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Court Rejects Government Efforts to Award Disgorgement in Preparer Injunction Case

Posted on July 6, 2016

Keith, Stephen and I have recently discussed a number of issues spinning from preparer misconduct, including the government attempting to use the Code’s broad injunction powers to shut down preparers who are gaming the system. Keith and I have also discussed a somewhat newer trend, with the government seeking the equitable remedy of disgorgement to force illicit preparers to give back some or all of the proceeds of their crooked return prep business. US v Mesadieu, a case from earlier this year out of a district court Florida, shows that there are limits on the government’s use of disgorgement as a remedy, at least in terms of its establishing the amount of disgorgement that the government may be entitled to receive. It also raises some questions about the remedy, and in particular whether the Mesadieu opinion might throw some roadblocks in these types of cases.

The case arose from the government’s seeking injunctive relief stemming from preparer Douglas Mesadieu, who had set up offices in Georgia, Florida and Texas, using eight entities that prepared around thirteen thousand returns in a three-year period. The allegations included that Mesadieu and others affiliated with Mesadieu and the entities goosed income and created deductions to place clients in position to receive the EITC (similar to what Carl Smith discussed in The Often Topsy-turvy World of EITC Litigation where at times the amount of the credit exceeds any income or SE tax liability):

The Government’s evidence shows that one of the ways Mesadieu’s companies’ manipulate the EITC is to create fake businesses to list on the taxpayer’s Schedule C, such as a transport services business, hair salon, or barber shop. Other times, the taxpayer’s Schedule C claims losses for a business but did not list a business name

Another tactic is to claim false unreimbursed employee expenses on a Schedule A. For example, expenses for non-deductible commuter miles or other business-related expenses for unreimbursed meals or uniforms would be claimed.

The schemes involved more than the EITC, as the government alleged that “[a]nother often-used strategy is to claim false charitable donations or education credits that the taxpayer testified he or she did not actually pay and did not tell the tax return preparer that the amounts were paid.”

While the court issued an order granting the government’s expansive injunction request, it ruled against the government on disgorgement. Mesadieu had two main arguments when it came to the disgorgement issue: 1) the court did not have power to order disgorgement in cases arising from return preparer injunction proceedings and 2) even if it did the government did not establish how much should be disgorged.

Is Disgorgement an Appropriate Remedy?

Mesadieu argued initially that the court should not have the power to compel disgorgement. In response to a previous motion, the district court held that courts had wide power under Section 7402(a) to order a disgorgement of a preparer’s ill-gotten gains. That section gives federal district courts jurisdiction “to make and issue in civil actions, writs and orders of injunction, and of ne exeat republica, orders appointing receivers, 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.” The statute also states that the remedies listed in Section 7402(a) “are in addition to and not exclusive of any and all other remedies of the United States in such courts or otherwise to enforce such laws.”

The emphasized statutory language in Section 7402(a) is what courts have relied on in allowing the government to seek disgorgement in preparer scheme cases. While not every type of federal case inherently implicates disgorgement powers, in upholding the right to order disgorgement in injunction cases against preparers the Mesadieu opinion distinguishes other statutes that are more narrowly drawn or which do not involve the public interest associated with revenue laws. The opinion discusses generally how 7402(a) “encompasses a broad range of powers necessary to compel compliance with the tax laws.” United States v. Ernst & Whinney, 735 F.2d 1296, 1300 (11th Cir. 1984). It also relies on cases that had specifically blessed disgorgement as an appropriate remedy under Section 7402(a) in similar circumstances.

How Much Disgorgement?

While the court found that it could order disgorgement, it held against the government, finding that the government failed to establish how much disgorgement was appropriate. Here is how it got there. The government argued first that all of Mesadieu and his related entities’ gross receipts should be disgorged or in the alternative, disgorgement would be based on the fees that related to an estimated percentage of the non-compliant returns. The amount that should be disgorged depends on the extent of the fraudulent activity; i.e., how much of the return preparation proceeds was attributable to the misconduct. To establish the misconduct, the government put on an expert, an IRS Senior Research Analyst, who problematically looked at returns from only one year and in one location:

To establish the amount of disgorgement, the Government relied on a random sampling of tax returns prepared by Mesadieu’s companies. In total, for all years of tax preparation, Mesadieu’s companies prepared around 13,000 tax returns. However, the random sample that the Government presented at trial consisted of only 230 tax returns prepared in Houston, Texas for the tax year 2012. The overall pool of tax returns from which the 230 were selected was approximately 3,600. Despite that 230 tax returns were selected for the random sample, only 115 taxpayers were interviewed regarding their tax returns to determine whether the information on the tax return was fraudulent. Those customers interviewed were not put under oath. From this, the Government’s expert testified that the percentage of “non-compliant” tax returns–meaning, a taxpayer underreports his taxes due–was 82.6%. Additionally, it is possible that as many as 25% of the tax returns were “compliant,” or correctly reported.

As an initial matter the court discussed the standard to determine the amount of disgorgement, emphasizing that the plaintiff only need “produce a reasonable approximation of the defendant’s ill-gotten gains.” Once the estimate is shown, the defendant has the burden to show that the plaintiff’s estimate was not reasonable. However if there are shoddy records and the estimation cannot be shown and “the exact amount of illicit gains cannot be accomplished without incurring inordinate expense,’ a court may set disgorgement at the ‘more readily measurable proceeds received from the unlawful transactions.'” (citations omitted).

