U.S. Files Complaint on Liberty Tax Fraud Detection Controls

UNITED STATES OF AMERICA,
Plaintiff,
v.
FRANCHISE GROUP INTERMEDIATE L 1, LLC, d/b/a LIBERTY TAX SERVICE,
Defendant.

IN THE UNITED STATES DISTRICT COURT
FOR THE EASTERN DISTRICT OF VIRGINIA
NORFOLK DIVISION

COMPLAINT

The United States brings this Complaint pursuant to 26 U.S.C. (the Internal Revenue Code (“I.R.C.”)) § 7402(a) for entry of an order requiring Defendant, Franchise Group Intermediate L 1, LLC, doing business as Liberty Tax Service and formerly operated within sub-entities of Liberty Tax, Inc. and JTH Holding, Inc. (“Liberty Tax”), and all those in active concert or participation with Liberty Tax, to refrain from specific acts, to enact and/or maintain specific controls to prevent the preparation of false or fraudulent tax returns at Liberty Tax Service stores, and to prevent the transmission of false or fraudulent tax returns by Liberty Tax to the IRS.

Jurisdiction and Venue

1. Jurisdiction is conferred on this Court by 26 U.S.C § 7402(a), granting that “[t]he district courts of the United States at the instance of the United States shall have such jurisdiction to make and issue in civil actions, writs and orders of injunction . . . and such other orders and processes, and to render such judgments and decrees as may be necessary or appropriate for the enforcement of the internal revenue laws.”

2. Venue is proper in this Court pursuant to 28 U.S.C. § 1391(b) because a substantial portion of the events giving rise to this action occurred within this judicial district, and Liberty Tax conducts business in this judicial district.

Defendant

3. Franchise Group Intermediate L 1, LLC (“Liberty Tax”) is a subsidiary of Franchise Group, Inc., a publicly traded, Delaware corporation headquartered in Virginia Beach, Virginia.

4. Liberty Tax markets tax return preparation services throughout the United States and Canada. Among its operations, Liberty Tax owns Liberty Tax Service-branded store locations and contracts with others as a franchisor of tax preparation stores branded as Liberty Tax Service (or operating as other brands).

5. John T. Hewitt established the Liberty Tax Service brand, founded the company, and opened its first store locations in the United States in 1998. Hewitt served as the Chief Executive Officer of the company up to 2017. Until 2018, Hewitt was Chairman of the company's Board of Directors and controlling shareholder with the authority to select a majority of the board members.

6. To expand the business, Liberty Tax engages third parties, known as “area developers,” to sell the rights to franchise territories throughout the United States. According to Liberty Tax, these area developers, in addition to having responsibility for selling Liberty Tax Service franchises, also serve as a “mentor and coach” responsible for “assist[ing]” other owners of Liberty Tax Service franchises within defined geographic areas with “all facets of [their] business, including office site selection and operational guidance, including marketing, training, and staffing.” Area developers typically receive 50% of both the franchise fee and royalties owed by franchisees under Liberty Tax Service franchise agreements.

7. According to the annual report filed by Liberty Tax, Inc. with the SEC in 2019, Liberty Tax has more than 2,800 franchise and company-owned tax return preparation offices in the United States. Liberty Tax also directly owns tax preparation stores. However, most Liberty Tax Service stores throughout the United States operate as franchisees in over 1,400 separate franchise territories, which in some instances include multiple store locations. Between 2015 and 2019, through the stores it owned directly and franchised throughout the United States, Liberty Tax filed approximately 1.3 to 1.9 million tax returns each year on behalf of its customers, making it one of the largest tax preparation businesses in the United States.

8. Typically, tax return preparers at Liberty Tax franchise and company-owned stores prepare federal income tax returns at individual store locations using Liberty Tax software, which transmits each tax return electronically to Liberty Tax. Liberty Tax, in turn, electronically files each federal tax return with the IRS.

9. For tax years from 2012 to 2018, over 88% of the electronically filed federal income tax returns prepared at stores Liberty Tax owned directly or franchised in the United States included a claim for a tax refund. In total, those income tax returns claimed over $28 billion in federal tax refunds.

