CPE Day December 5, 2013 Legal Issues Sandra S. Benson, J.D. Tax preparers routinely rely on information furnished by the client or third parties to prepare tax returns. Is the preparer responsible to verify the accuracy of the information provided? Does it matter if the preparer suspects the client documentation is incorrect or false but turns a blind eye or relies on verbal assurances? Is it possible that a tax preparer can be either civilly or criminally liable if the client supplies false information used to prepare the return? Legal Update 2013 Aiding and Abetting a Ponzi Scheme or other Fraud by Filing False Tax Returns: Can a Tax Preparer be Liable? Sandra S. Benson, J.D., Associate Professor* Department of Accounting Jones College of Business, MTSU December 5, 2013 *I am grateful to Duresha S. Rice, Graduate Assistant, for assistance in developing the PowerPoint slides from my article. ‘Tis the Season to Gear Up for Taxes • According to the IRS, there are 690,000 Federal tax preparers. • About 60% of taxpayers will use tax professionals this year to prepare their returns. • Can the preparer safely rely on the client’s documentation? In re MuniVest Services, LLC, et al., v. Metzler Locricchio Serra & Company, P.C., • Dante DeMiro founded MuniVest Services, LLC. He falsely promised clients (municipalities, credit unions, labor unions and a school district) that he would invest their funds in low-risk CDs. • 2013 WL 5636706 (Bkrtcy, E.D.Mich.) False Account Statements • He prepared false account statements showing the high rates of interest he promised. A Ponzi Scheming Client • Instead of investing the funds, DeMiro used those funds to gamble, purchase personal luxury items, buy real property, make loans, and make payments to other investors in the scheme to continue the scheme. IRS Audit • The IRS audited the 2008 and 2009 tax returns and assessed penalties against DeMiro exceeding $2.6 million for understating tax obligations. Guilty Plea • After his arrest in 2010, DeMiro admitted to operating a Ponzi scheme and pleaded guilty to bank fraud & wire fraud. He was sentenced to 10 years in federal prison & ordered to pay over $12m in restitution. “Conservative” Investor Victims • The largest victim, Mona Shores Public School District, which had invested $3.5 million, filed involuntary Chapter 7 bankruptcy petitions on October 12, 2010, against both DeMiro and MuniVest (Debtors). Bankruptcy Trustee Lawsuit • The Chapter 7 Trustee filed an adversary proceeding to recover assets for the benefit of the victims and creditors against the accounting firm that had prepared the 2008 and 2009 tax returns for DeMiro and MuniVest. Bookkeeper’s Documentation • MuniVest’s bookkeeper sent general ledgers to the accountant who reviewed them “line by line.” • The general ledgers showed that funds were used to pay business expenses of MuniVest and personal luxury expenses of DeMiro. According to the Bankruptcy Trustee: • The firm was negligent by failing to comply with AICPA standards. • The firm’s filing of false tax returns temporarily enabled the fraudster to evade detection by the investors and the IRS. Accounting Malpractice: • Michigan law requires four elements: 1. THE EXISTENCE OF AN ACCOUNTANT/CLIENT RELATIONSHIP; 2. NEGLIGENCE IN THE PERFORMANCE OF SERVICES BY THE ACCOUNTANT FOR THE CLIENT; 3. THAT THE NEGLIGENCE WAS THE PROXIMATE CAUSE OF AN INJURY; AND 4. THE FACT AND EXTENT OF THE INJURY ALLEGED. Michigan Court held: • VICTIMS WERE NOT THE CLIENTS OF THE FIRM What if Tennessee Law Applied? • Negligent Misrepresentation claim by a non-client: One who supplies false information for the guidance of others in their business transactions is subject to liability for pecuniary loss caused to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating that information. -Bethlehem Steel Corp v. Ernst & Whinney, 822 S.W. 2d 592, 596 (Tenn. 1991) Bethlehem Steel Corp v. Ernst & Whinney • Liability is limited to loss suffered by the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipient intends to supply it; and through reliance upon it in a transaction that he intends the information to influence or knows recipient so intends or in a substantially similar transaction. -Adopting §552 Restatement (Second) of Torts. Fraud • Michigan statute that allows