The court emphasized that there must be a “relationship between the amount of disgorgement and the amount of ill-gotten gain,” and a district court may not order disgorgement of an amount obtained without wrongdoing or obtained during a period where there is no record evidence of fraud. (citing to C.F.T.C. v. Sidoti, 178 F.3d 1132, 1138 (11th Cir. 1999)). Given that the expert testified that some of the returns were compliant, the opinion rejected the government’s argument that all of the receipts were subject to disgorgement, distinguishing cases where courts ordered all of the proceeds to be disgorged:

[T]hese cases are distinguishable because they involve an entire fraud. In those cases, either all of the defendant’s conduct was fraudulent or the defendant’s illegitimate activity is indecipherable from his legitimate activity. See, S.E.C. v. Lauer, 478 F. App’x 550, 557 (11th Cir. 2012)…In contrast, in the present case, Mesadieu’s tax preparation stores did not always prepare taxes fraudulently.

The opinion notes that while Section 7402(a) is broad, a “court’s power to order disgorgement is not unlimited.” The opinion describes and distinguishes  cases where all the proceeds were disgorged (like FTC cases involving phony claims in telemarketing and infomercials) where courts have struggled to distinguish legitimate gains from illegitimate gains, or cases where the facts make it impractical to distinguish between legitimate and illegitimate activity. The opinion emphasizes that its disgorgement power “extends only to the amount the defendant profited from his wrongdoing….Any additional sum is impermissible as it would constitute a penalty.”

The opinion then turned to the government’s alternative argument that an estimated percentage of non-compliant returns should provide the basis for disgorgement:

As the Court has determined that a disgorgement award of gross receipts is not a reasonable approximation, the Court must next consider the Government’s argument that the estimated percentage of non-compliant tax returns from the Texas sample is a sound methodology for separating illegal proceeds from legal ones. Under this method, the Government asks the Court to utilize the confidence interval of the non-compliant tax returns (73%-91.7%) to calculate Mesadieu’s companies’ illegal proceeds. To clarify, the Government urges the Court to use this percentage derived solely from the Texas sample of 2012 tax returns and apply it to the total gross profits of Mesadieu’s companies from its operations in all three states and for tax years 2013, 2014, and 2015.

Mesadieu argued that the government’s alternative approach was unreasonable because it essentially extrapolated from returns prepared in Texas and only looked at one year and failed to take into account the entire operations. The opinion agreed that reliance on such a limited sample was not reasonable:

The Court finds it is unreasonable to approximate the total disgorgement award in this case based on a sample limited to one tax year and one geographical area. Utilizing a random sample from a pool of only 3,600 tax returns to make a conclusion about 13,000 tax returns is not reasonable. There are approximately 9,400 tax returns that were inevitably not capable of selection. The Government’s sample provides no information as to the percentage of non-compliant tax returns in other years or in other states. The Government’s expert testified only as to the soundness of the sample methodology for the pool of 3,600 tax returns from which the sample was selected. Importantly, the Government’s expert testified that the sample data provides no information on whether the compliance rate from that sample is the same in other years. Accordingly, the Court finds that this sample is not generalizable to the universe of 13,000 tax returns.

Parting Thoughts

The Mesadieu opinion does not throw up an impossible burden for the government, as the government should have pulled most of the returns prepared by this business and should have had the ability to get pretty specific. While the opinion also notes a technical foot fault in that the government did not join the specific entities that Mesadieu controlled and questioned whether it could have ordered disgorgement with respect to the fees that those entities received, that too is remediable in future cases. If in the future the government dots the i’s and crosses the t’s in proving a reasonable approximation of returns with phony deductions and credits and properly joins all parties, what is the value of the disgorgement to the government?

Keith discussed the government’s use of its injunction and disgorgement powers in Return Preparer Shenanigans and expressed some skepticism that both remedies were likely to be effective, comparing them to “trying to pull up individual dandelions instead of putting down a fertilizer that kills them and prohibits growth. Aside from having to pull them up one by one, you invariably do not get the roots so it pops back up before long.” Likewise, Keith said he would be “surprised if the return preparation fees are sitting around in a bank account just waiting to be disgorged.”

If Keith’s skepticism is correct, I am not sure why the government would pursue disgorgement as a remedy though I have previously discussed in Restitution Based Assessment and Bad Tax Return Preparers: An Uneasy Mix why the government may have difficulties in pursuing restitution in these types of cases, perhaps thus making disgorgement more attractive. Alternatively, it could go the route of preparer penalties, assessable without deficiency procedures and then subject to administrative collection. Any result that ties in the preparer misconduct to dollars, however, suffers from the same “you cannot get blood from a stone” problem that Keith flagged.

In any event, the tax system is still plagued with preparers (and taxpayers) who view the tax system as an unwatched cookie jar. DOJ is emphasizing its injunction tools as part of its efforts to root out schemes and scams and it will likely try to use some means to impose a monetary cost on the preparers. I suspect we will see more of these cases and perhaps gain some more insight on calculating the amount of disgorgment when preparers such as Mesadieu have many thousands of returns spread across entities and multiple states.

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