In many kinds of criminal and non-criminal proceedings, attorneys often need to answer questions of amount in one sense or another. Usually, opposite sides of a case have differing opinions on issues like calculation of damages, lost revenues, taxes, and other key amounts. Particularly in the instance of criminal and fraud cases, the stakes are high and the evidence (incriminating, exonerating or both) is usually present but often elusive, incomplete or both.
Because victory often hinges on “the numbers,” there is a growing trend among attorneys to engage the services of a forensic accountant on complex cases. What is a forensic accountant? Universities all over the world offer courses in forensic accounting, and accountants have served in law enforcement roles in US law regulatory agencies (think “The Untouchables”), but really there is no single easy answer. Rather, think of a good forensic accountant as the accounting profession’s version of a renowned internal medicine specialist. Forensic accountants have to “know something about everything.” To truly qualify in that arena requires years of varied in-depth experience with a wide range of business, government and financial activities. Ask around and check references to find an accountant you’re comfortable working with. Be aware, also, that when, during the course of a case you choose to retain a forensic accountant may be as important as who you choose and what they find. Some recent cases of mine illustrate several of these points.
During the week ending April 4, 2003 prominent tax defense attorney, Dennis G. Kainen, Esq. retained me to assist him with the defense of a married couple residing in Miami-Dade County. I was fortunate enough to be referred to Mr. Kainen by an assistant state attorney who was familiar with my work from other cases. Our clients owned and operated two S-Corporation cash-basis-reporting businesses in the city of New York. The businesses painted the interiors of thousands of apartments under contracts they held with the management companies of various low-income housing projects. That meant that the revenue reported on their corporate tax returns was based on collection of their accounts receivables, and that neither corporation paid income taxes on any profits. It also meant that corporate profits and losses were passed through to our clients, for inclusion on their personal income tax returns.
Our clients were indicted on March 30, 2004. The indictment consisted of five counts of Tax Evasion under 26 U.S.c. Section 7201 and ten counts of making false statements under 26 U.S.c. Section 7206(1) and 18 U.S.c. Part 2 for allegedly underreporting approximately $10 million of income and for signing income tax returns that underreported the income, under penalties of perjury, for the tax years 1997 through 2001. In order to make these very serious income tax evasion charges against anyone, the Government is naturally required to calculate the amount of loss that it believes it suffered as a result of a taxpayer’s “scheme to defraud” them. In this case, they alleged that the amount of loss to the Government for the tax years 1997 through 2001 was $3,816,989. To some (especially the government), the outlook for our clients was quite grim.
The Government alleged that our clients’ “scheme to defraud” them was carried out by cashing some customer checks at check cashing stores and depositing others into a corporate bank account in the State of Florida, which they omitted from their corporate income tax returns and, consequently, did not pass through to their personal income tax returns.
During the process of interviewing the clients and reviewing their financial records, it became obvious to me that the IRS Criminal Investigation Agents assigned to the case had not done a complete investigation. Had they done so, they would have realized, as I did, that a comparison of the profit margins reported on the corporate tax returns with the Government’s own statistics for the industry clearly showed that the gross margins on the corporate tax returns were substantially inflated. As we learned during the subsequent investigation, the reason for the overreporting of gross margins on the tax returns was simple. Local political conditions in the neighborhoods where our clients’ companies worked required them to employ out-of-work local individuals and pay them in cash, as well as to locally purchase materials for the painting jobs, also in cash. Since the clients’ CPA did not know about those payments and expenses, he did not deduct them on the client’s S-Corporation tax returns. What my investigation also revealed was that our clients had in fact loaned over $2 million to the corporations that was misclassified by their CPA as revenue. When the unreported costs, expenses and shareholder loans were factored into the net income picture, the tax loss to the Government virtually disappeared.
Many accountants and attorneys would have assumed that the remedy for the misclassification of the $2 million of loans from the shareholders would be an amendment to the corporate returns for the relevant years. The brilliance of defense counsel, when presented with the findings of my investigation, was his realization of the effect of IRC Code Section 1341, Computation of Tax Where Taxpayer Restores Substantial Amount Held Under Claim of Right. Simply translated, this section says that if a loan from a shareholder is mistakenly classified as revenue, it is deductible as an expense in the year the mistake is discovered. Using this IRC Code Section allowed the defense team to reduce the net income of the corporations by $2 million. The effectiveness of using IRC Code Section 1341 was further enhanced by the incomplete investigation by the IRS Criminal Investigation Agents. Had they properly analyzed the invoice collections by our clients’ S-Corporations, as well as our client’s personal bank account records, brokerage accounts and credit card records and compared all of them as we did, they too would have learned that the CPA had over-reported the revenue of the S-Corporations by $2 million. As it played out, the misclassified shareholder loans and their treatment by defense counsel came as a complete surprise to the Government. At trial, the CPA for the S-Corporations testified that he never asked the clients if they made any loans to the corporations although he was, in fact, responsible for asking that very question.
