Expect Increased Criminal Enforcement of Employment Taxes

Congressional efforts, civil IRS enforcement, and the IRS's Criminal Investigation Division together with the DOJ Tax Division.

Employment tax withholding is a foundation of our voluntary compliance tax system. Employers are required to not only pay the employer's share of Social Security and Medicare to the government, but also to withhold the employee's share and the income tax related to the wages paid to the employee. Employers are required to withhold and pay over 12.4% Social Security tax on the maximum wage base of $106,800 for 2009 and 2.9% Medicare tax on all wages paid. In addition, an employer's obligation to withhold income taxes could easily be 20% to 35% of the wages paid to an employee. While employers are required to deposit the withheld taxes on a weekly or more current basis, and the IRS has instituted better monitoring devices over the years, the withheld employment taxes, also known as “trust funds” (because the employer withholds the taxes in trust for the government), are a tempting source of cash flow for employers with difficult choices in a difficult economic environment. Mishandling these funds could very well lead to a criminal violation of the tax laws, prosecution and substantial jail time for those involved.

Employment tax violations can run the gamut from the improper treatment of employees as “independent contractors,” in which case an employer does not withhold employment taxes ' to the non-payment of taxes withheld from employees or the use of fraudulent manpower leasing entities which withhold a portion of wages from the employees with no intention of ever paying over the amounts to the IRS. The IRS's Criminal Investigation Division has been investigating the most egregious, high-impact employment tax cases and preparing them for prosecution. Now, however, the budget deficit and the new focus of the IRS and DOJ guarantee an increase of all employment tax investigations and prosecutions. In fiscal year 2006, the IRS had initiated only 47 criminal investigations regarding employment taxes. That number jumped to over 160 investigations in fiscal years 2007 and 2008.

Criminal tax violations can be charged in an number of ways, including tax evasion under ' 7201 of the Internal Revenue Code (IRC), the filing of false employment tax returns under IRC ' 7206, or the willful failure to collect or pay over employment taxes under ' 7202. Where applicable, significant employment tax evasion schemes are charged under the general criminal conspiracy statute, 18 U.S.C. ' 371. In the most egregious cases, these employment tax schemes are sometimes charged as mail or wire fraud.

Treating workers as independent contractors and not as employees ' so called “worker classification” questions ' is a very significant compliance issue with the IRS. The government not only stands to lose much of the employment tax revenue related to these workers, but the tax compliance rate of workers not treated as employees is much lower than those who are treated as employees, especially if the mis-classified workers are not issued Forms 1099 reporting the income to the IRS. Worker classification, however, will normally be subject to civil rather than criminal enforcement because of the complexity of determining whether a particular worker is an employee or an independent contractor. It is the very rare case where the government can establish willfulness when it comes to worker mis-classification. Nevertheless, criminal cases are sometimes brought even though the government assumes a burden to prove willfulness that is often very difficult.

With respect to the nonpayment of withheld taxes, where the employer is treating the worker as an employee and accurately reports the wages and the withholding taxes on the employment tax return but fails to pay the liability on time, enforcement can be both civil and potentially criminal. Employers who fail to pay over these liabilities are faced with significant financial penalties, and the so-called “responsible persons” of a corporate employer can be personally liable for the withheld portions of the employment taxes under what is referred to as the “trust fund recovery penalty” under IRC ' 6672 ' an exception to the general rule that an employee is not liable for taxes owed by a corporation or limited liability company. Where a corporate officer or other responsible person has sufficient authority within the corporation and “willfully” fails to pay over the employment taxes to favor more pressing creditors, the responsible person can be personally liable for the unpaid trust fund taxes.

While most these types of cases are treated as civil matters, the same underlying facts which present a violation of ' 6672 also present a violation of ' 7202, which contains almost the same statutory language as the civil statute and is a five-year felony. Whether a case becomes criminal is primarily based upon its egregiousness ' the amounts involved, and whether the officer/owners of the company personally benefited from the non-payment ' and whether proof is available to establish guilt beyond a reasonable doubt. Nevertheless, any employer or corporate employee who has delayed turning over withholding taxes to meet some other corporate expense runs the risk of a criminal investigation and prosecution.

