required
Preparation            return, he or she should advise the
                       taxpayer promptly and recommend
                       corrective measures. The member
                       cannot inform the taxing authority
                       without the taxpayer's permission,
                       unless required by law. If the
                       taxpayer refuses to take corrective
                       measures, the member should consider
                       withdrawal. Where the member does
                       prepare the current-year return,
                       reasonable steps are required to
                       ensure the error is not repeated.

No. 7, Knowledge       The guidance in this statement is
of Error:              similar to that given in the context
Administrative         of return preparation, described above.
Proceedings

No. 8, Form and        Advice given to taxpayers should
Content of Advice      reflect professional competence
to Taxpayers           and serve the taxpayer's needs.
                       A member should assume that tax
                       advice will affect the manner in
                       which a matter or transaction
                       will be reported. In general,
                       a member has no obligation to
                       advise the taxpayer of subsequent
                       developments in the tax law
                       affecting earlier advice,
                       although exceptions to this
                       rule exist.