Posted by: Taxlitigator.com | December 20, 2014

The Effect of Latent Tax Liabilities on Stock Values by Avram Salkin

The IRS has consistently taken the position that potential tax liabilities of C corporations, S Corporations, and individuals should not be considered when valuing stock or other assets.  For example, should the stock of an S Corporation’s stock be reduced if the corporation holds assets that are worth far more than their tax basis?  If the appreciated assets are depreciable or amortizable, should the loss of future depreciation or amortization diminish value? If inventory has appreciated, will a hypothetical buyer consider the taxes payable on sale of the inventory when determining price?

Interestingly, the Department of Justice has just taken the position that taxes count in its fraudulent conveyance complaint filed against Deutsche Bank in the Southern District of New York.[1]  Included among the allegations in the Complaint are:

“First, a Deutsche Bank entity sold the corporation holding the appreciated stock to BMY for a price that did not represent fair value of it in light of, at a minimum, the tens of millions of dollars of tax liabilities on the built-in-gains.”

“The economic value of the stock to the shareholders of the company owning the appreciated stock is less than the market price of the stock.  Other factors being equal, the economic value of the stock is the market price less the taxes that will be due when the stock is sold.”

“The approximately $150 million purchase price paid by Deutsche Bank for the Charter stock was significantly greater than the economic value of the Charter stock if the built-in-gains associated with the BMY shares owned by Charter are taken into account.”

“At a minimum, the sales price did not account for the tax liabilities associated with the built-in-gain on the BMY shares owned by Charter.”

If the Department of Justice is willing to make such allegations, it is difficult to understand how the National Office of the Internal Revenue Service can take the position that tax liabilities based on built in gains or reduced benefits available from depreciation on undervalued assets do not affect the value of stock. It is inconsistent for the Government to make the foregoing allegations in a fraudulent conveyance case while constantly claiming that transfer taxes are underpaid when appraisers consider tax liabilities as part of their valuation process. They have it right in the Deutsche Bank case -potential tax liabilities affect value.  They have backed off to some extent in C corporation cases, but should get it right in S corporation, partnership and individual cases where taxpayers’ valuations reflect built-in-tax burdens.

AVRAM SALKIN – For more information please contact Avram Salkin at AS@taxlitigator.com. Mr. Salkin  represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com

 

[1] See U.S.. v. Deutsche Bank (Tax Case) 14 Civ 9669 (SDNY, 12/08/14). A copy of the Complaint is available at  http://www.justice.gov/usao/nys/pressreleases/December14/DeutscheBankTaxCasePR/Deutsche%20Bank%20(Tax%20Case)%2014%20Civ%209669%20Complaint.pdf

Posted by: Taxlitigator.com | December 7, 2014

How Long Should I Keep Tax Records?

Many taxpayers hoard records such that they can be appropriately prepared “if and when” an IRS examination occurs. Others often inquire as to which records should be maintained and for how long. Some routinely destroy relevant documents on the mistaken belief that an examination result will somehow be enhanced if certain documents simply don’t exist.

The length of time documents should be retained often depends upon the action, expense, or event the document records. Generally, records that support an item of income or deduction on a tax return should be retained until the applicable statute of limitations for that return runs out. The statute of limitations is the period of time in which return can be amended to claim a credit or refund, or that the IRS can assess additional tax. Returns filed before the due date are treated as filed on the due date.

General Rule. The general federal statute of limitations is 3 years from the filing date of the return. Many states have statutes that are one year beyond the expiration of the federal statute of limitations. However, the federal statute of limitations can be extended to 6 years in certain situations where there has been an omission of more than 25% of the gross income required to be hown on the return and is indefinite in the event of a civil fraud determination or the failure to file a return.

Taxpayers should keep copies of filed tax returns for at least 6 tax years to help in preparing future tax returns and making computations if an amended return is required. Generally:

  1. If the taxpayer owes additional tax and situations (2) and (3), below, do not apply; keep records for 3 years.
  2. If there is an omission of more than 25% of the gross income required to shown on the return; keep records for 6 years.
  3. If a return is not filed; keep records indefinitely.
  4. If a claim for credit or refund is filed after the filing of the original return; keep records for 3 years from the date the original return was filed or 2 years from the date the tax was paid, whichever is later.
  5. If a claim for a loss from worthless securities or bad debt deduction was filed; keep records for 7 years.
  6. Keep all employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.