The Government committed other critical errors in prosecuting its case, as well. One of these errors was not having independent expert testimony available concerning taxpayers and their almost total ignorance about the information required by their accountants for properly preparing tax returns. We, on the other hand, were able to provide expert testimony concerning taxpayer ignorance and the problems that arise when a company’s independent CPA does not ask all of the proper questions when preparing returns. The effect on the jury when the extent of the Government’s incomplete investigation was presented was to raise sufficient reasonable, doubt and win a complete acquittal for our clients on all 15 counts of the indictment.
The potential benefits of involving a forensic accountant apply to far more than just tax cases, however. Especially in criminal defense cases, bringing a forensic accounting team on board earlier rather than later can make an enormous difference. One of the most memorable criminal cases I’ve worked on illustrates this point well. The case landed on my desk several years ago, when a prominent criminal defense attorney retained my firm after the conviction of his client, to assist with a sentencing matter. The case involved the CEO of a group home health care agency who had been convicted of defrauding the Federal Government through an alleged Medicare-related illegal scheme. Defense counsel knew that the sentence the court would impose on the former CEO would be based largely on the amount of economic loss the Government suffered as a result of his allegedly illegal activities. Until retaining our firm, the only amount of loss put forward was (yet again) the result of the Government’s calculations. That calculation was presented in a report prepared by the Government’s case agent, and used during the process of indicting the client and at his criminal trial as evidence supporting his.conviction. Our analyses of both the methods used by Government’s agent and the records he used to make his calculation of loss revealed that his methodology was significantly flawed in several ways. The flaws were so egregious that they rendered his calculation of loss completely unreliable. In arriving at the supposed amount of loss to the Government, he ignored any number of critical factors including the specific Medicare statute governing his calculation as well as the results of a previous IRS investigation. Had he not committed those errors, he would have been forced to our conclusion, which was that the Government had suffered no loss whatsoever, and that the client had in fact not defrauded the Government at all and had been operating the firm at its own loss.
As a result of our report, the court criticized the work of the office of the U.S. Attorney and its agent in open court, ruled that the Government suffered no loss, that the maximum penalty sufferable by the client was probation and further invited the client’s counsel to move to vacate the conviction. The client was immediately released, pending the court’s final ruling. Approximately a year later, the trial judge overturned the conviction. Since then, the Court of Appeals has ruled that the trial judge exceeded his legal authority when he overturned the conviction and remanded the case back to him for re-sentencing. Had we not been retained, the client would almost certainly have faced at least five years in prison and a criminal forfeiture of several million dollars based on the amount of “loss” the Government had claimed. Had we been retained at the trial stage instead of sentencing, however, it is very possible that the jury would not have convicted the client, saving him years of emotional turmoil, his professional credibility, and the thousands of additional dollars he spent for post-conviction proceedings.
Commercial litigation, also, is very frequently based on voluminous piles of facts, figures, documents, and exhibits. In one memorable case I worked on a few years ago, we were retained late in the game by Plaintiff’s counsel to assist with a commercial arbitration. It was the position of the Plaintiff that its supplier/partner/financier had maliciously withheld and diverted to other of its licensed dealers, certain high-margin articles of inventory in an attempt to drive the Plaintiff out of business and unjustly seize its assets. We were brought into the matter less than a month before the arbitration hearing was scheduled to begin, and had to burn the midnight oil plowing through no less than 20 bankers’ boxes of disorganized discovery documents and other relevant paperwork. Fortunately, because the matter had already been in litigation for several years prior to our involvement, our client was intimately familiar with all of the paperwork involved, we were able to prepare a report legitimately supporting; our client’s allegations in extremely short order. Armed with our analysis, Counsel for our client was able to negotiate a multi-million dollar settlement with the defendant prior to completing the arbitration process. Had we been brought into the process earlier, it is possible that thousands of dollars in legal costs would have been saved and the same result achieved in a far shorter timeframe.
Two things that the above cases, and so many other cases I’ve worked on over the years, have taught me are to never assume a situation is hopeless, and to never assume that anyone else calculated anything correctly – even (or especially, some might say) the Government. What may look like a clear-cut case at first glance, frequently turns out to be just the opposite. Whatever happens before or during a case, you can always rely on a good forensic accountant to determine the answers to those all-important questions of amount as amount is key.
November & December 2004 / Volume 4 Issue 6 / Florida Edition
BANKING/Forensic Accounting
By Stanley Foodman, CPA