How to Identify a Potential Criminal Tax Matter Requiring an Attorney

Co-Editors: Steven F. Holub, CPA, MBA, and Kenneth M. Parker, CPA

IRS compliance employees are required to refer potential fraud matters to specialists within the IRS called fraud technical advisers (FTAs). An FTA is an experienced agent trained to assist the compliance employee behind the scenes in developing a plan of action to clearly establish affirmative evidence of fraud. The referral to an FTA is to be made when the compliance employee first sees any indications of fraud. Neither the taxpayer nor the taxpayer’s representative is notified of the referral. The plan of action is intended to develop a firm case for referral to Criminal Investigation before the taxpayer is aware that he or she is being investigated for fraud. Interviewing the taxpayer and/or the tax return preparer is a key component of this plan of action.

The indicators (badges) of fraud are listed by category in Internal Revenue Manual (IRM) Section 25.1.2.3. They include such conduct as omission of income; bank deposits from unexplained sources; concealment of bank and brokerage accounts; concealment of unexplained currency; failure to deposit receipts; substantial overstatement of deductions; false statements of material fact pertaining to an examination; failure to file required forms and returns; failure to maintain adequate records or maintaining more than one set of books; failure to make full disclosure of relevant facts to the accountant, attorney, or return preparer; and many more.

The IRM also advises that no single fact or circumstance by itself is a firm indication of fraud. There may be many reasons a return is not correct or that a taxpayer failed to file a required IRS form or make a required return. The U.S. Supreme Court has distinguished lawful conduct from an affirmative willful act of tax evasion. In Spies, 317 U.S. 492 (1943), the Court said, “[T]he law is complicated, accounting treatment of various items raises problems of great complexity, and innocent errors are numerous. . . . It is not the purpose of the law to penalize frank difference of opinion or innocent errors made despite the exercise of reasonable care.” On the other hand, an affirmative willful attempt to evade tax may be “inferred from conduct such as keeping a double set of books, making false entries or alterations, or false invoices or documents, destruction of books or records, concealment of assets or covering up sources of income, handling of one’s affairs to avoid making the records usual in transactions of the kind, and any conduct, the likely effect of which would be to mislead or to conceal” (emphasis added). This distinction is important because in cases were the law is not clear, such as tax shelter investigations and in certain collection investigations, misleading conduct is an important consideration in determining whether the IRS may view the matter as criminal.

In virtually every sophisticated criminal tax case with more than one defendant, the government also charges that the defendants conspired to obstruct the functions of the IRS by deceitful or dishonest means. This is the Klein conspiracy charge, the essence of which is obstructing the IRS in its audit or collection of taxes (see Klein, 247 F.2d 908 (2d Cir. 1957)). For example, in recent tax shelter cases, prosecution was based in part upon allegedly false statements made to the IRS during audits concerning profit motive and the business reasons for client investments (see, e.g., Coplan, 703 F.3d 46 (2d Cir. 2012)). In Beacon Brass, 344 U.S. 43 (1952), the Supreme Court held that a false statement to a revenue agent during an audit was a willful attempt to evade tax.

A problem for tax practitioners is that their investigation of underlying facts is not privileged if the IRS ultimately decides that the circumstances constitute a criminal matter. In that case, the practitioner’s investigation could be harmful to the client because the practitioner could be required to testify in response to an IRS summons or a grand jury subpoena. Under these circumstances, the tax practitioner may be compelled to reveal potentially harmful evidence in a criminal proceeding. This evidence would likely include discussions with the client that were believed to be confidential. These concerns also apply to an investigation of the underlying facts incident to a decision to make a voluntary disclosure respecting a foreign bank account.

This column discusses some of the circumstances where it might be appropriate to refer or involve an experienced criminal tax attorney and the importance of making a timely referral.

The Limits of the Tax Practitioner Privilege

Sec. 7525 provides a privilege for communications between a taxpayer and a federally authorized tax practitioner. Such communications are considered to be privileged as if made between a taxpayer and an attorney, under the same standards that apply to the attorney-client privilege. In general, this requires that the communications are made in confidence to obtain tax advice. It does not apply to tax shelters, to business or financial advice, or to information furnished to a preparer in connection with the preparation of a tax return. The work product doctrine may provide some protection to client communications.

However, the statute limits the scope of the tax adviser privilege to noncriminal matters before the IRS and to noncriminal tax proceedings in federal court brought by or against the United States. Because of this limitation, the statute is a trap for the uninformed. A tax practitioner may not know at the time he or she first sees an indication of fraud whether the underlying facts and circumstances, when fully known, will constitute a possible criminal matter. In these circumstances, where the necessity of privileged communications should be a paramount concern, there is no protection.