Criminal Employment Tax Violations

Like all other tax violations, criminal employment tax violations are covered by the federal Sentencing Guidelines. Even though the Guidelines are now “advisory,” in tax cases sentencing judges still must consider the “tax loss” computed under the Guidelines. Companies with large numbers of employees run up significant employment taxes and so can have a large tax loss with very significant sentencing exposure.

One example of an egregious case was that of a fraudulent payroll company, and its principal owner. The owner admitted that, between January and April 2003, he received approximately $4.3 million from a number of clients and falsely told them he would pay the funds to the IRS on their companies' behalf. Instead, he used the money to buy multiple luxury vehicles, spent close to $500,000 on hotels and casinos in Las Vegas, and bought a personal residence. He was sentenced to ten years in prison.

Conclusion

Even cases that are not so egregious can result in significant criminal sanctions. According to IRS statistics, the average incarceration rate for the past three fiscal years is around 80%, and the average period of incarceration has risen from 19 months in fiscal year 2006 to 29 months in 2008. Moreover, the harsher sentences came after the Supreme Court ruled that the Guidelines are only advisory. This suggests that employment tax violations may be viewed with increasing severity by the IRS, DOJ and the courts. So employers beware ' the tax man is coming.

Steven Toscher ([email protected]) and Dennis Perez ([email protected]) are principals in Hochman Salkin Rettig Toscher & Perez, P.C., where they specialize in criminal and civil tax litigation and controversy.

The Assistant Attorney General of the Tax Division of the Department of Justice (DOJ) recently reminded us that, over the next few years, the IRS and Tax Division will count as one of its priorities employment tax abuses. With ever widening budget deficits and economic limitations on raising taxes, the IRS will go in the only direction it can, that is, to mine the “tax gap” ' the difference between the taxes that should have been collected under current law and those that actually are collected.

In 2001, the tax gap was estimated at $345 billion per year. Approximately 17% was attributable to the under-reporting of employment taxes. A more current estimate of the tax gap is expected to be released in the next few months, and the smart money is guessing close to $500 billion, which suggests that there are $75 billion of underpaid employment taxes every year ' a potential source of more revenue without having to raise taxes.

In July of last year, armed with a report by the Government Accountability Office, the U.S. Senate urged the IRS to crack down on payroll tax cheats. Members of the Senate Homeland Security & Government Affairs Permanent Subcommittee on Investigations said the IRS's overall approach on voluntary compliance must be scrapped in favor of filing tax liens and other penalties for repeat offenders. The IRS responded that the it was refocusing its efforts, but Subcommittee members emphasized the need for criminal prosecution of repeat offenders. “If you've gotten notice that you haven't paid your payroll taxes and you've gotten those notices every quarter for two or three years,” one Senator asked, do we need “a task force to tell us that we need to put people in jail for that?”

Congressional efforts, civil IRS enforcement, and the IRS's Criminal Investigation Division together with the DOJ Tax Division.

Employment tax withholding is a foundation of our voluntary compliance tax system. Employers are required to not only pay the employer's share of Social Security and Medicare to the government, but also to withhold the employee's share and the income tax related to the wages paid to the employee. Employers are required to withhold and pay over 12.4% Social Security tax on the maximum wage base of $106,800 for 2009 and 2.9% Medicare tax on all wages paid. In addition, an employer's obligation to withhold income taxes could easily be 20% to 35% of the wages paid to an employee. While employers are required to deposit the withheld taxes on a weekly or more current basis, and the IRS has instituted better monitoring devices over the years, the withheld employment taxes, also known as “trust funds” (because the employer withholds the taxes in trust for the government), are a tempting source of cash flow for employers with difficult choices in a difficult economic environment. Mishandling these funds could very well lead to a criminal violation of the tax laws, prosecution and substantial jail time for those involved.

Employment tax violations can run the gamut from the improper treatment of employees as “independent contractors,” in which case an employer does not withhold employment taxes ' to the non-payment of taxes withheld from employees or the use of fraudulent manpower leasing entities which withhold a portion of wages from the employees with no intention of ever paying over the amounts to the IRS. The IRS's Criminal Investigation Division has been investigating the most egregious, high-impact employment tax cases and preparing them for prosecution. Now, however, the budget deficit and the new focus of the IRS and DOJ guarantee an increase of all employment tax investigations and prosecutions. In fiscal year 2006, the IRS had initiated only 47 criminal investigations regarding employment taxes. That number jumped to over 160 investigations in fiscal years 2007 and 2008.