Are the records connected to assets? Keep records relating to property until the period of limitations expires for the year in which the property is disposed of in a taxable disposition. These records will be relevant for purposes of determining any depreciation, amortization, or depletion deduction and to figure the gain or loss upon disposition of the property.

Generally, for property in a nontaxable exchange, the tax basis in that property is the same as the bases of the property transferred, increased by any money paid for the acquisition. Retain records applicable to the old property, as well as on the new property, until the period of limitations expires for the year in which the new property was disposed of in a taxable disposition.

When records are no longer needed for tax purposes, do not discard them until determining whether the records might be needed for other purposes such as for insurance purposes.

Many people have moved forward into the electronic world and operate within a paperless environment. Electronic storage of relevant documents provides a hassle free method of retaining documents far beyond the confines of an upper shelf in a closet or garage. If comfortable with a paperless environment, consider retaining rather than destroying documents for a considerably longer period of time than referenced above.

Posted by: Taxlitigator.com | November 24, 2014

Random Thoughts re IRS Examination Representation

It is extremely important to have a working knowledge and appreciation for the administrative process in which tax returns are fi led, reviewed and examined. This knowledge allows the practitioner an opportunity to provide an efficient, invaluable service to his clients and to the system of tax administration. The administrative process should not be abused merely because of the taxpayer’s desire to delay the determination and collection of any potential liability. Collection-related issues should be sorted out through an installment payment arrangement that would be negotiated through the normal collection process following conclusion of the audit.

ISSUE SPOTTING. A practitioner cannot know everything that one’s client will expect the practitioner to know. However, a practitioner should be able to “issue spot” matters within his field of expertise and, to a lesser extent, matters outside his field of expertise. The internet may be a practitioner’s best initial resource. There is a tremendous amount of information available on the Internet for the IRS and various state taxing authorities. Get comfortable accessing their sites.

Tax people need to be sensitive to non-tax issues. Otherwise, resolution of a tax dispute might inadvertently set up a securities case, a money-laundering structuring case, etc. against one’s client.

IRS AUDIT TECHNIQUES GUIDES. Be familiar with IRS Audit Technique Guides (ATG) when providing tax advice, preparing tax returns, preparing for an IRS examination and when preparing a client for an interview with the government. There are many publicly available ATGs that have been prepared by the IRS. Each ATG instructs the examining agent on typical methods of auditing a particular group of taxpayer, including typical sources of income, questions to be asked of the taxpayer and his representative during the audit, etc. These groups have been defined by type of business (i.e., gas stations, grocery stores, etc.), technical issues (passive activity losses), types of taxpayer (i.e., returns lacking economic reality) or method of operation (i.e., cash businesses).

A practitioner should not blindly proceed with an examination without being generally familiar with any potentially relevant IRS ATGs. Effective representation requires the ability to utilize all available resources, including the ATGs. Often, it may be beneficial to review relevant ATGs earlier in the process…perhaps while preparing the return. Preparers representing clients in an industry or having issues covered by an ATG should consider thoroughly reviewing the ATG with the client, before the return is filed.

ENGAGEMENT LETTERS. Engagement letters for tax-related matters should specify the scope and terms of the engagement. Services rendered should be within the scope of the engagement as clearly set forth in the engagement letter. If additional services are to be provided, additional engagement letters should be obtained. If a client relationship is terminated for any reason, written confirmation of the termination should be promptly provided to the client and the opposition. If the government has been involved, the government should also be clearly advised of the termination of the client relationship.

EXTENSIONS OF THE STATUTE OF LIMITATIONS. It is often a good practice to provide an extension of the applicable statute of limitations during the course of any audit or examination. However, it is also good practice to have extensions signed by the client, rather than the client’s authorized representative (even though authorized by a power of attorney). Years later, the client may not recall having given authorization to extend the statute of limitations. If their signature is on the extension (Form 872), the situation will not likely escalate. Further, it is almost always preferred to sign a limited extension with a specified expiration date (Form 872) rather than an indefinite extension for an unspecified term (Form 872-A).

