White collar defense attorneys and accountants engaged to assist in investigations conducted by the IRS Criminal Investigation Division are familiar with these words: “… the tax loss … is … $550,000 to $1,500,000 …” These, or comparable words, routinely appear in guilty plea agreements entered into with the United States by defendants and their attorneys in which the defendant admits to violating a criminal provision of the Internal Revenue Code.

Attorneys and accountants practicing in this area know that the amount of “tax loss” is then a crucial component to consider when the parties, including a Federal District Court judge, are assessing the potential and actual sentencing of a defendant. Why? Well the amount of the “tax loss” is a factor in determining the so-called “offense level” which, in turn, influences the “defendant's guideline range” set forth in the U.S. Sentencing Guidelines (guidelines). The “defendant's guideline range” specifically refers to the starting point of a potential period of incarceration for the offense set forth in the guidelines.

There is a commonly known, correlation between the tax loss and a potential punishment measured as some period of incarceration. It is also known there will be financial consequences to the defendant in the form of fines, restitution, penalties and/or taxes due the United States. These consequences are frequently addressed in guilty plea agreements with language as follows:

• “The defendant agrees to cooperate fully with the Internal Revenue Service concerning restitution, that is, personal taxes owed …”;
• “The defendant agrees to pay restitution as directed by the court to the Internal Revenue Service.”;
• “Prior to sentencing, the defendant will pay at least $… to the IRS to be applied to the taxes, interest, and penalties owed …”;
• “The defendant agrees to pay all remaining taxes, interest and penalties, as determined by the IRS to be due and owing … ; and
• “Prior to sentencing, the defendant will properly execute and deliver to the IRS Examination Division IRS Form 4549 or IRS Form 870 …”.

While the parties accept there will be financial consequences to the defendant, as outlined in the agreements, the full extent of those financial consequences can be masked (and may be duplicative) by the agreement language for persons not experienced with the interplay between the IRS criminal and civil process. What follows is a brief introduction to financial ramifications of these criminal plea agreement provisions on an individual defendant.

What Is Tax Loss?

Within the context of a criminal income tax related plea agreement and the guidelines, “tax loss” is a measure of the federal income tax that would have been due on the unreported income attributed to the taxpayer's criminal actions as contained in the plea agreement.

“Tax loss” is not synonymous with the amount a defendant may ultimately be obligated to pay the IRS. It is only one component of a potentially larger amount determined to be due to the IRS. However, the “tax loss” may be synonymous with court ordered restitution to the IRS.

A common measure of the “tax loss” for an individual defendant, permitted by the guidelines and used by practitioners and the U.S. alike, is 28 percent of the unreported income. For illustration,” $3,600,000 of unreported income would correlate to approximately $1,000,000 “tax loss” ($3,600,000 x 28 percent).

For purposes of this discussion, let's use the “tax loss” range of $550,000 to $1,500,000 contained in the title. The range is established by the U.S. Sentencing Commission for sentencing purposes. Simply stated, the actual “tax loss” calculated by the parties is more than $550,000 but not more than $1,500,000. Let's further assume that the actual tax loss is $1,000,000, a nice round dollar.

The “tax loss” is not necessarily the amount of unreported income for the period during which the United States is alleging the defendant willfully failed to accurately report income. The “tax loss” is a measure of the tax that would have been due on the unreported income that resulted from defendant's criminal conduct that was the subject of the plea agreement.

Assume, the defendant's “tax loss” is $1,000,000. In our experience, this $1,000,000 represents only a portion of the amount due the IRS. So, what else is included and how much more than $1,000,000 is the defendant obligated to the pay the IRS?

Taxes, Interest and Penalties

As Income tax plea agreements generally provide “ … The defendant agrees to pay all remaining taxes, interest and penalties, as determined by the IRS to be due and owing …” the defendant will likely owe the IRS more than the $1,000,000 tax loss. Penalties, interest and tax on non-criminal activity will be calculated and added to the $1,000,000 tax amount to determine the total amount due the IRS.

A hypothetical example may be best to properly illustrate this calculation. Key components for the hypothetical are:

• A tax loss, the absence of which eliminates the need for calculation and discussion; and
• The tax loss period which is most often measured in periods of three years or more. The multi-year period is used as evidence of willfulness, an element of most tax violations.

