U.S. v. Foster

Full title: UNITED STATES, Plaintiff, v. DUANE E. FOSTER, Defendant

Court: United States District Court, E.D. Michigan, Southern Division

Date published: Jul 1, 2002

Case No. 01-80264 (E.D. Mich. Jul. 1, 2002)

Opinion

Case No. 01-80264

July 1, 2002

DECISION AND ORDER DENYING MOTION TO SUPPRESS EVIDENCE

AVERN COHN, United States District Judge

I. Introduction

This is a criminal case. Defendant, a certified public accountant, is charged in a two count indictment with filing a false 1994 individual income tax return, (Count One) and a false 1995 individual income tax return (Count Two). Particularly defendant is charged with grossly understating his gross receipts, Schedule C on Form 1040, for each of the two years. Before the Court is defendant's motion to suppress¹ certain evidence in the hands of the government, essentially on the grounds that the revenue agent, Kathy McHugh (McHugh), who audited his returns, continued her examination after she had a firm indication of fraud in violation of Internal Revenue Manual § 4565.21 and defendant's constitutional right not to incriminate himself, and that McHugh's materially misrepresented the nature of the audit after she came to the subjective belief that a firm indication of fraud was present. The Government denies that McHugh made any material misrepresentation and denies that defendant suffered the loss of any constitutional right in the course of the audit. The government further says that McHugh did not violate the manual provisions since she suspended the audit only after the point in time at which there was a firm indication of fraud present. The Court conducted a two-day evidentiary hearing on the motion at which McHugh and one of the two lawyers who represented defendant during the course of the audit testified. Numerous exhibits, including McHugh's complete file, were received in evidence. For the reasons which follow the motion is DENIED.

1 The motion is styled Motion To Dismiss The Indictment, To Suppress Evidence And/Or For An Evidentiary Hearing. In reality it is a motion to suppress.

Defendant was not misled by McHugh and McHugh did not have a firm indication of the presence of fraud until the point in time she suspended the audit. Importantly, defendant was represented by two knowledgeable lawyers beginning early in the audit who, as do most lawyers representing a client in similar circumstances, knew considerably more about defendant's tax situation than did McHugh. It was only after the two lawyers thought full disclosure might dissuade McHugh from suspending the audit and referring the matter to the Criminal Investigation Division of the Internal Revenue Service, did McHugh have a firm indication of fraud. Additionally, nothing in McHugh's statements to the lawyers constituted an affirmative misrepresentation designed to deceive. In every audit by a revenue agent the possibility of a criminal referral exists if the facts as they unfold call for such a reference.

II. Factual Background

Based on the testimony at the evidentiary hearing and the exhibits received in evidence, and after weighing the evidence and assessing the credibility of the witnesses, the facts, briefly stated, are as follows:²

1. On or about May 8, 1996, the Internal Revenue Service (IRS) received a hand written letter from an informant describing understatements of income in the range of $150,000 to $200,000 a year by defendant. A ledger sheet allegedly prepared by defendant was included with the letter. The informant asked for a reward.

2. The letter was sent by the Criminal Investigation Division of the IRS to the Examination Division on July 2, 1996. The Examination Division initially rejected the claim for a reward. On December 4, 1996, the Examination Division reopened the case selecting defendant's 1995 income tax return for audit.

3. Nothing significant happened until July 21, 1998 when McHugh was assigned the task of auditing defendant's 1995 income tax return. McHugh was instructed to defer the audit until she requested of defendant that he file his delinquent 1996 and 1997 income tax returns. The statute of limitations had run on a civil audit of defendant's 1994 income tax return.

4. McHugh sent defendant a letter on August 5, 1998 requesting that he file his 1996 income tax return. Defendant called McHugh on August 10, 1998 acknowledging he had not as yet filed his 1996 and 1997 income tax returns and explaining why. Defendant estimated that he would be filing these income tax returns shortly. He did not do so.