a claim of professional malpractice against a certified public accountant where there is “[A]N ACT, OMISSION, DECISION OR OTHER CONDUCT OF THE CERTIFIED PUBLIC ACCOUNTANT THAT CONSTITUTES FRAUD OR INTENTIONAL MISREPRESENTATION.” -Mich. Comp. Laws. Ann. § 600.2962(1) (b) Elements of Fraud in Michigan 1) DEFENDANT MADE A MATERIAL REPRESENTATION 2) IT WAS FALSE; 3) DEFENDANT KNEW IT WAS FALSE WHEN MADE, OR MADE IT RECKLESSLY WITHOUT ANY KNOWLEDGE OF ITS TRUTH; 4) DEFENDANT MADE IT WITH THE INTENTION THAT IT SHOULD BE ACTED UPON BY THE PLAINTIFF; 5) PLAINTIFF DID ACT IN RELIANCE UPON IT; AND 6) PLAINTIFF SUFFERED INJURY AS A RESULT OF SUCH RELIANCE. Aiding and Abetting FRAUD • The court dismissed the fraud claim (no reliance) but refused to dismiss the aiding and abetting fraud claim. The federal district court adopted § 876 (b) of the Second Restatement of Torts. § 876 (b) of the Second Restatement of Torts Law: • (1) KNOWLEDGE OF THE WRONGFUL CONDUCT BY THE AIDER/ABETTOR Allegations • The firm “knew” that the Debtors purported to invest funds for investors, but instead used the funds to pay for daily expenses of the Debtors and for personal luxury expenses of DeMiro. § 876 (b) of the Second Restatement of Torts Law • (2) SUBSTANTIAL ASSISTANCE OF THE WRONGFUL CONDUCT BY THE AIDER/ABETTOR. Allegations • Firm’s assistance case was not just of ordinary accounting services, but instead consisted of preparation & filing of false tax returns that enabled debtors to evade detection. Does Tennessee Recognize Aiding & Abetting Tortious Conduct? • Yes, in a recent case against a law firm, the Court of Appeals said that the common law civil liability theory of aiding and abetting, requires that “the defendant knew that his companions' conduct constituted a breach of duty, and that he gave substantial assistance or encouragement to them in their acts.” - PNC Multifamily Cap. Institutional Fund XXVI LP v. Bluff City Cmty. Dev. Corp., et al., 387 S.W.3d 525 (Ct.App. 2012) Ignoring the Obvious Signs of Fraud • The firm instructed Debtors’ bookkeeper on how to book funds received from the investors. Ignoring the Obvious Signs of Fraud • Some of Debtors’ employees told the firm about their concerns about Debtors’ finances and DeMiro’s constantly wanting and pulling money out. Ignoring the Obvious Signs of Fraud • The firm reviewed the general ledgers “line by line” and these showed that the Debtors (DeMiro & MuniVest) did not invest funds for customers as promised, but instead showed that the funds were repeatedly used to pay business expenses of MuniVest and luxury personal expenses of DeMiro. Ignoring the Obvious Signs of Fraud • The firm was aware that the Debtors could not identify the entity or entities they owed in excess of $825,000 and said this was “unusual.” Ignoring the Obvious Signs of Fraud • The firm continued to provide accounting services, including false tax returns, despite “obvious signs of fraud.” -In re MuniVest Services, LLC, 2013 WL 5636706 (Bkrtcy, E.D.Mich) Were the Signs of Fraud SO Obvious? • Video - Were the Signs of Fraud So Obvious? • Dana Miller, Lapeer County Treasurer, became suspicious and triggered an investigation within 8 months into her job. • DeMiro had had a 13-year relationship with the county. • Miller said “My gut told me within three months of dealing with Dante DeMiro that he was not trustworthy. ” -Lynn Moore, “Dante DeMiro’s fall triggered by tenacious Lapeer County Treasurer Dana Miller” 7/16/11 http:// blog.mlive.com Feeling Based on: Miller’s observations of DeMiro: • Lies, unprofessionalism, and sloppy paperwork According to Miller, DeMiro • Never met deadlines. • Was late for appointments. • Talked on multiple cell phones when meeting. • Balked when Miller said she wanted to cash in CD and said he’d already renewed it. He backpedaled when Miller said she would call an attorney. • Sent computer screen shots for documentation of CD purchases. Why allow the claim to go forward? • Consider MuniVest and McLean bankruptcies and Trustee’s powers to file lawsuits to recover funds for victims. - Tax Standards: IRS Circular 230 • A practitioner must exercise due diligence 1. 2. 