DOJ’s Prosecution Of Health Care Exec Illustrates Unique Intersection Of Securities & Employment Tax Fraud Schemes

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In a recent criminal prosecution of a medical doctor/entrepreneur for defrauding his company’s shareholders, the government employed a novel theory of securities fraud premised, in part, upon the defendant’s failure to pay federal employment taxes withheld from his employees’ wages. The government alleged that the defendant, Sreedhar Potarazu, an ophthalmic surgeon licensed in Maryland and Virginia, made repeated false statements to shareholders about the financial condition of VitalSpring Technologies Inc., a company he founded, including concealing the fact that the company failed to pay more than $7.5 million in federal employment taxes. Ensuring that companies are fully compliant with their employment tax obligations is one of the top priorities of the Justice Department and Internal Revenue Service, and this case stands as a rare example of the confluence of the federal securities and employment tax laws.

Potarazu served as the company’s chief executive officer and also served on its board of directors. The government alleged that from at least 2008, Potarazu provided materially false and misleading information to VitalSpring’s shareholders to induce more than $49 million in capital investments in the company. According to the government, Potarazu induced investments from shareholders by making false representations, concealing material facts, and telling deceptive half-truths about VitalSpring’s financial condition, tax compliance, and alleged imminent sale. Potarazu represented on numerous occasions that VitalSpring was a financially successful company and that a sale of VitalSpring was imminent, which would have resulted in profits for shareholders. Potarazu concealed from shareholders that VitalSpring failed to account for and pay over more than $7.5 million in employment taxes to the IRS. Potarazu provided false corporate income tax returns to some shareholders that overstated VitalSpring’s income and omitted the accruing employment tax liability. From 2011 to 2015, in addition to his salary paid by VitalSpring, Potarazu diverted at least $5 million from the investors and VitalSpring for his own personal use.

Between 2007 and 2016, VitalSpring accrued federal employment tax liabilities of more than $7.5 million. The company withheld taxes from VitalSpring employees’ wages, but failed to fully pay over the amounts withheld to the IRS. As chief executive officer, Potarazu was a “responsible person” obligated to collect, truthfully account for, and pay over VitalSpring’s employment taxes. According to the government, ultimate and final decision-making authority regarding VitalSpring’s business activities rested with Potarazu. Potarazu was aware of the employment tax liability as early as 2007 and between 2007 and 2016, was frequently apprised of VitalSpring’s employment tax responsibilities by his employees. In addition, IRS special agents interviewed Potarazu in 2011 and informed him of the employment tax liability. In all but one quarter between the first quarter of 2007 and the last quarter of 2011, as well as the second and third quarters of 2015, Potarazu failed to file VitalSpring’s Employer’s Quarterly Federal Tax Return (Forms 941) with the IRS. Potarazu also failed to pay over any of the employment tax withheld from VitalSpring’s employees’ wages in all but one quarter between the second quarter of 2007 and the third quarter of 2011, as well as the third and fourth quarters of 2015. Between 2008 and 2015, instead of paying over employment tax, Potarazu caused VitalSpring to make millions of dollars of expenditures, including thousands of dollars in transfers to himself and others, the publication of his book, a sedan car service, and travel.

Potarazu eventually pleaded guilty to one count of securities fraud and one count of failing to account for and pay over federal employment taxes. In his guilty plea, Potarazu acknowledged that he provided materially false and misleading information to his company’s shareholders to induce further capital investments, including concealing the fact that the company had accrued a multi-million dollar tax liability as a result of unpaid employment taxes. On July 19, Potarazu was sentenced to nearly ten years in prison, and ordered to pay $49.5 million in restitution to shareholders and $7.6 million to the Internal Revenue Service. He was also ordered to forfeit several homes, vehicles, and bank accounts.

Aggressive criminal and civil enforcement of the federal employment tax laws has been a top priority of both the Justice Department and the IRS for the past several years. Amounts withheld from employee wages represent nearly 70% of all revenue collected by the IRS. According to a recent report from the Treasury Inspector General for Tax Administration (TIGTA), as of December 2015, 1.4 million employers owed approximately $45.6 billion in unpaid employment taxes, interest, and penalties. The Justice Department’s Tax Division reports that as of June 30, 2016, more than $59.4 billion of taxes reported on quarterly federal employment tax returns remained unpaid. Employment tax violations represent more than $91 billion of the “Tax Gap,” which measures the difference between the total amount of tax owed to the U.S. Treasury and the amount actually paid. During fiscal year 2016, employment tax investigations were one of the few categories of tax crimes for which IRS-Criminal Investigation initiated more investigations than in the prior fiscal year.

Employment tax schemes can take a variety of forms. Some of the more common schemes include employee leasing, paying employees in cash, filing false employment tax returns, failing to file employment tax returns, and “pyramiding.” Pyramiding refers to the practice of withholding taxes from employee wages, but failing to remit such taxes to the IRS. After the employment tax liability accrues, the business owner starts a new business and begins to accrue employment tax liabilities anew.

In securities fraud cases, the government often charges that a company’s books and records are manipulated in order to falsely inflate revenue and earnings. For example, in United States v. Hyunjin Lerner (S.D. Fla. Mar. 29, 2017), the indictment alleged that the defendant and his co-conspirators engaged in a complex accounting fraud, utilizing unsupported expense accruals, improper accounting entries, misclassification of expense items, and false revenue items, in order to boost the company’s revenue and earnings. Similarly, in United States v. Joseph A. Kostelecky (N. Dakota Jan. 6, 2017), the defendant was charged with securities fraud in connection with an alleged scheme to artificially inflate his company’s revenue based upon the booking of revenue from oil and gas contracts, where such contracts did not exist or the revenue from such contracts was not collectible. In United States v. Brian Block (S.D.N.Y. Sept. 8, 2016), the indictment charged the chief financial officer of a publicly-traded real estate investment trust with securities fraud in connection with his alleged fraudulent inflation of a key metric used to evaluate a REIT’s financial performance in filings made with the Securities and Exchange Commission.

In securities fraud cases alleging materially false and misleading statements, it is rare for such statements to involve a company’s general tax compliance. Even more rare are cases involving false statements about a company’s employment tax compliance.  Indeed, the Potarazu case may be the first securities fraud case to allege that shareholders and investors were misled about a company’s employment tax compliance. With the intense focus now being paid to employment tax enforcement by the Justice Department and Internal Revenue Service, we may well see more cases, like Potarazu, where securities fraud schemes and employment tax fraud schemes are intertwined.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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