10. In addition to direct control of company-owned stores, under terms of its franchise agreements, operations manuals, and other written guidelines created by Liberty Tax, Liberty Tax maintains a substantial degree of control over operations at Liberty Tax Service franchise locations by, inter alia:

11. Liberty Tax also maintains control over disbursement of federal tax refunds and distribution of fees charged to customers from the preparation of federal tax returns. Through its franchise and company-owned stores, Liberty Tax offers customers the ability to defer payment of fees charged by Liberty Tax Service stores. For these customers, Liberty Tax obtains custody over federal tax refunds after the IRS disburses them (before franchisees or customers receive any portion of them) and collects fees from the proceeds of the refunds. Typically, Liberty Tax then: (1) retains portions of the refund, either as royalties owed to the company as the franchisor, or as fees owed by customers from the preparation of tax returns at company-owned stores; (2) distributes any portion of the refund due to franchisees as fees owed by the customers from the preparation of the tax return, or applies those fees to outstanding debt owed by the franchisee to Liberty Tax; and (3) disburses any remaining amount of the refund to customers (either directly to the customer or through a Liberty Tax Service location).

12. Liberty Tax's internal systems and the structure of its franchise operation also give the company the control and capability to prevent the filing of potentially false or fraudulent federal tax returns with the IRS. For example:

13. Liberty Tax Service franchise agreements also provide multiple grounds for Liberty Tax to terminate franchise agreements without notice or opportunity to cure. Grounds for termination include a determination by Liberty Tax that a franchisee, or any person under its supervision and control, has committed a material violation of any law, rule, or regulation of a government agency associated with the operation of the franchise.

Fraud and Misconduct at Liberty Tax Service Franchise Locations

14. Between 2013 and 2018, the United States filed 10 separate civil law enforcement actions in U.S. District Courts throughout the United States against 12 franchisees of Liberty Tax, or their owners, former owners, or former managers, including:

Earned Income Tax Credit Fraud

15. The Earned Income Tax Credit (“EITC”) is a benefit for working taxpayers with low to moderate income. The amount of the EITC for which taxpayers may qualify increases in relation to their “earned income” until they reach a certain threshold, over which they become ineligible to claim the EITC. The EITC of a qualifying taxpayer increases with each additional eligible dependent claimed, up to three dependents. Therefore, under some circumstances, a taxpayer may improperly qualify for the EITC by reporting fictitious income.

16. Income that can qualify a taxpayer for the EITC includes:

17. Unlike W-2 Income, the IRS does not receive independent verification from an employer of the existence and amount of a taxpayer's Schedule C Income or HSH Income. Therefore, the accuracy of Schedule C Income and HSH Income reported on a federal income tax return used to claim the EITC depends upon the taxpayer and his/her tax return preparer.

18. The IRS estimates that between 21% and 26% of EITC claims are paid in error — both due to unintentional error as well as intentional disregard of the law. Given the potential for abuse in claiming the EITC, Congress authorized the Secretary of the Treasury to impose due diligence requirements on federal tax return preparers claiming the EITC for their customers. Due diligence requirements mandate that a tax return preparer must conduct an inquiry to verify whether his/her customer qualifies for the EITC amount claimed and must not know, or have reason to know, that any information used by the tax return preparer in determining the taxpayer's eligibility for, or the amount of, the EITC is incorrect. To verify compliance with due diligence requirements, a due diligence questionnaire must be submitted to the IRS along with any claim for the EITC.

19. In addition, federal law requires tax return preparers to retain records of individuals for whom they prepare federal tax returns, including copies of documents the preparer relied upon when preparing a federal tax return that claims the EITC. Liberty Tax Service stores typically retain these records in hardcopy customer files located either at each store or storage locations near each store.

20. A substantial portion of the tax returns prepared at Liberty Tax franchise and company-owned store locations and electronically filed with the IRS by Liberty Tax claim the EITC. For tax years from 2012 to 2018, approximately 41% of federal income tax returns that Liberty Tax electronically filed with the IRS included a claim the EITC – more than double the proportion compared against all other federal income tax returns electronically filed with the IRS during that period. In total, the EITC claimed by federal tax returns electronically filed by Liberty Tax during this timeframe exceeded $12 billion.