Not Every Omission or Failure Is a Criminal Matter

While a referral to an attorney should occur at the first indication of fraud, some judgment is required. In the everyday circumstances of a tax practice, a practitioner will learn facts that may require the client to amend a return or to file a delinquent form. As indicated by the Supreme Court in Spies, the tax law is too complex to assume that every omission or failure requires review by a criminal tax attorney. The challenge for the tax practitioner is to know the difference between a routine correction and a potential criminal matter.

It is helpful in these circumstances to understand what facts and circumstances might be selected by the IRS for consideration as a criminal matter. First, to establish a criminal case, the IRS must believe that it can establish by evidence beyond a reasonable doubt that the omission or failure arose from a willful violation of law, as opposed to a mistake or simple negligence. This requires the IRS to establish that the taxpayer had a specific intent to violate the law. Frequently, the taxpayer inadvertently admits that his or her conduct was intentional. For example, in McGill, 964 F.2d 222 (3d Cir. 1992), the court upheld the conviction of a self-employed attorney who admitted that, to avoid IRS levies for his past due taxes, he had stopped using his personal checking account and had begun using his wife’s account and a joint account with other lawyers. He admitted that he used these accounts “thinking that the IRS wouldn’t bother the money.”

Thus, the starting point for the IRS in a criminal investigation is early interviews of the taxpayer and the tax return preparer. IRS agents will want to establish that the taxpayer was specifically advised of the duty to do something or not do something. For example, the tax preparer might be asked whether the taxpayer was told to deposit all income to a business bank account or whether the taxpayer told the preparer that all bank accounts were provided. Or perhaps the inquiry might be: “Did you ask the taxpayer whether he has a financial interest in any foreign bank account?” The evidence must clearly show that the taxpayer was aware of the legal duty.

Second, a criminal matter ordinarily involves a pattern of three or more years and multiple returns. Absent the most egregious circumstances, it is unlikely that a single tax return would be selected by the IRS as a criminal matter. This is because one of the chief indicators of willful fraud is a pattern of conduct. A single act or omission may be entirely consistent with a mistake or negligence.

Third, a criminal case ordinarily involves a significant tax loss. This is because the Federal Sentencing Guidelines specify certain prescribed periods of probation or incarceration, depending upon the amount of the tax loss. For example, under current guidelines, the court may consider a defendant to be eligible for a sentence that does not involve incarceration, such as probation and home detention, where the tax loss does not exceed $30,000 and the defendant accepts responsibility for the offense (U.S. Sentencing Guidelines §2T4.1; §3E1.1; ch. 5, part A (2012)). Assuming that the government seeks general deterrence through sentences that involve some incarceration, one may surmise that a tax loss of less than $30,000 would not ordinarily be selected by the IRS as a criminal matter.

Accordingly, when deciding whether the circumstances involve a potential criminal matter, the practitioner should consider the complexity of the underlying applicable tax law. The practitioner should also consider the likelihood that the circumstances may involve a pattern of conduct extending over multiple years and a significant tax loss. The judgment about these facts should be made by a review of the existing file and from the practitioner’s overall knowledge of the client’s circumstances, without engaging in detailed discussions with the client.

Voluntary Disclosures

The IRS position on voluntary disclosures has evolved over many years. Before 1952, the IRS policy was essentially a grant of immunity. Taxpayers were assured that they would not be criminally prosecuted if they chose to fully disclose and promptly correct a past tax fraud before any civil or criminal tax investigation had begun. In 1952, the IRS discontinued this policy after congressional hearings concluded that there was corruption and laxity of enforcement in the implementation of the policy. After that, the IRS followed a practice of not recommending criminal prosecution where a taxpayer made a “timely” voluntary disclosure. A timely voluntary disclosure is one made before certain events have occurred. For example, the disclosure is timely if it is made before the taxpayer has been notified that the IRS intends to commence an examination or investigation. This means that the taxpayer’s desire to self-correct is not a defense if the past fraud is about to be discovered through a pending government action or by information furnished to the IRS by a disgruntled former employee or spouse (IRM §9.5.11.9).

While the IRS does not assure or guarantee immunity from criminal prosecution, it does not appear anyone has ever been prosecuted after making a full and timely voluntary disclosure. This requires a taxpayer to cooperate in the determination of the correct tax liability and to make good-faith arrangements to pay taxes, penalties, and interest in full.

The reasons for the policy are apparent. First, the tax system works much better if taxpayers voluntarily correct their past misbehavior, even criminal behavior. Voluntary correction is to be encouraged, especially where the IRS does not have the resources to prosecute everyone who has engaged in a particular pattern of criminal tax behavior. Second, a jury may consider the taxpayer’s voluntary corrective acts as evidence that the past failures were not willful but, rather, the result of negligence or other mitigating circumstances. In short, a jury may want to acquit someone who has voluntarily done the right thing before being discovered and has then promptly paid or made bona fide arrangements to pay all taxes, penalties, and interest.

