Originally published on Forbes.com on June 26th, 2012
In my mind a tax plan that ends you up in any sort of court, even Tax Court, even if you win, is not that great a plan. To win in Tax Court, you have to have lost on the audit, lost on appeal and then lost on appeal a second time, all of which is pretty expensive. If you lose in Tax Court, that is really bad and really expensive, but it is not as bad as it can get. An illustration of how bad it can get is the recent Seventh Circuit decision in the case of John Psihos. Mr. Psihos was appealing his two year prison sentence and restitution order in the amount of $837,724. He lost.
The case concerned the operation of Flanagan’s Bar in Chicago. Flanagan’s was the most thriving of the three restaurants that Mr. Psihos is involved in. Around 2005, he explored selling Flanagan’s going so far as to have it advertised. A couple showed significant interest in the place and met with him three times. Mr. Psihos’s tax saving plan was elegant in its simplicity. He simply did not report his entire gross income. Besides not being a legitimate strategy, the plan has another flaw. If you decide to sell the business, it will not appear to be worth nearly as much as it really is. Mr. Psihos addressed that contingency by keeping extremely detailed records of his actual cash receipts. He told the couple that he had the records that showed what he was “actually getting”.
As it turned out the couple was not actually interested in buying Flanagan’s, although they were rather interested in the records of what the actual receipts were. The couple was actually a pair of undercover IRS criminal investigators. Before long the records were seized and used as evidence to show that the receipts of Flanagan’s had been understated by roughly $2.5 million between 2001 and 2004.
The essence of Mr. Psihos’s appeal was that the tax loss that formed the basis of his sentence and restitution was overstated. There is this subtle distinction between tax loss for purposes of sentencing and tax loss for purposes of restitution. One is based on what you were trying to evade and the other on what you actually succeeded in evading. Mr. Psihos tried to argue that a large portion of the unreported receipts were spent on deductible expenses. The Court did not buy the argument for either sentencing or restitution:
First, there is absolutely no basis to determine the amount of purported cash payments because, even under Psihos’s version of events, he did not keep track of the various claimed outlays. Second, and relatedly, if Psihos had truly shifted cash to Café Oceana—the largest reduction he seeks—then he would be entitled to a reduction in restitution only if Café Oceana had reported those cash inflows as revenues; yet Psihos lacks the corresponding records from Café Oceana showing its receipt of those funds, and in turn its reporting the money as revenue to the IRS. Third, Psihos kept no record of the cash payments to bouncers and promoters, which in turn creates a near certainty that the government suffered a loss of taxes owed by those recipients.
Mr. Psihos claimed the tax loss was just over $20,000. I was really intrigued by the gap, so I thought I would run the case by my friend James. James has had a career a lot like mine, although it was a bit bumpier. He tends to speak his mind in circumstances where prudence might dictate silence. He is straight as an arrow, although you might not guess that from the way he talks sometimes. He has some friends who are a bit on the sketchy side though.
Me: So what is your gut feel ? Did he evade 20 grand or 800 grand ?
James: I think it has to be somewhere in between. The case reminds me a little of somebody Louie the Louse wanted to refer to me. I’ll call the guy Joe. He was from ———
Me: “The old country” ?
James: Yeah right the old country. Anyway you know how they are in the old country.
Me: They are a proud people, who stick together, have tight knit families, respect their elders and work very hard.
James: Right. And they hate to pay taxes. Anyway there were some old country guys in__________
Me: The big city ?
James: Right the big city. They loaned Joe some money to start this retail operation. Of course they didn’t want any 1099-INTs, so he couldn’t deduct the interest that he was paying them. And then there were all the cousins and such.
Me: Fellow old country immigrants who did not have green cards no doubt.
James: Right. So he had to pay them cash. Then there is the cost of sales problem. You are skimming all this cash off the top your gross margin looks way out of whack.
Me: So you have to skim even more to pay for some of your goods with cash. Possibly the items that “fell off the truck”.
James: I swear the guy must have been skimming like $20,000 a month and I think he was probably overpaying his own taxes.
Me: So what did you do?
James: I told the guy I was real sorry, but I couldn’t help him. I know you can’t write what I told Louie the Louse he could do with his referrals.
Me: There are those awkward contributor guidelines.
James: Anyway the other thing I find a little funny is that if this guy Psihos was lying on his tax returns all those years, why would anybody think he was telling the truth when he was trying to get top dollar from selling the place ?
Me: So you think it he was hoist on his own petard ?
James: I’ve got a better way of putting it, but I know you can’t write it, so I’ll have to agree with you.
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