21. At the Liberty Tax Service stores operated by 10 of the 12 individuals sued in the civil law enforcement actions commenced by the United States referenced above, including against Doletzky, Garno, Bass, Davis, Comer, Haynes, Kone, Sanchez, Ahmed, and Hueble, tax return preparers committed EITC fraud and violations of earned income due diligence requirements when reporting Schedule C Income on federal income tax returns. Specifically, during a period from 2010 to as recently as 2016, employees of Liberty Tax Service stores owned or operated by these Liberty Tax Service franchisees (and in some instances, these individuals personally) prepared federal income tax returns for customers that claimed false EITCs by:

22. Similarly, at four of the Liberty Tax franchisees sued by the United States (Kone, Doletzky, Bass, and Garno), employees of these Liberty Tax Service stores (and in some instances, these individuals personally) prepared federal income tax returns that reported false HSH Income in order to claim the EITC for customers. Each of these four Liberty Tax franchisees recruited customers, including homeless individuals, and then prepared fraudulent federal income tax returns on their behalf that reported fake HSH Income to claim the EITC or incorrectly reported Schedule C Income as HSH Income, thereby evading self-employment taxes. For example:

23. Liberty Tax transmitted tax returns to the IRS, prepared at Liberty Tax Service stores operated by Doletzky, Garno, Bass, Davis, Comer, Haynes, Kone, Sanchez, Ahmed, and Hueble, that reported false Schedule C and/or HSH Income and made fraudulent claims for the EITC. Liberty Tax had notice (or should have had notice) of EITC fraud involving Schedule C and HSH Income at Liberty Tax Service franchise locations, but failed to take adequate measures to stop the practice. For example:

Improper Dependent Claims, False Expenses, Fraudulent Claims for Refundable Education Credits, and PTIN Violations

24. In addition to inflating income to claim improper EITC refunds, a pattern of additional misconduct existed at Liberty Tax Service franchisees that included the 12 franchisees, owners, former owners, or former managers sued by the United States in the civil enforcement actions described above. From as early as 2012 to as recently as 2017, these Liberty Tax Service franchisees prepared federal income tax returns that included improper dependent claims, false claims for expenses, fraudulent claims for refundable education credits, and violations of federal Preparer Tax Identification Number (“PTIN”) regulations as follows:

25. Liberty Tax was capable of tracking (or in fact did track) each form of misconduct described in Paragraph 24 and had the ability, both in practice and legally under its franchise agreements, to take additional measures to prevent violations of federal law or terminate franchisees for those violations. For example:

A. Liberty Tax issued “red flag” or “fraud alerts” for franchisees that prepared unusually high numbers of tax returns that claimed refundable education credits. Nevertheless, Liberty Tax either took no action or took insufficient additional measures in response, such as onsite reviews of Liberty Tax Service stores. Onsite reviews or even remote reviews of customer files would have revealed the presence of unreliable (including incomplete and blank) “Education Expenses Detail Sheets” distributed among Liberty Tax franchisees to purportedly substantiate education credits in place of Forms 1098-T.

B. Liberty Tax's systems tracked PTIN use. For example, in 2014, from those systems, Liberty Tax's compliance personnel knew that at one of Doletzky's Liberty Tax Service stores, of 1,597 tax returns prepared during that year, implausibly, 1,528 (i.e., nearly 97%) of those returns identified two individuals as the only preparers of the returns.

C. Similarly, had Liberty Tax taken measures to review customer files located at these Liberty Tax Service stores, the company would have discovered the absence of required supporting documentation for claimed expenses reported on tax returns to improperly reduce customers' federal income tax liabilities. These steps would have also revealed inconsistent or lack of any documentation to support dependent claims reported on tax returns.

“Elite 18” and “Million Dollar Club” Franchisees

26. Liberty Tax marketed franchisees it considered top performers in the Liberty Tax Service system as examples for other franchisees to follow, including at meetings and events held by Liberty Tax for its franchisees.

