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IRS Audit of Return Preparer’s Customers Rejected as Means of Proving Loss Under Sentencing Guidelines

U.S. v. Schroeder, 536 F.3d 746 (7th Cir. 2008) involved the prosecution of a tax return preparer under 26 U.S.C. § 7206(2). This statute makes it a crime to willfully aide, counsel, or advise the preparation or presentation of a false U.S. tax return. Section 7206(2) is punishable by a maximum of three years in prison, and a $100,000 fine if the defendant is a person, or a $500,000 fine if the defendant is a corporation.

Mr. Schroeder was a tax return preparer. He was indicted on 21 counts of tax preparer fraud. Schroeder pled guilty to one count of tax preparer fraud in violation of 26 U.S.C. § 7206(2) and in the plea agreement admitted that the false tax returns resulted in a loss to the United States Treasury of at least $161,000.

At the sentencing the government contended that the tax loss was $428,000. The additional tax loss over the amount in the plea agreement significantly increased Schroeder's sentencing guidelines score.

The IRS determined the tax loss by a civil audit of the defendant's clients. The audits were conducted to determine the correct tax liability. Written requests were sent to Schroeder's clients asking them to provide proper documentation to substantiate deductions. Any customer who did not respond or who did not provide proper documentation to substantiate deductions had their taxes adjusted by disallowing the deductions.

The purpose of the audit of Schroeder's customers was not to determine who was responsible for the improper deductions, i.e. Schroeder or his clients, but rather to determine the total amount of the loss incurred by taking improper deductions. Mr. Schroeder's attorney objected to utilizing this audit technique because it did not establish that the underpayment of tax was due to Schroeder's conduct. The government argued that the audit revealed deductions that were not properly substantiated.

In determining the amount of loss for sentencing purposes, the government is required to prove the loss by a preponderance of the evidence, and not beyond a reasonable doubt, as is required to determine guilt. In addition, the court is allowed to accept evidence that would not be admissible in a trial.

Schroeder was originally sentenced to 42 months incarceration. This sentence was obviously improper since the maximum for the one count was 36 months. Somehow, the judge, prosecutor, and, defense attorney failed to recognize this mistake. Schroeder appealed and both the defense and government acknowledged that the sentence was illegal and asked the appellate court to remand for re-sentencing. At re-sentencing the defense attacked the method of computing the tax loss. Before allowing the defense counsel to make his presentation, the judge stated that he was accepting the amount of the tax loss as computed. The appeals court said that such conduct by the trial court denied the defendant his right to due process since the hearing was not fair.

The Court of Appeals rejected the use of this civil audit to attribute criminal liability for the tax loss. The major flaw of the audit was that the audit did not purport to attribute responsibility for the improper deductions, but rather whether the deductions could be substantiated.

The Court, in rejecting the use of the audit to determine tax loss in the criminal case stated:
The government contends that the civil audit is circumstantial evidence of Schroeder's culpability for the additional tax loss amount, pointing out that almost all the taxpayers who were audited told IRS agents that they could not provide documentation supporting the itemized deductions claimed on their tax returns. The government also notes that the inaccurate deductions on the audited returns were of the same type that Schroeder admitted to having falsified. But these facts do not make it more likely that the overstated deductions were due to Schroeder's criminal conduct than to a mistake or fraud on the part of the taxpayer clients. The district court treated the underpayments that were detected in the audit as frauds attributable to Schroeder without conducting any analysis as to what evidence proved that Schroeder's unlawful conduct caused the underpayments.

Schroeder at 755.

The IRS is vigorously prosecuting tax return preparers who violate 26 U.S.C. § 7206(2). This case may be helpful if the government is determining the tax loss based upon a civil audit of the preparer's customers.

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