In one of the climactic scenes from 1954’s On The Waterfront, Crime Commission prosecutors had to make their corruption case against union boss Johnny Friendly (a/k/a Michael Skelly) by convincing a reticent yet pure-hearted Terry Malloy to come forward and tell what he knew about corruption in the International Longshoremen’s Association, beginning with the murder of Joey Doyle, because an underling insisted that “we were robbed last night and can’t find no books.”

If that same case came up in 21^st Century tax court, Eva Marie Saint and Karl Malden could’ve stayed at home rather than serving as Marlon Brando’s cheering section, because government prosecutors could reconstruct the ILA’s income, based on the records retention requirements in Section 6500 et seq.

In other words, the conventional wisdom that only divine beings can create something out of nothing does not apply in income tax evasion cases. Is it enough for the government to pull a metaphorical rabbit out of a metaphorical hat, or are there some additional requirements?

Burden of Proof

In all criminal cases, the government must prove each element of the offense beyond a reasonable doubt. There are three elements in a standard tax evasion case:

• Substantial Tax Deficiency: “Substantial” is a fact-specific inquiry that’s left up to the jury, which must employ the everyday meaning of this word. The Third Circuit has also approved a definition of the term (“Whether the amount is ‘substantial’ turns on whether under the surrounding circumstances the amount of the deficiency would be significant to an ordinary person”) that really isn’t very useful. If “substantial” means “more than noticeable,” we’re probably talking somewhere around 15 or 20 percent in additional taxes.
• Affirmative Attempt to Evade Tax: In an analysis borrowed from criminal conspiracy laws, the government must first prove that the taxpayer formulated an intention or scheme to evade the tax, and secondly, that the taxpayer committed at least one overt act in furtherance of that scheme.
• Willful: Normally, if taxpayers paid any bills other than their income tax bills, they willfully evaded their income tax obligations.

As for reasonable doubt, the Third Circuit has approved the following instruction: “A reasonable doubt is not a caprice or whim; it is not a speculation or suspicion. It is not an excuse to avoid the performance of an unpleasant duty. And it is not sympathy.”

The overall burden of persuasion never moves away from the government, but the burden of production sometimes shifts. Initially, the government has the burden of production as well, because there must be sufficient evidence to convince a reasonable juror that the defendant is guilty.

This shift occurs in income reconstruction cases. Assume the government shows that Tom Taxpayer underreported his income by $100,000, using one of the methods discussed later. However, if Tom produces evidence that he had expenses and deductions which reduced the tax to the point that it was no longer “substantial,” the government’s case must fail, unless it can refute Tom’s version of events.

Methods of Proof

To determine the amount “due and owing,” and hence the amount of criminal liability, the Service can use one of three reconstruction methods, either during the initial case in chief or later during the sentencing portion.

Prosecutors can use the direct method to either establish unreported income or, in a few other cases, to refute taxpayers’ claims regarding expenses and deductions. Typically, the government compares the claimed or reported amount on the tax form to the actual receipt, and ipso facto, it effectively meets both the burden of production and the burden of persuasion, because it is almost impossible for a defendant to explain away direct proof of this type. In other cases, these receipts can “fill in the blanks” in an allegedly fraudulent return.

It always starts with the taxpayer’s return, which is admissible under an exception to the hearsay rule. So, the Service can use the taxpayer’s admitted income as a baseline. The taxpayer can always argue that the actual income was lower (e.g. $75,000 instead of $100,000), but lots of luck with that, because taxpayers don’t normally overstate their incomes. Similarly, if the taxpayer wants to reduce the additional tax liability by coming up with additional deductions, the taxpayer must explain why these deductions weren’t on the return to begin with.

It’s not unusual for the government to use different amounts during the guilt/innocence and sentencing phases. To return to our friend Tom, the Service might only establish $75,000 in unreported income during guilt/innocence, because the evidence regarding the other $25,000 is a little shaky. Later, at the penalty phase, prosecutors can use the $100,000 amount to maximize the criminal penalties against poor Tom.

In all criminal cases, if there is no “smoking gun,” the prosecutor must rely on circumstantial evidence. In tax prosecutions, courts closely scrutinize such indirect methods of proof, increasing the likelihood of a successful appeal. There’s a multi-step process. As a threshold, the government must establish there is no direct evidence available; the evidence must be either entirely unavailable or so full of errors that it’s completely unreliable. This barrier prevents prosecutors from ignoring hard evidence that may not be as damning in favor of “circumstantial” evidence that artful lawyers can doctor up. Next, the government must point to a source of income that the taxpayer could have accessed. For example, Tom may have reported $100,000 of income from a consulting company in 2015 and zippo in 2016.

If the judge determines that the prosecutors met both elements of the preliminary test and therefore may use indirect evidence, there are five approved models:

• Net Worth Method: The IRS goes to the beginning of the first prosecution year to determine the taxpayer’s noncash, asset-based worth. If the net worth increased after subtracting any non-taxable receipts, the increase probably came from unreported income. There are several defenses:
  • Cash Hoard: Lots of people (well, okay, maybe not lots of people) keep substantial amounts of cash under the mattress that came from income reported in prior years, and this could be the phantom source the Service wants to tax. If the taxpayer recently filed bankruptcy or borrowed substantial amounts of money, the cash hoard defense is harder to establish in the minds of the jurors.
  • Nontaxable Income: Inheritances, gifts, and loans can all inflate net worth, at least temporarily. The taxpayer must tread carefully when introducing this defense to avoid running afoul of Section 1001 gain/loss rules and ethical problems involving false statements.
  • Accuracy: This argument is just straight-up “you crunched the numbers wrong.”
• Expenditures: If the taxpayer “wasted his substance with riotous living (to borrow a phrase from the story of the prodigal son)”, the Service cannot use the net worth method, and must convince the jury that the taxpayer spent so much money that there must have been an additional income somewhere. In Taglianetti v. U.S., the First Circuit held that the IRS must only establish an opening and closing net worth with reasonable certainty.
• Cash Expenditures and Bank Deposits: This hybrid method basically combines the first two; the chief advantage for the government is that there is no need to establish starting and ending net worth. Furthermore, the government need only produce sufficient evidence for a reasonable juror to find fraud, as opposed to any of the classic fraud badges (g. hidden accounts or duplicate books).
• Percentage Mark-Up: If the taxpayer is in a trade or business, the IRS sometimes takes the inventory and multiplies it by a predetermined profit margin to arrive at an unreported income figure. There are a lot of holes in this method, not the least of which is that item markup varies greatly under different circumstances, so the Service normally only uses this method in civil court, where there is a lower burden of proof.
• Disproving Overstated Deductions: In something of a reverse net-worth argument, the IRS may try to prove that the taxpayer didn’t have enough income to claim certain deductions; this method assumes that the taxpayer didn’t have any leftover money from previous years, and that’s often a tenuous assumption.

When appeals courts review evidence, they always give lots of deference to whatever the jury decided. So, if the jury convicts the taxpayer, the taxpayer must prove on appeal that the evidence was almost laughably inadequate and no reasonable juror could have possibly voted to convict based on such proof.

Anyone who has ever faced off against the IRS knows all too well that this agency has a number of tools to collect what it claims the taxpayer owes, and in an audit situation, these tools are powerful and intimidating. They are still present, for the most part in criminal court, but this forum is a much more taxpayer-friendly environment, especially if there is no direct evidence supporting an income tax evasion claim. In short, if the Service has to work hard to obtain a conviction, there is a higher likelihood of a positive outcome for the taxpayer.