27. Liberty Tax designated certain franchisees as the “Elite 18” of the Liberty Tax Service system. In April 2012, according to Liberty Tax, this status was “reserved” for top franchisees and “was created to recognize a special category of franchisees who's [sic] performance and attitude have set the standard for the [Liberty Tax Service] organization.” Liberty Tax invited franchisee members of the “Elite 18” to attend special events, such as retreats led by senior executives of Liberty Tax.

28. Similarly, Liberty Tax created what it designated as the “Million Dollar Club” and selected franchisees to be its members. In September 2013, according to Liberty Tax, “[t]his club was formed to provide specialized trainings to select franchisees who have demonstrated an elevated pattern of success in the hopes that they will join the exclusive rank of 'Elite 18,' a group of franchisees who represent [the] highest revenue producing entities.” Liberty Tax informed franchisees that “[p]articipants of the Million Dollar Club [would] be invited to attend specialized training and conference calls held throughout the year,” including meetings with Liberty Tax's then “CEO, John Hewitt and other franchisees producing at their level to discuss issues they deem important.”

29. Liberty Tax focused on the financial performance of franchisees when designating franchisees as “Elite 18” members or members of the “Million Dollar Club,” while failing to maintain adequate controls to scrutinize the tax return preparation practices of those franchisees and/or failing to timely terminate franchisees despite indications of improper or fraudulent tax return preparation practices.

30. Of the 12 Liberty Tax franchisee Defendants referenced above, Liberty Tax designated 6 of them as members of the “Elite 18” or the “Million Dollar Club,” including Doletzky (Elite 18), Comer (Elite 18), Haynes (Million Dollar Club), Kone (Million Dollar Club), Sanchez (Elite 18), and Ahmed (Elite 18).

Necessity for an I.R.C. § 7402(a) Order

31. Liberty Tax's annual report filed in 2019 admitted that the company “did not maintain effective internal control over financial reporting as of April 30, 2019,” and “[t]he control environment, risk assessment, control activities, information and communication, and monitoring controls were not effective. 'Tone at the top' issues contributed to an ineffective control environment.” Moreover, that annual report also disclosed weaknesses in “contemplating fraud risks,” “identifying and assessing changes in the business that could impact the system of internal controls,” and:

32. As described in detail above, common forms of tax fraud and tax law violations occurred across Liberty Tax Service franchisees, including the following (with an “X” indicating a common form of fraud/tax law violation):

	Earned Income Tax Credit Fraud (fake income)	Fabricated Expenses (Schedule A or Schedule C)	False or Improper Dependents	Fraudulent Claims for Education Credits	PTIN Violations
Doletzky Litigation (Doletzky)	X	X	X	X	X
Doletzky Litigation (Garno)	X	X	X	X	X
Doletzky Litigation (Bass)	X		X	X	X
Davis Litigation	X	X	X
Comer Litigation	X	X	X		X
Haynes Litigation	X	X	X		X
Kone Litigation	X
Sanchez Litigation	X	X	X
Ahmed Litigation	X	X	X	X
Hueble Litigation	X	X	X
Brock Litigation				X
Leger Litigation				X

33. In sum, Liberty Tax's failure to maintain adequate controls over financial reporting extended to controls over tax returns prepared by its franchisees that it transmitted to the IRS. For each of the forms of fraud or improper claims reported on federal income tax returns addressed above, Liberty Tax tracked information that revealed anomalies that warranted further investigation or action by Liberty Tax. Liberty Tax, however, failed to take sufficient measures to prevent fraud and errors on tax returns prepared at its stores. In many cases, Liberty Tax only terminated franchisees that filed fraudulent federal tax returns after the United States or other law enforcement agencies commenced actions against the franchisee. Liberty Tax knew or should have known of misconduct at Liberty Tax Service franchisees and failed to timely or to effectively act to prevent the continued filing of false or fraudulent federal income tax returns. For these reasons, an Order issued by this Court under I.R.C. § 7402(a) requiring Liberty Tax to take specific tax law compliance measures and implement and/or maintain specific controls to prevent the filing of false or fraudulent federal tax returns is “necessary or appropriate for the enforcement of the internal revenue laws.”