3. IN PREPARING OR ASSISTING IN THE PREPARATION OF, APPROVING, AND FILING TAX RETURNS, DOCUMENTS, AFFIDAVITS, AND OTHER PAPERS RELATING TO INTERNAL REVENUE SERVICE MATTERS; IN DETERMINING THE CORRECTNESS OF ORAL OR WRITTEN REPRESENTATION MADE BY THE PRACTITIONER TO THE DEPARTMENT OF TREASURY; AND IN DETERMINING THE CORRECTNESS OF ORAL OR WRITTEN REPRESENTATIONS MADE BY THE PRACTITIONER TO CLIENTS WITH REFERENCE TO ANY MATTER ADMINISTERED BY THE INTERNAL REVENUE SERVICE. -31 C.F.R. §10.22(a). IRS Circular 230 • Reliance on othersExcept as provided in §§ 10.34, 10.35 and 10.37, a practitioner will be presumed to have exercised due diligence for purposes of this section if the practitioner relies on the work product of another person and the practitioner used reasonable care in engaging, supervising, training, and evaluating the person, taking proper account of the nature of the relationship between the practitioner and the person. -31 C.F.R. §10.22(b). IRS Circular 230 Section 10.34(d) • Relying on information furnished by clientsA practitioner advising a client to take a position on a tax return, document, affidavit or other paper submitted to the Internal Revenue Service, or preparing or signing a tax return as a preparer, generally may rely in good faith without verification on information furnished by the client. The practitioner may not, however, ignore the implications of information furnished to, or actually known by, the practitioner, and must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete. -31 C.F.R. § 10.34(d). AICPA Statement on Standards for Tax Services No. 3 Introduction _____________________________________ _____________________________________ AICPA Statement on Standards for Tax Services No. 3 Statement ______________________________________ ______________________________________ AICPA Statement on Standards for Tax Services No. 3 Statement (cont’d) _______________________________________ _______________________________________ AICPA Statement on Standards for Tax Services No. 3 Statement (cont’d) _______________________________________ _______________________________________ Technology in Partnership, Inc. (TIP) v. Rudin • The plaintiff - President with 60% ownership. Defendant–VP with day-today responsibility and 40% ownership. • In May 2010, the plaintiff asked the Defendant-VP for financial documentation, and when he was denied, he locked the VP out and located the financial records. - Technology in Partnership, 2011 SL 4575237 (S.D.N.Y.) TIP Case • The plaintiff claimed the VP received excessive compensation and diverted TIP funds in various ways by sending checks to relatives. TIP Case • The plaintiff sued two accounting firms which provided tax services for TIP for malpractice, breach of fiduciary duty, fraudulent concealment, and civil Racketeer Influenced and Corrupt Organizations Act (RICO). Accounting Malpractice • In New York, the plaintiff must prove • (1) THE ACCOUNTANT’S DEPARTURE FROM THE ACCEPTED STANDARDS OF PRACTICE, AND • (2) THAT THE DEPARTURE WAS THE PROXIMATE CAUSE OF THE INJURY. Alleged Errors • Firm allegedly failed to • Would performance of verify the identity of the these things have corporation’s officers prevented the funneling and the extent of their of TIP funds to the VP ownership in the defendants? company for TIP’s tax • Yes, according to the returns and did not plaintiff' complaint provide copies of the alleging defendants returns to the plaintiff. were grossly negligent, but The Court Disagreed • The Court cited the AICPA Professional Standards § T.S. 300.02 (2011) and concluded: • Relying on the information furnished by the VP, who was the director and officer responsible for TIP’s financial filings, was not a departure from accepted practice. Shaiman v. Carpet One of the Hamptons • An accounting firm sued a client for unpaid services in connection with two audits by the New York State Department of Taxation and Finance. • The client countersued the firm for malpractice in connection with the tax returns prepared by the firm. - Shaiman, 911 N.Y.S.2d 696 (2010) Court’s Findings of Facts: • Firm utilized the sales figures and financial information prepared by the Defendant’s bookkeeper without independently verifying the numbers. Court’s Findings of Facts: • Accountant was concerned with the large % of non-taxable sales the client declared for capital improvement projects. • However, he asked only for oral explanations. Audits • The client was selected for audit. Audits showed – Client routinely issued Capital Improvement Certificates in error – Under-reported its sales by nearly $4 million – Did not charge sales tax but included an additional charge for “padding” equal to the sales tax rate on some sales Stealing the tax? • Shaiman gave the opinion that the client was “stealing” the tax on the latter transactions. • Shaiman was assured by the client that this practice would stop. • Shaiman continued to represent the client. Court’s holdings: • Firm’s claim: – Court awarded $15,000 for services in connection with the two audits. • Client’s counterclaim: – Court found that the firm was negligent by failing to discover the $1.3 million discrepancy in reported sales on the 2000 State sales tax and Federal income tax returns. Court Opined: • Firm had knowledge of, or at least a reason to believe, the figures presented were inaccurate and incomplete and its failure to demonstrate that it made reasonable inquiry and/or request back-up documentation. Court Concluded that • The firm could not ignore an apparent inaccuracy or turn a blind eye to an obvious discrepancy ($1.3 million difference on 2000 State and Federal tax returns). • Firm failed to make reasonable necessary inquiries to verify the accuracy of the data which, on the tax returns themselves, appeared “to be incorrect, inconsistent, or incomplete.” • Firm deviated from then generally accepted accounting principles (See 10 C.F.R. §10.34). Aiding and Abetting Filing False Returns: Criminal Concerns • It is a criminal offense to file a false return or aid or assist in preparation of a false return (26 U.S.C. § 7206(1)-(2)). • Akaoula argued on appeal from her criminal conviction that she was entitled to rely upon the signatures of the parties to verify the information contained therein based upon § 10.34(a)(3). - U.S. v. Akaoula, 1999 WL 61396 (C.A.10, Utah) Aiding and Abetting Fraud: Criminal Concerns • The appeals court held that this argument was meritless. – IRC § 10.34(a)(3) does not allow a return preparer to “ignore the implications of the information furnished to, or actually known by, the practitioner.” • The preparer must inquire if the information appears incorrect, inconsistent or incomplete. Aiding and Abetting Filing False Returns: Criminal Concerns • The AICPA has prepared a practice guide with very helpful considerations. • See AICPA Tax Division, Client Criminal Matters and the CPA: Practice Guide, January 2011. What did the Madoff Tax Preparers’ Know? Criminal Charges Against Madoff Accountants Update on Robert W. McLean Ponzi Scheme • McLean worked as a broker until the late 1980’s when he started using other people’s money for his day-trading enterprise. • His business grew through trust. The Business Model • Obtain cash from “investors” in exchange for unsecured promissory notes (avoids regulatory oversight). • Pay a high and steady rate of interest ( majority of 10% or more), with no mention of compensation. • Tell investors the accounts are pooled in futures trading. Keep the “strategy” proprietary (be evasive or tell some investors it will “go away” if it is explained). • Keep operations tightly controlled. • Give no prospectus. Prepare bogus Statements of Account upon request. Expanding the Network • Citizen of the Year • Extravagant lifestyle • McLean was a passionate giver (of other people’s money) The Sinking Ship • By early 2000s, McLean’s situation was DIRE. • The scheme crashed in 2007 when investors demanded large payments. Final Closing of the McLean Bankruptcy Estate _______________________________________ _______________________________________ Practical Tips • Consider whether to engage in a relationship or continue a relationship with a client based on information received during client in-take or when preparing the tax return. Practical Tips • Make reasonable inquiries if the information appears to be incorrect, inconsistent or incomplete. • Cross-reference other tax returns for inconsistencies. Practical Tips • Do not ignore the IMPLICATIONS of the information provided, or actually known to you. • Do not ignore your intuition. Practical Tips • Besides keeping up with required standards, consider Circular 230 Section 10.33 which sets forth best practices for tax advisors.