5. On September 10, 1998, McHugh wrote defendant notifying him that his 1995 income tax return had been assigned to her for audit and requested an appointment. IRS publications relating to a taxpayer's rights were enclosed with the letter.

6. The initial appointment between McHugh and defendant, scheduled for October 13, 1998, was rescheduled to October 27, 1998. The letter confirming the appointment included an Information Document Request. Prior to October 21, 1998, McHugh obtained information concerning defendant's income and assets from IRS data bases and public records. McHugh also contacted the informant and received information as to defendant's business operations and vacations and real estate holdings. The informant also sent McHugh additional information. McHugh's gathering of information in advance of the appointment with defendant, including meeting with the informant, was customary IRS practice.

7. On October 27, 1998, McHugh interviewed defendant primarily about his business background, income, banking practices and assets. Defendant told McHugh:

— how he financed the $287,000 down payment on his new house

— that he personally deposited all his business receipts and that he reported all his income

— that the gross receipts for his accounting business were based on bank deposits into a single bank account at Michigan National Bank

— that his rental receipts were deposited into a single bank account at National Bank of Detroit

— that he maintained a personal account at Wayne County Teacher's Credit Union and that he had no other personal or business accounts

— that he was not sure if he still had copies of his billing invoices and that he did not maintain a computerized billing system

8. On October 27, 1998, defendant gave McHugh copies of various of his records including

2 Appendix B, Chronology of Investigation, to the GOVERNMENT'S RESPONSE AND SUPPLEMENTAL BRIEF IN SUPPORT THEREOF TO DEFENDANT'S POST EVIDENTIARY HEARING BRIEF ON HIS MOTION TO DISMISS INDICTMENT, SUPPRESS EVIDENCE AND/OR FOR AN EVIDENTIARY HEARING, is a detailed narrative of the facts relating to the McHugh audit beginning with the handwritten informant's letter to the Internal Revenue Service and ending with the last contact McHugh had with the lawyers representing defendant. It is a credible account of the facts.

— a hand written list of his 1995 cash receipts

— a computer print-out of his 1995 general ledger and a computer print-out of the "Transactions Edit List" for 1995 which included a list of his accounts and the check register.

The listing of cash receipts reflected bank deposits into an account at Michigan National Bank and was consistent with Line 1 of Schedule C of the 1995 income tax return.

9. After reviewing the records provided by defendant, McHugh gave him a second request for documents to be produced at the next conference scheduled for November 5, 1998.

10. On November 4, 1998, defendant retained the service of an experienced tax lawyer.³ One of defendant's lawyer's called McHugh to advise her of the representation (voice mail message) and that he would call her for an appointment after he talked to defendant.

11. On November 12, 1998, McHugh called the lawyer since he had not called her. She was advised defendant had retained the services of an accounting firm who would be preparing the delinquent 1996 and 1997 income tax returns. The lawyer then asked McHugh for a copy of her interview notes of her October 27, 1998 meeting with defendant. Rather than giving the lawyer a copy of her notes, McHugh said that he could record her recitation of summaries that she would read to him from her notes. Later that day, McHugh called the lawyer and read over the phone an almost verbatim account of her notes which the lawyer recorded. The tape of what McHugh told the lawyer was not introduced in evidence.

12. In the November 12, 1998 phone conversation, the second lawyer testified that McHugh was asked whether the audit was random or part of a program or that there was some other basis for it. The lawyer said that McHugh replied that she was not sure and thought it was because of a failure to file tax returns. The lawyer did not say that McHugh was specifically asked whether an informant was involved. McHugh testified that she had no recollection of such a conversation. It is not clear whether the conversation was taped. No weight is given to the phone conversation, whatever its contents.