34. Moreover, the scope of the resources spent by the United States to date to enforce tax law compliance at Liberty Tax Service stores, as well as the harm discovered as a result, provide further support for the necessity and appropriateness of an Order by this Court under I.R.C. § 7402(a). Specifically:

35. As addressed above, Liberty Tax Service files over 1 million tax returns each year and is one of the largest tax preparation companies in the United States. Liberty Tax has the capacity to maintain and, ultimately, improve controls to prevent the filing of false or fraudulent federal tax returns with the IRS. At the same time, the United States, including the IRS, has finite resources to detect false or fraudulent federal income tax returns, recoup improper tax refunds, and initiate civil enforcement actions in U.S. District Courts. Therefore, court-ordered enhancements to Liberty Tax's tax law compliance measures through an Order under I.R.C. § 7402(a) are “necessary or appropriate for the enforcement of the internal revenue laws.”

REQUESTED RELIEF UNDER I.R.C. § 7402(a)

36. The United States incorporates by reference paragraphs 1 through 35.

37. Under I.R.C. § 7402(a), this District Court has “such jurisdiction to make and issue in civil actions, writs and orders of injunction . . . and such other orders and processes, and to render such judgments and decrees as may be necessary or appropriate for the enforcement of the internal revenue laws.”

38. Unless the Court enters an order pursuant to I.R.C. § 7402(a) that requires Liberty Tax to refrain from specific acts and to enact and/or maintain specific controls to prevent the preparation of false or fraudulent tax returns at Liberty Tax Service stores, Liberty Tax Service stores are likely to continue to engage in improper conduct, including the preparation of false or fraudulent federal income tax returns. Without an I.R.C. § 7402(a) order, the United States will suffer irreparable injury by wrongfully providing federal income tax refunds to individuals not entitled to receive them.

39. The irreparable injury posed by the United States if the Court does not enter an I.R.C. § 7402(a) order outweighs the harm to Liberty Tax – in this instance the financial cost of maintaining and enhancing Liberty Tax's controls to prevent the preparation of false or fraudulent tax returns at Liberty Tax Service stores.

40. An order pursuant to I.R.C. § 7402(a) is in the public interest because, backed by the Court's contempt power if needed, it will cause Liberty Tax to refrain from specific acts and to enact and/or maintain specific controls to prevent the preparation of false or fraudulent tax returns at Liberty Tax Service stores. The impact of an I.R.C. § 7402(a) order, and the resulting benefit to the public fisc from the filing of accurate federal income tax returns is a particularly compelling public interest given the size of Liberty Tax's business – transmitting over 1 million federal income tax returns to the IRS each year.

41. Pursuant to I.R.C. § 7402(a), the Court should enter an order requiring Liberty Tax, and all those in active concert or participation with Liberty Tax, to enact and/or maintain specific controls to prevent the preparation of false or fraudulent tax returns at Liberty Tax Service stores and to prevent the transmission of false or fraudulent tax returns by Liberty Tax to the IRS.

WHEREFORE, the United States seeks, inter alia, a Section 7402(a) Order that:

Dated: December 3, 2019.

Respectfully submitted,

G. ZACHARY TERWILLIGER
United States Attorney

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

By. James F. Bresnahan II
Russell J. Edelstein, Trial Attorney
MA Bar No. 663227
(Pro Hac Vice Application Pending)
James F. Bresnahan II, Trial Attorney
VA Bar No. 80164
Counsel for the United States of America
U.S. Department of Justice — Tax Division
P.O. Box 7238 — Ben Franklin Station
Washington, D.C. 20044
Phone: (202) 616-2704 (Edelstein)
Phone: (202) 616-9067 (Bresnahan)
Fax: (202) 514-6770
Email: russell.j.edelstein@usdoj.gov
Email: james.f.bresnahan@usdoj.gov

Sean D. Jansen, Assistant U.S. Attorney
VA Bar No. 82252
Office of the United States Attorney
Counsel for the United States of America
101 West Main Street, Suite 8000
Norfolk, VA 23510-1671
Phone: (757) 441-6331
Fax: (757) 441-6689
Email: sean.jansen@usdoj.gov