The Offshore Program

In 2009, the IRS initiated a program of limited duration for taxpayers with undisclosed reportable foreign accounts and entities to “eliminate the risk” of criminal prosecution and reduce applicable penalties by voluntarily disclosing them. The IRS offered a second voluntary disclosure program of limited duration in 2011 and followed this in 2012 with a third program with no set ending date. The offshore voluntary disclosure program could offer significant benefits for taxpayers who may have engaged in conduct that could be viewed as criminal. They will receive a clear assurance that they will not be prosecuted, and they can avoid the full brunt of civil penalties that otherwise could far exceed amounts concealed in offshore accounts.

However, the initiative differs from other IRS voluntary disclosure provisions in another, more troublesome way. In the past, a voluntary disclosure included the expectation of a full audit to determine the correct tax liability and appropriate penalties. There were no limitations on the taxpayer’s ability to offer mitigating evidence. That kind of audit is generally not possible under the program, and under the normal process IRS auditors are confined to a very limited review of information. This means that the taxpayer is not able to offer evidence that the prior failures to report were not willful but caused by inadvertence, negligence, or mistake. Evidence such as reasonable cause and the good-faith reliance on the advice of others will not be considered. It is a one-size-fits-all “package” deal.

For taxpayers with defenses or explanations, therefore, a voluntary disclosure under the program is problematic. They may be required to pay much higher amounts than they might otherwise pay if all of the facts and circumstances were taken into account. For example, the penalty assessed under the program is 27.5% of the highest aggregate balance in a taxpayer’s offshore accounts, although a limited number of taxpayers may qualify for a 12.5% or 5% penalty rate. Taxpayers must also pay accuracy-related penalties on their offshore-related underpayments of tax for all years and failure-to-pay or failure-to-file penalties if applicable. Currently, the IRS also requires the taxpayer to waive the limitation period and cooperate in an eight-year lookback for amended returns, with the taxpayer accepting liability for all taxes, interest, and the accuracy and/or delinquency penalty for the eight years. Once the taxpayer enters the program, these tax, interest, and penalty assessments are imposed unless the taxpayer elects to “opt out” of the program, with the IRS explicitly withdrawing the representation that it will not recommend criminal prosecution.

Recently, the IRS notified a number of taxpayers who had been accepted into the voluntary disclosure program and after they had disclosed potentially incriminating information that they were ineligible to participate since, according to its frequently asked questions on the disclosure programs, the IRS may announce that certain taxpayer groups that have or had accounts at specific financial institutions will be ineligible due to U.S. government actions in connection with the specific financial institutions (see FAQ No. 21, 2012 Offshore Voluntary Disclosure Program Frequently Asked Questions and Answers). That is apparently what happened in these cases.

This means that a taxpayer should carefully consider all ramifications of the “package” deal before entering the program. Most important, a determination should be made whether the underlying circumstances reflect past criminal behavior. Is there evidence that the taxpayer was aware of the duty to report the offshore accounts? Is there a pattern of misconduct extending over several years? Is there a significant unreported tax liability? Are there mitigating circumstances, including mistaken or negligent reliance on others? Because the IRS may view the circumstances as a criminal matter, this analysis should be made by an attorney, so that it remains privileged.

Assisting the Attorney Under a Kovel Arrangement

Referral to an attorney might not require an accountant tax practitioner to be excluded from an analysis of the underlying facts. Where the attorney determines that the accountant’s services are necessary to the attorney’s understanding of the facts, the attorney will likely retain the accountant under what is called a Kovel agreement. This is a long-standing practice based upon the opinion in Kovel, 296 F.2d. 918 (2d Cir. 1961). There, the court determined that the assistance of an accountant was necessary to the attorney’s understanding of complex financial matters. The court compared the assistance with that of a foreign language interpreter.

The attorney must also determine, however, whether retaining the accountant is in the best interest of the client and is ethical. To illustrate, the attorney may determine that the better course of action is to “freeze” the accountant’s knowledge. If the attorney anticipates that the government may call the accountant as a witness in future proceedings, it may be a conflict of interest to provide information to the accountant in the course of the case analysis. Accordingly, in certain circumstances it might be better for the accountant to be excluded from the privileged investigation.

Conclusion

A federal tax practitioner should consider referring a case to an experienced criminal tax lawyer when the circumstances indicate that the IRS may consider the taxpayer’s conduct criminal. The referral should be made at the first indication of fraud. A referral is also appropriate when sensitive matters are to be reviewed, such as the audit of an aggressive tax shelter involving economic substance questions, and troublesome collection cases that may involve some elements of concealment or deception by the taxpayer. The underlying circumstances involving offshore bank accounts, audits of clients who may have had an undisclosed financial interest in offshore bank accounts, and proposed voluntary disclosures of these accounts should also be reviewed by an experienced criminal tax lawyer.