FREEDOM OF INFORMATION ACT REQUESTS. It is often advisable to submit a request under the Freedom of Information Act (FOIA) following the unagreed resolution of a federal tax examination. It should also help tailor discussions at the next administrative level while providing insight into what the next government representative assigned to the case will be reviewing. The process is relatively simple and inexpensive. Relevant information regarding the submission of a FOIA request is readily available at irs.gov by searching “FOIA.”

TAXPAYER ADVOCATE SERVICE. If an examination problem seems overwhelming, consider contacting the Taxpayer Advocate Service (TAS). TAS is an independent organization within the IRS whose employees assist taxpayers who are experiencing economic harm, who are seeking help in resolving tax problems that have not been resolved through normal channels or who believe that an IRS system or procedure is not working as it should.

RESPOND TIMELY AND SEEK RESOLUTION AT THE EARLIEST OPPORTUNITY. Throughout, treat all government representatives with respect and act like the professional that you want others to know and respect. Cooperate within your client responsibilities and respond timely to all requests, even if the response is a request for additional time to respond.

It is generally advisable to attempt to resolve any civil tax dispute at the earliest opportunity. A lengthy examination may be costly from the perspective of the expenditure of time and effort involved, as well as the taxpayer’s degree of frustration with the normal administrative process. Further, a prolonged audit is more likely to uncover potentially sensitive issues that could generate increased tax deficiencies, penalties or the possibility of criminal sanctions.

WHEN IN DOUBT . . . GET A DOG! A busy tax practice can be surrounded by minefields. Never underestimate the IRS’s ability, desire and resources to examine tax returns and collect taxes. Document your client advice in writing, limit the nature and scope of services to be provided in your engagement letter, establish a system of checklists (and follow the system) and use your best judgment.

If the taxpayer is unwilling to accept and follow your advice, strongly consider terminating the engagement. Life is short and the headaches of trying to convince someone to do the right thing may simply not be worth your effort. There is a reason many people become clients, and it is not because they routinely coordinate all relevant information necessary to the preparation of a return nor do they routinely provide such information in a timely manner. If you encounter an undeserving or possibly disrespectful taxpayer-client, let them go and move on with your practice.

Lastly, you cannot be all things to all people, regardless of the effort and personal sacrifice. Perhaps most importantly, remember that the taxpayer is your client, not your friend . . . if you feel the need for friends . . . get a dog!

AGOSTINO & ASSOCIATES –To download a great article prepared by our very close friends at the Law Firm of Agostino & Associates in Hackensack, NJ ( www.agostinolaw.com ), see the Agostino & Associates November Newsletter https://drive.google.com/file/d/0B719qAMBEjGQUjlDb3VJTDVkZDA/view?pli=1

The Taxpayer Advocate Service – Guarantors of the Taxpayer Bill of Rights By Frank Agostino & Matthew Turtoro –  The Taxpayer Advocate Service (“TAS”) is often the most viable means available and is tasked with assisting taxpayers resolve problems with the IRS; identifying areas in which taxpayers have problems dealing with the IRS; proposing changes in the administrative practices of the IRS to mitigate problems; and identifying potential legislative changes that may mitigate problems. Tax professionals should understand that a TAS filing can help preserve the rights of their client and remedy IRS malfeasance.

Representatives must know when to contact TAS and how TAS may be able to provide immediate assistance for even the most difficult, complex scenarios. GREAT ARTICLE – FOR THE FULL ARTICLE SEE https://drive.google.com/file/d/0B719qAMBEjGQUjlDb3VJTDVkZDA/view?pli=1

AGOSTINO & ASSOCIATES, with a national practice based in Hackensack, NJ, specializes in tax and tax controversies (civil and criminal), offers in compromise, voluntary disclosures, tax lien discharges,  innocent spouse determinations, forfeitures, estate planning and probate, contract and contract litigation.  A firm comprised truly great, caring people who want the best for their clients !

For further information, contact Frank Agostino or Matthew Turtoro directly at (201) 488-5400 or visit  www.agostinolaw.com

Posted by: Taxlitigator.com | November 18, 2014

Voluntary Disclosures by Non-Filers

Practitioners often struggle with the issue of whether a taxpayer can avoid a criminal tax investigation by making a disclosure to the IRS. A “voluntary disclosure” generally involves the process of contacting the IRS in some manner and voluntarily reporting previously undisclosed income (or false deductions) through an amended return or the filing of a delinquent return. A taxpayer’s timely, voluntary disclosure of a significant unreported tax liability is an important factor to the IRS in considering whether the matter should be referred to the U.S. Department of Justice for criminal prosecution. Properly resolving this issue can mean the difference between a taxpayer being criminally excused of a tax crime or being convicted on the basis of admissions derived from the voluntary disclosure itself.

