TO FILE OR NOT TO FILE AN AMENDED RETURN TO CORRECT AN ORIGINAL RETURN THAT HAS CRIMINAL TAX DIMENSIONS – THAT IS THE QUESTION

Your client has filed a fraudulent return underreporting his tax liability. He now has misgivings. He comes to you and expresses great concern. What should you do?  This is a continuation of Part 1 that was posted October, 2, 2013.

EGGSHELL AUDITS: KEEPING THE SHELL OF THE EGG FROM CRACKING WHEN THERE ARE CRIMINAL TAX ISSUES

In an “eggshell audit,” you must walk on eggshells to represent your client effectively in the civil examination without exposing the fraud, all the while honoring your duties to the tax system not to mislead the revenue agent. Although it is theoretically too late for disclosure once the civil examination has begun, the practitioner might still be able to obtain a reasonable level of assurance from the revenue agent that he will not refer the matter to CI, so that disclosure of the fraud will not result in a referral for criminal investigation.

There are many instances in which disclosure to the agent may be the best option. For example, if the taxpayer has failed to pay income from foreign bank accounts, the IRS may be willing to allow the taxpayer to disclose the problem, pay a reduced penalty, and move on without a criminal referral. In other cases, you may be convinced that it is not a matter of “if,” but “when,” the revenue agent will uncover the fraudulent item. In that case, the best strategy might be to disclose the error in the hope that by correcting it, any evidence of willfulness will be substantially undermined.

It should come as no surprise that special agents have more cases to work than they can handle. Therefore, they are more inclined to drop cases in which the taxpayer has disclosed the item and paid all appropriate taxes and penalties. This strategy often requires the taxpayer to be transparent and to fully disclose in order to convince the agent that he is acting in good faith and deserving of such grace.

Assuming that the civil examination will proceed without a full disclosure by the taxpayer, priority number one is to limit the contact between the agent and the taxpayer. This is good practice even if the case has no criminal overtones. Ask the agent to make all requests for information through you. It is even better to ask the agent to make all requests in writing so that there is no confusion about what the request was and whether the response was truthful or misleading.

Ultimately, if the agent is unrelenting in demanding an interview with your client, make sure that he is prepared to answer honestly or to assert the Fifth Amendment when appropriate. You should remain vigilant at the interview to prevent the client from accidentally answering questions for which the privilege should be asserted.

The most critical task for the practitioner is to “audit” the agent. In tax parlance, that means tracking the investigation to keep on top of what the agent knows. During the civil phase of an investigation, revenue agents must notify the taxpayer before contacting third parties and must keep a record of third parties contacted. And section 7609 requires that the IRS notify the taxpayer of summonses issued to third parties. That notice requirement applies only in the civil examination phase and not in criminal investigations.

Much to the chagrin of the meticulous tax practitioner who is attempting to track every move of the revenue agent, the IRS can obtain information from third parties without compulsory process. Under what circumstances can this happen? When a witness voluntarily provides information to the revenue agent without a third-party summons. In that case, the information has likely been stored in the file, and will remain so until requested by the defense.

That possibility presents somewhat of a challenge for the practitioner. Only by interviewing and establishing a good relationship with witnesses in advance does the practitioner stand any chance of learning about these conversations. The practitioner should go one step further and ask the witness to call him if he or she is contacted by the IRS. Only by tracking the agent’s activities will the practitioner know what the agent knows.

It is important in this process to keep in touch with the agent. The practitioner can learn a lot, even if the agent does not specifically say that he suspects fraud or is in the process of transferring the matter to CI. However, never forget the lesson learned from cases like Kontny and its progeny: Revenue Agents can affirmatively mislead the taxpayer and his representative, but generally are discouraged from doing so.

The careful and experienced practitioner can often sense when the audit has turned criminal just as the antelope can sense – from a distance – the arrival of their natural predator, the lion. One of the classic indicia of a referral to CI is when the civil audit turns quiet. Civil examinations are conducted on a time line, which may vary from case to case, but if the audit is not progressing, the practitioner needs to know why. Often, it is because the agent is swamped with other work, is out of the office for training, or has been transferred.

But inactivity can also mean something else – even more sinister than an innocuous training event. In fact, it may mean that the civil agent has referred the case to CI. It is for that reason that when the civil audit turns quiet, the practitioner should touch base with the agent or his supervisor just to find out what is going on. In doing so, the practitioner must be careful not to tip the agent that he is overly concerned about it.