13. On November 24, 1998, the lawyers scheduled an appointment with McHugh for December 10, 1998. On December 10, 1998, McHugh and the second lawyer met at defendant's office. The lawyer deferred answering questions until he knew what direction the audit was going. McHugh responded that the audit had not really begun inasmuch as she had not yet seen detailed source documents. The lawyer told McHugh an accounting firm was completing defendant's 1996 and 1997 income tax returns and that she would be furnished copies within two weeks. McHugh was told by the lawyer that defendant's earlier statement that he did not have a computerized billing system was a mistake.⁴

14. The 1996 and 1997 income tax returns were filed directly with the IRS on December 24, 1998. Copies were not sent to McHugh at the time they were filed.

15. On January 14, 1999, McHugh met with both tax lawyers at their office. They first went through McHugh's initial document request. McHugh was told there were additional papers responsive to it. The lawyers then gave McHugh a copy of a proposed 1995 amended tax return prepared by the accounting firm and told her it was a draft to be used as a guide by her.

McHugh was then taken to another room where there was a large box of records, including what she was told were additional bank statements from four different bank accounts of which she was previously unaware. It was at this moment McHugh felt she had a firm indication of fraud. McHugh prepared various lists and noted that other records were present. McHugh gave the lawyers a new document request and scheduled a follow-up appointment. It was against IRS procedure for McHugh to advise the lawyers that she was contemplating a recommendation for a criminal investigation. McHugh suspended any further activity on the audit that day.

16. McHugh had no further contact with defendant or his lawyers except for a telephone call to the lawyers to cancel the previously scheduled appointment and to advise a referral had been made.

3 The retained lawyer and his partner jointly represented defendant. The partner, for a short period of time, worked as a revenue agent.

4 In an earlier filed affidavit the lawyer stated in part that McHugh said that "She just wanted to get the 1995 audit of Mr. Foster closed." In a file memo written by McHugh following the meeting there is no reference to such a statement. It is highly unlikely McHugh would have made such a statement.

III. The Law

As explained in United States v. McKee, 192 F.3d 535, 537-538 (6th Cir. 1999),

The IRS splits the responsibility for enforcing the nation's tax laws between its two investigative divisions. The Criminal Investigative Division ("CID") is charged with investigating criminal violations of the tax code and related federal statutes. CID investigators are called "special agents." Like many other criminal law enforcement agents, they carry firearms and badges. In addition, special agents must recite an administrative warning prior to soliciting information from taxpayers. See Beckwith v. United States, 425 U.S. 341, 343, 96 S.Ct. 1612, 48 L.Ed.2d 1 (1976) (quoting warning provided by special agents).

On the other hand, the Examination Division of the IRS is responsible for conducting civil tax audits. Examination Division investigators are known as "revenue agents."

In contrast to special agents, revenue agents do not carry firearms; nor are they required to provide taxpayers with an administrative warning. Although an Examination Division audit typically concludes with some sort of civil settlement between the IRS and the taxpayer, such an audit may uncover evidence that causes the revenue agent to refer the case to the CID for criminal investigation. Under IRS regulations, a revenue agent who uncovers a "firm indication of fraud on the part of the taxpayer" must immediately suspend her audit and refer the case to the CID. See Internal Revenue Manual § 4565.21(1). At that point, the CID enters the case and the IRS' efforts become focused on the possibility of criminal [prosecution]. See generally, Michael I. Saltzman, IRS Practice and Procedure ¶¶ 12.01 12.03[1][a]. Peters, 153 f.3d at 447.

The issue is when McHugh had a "firm indication of fraud on the part of defendant." As pointed out in McKee, 192 F.3d at 541, "IRS regulations explicitly prohibit a revenue agent from developing a criminal case against a taxpayer under the guise of a civil investigation." This is no more than saying that to continue a civil investigation which is designed to develop a criminal case would be a violation of a taxpayer's Fourth and Fifth Amendment rights. Effectively what is involved in such a situation is, as described in United States v. Peters, 153 F.3d 445, 451 (7th Cir. 1998), an unreasonable consensual search under the Fourth Amendment and a denial of due process under the Fifth Amendment because "the consent was induced by fraud, deceit, trickery, or misrepresentation by the revenue agent."

