One of the most frequent disputes in IRS audits is whether the taxpayer had unreported income. This is income that the taxpayer failed to report on his or her income tax return. This typically involves cash a business or service provider received from clients. It may also include non-cash deposits into financial accounts.
This “income probe” is one of the first things IRS auditors are trained to check.
The IRS will often do a bank-deposit analysis or, absent records, use a net worth method for estimating the amount of income the taxpayer received. The taxpayer then has to do their own analysis to rebut the IRS’s contentions.
If the unreported income ends up being litigated in court, the taxpayer will often have to hire a forensic accountant to reconstruct and testify as to the taxpayer’s income. The recent United States v. Buhla, No. 1:19-cr-01631-DHU (D.N.M. 2022) case provides an opportunity to consider when a court will allow a party’s forensic accountant to testify as to their opinion as to the income a person or business received.
Facts & Procedural History
This is a case involving the parties that operated a Best Choice Inn hotel. The hotel was owned by a legal entity owned by one of the individuals who operated the hotel. They also operated the hotel via their own single-member LLCs.
The government arrested the operators and charged them with, among other things, money laundering. According to the government, the Defendants allegedly ran a sex and drug trafficking enterprise at the hotel under the pretense of being legitimate owners, managers, and employees.
The case focused on the activities and deposits to the business checking accounts.
The defendants intended to introduce the expert testimony of a forensic accountant. She was to testify as to Best Choice Inn’s books and financial records and police practices and interviews, false confessions, and vice investigations, including prostitution and human trafficking.
The court’s opinion addressed the Motion to Exclude Expert Testimony.
The Frye & Daubert Standard
The opinion as to factors or events of so-called “lay experts,” i.e., those who are not experts, cannot be admitted into evidence in a court proceeding. Only experts can testify as to their opinion as to facts or events that require special knowledge. These rules prevent parties to litigation from influencing the judge or jury by putting on suspect testimony.
The courts have long applied the Frye standard, from Frye v. United States, 293 F. 1013 (D.C. Cir. 1923), in deciding whether to admit expert opinions. The Frye standard focuses on whether the methods employed by the purported expert are accepted by other experts.
The Frye standard was largely replaced by the Daubert standard, from Daubert v. Merrell Dow Pharmaceuticals Inc., 509 U.S. 579 (1993). The Daubert standard is more nuanced and focuses not on whether the methods are accepted by others, but on whether the methods are based on scientific principles.
Federal Rule of Evidence 702
The Federal Rules of Evidence were modified to conform to the Daubert standard.
The admissibility of expert testimony is governed by Federal Rule of Evidence 702 and prior case law that describes the Frye and Daubert considerations can help provide insight but have been overruled if they conflict with FRE 702.
FRE 702 provides that a witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if:
- the expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue;
- the testimony is based on sufficient facts or data;
- the testimony is the product of reliable principles and methods; and
- the expert has reliably applied the principles and methods to the facts of the case.
The evidence also has to be relevant to be admissible.
The “Expert” Requirement
This brings us back to this case. The defendants intended to introduce the expert opinion of a forensic accountant. The government objected to her being an expert on the subjects at issue in the case.
The court considered the forensic accountant’s credentials and background:
Ms. McHard is the founding partner of McHard Accounting Consulting, LLC, a position she has held since 2009. She holds a Bachelor of Arts and a Master of Business Administration from the University of New Mexico. After completing her studies, Ms. McHard then spent twelve years working in financial firms, where she held positions such as staff accountant, auditor, and senior manager. She is a Certified Public Accountant (CPA), a Certified Fraud Examiner (CFE), a Master Analyst in Financial Forensics (MAFF), and Certified in Financial Forensics (CFF). She is also a Private Investigator and a Chartered Global Management Accountant. She is part of at least 11 professional associations and committees such as the American Institute of Certified Public Accountants and Association of Certified Fraud Examiners and she has given scores of professional speeches. In addition, she has also authored or coauthored at least seven texts that have been published in industry-specific papers such as Fraud Magazine, The Champion, and other professional publications. Ms. McHard has participated as an expert witness at least several dozen times.
Given this background, the court concluded that the accountant could testify about the topics of forensic accounting, record reconstruction, tracing of transactions, revenue collection and reconstruction, and like topics.
The court concluded that she could not testify as an expert on the topics of sex trafficking and narcotics.
Relevance & Reliability
The forensic accountant concluded that the defendant’s deposited all of their illegal income into their bank account. This income was allegedly $130,000 over a seven-month period. Presumably, the defendants wanted to introduce this evidence to show that its normal hotel operations would have produced this amount of income and, therefore, there was no evidence of illegal income or money laundering.
The court considered the forensic accountant’s methodology:
Ms. McHard began by noting that she has reviewed case-facts and documents, and then described the Best Choice Inn’s paper bookkeeping system of tracking room rentals on index cards and tracking payments that were then reported to Mr. Bhula’s accountant for tax preparation. Ms. McHard stated that common “red flags” of illicit trade are currency not being deposited into a bank and cash not being reported. Mot. Hr’g. Tr. at 83:4. To test for these red flags, Ms. McHard relied on a fraud examiners manual and an IRS field guide, and then analyzed transactions specified in the Superseding Indictment by creating a spreadsheet that compared the Best Choice Inn’s revenue to bank account deposits. She determined that, with one exception, the Best Choice Inn’s currency was deposited into a bank account.
The court concluded that the factual support and her experience were sufficient to allow the testimony of her reconstruction of the hotel’s books.
While this is not a civil tax fraud case, the same rules apply to civil tax litigation. FRE 702 allows the court to admit expert testimony as to reconstructed books and records. As in this case, this testimony can be used to establish the amount of income the taxpayer received. For disputes in the federal courts, such as the U.S. Tax Court, this type of evidence can rebut testimony by the IRS agent who performed a bank deposit or net-worth method estimation. This case shows that to be admissible, the expert has to qualify as an expert and the testimony has to be based on records and reliable methods.