Certainly, the IRS has a somewhat limited capacity to perform criminal investigations. However, a significant amount of time is not required to criminally investigate and prosecute a non-filer, particularly one who files delinquent or amended returns following an IRS inquiry. Without adequate representation, the perceived light at the other end of the voluntary disclosure tunnel . . . may be the IRS train coming straight at the taxpayer!

Why Consider a Voluntary Disclosure? Non-compliant taxpayers rarely do so as a result of some patriotic tendencies. Most often there is some type of triggering event that is causing sleepless nights such as a potential divorce or break-up of a business relationship that might uncover prior tax indiscretions.

IRS Voluntary Disclosure Practice.  Since 1952, the IRS has maintained an informal IRS voluntary disclosure practice[1] that creates no substantive or procedural rights for taxpayers, but rather is a matter of internal IRS practice, provided solely for internal guidance to IRS personnel. Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution. A timely voluntary disclosure will not guarantee immunity from criminal prosecution, but a true voluntary disclosure will normally result in the IRS not even recommending a criminal prosecution to the Department of Justice.

A voluntary disclosure must be truthful, timely and complete, and the taxpayer must demonstrate a willingness to cooperate (and must in fact cooperate) with the IRS in determining the correct tax liability. The taxpayer must make good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable. Additionally, the policy only applies to income earned through a legal business – – so called “legal source” income. Al Capone could not take advantage of the policy.

To be timely, the disclosure must be received before: (i) the IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation; (ii) the IRS has received information from a third party (e.g., informant, other governmental agency, the media, or a soon to be ex- spouse or business partner) alerting the IRS to the specific taxpayer’s noncompliance; (iii) the IRS has initiated a civil examination or criminal investigation which is directly related to the specific liability of the taxpayer; or (iv) the IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena).

Any taxpayer who contacts the IRS regarding voluntary disclosure will likely be directed to IRS-Criminal Investigation (CI) for an evaluation of the disclosure. To determine whether the disclosure is truly voluntary, the IRS will review the actual status of any prior interest in the taxpayer, the taxpayer’s potential knowledge of such interest, and the taxpayer’s fear of some potential trigger that could have alerted the IRS. A voluntary disclosure cannot be made anonymously. Any plan by a taxpayer, or their representative, to resolve a tax liability, file a correct return, or offer payment of taxes for an anonymous client is not to be considered a voluntary disclosure.

A voluntary disclosure does not occur until IRS has actually been contacted. As such, it is imperative that the disclosure occur as quickly as possible. IRS will rarely recommend prosecution if there has been a timely voluntary disclosure. Since returns filed pursuant to a timely voluntary disclosure have significant audit potential, they should be “bulletproof” in correctly reflecting the taxpayer’s income and expense items.  Due to various federal-state information sharing agreements, any applicable state returns should be contemporaneously filed or amended with the federal returns. Returns for related entities should also be contemporaneously filed or amended. Questions or doubts should likely be resolved in favor of the government.  If a return filed pursuant to a voluntary disclosure is less than accurate, the taxpayer is compounding – – not helping the problem.

Disqualifying Factors. Counsel should inquire whether the taxpayer is currently the subject of a criminal investigation or civil examination; whether the IRS notified the taxpayer that it intends to commence an examination or investigation; whether the taxpayer is under investigation by any law enforcement agency; whether source of any income is from an illegal activity; whether the taxpayer has any reason to believe that the IRS has already obtained information concerning the tax liability to be reported pursuant to the voluntary disclosure.[2]

How many returns must be filed or amended? While there is certainly no well-established rule as to how many returns must be filed in making a voluntary disclosure, the general consensus is probably six tax years since the applicable statute of limitations for most tax related crimes is six years.  However, depending on the applicable facts and circumstances, a voluntary disclosure is sometimes limited to fewer than six tax years. The disclosure should eliminate any government concern that there might be any potential issues with respect to a particular tax year for which the applicable statute of limitations for criminal prosecutions has not already expired. In some situations, additional returns could be in order since the statute of limitations for a criminal prosecution is tolled for the period of time a taxpayer is outside of the United States or is a fugitive from justice.