As pointed out in Peters, 153 F.3d at 452-453,

Nonetheless, as the district court noted, the "firm indications of fraud" standard is a difficult standard for federal courts to apply because it is inherently vague and depends, in large part, on the good faith and professional judgment of the revenue agents conducting the investigation at issue.

"[T]he `firm indications of fraud' rule cannot be expressed in a set of absolute criteria and.., the facts and circumstances of each case must be assessed in their own light." 153 F.3d at 453.

Also,

The case law suggests that a revenue agent has developed a firm indication of fraud when she has established that the taxpayer has engaged in a consistent patter of substantial underreporting of income and/or overstatement of deductions such that an intent to evade taxes can be inferred.

Id. at 455. Further, "a firm indication of fraud should be distinguished from a first indication of fraud." Id. at 455.

Finally,

... evidence will be suppressed only upon a clear showing that the taxpayer was tricked or deceived. In the absence of a clear showing that the taxpayer has been tricked or deceived by the government agents into providing incriminating information, the documents and statements obtained by the Internal Revenue agents are admissible.

McKee, supra, 192 F.3d at 541 (internal citations and quotation marks omitted).

IV. Analysis A.

Defendant argues that McHugh, on November 12, 1998, misrepresented the nature of her examination in her response to the lawyers' question as to how the examination began when she stated she was not sure. Assuming for the sake of argument McHugh did not explicitly state that the audit began with an informant seeking a reward, there is nothing in her response to suggest she was endeavoring to affirmatively mislead the lawyers as to the true nature of her investigation or that she tried to trick or deceive the defendant. As stated in Peters, supra, 153 F.3d at 457, n. 16:

We note at the outset that the IRS did not have an affirmative duty to warn [the taxpayer] or her representatives that the audit could lead to criminal consequences or that it was prompted by an informant's tip.

Further, as explained in United States v. Kontny, 238 F.3d 815, 819 (7th Cir. 2001),

Proof of deceit must be linked up to the constitutional standard of threat or promise. Deceit by itself is neither

Nothing in anything McHugh said in the November 10, 1998 conversation suggests either a threat or a promise. She said she was doing an audit and that is what she was doing.

B.

As to when McHugh first became aware of a "firm indication of fraud," this did not occur until the January 14, 1999 meeting. Up to that point McHugh did not have available to her what has been described as detailed source documents. At the October 27, 1998 meeting with the defendant, McHugh was given very little in the way of information or documents. On her own, McHugh had gathered from internal IRS data bases as well as public records and documents furnished by the informant, additional information — information sufficient to suggest that the 1995 income tax form, and particularly Schedule C, was not accurate. However, what she did have certainly was not sufficient to firmly indicate the presence of fraud.

There can be no doubt that the lawyers, once they saw the accounting firm's draft of an amended 1995 income tax form, knew that the filed Schedule C grossly understated taxpayer's 1995 gross receipts and that once McHugh saw it she would know that also. What happened here was that they hoped that by voluntarily disclosing this fact they could dissuade McHugh from a referral. This did not happen. When McHugh saw the draft 1995 amended income tax return for the first time and was made aware of the additional bank accounts, McHugh knew there was a firm indication of fraud present. McHugh quickly concluded her meeting with the lawyer as she was instructed to do by IRS procedures and then went back to her office and put together the necessary forms for a referral to the Criminal Investigation Division. McHugh is an experienced revenue agent. McHugh was well aware of how to conduct a civil audit and what indications must be present to cause her to suspend it. There is a vast difference between a suspicion that something is not right and a firm indication of fraud. McHugh knew the difference and when her suspicions ripened to firm indications she stopped the audit. There is nothing in McHugh's actions during the course of the audit to warrant suppression of any information given to her during the course of the audit or to warrant suppression of any documents given to her.⁵

5 The information and documents which defendant has moved to suppress are described in Exhibit A, Listing of Evidence to be Suppressed, to Defendant's SUPPLEMENTAL MATERIALS FOR ORAL ARGUMENT.