Bad Records Keeping a Felony? Supreme Court to Weigh In

Man in Handcuffs Jailed for Felony Tax Obstruction

Could lazy records keeping or document retention result in felony tax obstruction charges? Could not following an accountant's advice land a business owner in prison? If the Supreme Court of the United States upholds a recent Second Circuit decision calling bad records keeping a felony, they might. But not if the U.S. Chamber of Commerce and National Federation of Independent Business can help it.

Tax Obstruction Charges for Bad Records Keeping

Carlo Marinello was a small business owner in upstate New York. He was charged and convicted of misdemeanors for the willful failure to file personal tax returns and corporate tax returns and felony tax obstruction under section 7212(a) of the Internal Revenue Code. This "Omnibus clause" makes it a felony to "in any other way corruptly or by force or threats of force (including any threatening letter or communication) obstruct[] or impede[], or endeavor[] to obstruct or impede, the due administration of this title." The prosecutor argued that Marinello "corruptly" failed to maintain corporate record keeping or furnish complete and accurate records to an accountant he consulted but did not hire.

The Omnibus Clause and Intent

The Second Circuit Court of Appeals upheld the conviction, ruling that an act that has the effect of impeding or obstructing the administration of the Internal Revenue Code, or attempting to, counted as felony tax obstruction under the Omnibus Clause, whether or not the activity was actually directed at the IRS or its processes. This interpretation made obstruction with the Code itself a criminal act, not just the investigations of the tax authority. This broad interpretation of the Omnibus Clause has the potential to drastically change the way business owners and the IRS interact. Perhaps that is why the Supreme Court granted certiorari to review the case in the next term.

The Chamber of Commerce and National Federation of Independent Business Weigh In

In anticipation of oral arguments, the U.S. Chamber of Commerce and the National Federation of Independent Business have filed an amici brief in support of business-owning taxpayers. The Chamber calls itself "the world's largest business federation" representing more than three million businesses across the country. The NFIB is a small business advocacy association. Together, they asked the Supreme Court to overturn the Second Circuit decision, calling it:

[S]o overbroad and expansive that it threatens to criminalize a wide array of lawful business conduct, vastly increase the cost to small businesses of ordinary course tax compliance, result in businesses paying more taxes than they owe in order to avoid being accused of a felony, and chill the important role that taxpayer challenges play in the development of the tax law.

The amici brief broke down how the Second Circuit's opinion could put everyday business owners at risk of felony charges.

The Normal Course of Business Turns Criminal

The brief explained how a broad interpretation of the Omnibus Clause could turn everyday business practices into criminal activity:

  • Using complex business structures for tax purposes could "impede" the tax code by making audits more difficult.
  • Taking deductions on close cases that are arguably not "ordinary and necessary" or are not supported by records could impede the administration of the Code.
  • Not voluntarily correcting errors in when revenue was reported, makes the IRS's job more difficult.
  • Failing to withhold taxes from employees, could impede the administration of the Code even without the intent to evade taxes.
  • Bad records keeping and failure to make decades-old documents available may make investigations more difficult even when the business is not aware of them.
  • Avoiding expenses by not obtaining a "Plantation Patterns letter" regarding the terms of business loans would cause the IRS to do a more thorough investigation if there was an audit.
  • Interviewing accountants the company does not hire without providing complete financial documentation, or not complying with conflicting tax preparers' advice.

"Corruptly" Requirement Provides No Security

The Second Circuit's broad interpretation of the Omnibus Clause does require that a taxpayer acted "corruptly." But that means the act was done with the intent to obtain an unlawful benefit, for the taxpayer or someone else, and resulted in obstruction. It does not require an intent to obstruct the tax code or an investigation.

It isn't that these unlawful benefits were legal before. However, until the Second Circuit's opinion, many of these behaviors would have resulted in the loss of a deduction, shifting a burden of proof, or at worst the imposition of a penalty. Now they could expose business owners to federal felony charges.

Full Enforcement Will Raise Tax Compliance Costs for Small Businesses

Small businesses spend three times as much per employee on tax compliance than their larger counterparts, according to the Small Business Association. Even then, most small businesses avoid elaborate tax compliance structures to save money, even if it means they lose some deductions. By attaching criminal charges to these omissions, the Second Circuit opinion drastically increases the cost of doing business and complying with the complex tax code.

Broad Interpretation Opens the Door to Selective Enforcement

The Second Circuit's opinion makes it likely that any business owner could be charged with a felony if a prosecutor decided to look closely at the business's records and practices. There is no way for the IRS to prosecute every business. That opens the door for prosecutors to choose which companies receive close scrutiny based on who they are rather than what they do. The brief says:

Today, public opinion has turned against or could turn against companies that sell products considered to be controversial (at least in some quarters), ... or whose owners are controversial, or who are controversial because of whom they sell to or refuse to sell to or whom they employ.

It arms prosecutors with a weapon to use in a discriminatory way without review by the courts.

Threats of Felony Charges Deter Taxpayers From Filing Lawsuits

Because the "corruptly" intent threshold is so low, it could potentially be used any time a taxpayer misconstrued a tax rule. Challenging the IRS in court on close calls would become a matter of risk: whether a tax deduction is worth the chance of a felony prosecution.

A broad interpretation of the Omnibus Clause can turn everyday business decisions and human error into potential felony prosecutions. It will be up to the Supreme Court to decide whether that was what the Internal Revenue Code was intended to do, or if some stricter form of intent is more appropriate.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years’ experience. If you have questions about tax reporting requirements or obstruction prosecutions, contact Joe Viola to schedule a consultation.

Categories: Tax / IRS Penalties