Typically, in a civil context, it is also the IRS policy to enforce the filing of returns for the prior six tax years. In considering whether shorter or longer periods should be civilly enforced, the IRS will determine the prior history of non-compliance, the possible existence of income from illegal sources, the effect on voluntary compliance, the anticipated revenue in relation to the time and effort required to determine the tax due, and special circumstances existing in the case of a particular taxpayer, class of taxpayer, or industry, which may be particular to the class of tax involved.

Counsel must determine whether to contact the IRS before submitting a voluntary disclosure and actually filing the delinquent or amended tax returns. Some practitioners prefer to submit a Freedom of Information Act (FOIA) request or request IRS transcripts seeking income information already in the possession of the IRS before filing the returns.

No Specified Format Required. Information may be provided either verbally or in writing but must include a statement on behalf of the taxpayer indicating that they are willing to cooperate with the IRS in determining the correct tax liability and make good faith arrangements to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable in full. Some practitioners simply choose to file the delinquent or amended returns, with payment, with the appropriate IRS service center (now referred to as a “campus”) by certified mail, return receipt requested as set forth in Example 6.A of IRM 9.5.11.9  accompanied by a cover letter from a lawyer which encloses amended returns from a client which are complete and accurate (reporting legal source income omitted from the original returns), and which offers to pay the tax, interest, and any penalties determined by the IRS to be applicable in full. If pursuing a voluntary disclosure – specifically reference Example 6.A of IRM 9.5.11.9 in the lawyers cover letter accompanying the amended returns.

Finally, some practitioners prefer making the voluntary disclosure in a meeting with the Special Agent in Charge of the local IRS-CI where the investigation would be conducted. At this meeting, the potential voluntary disclosure would initially be discussed in a hypothetical format. Counsel would generally outline the facts in hypothetical form (probably in writing) and would request whether IRS-CI would consider the return filing to be a voluntary disclosure in order to avoid recommendation of a criminal prosecution. Counsel may also attempt to secure an IRS waiver of all applicable penalties before revealing the taxpayers identity.  In the event that IRS-CI responds affirmatively, counsel would then disclose the client’s identity and taxpayer identification number. However, IRS will assert that there has not been the requisite “disclosure” until the taxpayers information has been provided to the IRS.

Department of Justice – Onboard? The IRS investigates tax crimes and, when they deem it appropriate, makes a referral to the Tax Division of the Department of Justice for prosecution. The Criminal Tax Manual for the Department of Justice provides that whenever a person voluntarily discloses that he or she committed a crime before any investigation of the person’s conduct begins, that factor is considered by the Tax Division along with all other factors in the case in determining whether to pursue criminal prosecution. If a putative criminal defendant has complied in all respects with all of the requirements of the Internal Revenue Service’s voluntary disclosure practice, the Tax Division may consider that factor in its exercise of prosecutorial discretion. It will consider, inter alia, the timeliness of the voluntary disclosure, what prompted the person to make the disclosure, and whether the person fully and truthfully cooperated with the government by paying past tax liabilities, complying with subsequent tax obligations, and assisting in the prosecution of other persons involved in the crime.[3]

Further, the Policy and Procedures Memoranda for the Department of Justice acknowledges that the IRS’s voluntary disclosure policy remains, as it has “since 1952, an exercise of prosecutorial discretion that does not, and legally could not, confer any legal rights on taxpayers. If the IRS has referred a case to the Tax Division, it is reasonable and appropriate to assume that the IRS has considered any voluntary disclosure claims made by the taxpayer and has referred the case to the Division in a manner consistent with its public statements and internal policies. As a result, our review is normally confined to the merits of the case and the application of the Department’s voluntary disclosure policy set forth in Section 4.01 of the Criminal Tax Manual.”[4]

What to do? A taxpayer’s timely, voluntary disclosure of a significant unreported tax liability is an important factor to the IRS in considering whether the matter should be referred to the U.S. Department of Justice for criminal prosecution. Properly resolving this issue can mean the difference between a taxpayer being criminally excused of a tax crime or being convicted on the basis of admissions derived from the voluntary disclosure itself.

