You wake up out of a sound sleep. You look over at your clock. It’s three o’clock in the morning. Your heart is pounding. Your entire body is trembling. Beads of sweat are rolling down your forehead, and it has nothing to do with the ambient temperature inside. You know this feeling. You’ve felt it before.

Your mind begins to race. Before you know it, you’re now daydreaming back to that day three months ago – the day when you got that dreaded call. For you, it was a day that will live in infamy. That one call, barely a minute long, has single-handedly caused an untold amount of anxiety and countless sleepless nights. It’s funny how the mind works – always reliving the past, as if it can somehow be altered. And while it is of course possible to learn from past mistakes, all that this exercise has succeeded in doing is conjuring up bad memories that you’d rather suppress into the deep recesses of your mind. At the same time, it has caused you to be critical of yourself and second-guess decisions that you made earlier.

Right about now, you’d gladly submit to the “rack and screw” method than allow another fleeting thought about this dark episode pass through your mind. Indeed, medieval torture might be more bearable than enduring this mental torment. However, not unlike other sleepless nights, your mind refuses to quit. And it is now fixated on the question: “How did this happen?” Your mind drifts back to that day ten years ago when the Cashcows walked into your office.

You are the tax preparer for Mr. and Mrs. Cashcow. Mr. and Mrs. Cashcow own the “Gold Cow,” a family restaurant located outside of Milwaukee. The couple has a checking account with their local bank, Valley National Bank, and a payroll account at the same bank. All receipts from the restaurant are deposited into the checking account, and transfers are made from the checking account to the payroll account to pay wages and employment taxes.

The Cashcows had no other income outside of the restaurant business for most of their lives. However, in later years, they opened a securities account with a discount brokerage firm. That account generated small amounts of interest and dividends, which the Cashcows reported.

You’ve been preparing the Cashcows’ individual income tax returns for the last ten years. Your practice is to review the restaurant’s bank account statements and returned checks to determine the income and deductions for the Golden Cow, which you then report on Schedule C of the Cashcows’ individual income tax returns.

As a means of verification, you reviewed the restaurant cash register tape in order to compare the total receipts of the restaurant to the deposits in the bank account each year. Mr. and Mrs. Cashcow gave you the dividends and interest from the brokerage account each year, but not the brokerage account statements.

While sitting at your office one afternoon, you get a call from Diligent Dan, an IRS civil examiner. Dan congratulates you and informs you that the Cashcows’ 2012 income tax return was selected for civil examination.

You contact Mr. and Mrs. Cashcow to give them the exciting news. There is dead silence on the other end of the line. That silence is followed by heavy breathing and panting. Mr. Cashcow is the first one to talk. He says, “there is something that we forgot to tell you.”

Continuing, Mr. Cashcow says, “You recall that securities account that Sally and I have? Well, from time to time over the years, Sally and I took small amounts of cash from the cash register to pay for personal items and to pay vendors. We didn’t take very much in the beginning. However, as Sally and I approached retirement, we began to keep more and more of the cash out of the cash register. And, well, we sort of deposited the money that we ‘skimmed’ from the Golden Cow into our brokerage account.”

Your heart drops. It didn’t take long for you to realize that this audit would be unlike any other. Indeed, it was going to be an “egg shell audit.” An eggshell audit arises when a taxpayer who has filed one or more false returns in previous years is selected for audit. The eggshell analogy is used to illustrate how this examination can go from being civil to criminal at the drop of a hat. Indeed, civil audits are one of the primary sources of referrals to Criminal Investigations (CI).

What makes eggshell audits ever so delicate is the fact that the taxpayer’s criminal problems are largely unknown to the IRS at the start of the audit. The diligent practitioner will have done his homework and ascertained that there is a problem and the parameters of the problem. The strategy then becomes damage control.

There are three potential outcomes in an eggshell audit:

(1) The examiner may never notice the criminal problem on the return. In that case, the taxpayer is never presented with the dilemma of responding to that issue. The examiner will close the audit with such civil recommendations as he thinks appropriate.

(2) The examiner may spot the sensitive issue, but the taxpayer’s representative is able to convince the examiner that the case is best resolved civilly and that the taxpayer’s conduct does not warrant a referral to Criminal Investigations (CI). The role of the unseen Fraud Referral Specialist must be considered at every step!

(3) The examiner determines that the case has sufficient criminal potential and refers it to CI. This can happen anytime during the audit process, but it often happens toward the end when the agent analyzes what he has and confers with the fraud referral specialist. In this situation, the representative must make sure that the taxpayer does not do anything during the course of the investigation to exacerbate his problems.

The following posts will highlight eight tips for surviving an eggshell audit:

Next:  Tips #1 And #2 – Establish Your Priorities And Communicate Them To Your Client, and Don’t Make Your Client’s Problems Your Own

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