Criminal tax violations can be charged in an number of ways, including tax evasion under ' 7201 of the Internal Revenue Code (IRC), the filing of false employment tax returns under IRC ' 7206, or the willful failure to collect or pay over employment taxes under ' 7202. Where applicable, significant employment tax evasion schemes are charged under the general criminal conspiracy statute, 18 U.S.C. ' 371. In the most egregious cases, these employment tax schemes are sometimes charged as mail or wire fraud.

Treating workers as independent contractors and not as employees ' so called “worker classification” questions ' is a very significant compliance issue with the IRS. The government not only stands to lose much of the employment tax revenue related to these workers, but the tax compliance rate of workers not treated as employees is much lower than those who are treated as employees, especially if the mis-classified workers are not issued Forms 1099 reporting the income to the IRS. Worker classification, however, will normally be subject to civil rather than criminal enforcement because of the complexity of determining whether a particular worker is an employee or an independent contractor. It is the very rare case where the government can establish willfulness when it comes to worker mis-classification. Nevertheless, criminal cases are sometimes brought even though the government assumes a burden to prove willfulness that is often very difficult.

With respect to the nonpayment of withheld taxes, where the employer is treating the worker as an employee and accurately reports the wages and the withholding taxes on the employment tax return but fails to pay the liability on time, enforcement can be both civil and potentially criminal. Employers who fail to pay over these liabilities are faced with significant financial penalties, and the so-called “responsible persons” of a corporate employer can be personally liable for the withheld portions of the employment taxes under what is referred to as the “trust fund recovery penalty” under IRC ' 6672 ' an exception to the general rule that an employee is not liable for taxes owed by a corporation or limited liability company. Where a corporate officer or other responsible person has sufficient authority within the corporation and “willfully” fails to pay over the employment taxes to favor more pressing creditors, the responsible person can be personally liable for the unpaid trust fund taxes.

While most these types of cases are treated as civil matters, the same underlying facts which present a violation of ' 6672 also present a violation of ' 7202, which contains almost the same statutory language as the civil statute and is a five-year felony. Whether a case becomes criminal is primarily based upon its egregiousness ' the amounts involved, and whether the officer/owners of the company personally benefited from the non-payment ' and whether proof is available to establish guilt beyond a reasonable doubt. Nevertheless, any employer or corporate employee who has delayed turning over withholding taxes to meet some other corporate expense runs the risk of a criminal investigation and prosecution.

Criminal Employment Tax Violations

Like all other tax violations, criminal employment tax violations are covered by the federal Sentencing Guidelines. Even though the Guidelines are now “advisory,” in tax cases sentencing judges still must consider the “tax loss” computed under the Guidelines. Companies with large numbers of employees run up significant employment taxes and so can have a large tax loss with very significant sentencing exposure.

One example of an egregious case was that of a fraudulent payroll company, and its principal owner. The owner admitted that, between January and April 2003, he received approximately $4.3 million from a number of clients and falsely told them he would pay the funds to the IRS on their companies' behalf. Instead, he used the money to buy multiple luxury vehicles, spent close to $500,000 on hotels and casinos in Las Vegas, and bought a personal residence. He was sentenced to ten years in prison.

Conclusion

Even cases that are not so egregious can result in significant criminal sanctions. According to IRS statistics, the average incarceration rate for the past three fiscal years is around 80%, and the average period of incarceration has risen from 19 months in fiscal year 2006 to 29 months in 2008. Moreover, the harsher sentences came after the Supreme Court ruled that the Guidelines are only advisory. This suggests that employment tax violations may be viewed with increasing severity by the IRS, DOJ and the courts. So employers beware ' the tax man is coming.

Steven Toscher ([email protected]) and Dennis Perez ([email protected]) are principals in Hochman Salkin Rettig Toscher & Perez, P.C., where they specialize in criminal and civil tax litigation and controversy.