Counsel should likely determine whether to contact the IRS before submission of a voluntary disclosure and should be consulted before actually filing the delinquent or amended tax returns. If not properly coordinated (or not timely), submission of amended or delinquent returns might be deemed an important admission in a later criminal proceeding. If timely and submitted in accordance with the IRM, a timely voluntary disclosure can avoid a criminal referral and may significantly reduce or possibly eliminate the imposition of civil penalties on any resulting tax deficiency.

Generally, people who come forward and file returns prior to being contacted by IRS are not pursued through a criminal investigation, might be able to reduce or eliminate potential civil penalties, and may be able to coordinate an effective installment payment arrangement (or Offer in Compromise) for any resulting deficiencies. Regardless, a non-filer should not wait since the “first knock on the door” may be that of a special agent from IRS-CI.

[1] Internal Revenue Manual (IRM) 9.5.11.9

[2] IRM 9.5.11.9.5

[3] Section 4.01, Criminal Tax Manual, U.S. Department of Justice (2008)

[4] Policy Directives Memoranda, Section 3, Policy Directives and Memoranda, Tax Division, U.S. Department of Justice (02/17/1993)

Posted by: Taxlitigator.com | November 3, 2014

Warning Signs of an IRS Criminal Tax Prosecution Referral

Every IRS examination potentially involving tax fraud requires a thorough examination of not only what transpired but, almost more importantly, why something did or did not transpire. Tax practitioners must understand the process by which a civil tax case winds its way through the system. Identifying the decision-makers and the factors they consider important may have an impact on the ultimate resolution of the examination. There is no substitute for mastering the facts and anticipating which, if any, “badges of fraud” may arise so as to be able to prepare a cogent response during the civil examination.

Of equal importance, counseling a client not to perpetuate possible badges of fraud during the investigation, including falsifying, destroying or altering records, continuing questionable practices into the present and future years, or transferring or concealing assets under investigation may be the difference between a civil resolution and a criminal referral.

IRS FRAUD TECHNICAL ADVISORS. The IRS has historically maintained a fraud referral program involving cases initiated by the civil examination and collection functions of the IRS, that are subsequently referred to IRS Criminal Investigation (CI) for criminal investigation and possible prosecution by the Department of Justice. When a civil revenue agent or revenue officer investigates a case and determines there are “firm indications of fraud,” they are to “refer” the case to CI for a criminal investigation.[i]

IRS Fraud Technical Advisors (FTA), formerly known as Fraud Referral Specialists, coordinate activities on behalf of both the civil and the collection functions of the IRS. FTA’s have been selected to target civil fraud cases for civil fraud penalty and criminal referral potential and serve as consultants to revenue agents conducting civil examinations. The FTA assists the examining agent in fraud case development identifying “badges of fraud,” often working behind-the-scenes coordinating the gathering of documentation and the interviewing of witnesses, including the taxpayer.

Knowing that an FTA could be consulting on an audit having issues with criminal potential, the issue of whether the taxpayer should submit to an interview by the civil agent is quite sensitive. The taxpayer may be forced to submit to an interview, but if asked a question which may be incriminating, the taxpayer should likely assert constitutional protections to avoid answering the questions. Claiming of a Fifth Amendment privilege, however, may merely confirm the agent’s suspicions and could encourage the agent’s referral to CI. Thus, the best course of action is often to allow experienced tax counsel to handle the interactions with the agent in hopes of persuading the agent to gather information through alternative means.

The IRS examiner, with assistance from the FTA, must know when to suspend action on a case and prepare a criminal referral when there is a firm indication of fraud. If the examiner stops too soon, all information necessary to document firm indicators (affirmative acts) of fraud may not be developed sufficiently for IRS Criminal Investigation (CI). The IRS examiner or group manager can not obtain advice and/or direction from CI for a specific case under examination. The FTA is available for this consultation.

WARNING SIGNS OF A CRIMINAL REFERRAL. The IRS investigates civil and criminal tax fraud; the Tax Division of the U.S. Department of Justice prosecutes criminal tax fraud cases, many of which have been referred for prosecution from the IRS. A long, unexplained period of silence after much investigative activity by the civil revenue agent or revenue officer during the civil examination should cause a degree of concern that an FTA has been consulted. Since civil agents are extremely discreet about informing the taxpayer’s representative that they are contemplating a criminal referral, experienced representatives have learned to identify certain activities by the agent, prior to the period of silence, as indicating a potential referral to CI.