After the revenue agent has finished working on the case, it can take one of two directions. First, the agent may not believe the case to have any criminal overtones, in which case he will close the audit with such civil recommendations as he deems appropriate. Alternatively, the agent may determine that the case has sufficient criminal potential such that it should be referred to CI. Although the IRM requires that the agent refer the case to CI when he has a “firm indication of fraud,” agents are taught to consult with their managers and/or a fraud referral specialist to review the fraud potential in an examination. Thus, although a referral can occur anytime during the civil examination phase, it usually happens near the end.

THE CRIMINAL REFERRAL

A criminal investigation conducted by the IRS is different from a civil investigation. Criminal investigation of taxpayer returns or fraudulent activity is conducted by the Criminal Investigation Division of the IRS (CI). CI is the heavy artillery of the IRS arsenal. It is used in only a small percentage of cases, but its impact can be devastating. It can bring personal, social and financial ruin, loss of professional licenses, huge monetary fines, and incarceration.

I. BADGES OF FRAUD

The largest source of criminal tax investigations is none other than the Examination Division of the IRS. The IRM provides detailed instructions to Revenue Agents and other Examination personnel for when to suspect that tax fraud has been committed. The IRM identifies various badges of fraud, organized categorically as to income, expenses, books and records, taxpayer conduct, and methods of concealment.

There are both substantive clues and behavioral clues. Substantive clues include large unexplained increases in net worth and excessive deductions. Behavioral clues include procrastination, failure to cooperate, quick agreement to adjustments, undue concern about closing the case quickly, concealing or destroying records, and transferring assets. Obviously, great care is needed in applying this guidance since, read expansively, one or another badge of fraud arguably would exist in most, if not all, civil audits.

II. SIGNS OF A CRIMINAL REFERRAL

Often you won’t know that an IRS criminal investigation has started until it is too late. But sometimes there are “warning signs.” Below is a list of events that suggest that the revenue agent may be considering a referral to the criminal investigation division:

(1) Undue Interest: The agent shows an undue amount of interest in a sensitive transaction.

(2) The Disappearing Agent: A revenue agent who has been pressing you for payment suddenly disappears or won’t return your calls. If the agent states that he will be away “in training” for a month or more, this often may be an excuse to buy time for the criminal referral to be considered by CI.

(3) Bank Records Analysis: Your bank notifies you that CI (using a summons), or the local U.S. Attorney’s Office (using a grand jury subpoena), has requested copies of your bank records. The agent examines in great detail those records that can be used to impeach items reported on your return.

(4) Questions on Intent: The agent poses questions that focus on your intent. For example, the agent asks questions specific to what you knew or who gave you the instructions to take certain positions.

(5) The Winning Lottery Ticket: The IRS notifies you that one of your previous tax returns has been “selected” for audit, and you know that in the tax year in question there was an understatement of income or an overstatement of deductions.

(6) A special visit: A Special Agent contacts you.

III. STANDARD FOR REFERRAL TO CI

The manual instructs agents to refer a case to CI upon discovery of “firm” indications of fraud. See I.R.M. § 25.1.2. The manual also indicates that the taxpayer’s representative should not be told that the referral has been made.

When the Revenue Agent observes indications of fraud, he typically discusses the matter with his superior: the Group Manager or equivalent. They will then seek the aid of an IRS Fraud Referral Specialist, who is in the same division of the IRS and so is easily accessible to the agents.

These officials will formulate a plan, if needed, to resolve any gaping holes in the development. If they conclude that there are “firm indications necessary for a successful fraud case,” the case will be referred to CI. Typically, the acceptance rate for such referrals is around 50%.

RETRIAL OF DAUGERDAS IN TAX SHELTER SCHEME IN FULL SWING

The retrial of former Jenkens & Gilchrist partner Paul Daugerdas in an illegal tax shelter prosecution is underway. Mr. Daugerdas and former BDO Seidman Chief Denis Field are accused of marketing and giving legal cover for tax shelters that had no economic purpose except to avoid taxes.

Field, Daugerdas, and two others, Donna Guerin, a former partner at Jenkens & Gilchrist and former banker Davis Parse of Deutsche Bank, were convicted in the scheme in 2011. Judge Pauley granted a retrial for Daugerdas, Field, and Guerin because of juror misconduct by Catherine Conrad, a suspended lawyer who lied about her identity and criminal history during voir dire.

Guerin elected not to have his case retried, instead taking a plea deal earlier this year. He was subsequently sentenced to eight years in prison. But Daugerdas and Field pressed on. Daugerdas is represented by Henry Mazurek of Clayman & Rosenberg. The U.S. Attorneys handling the prosecution are Stan Okula, Nanette Davis, and Niketh Velamoor.

In accordance with Circular 230 Disclosure