Originally published on Forbes.com Aug 11th, 2014
Curtis L. Morris was before the Tenth Circuit recently appealing his conviction and sentence. He was found guilty of three counts of mail fraud, seventeen counts of making false claims, and one count of conspiracy. The judge gave him a downward adjustment from the guidelines and sentenced him to 120 months. Somehow 10 years sounds longer, but that is neither here nor there. Not to spoil the surprise, but his appeal went nowhere. Nonetheless, there was one really good point he made. I can understand why it did not entitle him to more of a break, but still, it is worth considering. Essentially he was saying that his crime should not have worked at all and that he was being prosecuted out of spite and embarrassment. Well, at least the first part was true.
So You Want To Do Some Tax Fraud
In order to commit tax fraud, you need two things – a reason and a method. I think the most common reason is that some think it would be better if the money were in their hands than in the government’s. Others don’t find simple greed that satisfying and are influenced by what we might call rationales. Something like the Sixteenth Amendment never really was ratified. If they believe the rationale deeply enough and it has at least some plausibility, that can actually get them out of criminal trouble – it’s called the Cheek defense.
More important to be an actual successful Tax Fraudster is a means. When the Big Four accounting firms opened up tax fraud shops, as described in Tanina Rostain and Milton Regan’s great book Confidence Games, they used special-purpose partnerships, which were very unlikely to be audited. The rationale was a dense “legal opinion” that justified creating basis out of thin air, which was characterized as a “get out of jail free card”. The means for the scheme that Mr. Morris was involved in was much less sophisticated and it is rather extraordinary that it worked at all for any period of time.
The OID Fraud- The Means
OID stands for original issue discount. Original Issue Discount is interest income you are required to pick up (or deduct if you are on the other side of the transaction). It’s a mathematical present value thing. If you buy a $1,000 bond that pays you $40 in interest every year and your $1,000 back at maturity, there is no OID. Debt instruments that vary from that simplicity, by backloading the return (For example paying no current interest and more than $1,000 at maturity to take a simple example) can create original issue discount. What you have to do is figure out how much income to pick up each year, so that you end up with a level return. The thing is that most tax work requires a fourth-grade education in math. OID involves college or arguably graduate school level math, so it can confuse the hell out of most tax practitioners. As it happens, the reality of OID computations had absolutely nothing to do with the OID fraud. It was purely a matter of form abuse.
Here is Form 1099-OID. All the fancy math is distilled in Box 1. All the tax practitioner, with his or her fourth-grade math, has to do is add that number to income (and basis in the instrument if they are thorough). The interesting number is in Box 4 – Federal Tax Withheld. That is supposed to mean that somebody paid some money to the federal government that you get to treat as a payment on your return. You would expect that the number in Box 4 would be 30% or less of the income numbers in Boxes 1, 2, or 3. You would also expect that the IRS computers would cross-check the number in Box 4 against reports of money that was actually received. As it turns out, the only thing they were checking, in some cases, was that the 1099-OID numbers on the 1099-OID attached to your return matched your return. Nothing, other than blatant illegality, prevented you from putting whatever number you wanted into Box 4 and claiming the “payment”.
Mr. Morris’s argument was that something that ridiculous should not have worked at all.
The scheme worked when the IRS matched the withholdings claimed in the tax returns to the Forms 1099-OID and paid refunds after being fooled into believing that more taxes had been withheld than required. For his services, Morris charged a modest fee, but requested 1% of the refund from two clients and actually received that amount from one of them. In total, Morris prepared Forms 1099-OID and returns for himself and 20–25 clients requesting $21,166,468.00 in refunds. The IRS mistakenly paid $2,299,775.26…..
In closing, Morris argued that the IRS had unfairly targeted him because of its anger at having paid out public funds: “They aren’t happy that they used our money and paid Mr. Armstrong a lot of money. They’re not happy about it.”
In the appeal, Mr. Morris argued that the prosecutor’s response to that statement was prejudicial.
If they get the money … they rationalize it and say, you know what? I am owed that money…. they say, you know, it’s the IRS. They’re a big organization. It’s their mistake. They should go after the banks anyway. So they rationalize it that way. They say to themselves, all I did was get one over on the man.
Well, ladies and gentlemen of the jury, the man is you. The man is you. The man is me. The man is all of us. And what these people are doing at the end of the day is trying to get one over on us.
The Court found that the prosecutor’s statement was not improper.
Considering the government’s statements in context here persuades us that they weren’t improper. Importantly, twice in his closing argument—which of course preceded the government’s rebuttal argument referencing “the man”—Morris blamed the IRS for any mistaken use of “our money.”
OID Fraud – The Rationale
The rationale for the OID fraud is really wackadoodle. Here is one of the sites that explains it. The underlying theory is that the government has “strawman” bank accounts for all its citizens that were first created in 1933 when the country went off the gold standard. Here is how one sited advocating the technique explains it:
1099 OID Process:IRS works for creditors. IRS has forms that allow you to be a creditor and acquire funds that are in escrow. An outstanding balance, for instance, on an American Express card is in escrow. The funds are there – you just have to tell the IRS with the proper tax filings to access those funds and pay that guy off with them or return those funds to me.You can OID any funds that go out of your bank account – and get them back. Acquire escrow funds with a 1099-A.If you file a 1099-OID as Recipient, those get reported on a 1040 if you want to get the funds returned.1099-As don’t get reported; neither do OIDs when you’re the Payor. i1040 is available on the IRS website; it gives line by line instructions for the 1040.
When Your Co-defendant Is Constitutionally Challenged
Mr. Morris’s complaint was that his co-defendant, Richard Armstrong, was still drinking the Kool-Aid, spouting statements like:
Good morning, ladies and gentlemen of the jury. I conditionally accept these proceedings on proof of claim that I am not here today as the paramount security interest holder in all property and collateral, both registered and unregistered, belonging to Richard Armstrong appearing specially, not generally, and on proof of claim that there is not a notice before this Court to continue this public proceedings pending completion of the ongoing private administrative record which, when completed, will have the likelihood to set off, settle, and resolve this matter without wasting valuable public resources.
I now move this Court to continue these proceedings, these public proceedings, for 60 days to resolve the matter privately. Thank you.
Morris might have had a point. With a co-defendant like that who needs a prosecutor? That argument also got him nowhere.
…..the record shows that the district court minimized any prejudice to Morris that may have resulted from Armstrong’s self-representation. Apart from silencing and disciplining Armstrong when appropriate, the court gave limiting instructions.See Zafiro , 506 U.S. at 540 (“imiting instructions, often will suffice to cure any risk of prejudice.”). The court instructed the jury that it could decide the case based only on the evidence, that statements by counsel and Armstrong (including opening statements and closing argument) weren’t evidence, and that in reaching separate verdicts the jury was to consider the evidence against each defendant.
Why OID?
I learned the basics of what goes into OID computations when I was getting a master’s degree in applied mathematics, but that probably makes it sound a little harder than it is. Just remember (1+r)^t. As a matter of fact, with excel you don’t even have to remember that anymore, but I still use it. I found though that it was pretty tough to find a staff person to work on the OID computations that a client of mine generated. Remember the population I was drawing from had at least bachelor’s degrees in accounting and had grown up using computers. It really seems that people for whom present value concepts become intuitively obvious are rather rare. This is what may account for the wackadoodle redemption theorists latching on the OID form, since they are constitutionally incapable of understanding what OID actually is and will not find too many people who are able to explain it to them. What is really sad is that the IRS systems were so porous that the technique often worked on a superficial level.