6th Circuit limits the use of illegal income sentencing enhancement for tax evasion

Decided on March 6, 2013, the 6th Circuit’s decision in The United States v. Smith further clarifies the limits to the “illegal income” sentencing enhancement for tax evasion.  In Smith, the defendant was convicted for a tax evasion scheme where he failed to report income earned from his insurance business.  The scheme was discovered by the IRS agent when he compared the tax returns filed by the defendant to un-submitted tax forms sent to a bank for the purpose of obtaining a loan.

The defendant’s sentence was increased for failing to report illegal income.  The defendant had been engaged in “rebating” which is a civil offense in Tennessee.  Rebating occurs when an insurance agent induces an individual to purchase a policy by promising to return to them a portion of the premium.  Rebating is considered an unfair trade practice in Tennessee, but it is not considered a criminal activity.  The defendant was found guilty by Tennessee regulatory authorities of rebating and revoked Smith’s license.

Since it was not considered illegal under Tennessee law, the defendant argued that it was improper to classify rebating as illegally obtained income and increase his sentence.  In response, the government argued that under federal law, rebating constituted wire fraud and was sufficient to qualify as illegally obtained income.  The government argued that the insurance companies would not have allowed Smith to sell policies had they known that he engaged in rebating, and this constituted wire fraud.

The District Court agreed and imposed the sentencing enhancement.  But the Appeals Court reversed, finding that the non-payments were insufficiently linked to the rebating conduct and insufficient evidence demonstrating that rebating qualified as wire fraud under federal law.  The 6th circuit was found that no authority supported the argument that rebating constituted wire fraud.  And even if rebating had qualified as wire fraud, there was not a sufficient finding relating the practice of rebating to the defendant’s unreported income.  Merely proving that the defendant engaged in illegal conduct in addition to evading his income taxes was not sufficient for the sentencing enhancement.  The court ruled that the illegal activity must be demonstrated to have generated the income that the defendant failed to report.

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