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Wednesday, November 30, 2005

Tax and Criminal Law

So here's another interesting "tax and" topic:  the criminalization of tax shelters (and, possibly, tax practice?).  This is a thought I have only preliminarily considered, so I will merely present the problem and hope that those with more experience will weigh in.  Apologies in advance for a long post; but I think it's worth it.

Tax shelters have a bad reputation, for some pretty obvious reasons.  Among other things, abusive tax shelters illegitimately deprive the government of revenue, force the rest of us to pay higher taxes to make up for that deprivation, and generally breed disrespect for the tax system.  Note that in that last sentence I added the descriptive "abusive," however.  Not all tax shelters are illegitimate, at least in the eyes of the law.  While most tax experts will agree that abusive tax shelters have become a big problem, those same folks will disagree over precisely how to distinguish legitimate non-shelter tax planning from tax shelters, and legitimate from abusive tax shelters. 

Most people know the story of the demise of the Arthur Andersen accounting firm.  Certain partners of the firm behaved very badly in connection with the Enron scandal.  The Department of Justice indicted the entire Andersen firm (not just the partners) for the actions of those individuals.  The indictment alone destroyed Andersen and eliminated the jobs of tens of thousands of employees who had nothing to do with the Enron case, long before Andersen was ever convicted.  Moreover, even though the DOJ won at trial, the Supreme Court last term overturned Andersen's conviction and, in so doing, strongly hinted that Andersen likely was not guilty of the crime for which it was indicted.

More recently, another top accounting firm, KPMG, came under scrutiny for its tax shelter promotion activities.  Under threat of criminal indictment, KPMG decided to save itself from Andersen's fate.  KPMG admitted criminal culpability, paid a hefty fine, and agreed to implement a compliance and ethics program and submit to several years of government monitoring in exchange for deferred prosecution.  Yet, as I understand it, many people believe that the tax shelters promoted by KPMG were at least arguably within the boundaries of the tax laws and not abusive at all.  (Vic Fleischer thinks otherwise.)

The federal tax laws are enormously complex and often ambiguous.  Reasonable people disagree all the time over their meaning.  The IRS's win/loss record before the courts in recent civil tax shelter cases is less than stellar.  And the courts did not have the chance to consider whether the IRS's interpretation of the relevant tax laws was correct with respect to KPMG's tax shelter activities.  Even if the IRS's interpretation was correct, if reasonable people can disagree over the law's meaning, shouldn't the rule of lenity apply to preclude criminal sanctions?  The tax laws contain extensive civil penalties for failure to adhere to tax rules and regulations and for improper behavior in representing clients before the IRS.

I suspect this is a common issue in criminal law generally:  prosecutors "throwing the book" at accused criminal defendants, interpreting criminal statutes creatively (notwithstanding the rule of lenity), and obtaining guilty pleas without having their legal interpretations tested in court as the defendants seek to avoid spending the rest of their lives (rather than just a few years) in jail.  The Wall Street Journal regularly accuses Eliot Spitzer of such behavior.  I am sure that I have seen articles decrying such prosecutorial behavior in cases involving less well-heeled defendants.  Presumably, smart academics have come up with good arguments both for and against this approach to criminal law enforcement.

Most of the discussion at this point has centered on the wisdom of indicting entire firms for the misdeeds of a few partners/employees.  Since the tax laws are often ambiguous and difficult to interpret, and the line between legitimate tax planning and abusive tax shelters is far from clear, is there a risk that the IRS and the DOJ will essentially criminalize the practice of tax law?  Should we care if legitimate tax planning is chilled because tax lawyers fear being indicted?  Should we adopt the view that the DOJ is justified in threatening tax lawyers and accountants with criminal prosecution to put a stop to the scourge of abusive tax shelter activities, and we can trust the IRS and DOJ to use prosecutorial discretion wisely?  Again, I don't have any answers here; only questions.

Further discussion (and links to even more discussion) here, and interesting PBS reports on tax shelters and congressional testimony by KPMG execs (before prosecution) here and here.

Posted by Kristin Hickman on November 30, 2005 at 03:56 PM in Criminal Law | Permalink


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Thanks for your post, Kristin. First, let's take the "lenity" question off the table: the mens rea for almost all tax offenses is "willfulness," which means that the defendants have to know that their conduct is unlawful. That is basically just for the reasons that you say -- tax is complicated, controversial, and so on. (Readers may dimly recall Cheek v. U.S. from their crim class.) And "willfulness" is what got AA off the hook (or, really, the phrase "knowingly...corruptly" in a federal obstruction of justice statute, but the Court said that meant the same thing as willfulness).

So, the remaining question, it seems to me, is whether tax shelter cases are different from other tax fraud cases. Should it matter, for instance, that a given shelter has not been specifically rejected by a court or the IRS? I think not. I suppose one could claim, in a very strictly positive sense, we cannot "know" what the law is until it is laid out by a court. But even accepting that claim, it seems to me that wilfulness, and the rationales you articulated behind it, should still permit punishment for those who can only predict with very great certainty that a court *would* reject their view.

I can't comment about the facts of the KPMG case in particular. But it is interesting to note that the indictments allege a lot of conduct that suggests efforts by the defendants to shield the shelters entirely from judicial scrutiny. That kind of concealment has long been one of the hallmarks of willfulness -- you wouldn't be hiding it if you thought it was any good.

This leads to one final problem. We might say that if we had, say, 5 or 10% confidence in our shelter, we might try very much to avoid judicial resolution of its merits. A somewhat unresolved question, it seems to me, is whether a non-zero but very low level of confidence is the equivalent of believing a shelter is unlawful for willfulness purposes. If so, then perhaps it is right, as you say, that we ultimately trust DOJ to pick which cases to "criminalize." Sniff, sniff...I smell a paper.

(All views belong to the poster and not any organization or entity he may be affiliated with. This post is not intended as tax advice and cannot be relied upon as such. Etc.)

Posted by: BDG | Dec 1, 2005 10:47:15 AM

Hi Vic. I'm a little clueless on the crim side, too. But the little spot research that I have done suggests that the rule of lenity does apply to corporate defendants. There seem to be different perspectives on the rule; but at least some scholars emphasize not just the potential loss of liberty for individual criminal defendants (which isn't necessarily true in every criminal case, is it?), but the broader proposition that people are entitled to know what the law prohibits them from doing so they can shape their conduct accordingly, and further that the rule operates to prevent government officials from exercising their discretion in an arbitrary and oppressive manner.

Posted by: KristinHickman | Nov 30, 2005 9:27:05 PM

Hi Kristin. Great post. More thoughts later when I have a chance.

Point of information, as I'm a little clueless on the crim side. Does the rule of lenity apply to corporate defendants? If so, why? No one loses their liberty if KPMG is indicted.

Posted by: Vic Fleischer | Nov 30, 2005 6:21:10 PM

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