The National Law Review recently featured an article by Paul L.B. McKenney of Varnum LLP regarding Cash Business Owners in Michigan:
The proverbial “second set of books” cat and mouse game with taxing authorities now reflects the fact that most point-of-sale, or POS, bookkeeping is done electronically. Michigan recently joined numerous other jurisdictions by enacting tax enforcement spawned legislation making the sale, purchase, installation, transfer or mere possession of any “zapper” software subject to a felony. Zappers are also known as automated sales suppression devices. Michigan’s statute contains a mandatory minimum of one year incarceration and severe monetary sanctions. See MCLA § 750.411w. The statute defines a zapper as a software program, however accessed or possessed, that “falsifies the electronics records of electronic cash registers and other point-of-sale systems, including, but not limited to transaction data and transaction reports.” MCLA § 750.411w(4)(a). In essence it creates a second set of books, albeit electronic. While the sole purpose of zappers is tax evasion, the prosecution does not have to prove intent, merely use, sale or possession. The zapper software is typically run off a USB thumb drive rather than residing on the computer’s hard drive to avoid leaving evidence of its use. However, as noted below, there is a readily identifiable electronic trail. Zappers have been quietly marketed by freelancing IT types and certain cash register sales people.
A not uncommon example illustrates what a zapper does. Assume a restaurant or other cash receipts business grosses $250,000 per month and is highly profitable. A zapper software “entrepreneur” visits the restaurant early in the month and is told precisely what recorded cash bank deposits are as well as credit card charges totals by day. Alternately, the peddler may sell a USB drive and also provide needed technical support. Assume reported sales total $200,000 and there is $50,000 of unreported cash, or “skim.” The zapper software will quickly and accurately modify the sales records a) by transaction b) by day c) to the penny resulting in the credit card charges and cash deposits equaling what is reported on the books. Thus a traditional audit will find that everything appears to be in order, at least until someone finds evidence of the zapper.
Zappers represent significant lost sales tax and other tax dollars to states. For example, three years ago California estimated zappers at restaurants cost that state $2,800,000,000 in receipts and the corresponding New York estimate was $1,700,000,000. See “State governments target tax-cheating software,” Bloomberg Businessweek, April 3, 2012. In an era of record state fiscal problems, this is real money.
The recent Michigan legislation is effective as of August 29, 2012. It is patterned after another enforcement problem the Michigan Department of Treasury encountered and overcame, false cigarette tax stamps. The Michigan Treasury was hemorrhaging cash because of cigarettes that were brought in from out of state and counterfeit Michigan stamps were purchased on a flourishing underground market. The Department of Treasury urged the legislature to adopt legislation that the mere possession of cigarettes with counterfeit stamps required a minimum prison term. Legislation followed, the minimum mandatory jail time virtually ended the fake stamp problem overnight and Treasury receipts from cigarette taxes swelled.
Economic Sanctions Too
The zapper legislation has teeth. In addition to the one-year minimum mandatory term, there is a fine of up to $100,000. However, from a monetary perspective, there is another more costly provision with which requires disgorgement of “all profits associated with the sale or use of …” a zapper. In the above example, if the skim is $50,000 a month, then $600,000 a year is subject to forfeiture. The offending party is also responsible for all Michigan sales, withholding and other taxes, penalties and interest. These other levies include the corporate income tax and individual income tax. Typically cash businesses that use zappers, such as restaurants and retailers selling small dollar amount items, also pay employees all or some of their wages in cash “under the table” and/or purchase food or inventory.
Zapper programs originated in Europe and migrated first to Quebec in North America. They came from jurisdictions where there were value added taxes. The Internal Revenue Service has taken certain steps to target businesses that might employ zappers, and the State of Michigan has taken notice. It should be pointed out that Michigan’s vigorous criminal and civil penalty regime is separate and distinct from the Internal Revenue Service, which is also free to pursue the same individual and business. There is an exchange of information agreement between the Internal Revenue Service and the Michigan Department of Treasury.
Zapper’s Electronic Fingerprints and Enforcement
Those selling zappers to business owners tout that it leaves no electronic fingerprints, and thus is invisible to the IRS and other law enforcement agencies. That dog don’t hunt. The reality is that zappers leave telltale electronic fingerprints, and the IRS and other agencies have sophisticated criminal techies who can readily check a computer system and flag evidence of a zapper.
How have the IRS and Michigan uncovered businesses running zappers? A secret ceases to be secret when two or more people know about it. When the owner, the manager of a restaurant or store, the zapper software peddler and others, such as the controller or bookkeeper, key employees at the restaurant, at least one or more people at each location, etc. know about the zapper, only one needs to talk. Somebody may have reason to talk, such as a problem with the DEA, IRS, FBI or other law enforcement agency and will readily give up the business owner in exchange for no prosecution or a reduction in charges or sentencing. For example, a metro Detroit freelance IT salesman peddling zappers to bars and restaurants was discovered when a party with law enforcement issues named him. That salesman, in exchange for an extremely lenient sentence, in turn identified and cooperated with Federal law enforcement in prosecuting numerous customers for tax evasion. Some of his customers went to jail. The IRS and other federal and state agencies are seasoned veterans of how to play that game most effectively.
Reality
Those who raid businesses with search warrants typically take away computers, hard drives, USB thumb drives, and other hardware for inspection by highly sophisticated technicians. What does a cash business owner face if his or her business is raided by the State Police or other tax or law enforcement personnel and evidence that a zapper has been applied to the electronic books is uncovered? A plethora of problems. A short, non-inclusive list includes:
- The new Michigan legislation and its mandatory jail time and economic sanctions;
- Michigan criminal sanctions for various false returns as well as associated civil tax liabilities, fraud penalties and other penalties and interest;
- IRS criminal issues including, a five year evasion felony per year and a three year max for false statements on a tax return,
- Myriad IRS civil liabilities for income tax and payroll taxes and associated penalties as well as interest, compounded daily, and
- If there is fraud, then there is no civil statute of limitations in tax. The IRS and Michigan can and do go back many, many years.
In a well-publicized local zapper case, the owner of the LaShish chain of thirteen suburban Detroit restaurants and his wife were found by the IRS with zapper software that underreported over $16,000,000 in skimmed revenues. The owner was indicted on tax and other charges, is currently a fugitive living in Lebanon, his wife went to jail, and the government seized and sold the formerly prosperous restaurants.
Passive Business Owners & Entities With Multiple Locations
Owners are not the only ones who might want to skim, and use a zapper to hide it. A absentee owner as well as owners of multiple locations have two problems if managers or key employees use zappers to hide embezzlement. In addition to being the victim of the skim, the larcenous employee will tell the IRS and Michigan Treasury that the owner must have done it, and the owner has criminal and civil exposure. Such owners can protect themselves by unannounced electronic audits to determine if any zappers have been used. A telltale sign is that servers, per managers, need to be replaced with unusual frequency. That can well be an attempt to hide evidence of electronic tampering..
What To Tell Clients
Smaller business clients that have zappers are not going to boast about it to their counsel. You might pass along a proverbial word to the wise to cash business owners. This new zapper law is out there, it has teeth, and those who ignore it do so at their peril to both personal liberty and treasure. Also, as noted just above, beware of skimming employees.
© 2012 Varnum LLP
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