An article in Tax Notes Today outlining comments made by an assistant U.S. attorney based in New Haven, Connecticut highlighted that tax preparers may get entangled in criminal tax prosecutions when they fail to insure clients are properly documenting loans from a business.[1]

Christopher W. Schmeisser was speaking at a criminal tax conference held at Quinnipiac University School of Law in North Haven, Connecticut. Mr. Schmeisser indicated that loans are often used as part of a scheme for a taxpayer to avoid paying taxes.

Under the IRC, §61 generally requires any accession to wealth to be treated as gross income, subject to tax, absent a provision elsewhere in the IRC that excludes the transaction from being taxable. Receipt of funds from a loan is not treated as an accession to wealth since the taxpayer’s net worth does not immediately change as a result of the transaction.

However, for receipt of funds from a loan to be excluded from income, there must be an actual loan being made. While the test of whether an actual loan is being made is based on all available facts and circumstance, factors that indicate a transaction is a loan include:

A document outlining the terms of the loan that is executed by the parties;
Actual intent of the parties to enter into a loan agreement which includes, among other things,
- A review of the capability of the borrower to repay the loan by the lender;
- An appropriate rate of interest being set on the loan, given the term and risks involved;
- Considering the need for security for the loan, and taking normal steps to secure the debt (such as recording the lien for a debt that claims real property as security for the debt);
- Enforcement of the terms of the loan by both parties to the agreement; and
- Intent on the part of the borrower to repay the loan at the time it is made.

As with any other related party transactions, loans between related parties are subject to special scrutiny to insure the transaction’s substance is what the parties claim.

Mr. Schmeisser notes that taxpayers looking to avoid paying tax may look to attempt to classify cash receipts as “loans” when such receipt would otherwise be a taxable transaction. He notes a crucial item that is used to decide if the preparer was criminally assisting in the preparation of fraudulent returns is whether the preparer took the basic step of looking at documentation that should have been prepared for the loan.

As the article notes:

Schmeisser said that in some of the cases he has handled, “there’s just no effort by the preparer to actually do any of the appropriate paperwork.”

“Year after year, there is substantial monies coming out of entities where there is no loan documentation prepared, no actual reflection of interest accrued, no recording of any payment of interest because no interest was paid,” Schmeisser continued. “Everything is just sort of thrown into a loan file bucket, which is pretty obviously just an effort to delay and defer the payment of taxes on income.”[2]

Before you decide that this is “outlier” thinking from one U.S. Attorney’s office, you should consider a case that led to a long discussion on the TaxTalk discussion group sponsored by the California Society of CPAs last year. In that case, a Bay Area CPA was convicted of aiding and abetting the filing of a false tax return based largely on accepting the client’s position that the funds he had obtained were “loans” representing advances on management fees from an investment fund rather than income that should have been taxed currently.

The Justice Department issued a press release in July of 2018 publicizing the conviction.[3] The Mercury News reported in December of 2018 that the CPA was eventually sentenced to eight months in prison, one year of supervised release following that term and fined $20,000.[4]

The CPA was convicted of violating IRC §7602(2) which provides:

Any person who—

…

(2) Aid or assistance

Willfully aids or assists in, or procures, counsels, or advises the preparation or presentation under, or in connection with any matter arising under, the internal revenue laws, of a return, affidavit, claim, or other document, which is fraudulent or is false as to any material matter, whether or not such falsity or fraud is with the knowledge or consent of the person authorized or required to present such return, affidavit, claim, or document;

…

shall be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 3 years, or both, together with the costs of prosecution.

Peter J. Reilly in his Forbes blog described the transactions that led to the CPA’s problems as follows:

Beginning in 2007, Burrill Capital began taking its management fees a little early to deal with "cash flow" problems. By 2012, it had taken more than it could possibly earn before the fund's scheduled closing - over $18 million. In 2012, there was a capital call on the investors purportedly to fund investments. but some of that went to the prepaid management fee.[5]

The CPA handling the tax return did attempt to analyze the taxability of these “advances” on the management fee. The client insisted the payments were in the nature of loans. The CPA handling the tax return noted that the audit of the Fund which had paid this “loan” to the taxpayer’s business had issued an unqualified opinion on the Fund treating these as loans. Eventually the CPA who issued that unqualified opinion was subject to discipline by the SEC and the California Board of Accountancy, but those actions had not begun when the tax return was being prepared.[6]

Mr. Reilly’s article notes, this was not a case where the CPA simply moved an entry to loans to get rid of the income, nor did he even just accept the client’s orders to report it as nontaxable:

The deferred revenue was noticed by the staff and that raised a tax concern, because even though something might not be income under GAAP, it can be taxable income when received. The problem escalated to Mr. Berger, the tax partner on the account and it got a lot of attention. Here he is just trying to get somebody's tax return done. Somebody who has done something that he should not have done. He still has to file a tax return.