The following table illustrates these components, assuming the aforementioned tax loss of $1,000,000 is allocated evenly over there tax periods beginning with calendar year 2012 and continuing through 2014.

Based upon this hypothetical, the total amount due the IRS including penalties and interest is $1,961,794 on a tax loss of $1,000,000 or approximately 200% of the tax loss. In its simplest form, these amounts are also the amounts that will be shown on the IRS Form 4549—Income Tax Examination Changes or IRS Form 870—waiver of restrictions on assessment and collection of deficiency that the defendant will be expected to execute before sentencing. Alternatively, the plea agreement may require the preparation and submission of amended income tax returns (form 1040X). Regardless of whether the defendant executed Form 4549, 870 or 1040X, the defendant will be agreeing to a financial obligation to the IRS that is approaching $2,000,000 and continuing to grow until satisfied.

The civil fraud penalty alone is a material portion of the total amount due the IRS and represents 75 percent of the underlying tax. The assessment of the civil fraud penalty is an expected consequence of the agreement to plead guilty to a criminal income tax violation such as tax evasion or filing a false income tax return. Internal Revenue Code Section (IRC) 6663 provides in part “… there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.” In this context, the aforementioned “tax loss” will be deemed to be an underpayment which is attributable to fraud.”

The assessment of the civil fraud penalty in these circumstances is standard practice. Any expectations to the contrary will likely be met with disappointment. Similarly, plans to compromise (i.e., reduce) the amount due the IRS at some later date through normal IRS collection procedures process will unlikely yield a favorable result.

Due to the current relative positive interest rate environment, amounts due the IRS in recent years has fluctuated between 3 percent and 4 percent. The actual rates are adjusted quarterly based upon the federal short-term rate. The negative is the interest accrued from the due date of the return and continues until the amount due is paid in full.

“… restitution as ordered by the Court …”

An issue that has created some angst in recent years is this concept of “… restitution as ordered by the court …” To be fair, maybe it's not the concept of “restitution” as much as the manner in which it was implemented by the IRS and Department of Justice (DOJ)… The “restitution” amount is often used synonymously with the “tax loss” described earlier. Using our earlier hypothetical, the court might order the defendant to pay $1,000,000 restitution during the period of incarceration and supervised release.

When first implemented many taxpayers were required to make restitution payments to the clerk of the court (i.e., U.S. Department of Justice). A lack of coordination between IRS and the DOJ created unnecessary confusion and duplication for defendants and their representatives. Defendants would make required payments to DOJ only to learn that the IRS had either not been notified or failed to accurately track the payments. As the tax loss had also been assessed by the IRS on the form 4549 or 870 (see above), a duplicate liability/amount due to the IRS was shown in IRS records. Without coordination between departments, the IRS would eventually institute civil collection procedures to recover the amount of “tax loss” assessed that had already been paid to DOJ as restitution.

Changes introduced in recent years have addressed these issues. First, the IRS assesses and collects restitution ordered in criminal tax matters in the same manner it pursues other income tax assessments. Prior confusion is eliminated by having income tax plea agreements direct that restitution be paid to the IRS. Also, the IRS implemented changes to its manual forming a Technical Services Centralized Restitution Assessment Group and imposing specific reporting requirements.

Closing Comments

The above narrative outlines potential civil/financial consequences to a defendant who has entered into a plea agreement to resolve certain income tax violations. In the above hypothetical a $1,000,000 tax loss increases to approximately $2,000,000 when interest and penalties are calculated. While criminal defense attorneys must address the potential criminal consequences of an agreement with the client/defendant, a clear understanding of the likely civil consequences on the client is necessary when entering into an income tax plea agreement and advising their clients.

Edward Waddington, CPA, is a partner in Marcum's Philadelphia office and a member of the firm's advisory services division. He consults with clients on numerous facets of financial reporting and planning, along with tax controversies, business valuations and business disputes. His testimony as an expert in accounting/tax and business valuation has been accepted in various courts in Pennsylvania, New Jersey, and North Carolina, and the United States Tax Court. Ricardo J. Zayas, CPA, CFE, CVA, CFF, is a partner in Marcum's Philadelphia office and a member of the firm's advisory services division. He provides investigative accounting and litigation support services to attorneys, insurance companies, corporate and governmental units.