At the end of the day, when you are looking at Burrill's return, you have to decide- was he borrowing from Peter to pay Paul or was he robbing from Peter to pay Paul. After a lot of agonizing Berger concluded it was the former, in which case the returns he signed were correct. He encouraged the client to document the loan status of the payments, which they did do, drafting a note form Burrill to the fund. Subsequently, the note was torn up because it was not consistent with the story coming out of the other side of the mouth that was being fed to PwC to hoodwink the investors.

Berger did not believe that Burrill was avoiding tax on the $18 million - just deferring it.[7]

However, the downside was that it was pretty clear the client did want it reported as a loan and reports from the trial indicate that the client was a “demanding” client. Whether or not it truly was the case, it’s not that difficult to see a jury deciding that the decision to treat it as a loan was “tainted” by the knowledge a different answer would result in the loss of a major client (and the fees related to the same).

Similarly, when the CPA discovered that there was no documentation to support the loan (and thus recommended the client draft a note), that arguably undercut the CPA’s reliance on the audit report of the fund this was truly a loan--rather, arguably, the CPA had now discovered a reason to believe there had been deficiencies in the audit with regard to these payments. That is, why hadn’t the lack of documentation troubled the auditor? Again, in retrospect it’s not hard to see how a prosecutor could put this to the jury in a very bad light.

While I have no doubt the CPA had no bad intent--and thus, that the jury should have acquitted based on lack of criminal intent--I also can easily see how a non-accountant might have a difficult time believing that. All reports on the CalCPA TaxTalk from individuals who had interactions with this CPA suggested that he was a well-respected and upstanding professional. Nevertheless, he ended up with a conviction.

To be sure, criminal charges most often occur when there is a substantial amount of income in question--in this case it was $18 million. It also didn’t help that the client also ended up being charged with other crimes related to having obtained the $18 million from the fund. The client also clearly had indicators of being a “bad” client that makes impossible demands by bringing data in late so all decisions must be rushed and pushing back against any treatment that results in higher taxes. That sort of client is one that your malpractice carrier will tell you is the most likely to generate a claim-and, quite often, be the one filing the claim against the CPA.

But, conceptually, the above issue has likely confronted other CPAs in various situations. Even for non-demanding clients, CPAs too often go overboard in attempting to avoid having to give bad news by “adjusting” transactions after the fact to have them fit a more tax favorable fact pattern.

For instance, the author knows of discussions made in public forums over the years where CPAs discussed using a journal entry after the fact to treat distributions from an S corporation in excess of the shareholder’s basis as a “loan” from the shareholder to the corporation. The same discussion makes it clear that the plan is to treat it as “paid off” via a distribution (again made with journal entries rather than an actual exchange of checks) when the corporation later has income.

The problem with that plan is that:

There was no intent to enter into a loan when the original payment was made since
- No documents were drawn up at that time and
- The shareholder had no intent to repay the amounts advanced;
At the time of the journal entry, the CPA’s own workpapers and statements most often make clear there is still no intent to repay the funds; and
The real reason for this revised view of the transaction to avoid taxes that the taxpayer clearly owes taxes if the original form and substance of the transaction is respected.

In many ways, that “tax planning” is far less defensible than what the CPA was sentenced to prison time for.

Even if we accept that it’s “OK” to do this since the numbers are relatively small (let’s assume it’s $18,000 rather than $18 million),[8] it becomes that much harder the next time to refuse to do the same thing when the numbers are larger. After enough iterations, a CPA can find him/herself now making that $18 million adjustment (something, again, the CPA in this case did not do) to avoid admitting (to him/herself as much or more than to the client) that doing the smaller “fixes” in earlier years were not allowable under the law.

[1] Kristen Parillo, “Preparers Warned to Be Vigilant About Documenting Loans,” Tax Notes Today, May 20, 2019, 2019 TNT 97-6, https://www.taxnotes.com/tax-notes-today/criminal-violations/preparers-warned-be-vigilant-about-documenting-loans/2019/05/20/29j26 (subscription required)

[2] Ibid

[3] The United States District Attorney’s Office, Northern District of California, “Bay Area CPA Convicted of Fraud,” July 18, 2018, https://www.justice.gov/usao-ndca/pr/bay-area-cpa-convicted-tax-fraud

[4] “Walnut Creek Accountant Sentenced in Tax Fraud Case,” The Mercury News, December 15, 2018, https://www.mercurynews.com/2018/12/15/sf-walnut-creek-accountant-sentenced-in-tax-fraud-case/

[5] Peter J. Reilly, “CPA Convicted Of Assisting On False Tax Return - Did He Get A Raw Deal?,” Forbes website, November 23, 2018, https://www.forbes.com/sites/peterjreilly/2018/11/23/cpa-convicted-of-assisting-on-false-tax-return-did-he-get-a-raw-deal/#17d221346198

[6] Ibid

[7] Ibid

[8] And, to be clear, I do not agree with that view.