In cases involving allegations of unreported income, the agent’s request and summonsing and photocopying of all bank account information could raise the specter of a criminal referral, especially if the agent has stumbled upon a “side account” which was not accounted for in determining the taxpayer’s income. By summonsing the information, the agent ensures that the case file will include copies of bank statements, deposited items, deposit slips, bank wire confirmations and canceled checks, which could be evidence of the unreported income.

A civil agent’s questions about the taxpayer’s “lifestyle,” expenditures and other information may indicate that the agent is undertaking a financial status type of an examination to determine whether the income reported on the return supports the taxpayer’s financial lifestyle. If the revenue agent requests information as to the taxpayer’s assets and liabilities at the beginning and end of a tax year, this could suggest that the agent has determined that the taxpayer’s books and records do not adequately reflect income and that an indirect method of proof of income, such as a net worth method, is being considered. The net worth and expenditures methods described in a previous Blog on this site are well-recognized indirect methods of proof that have often been used in reconstructing income in criminal tax cases.

A taxpayer’s representative may be alerted when the civil agent requests information such as supplier invoices, price lists, customer ledger cards, and other information that could be used as circumstantial evidence to prove unreported gross receipts. Also, if the civil agent requests the taxpayer either to submit to an interview or to answer questions in writing that relate to the taxpayer’s knowledge or intent of the facts and circumstances surrounding alleged unreported income or false deductions; or the agent refuses to discuss in detail the status of the audit and the possibility of concluding the audit in the near future, a criminal referral may be under consideration.

PARALLEL CIVIL AND CRIMINAL PROCEEDINGS. The IRS has dramatically altered its practices in conducting criminal investigations.  It had been long-standing IRS policy that the IRS did not engage in parallel civil and criminal enforcement activity.  If a civil audit unearthed a “firm indication” of fraud, the revenue agent has been directed to suspend the examination without telling the taxpayer and would prepare a Form 2797 (“Referral Report of Potential Criminal Fraud Cases”).  The FTA would be available to assist the agent in preparing this report which sets forth a detailed factual presentation of factors supporting the fraud referral, including (1) affirmative acts of fraud; (2) taxpayer’s explanation of the affirmative acts; (3) estimated criminal tax liability; and (4) method of proof used for income verification.[ii]

The fraud referral report is then transmitted to a CI Lead Development Center and is quickly followed by a conference between the referring civil agent and their group manager, the evaluating CI special agent and their supervisory special agent and the FTA. In this conference, tax returns, evidence and factors leading to the referral are reviewed and discussed.  Shortly thereafter, the same parties meet again at a disposition conference to discuss CI’s decision to accept or decline the referral. IRS Counsel may also be invited to this meeting to offer legal advice, if it is deemed necessary.[iii] A final decision as to whether the referral meets or does not meet the criminal criteria typically occurs shortly after the disposition conference.  This period of time, when the fraud referral is being considered, is usually marked by a long, unexplained silence on the part of the civil agent, which may indicate to the taxpayer’s representative that a referral has been made to CI.

Somewhat recently, the IRS has moved from this policy to a nearly opposite mode of operation. It was long thought bad policy to risk the perception that the IRS civil tax enforcement activities might be perceived as being used to develop criminal charges. Fundamental Constitutional rights not to provide evidence against oneself, to counsel, and to due process, are at some risk when a taxpayer is compelled to provide information to government taxing authorities. As a result, it had long been the IRS’s practice for civil examinations to defer to criminal investigations. At the conclusion of the criminal proceedings, the civil examination would resume.

In a dramatic and remarkable change, the IRS has shifted to practices that often include parallel civil and criminal proceedings. The IRM includes a provision that “[t]he criminal and civil aspects of a case do not present an either/or proposition. Rather, the criminal and civil aspects of a case should be balanced to the extent possible without prejudicing the criminal prosecution.”[iv]  Now, instead of the cessation of civil activity during the pendency of a criminal investigation, the IRS’s civil and criminal enforcement activities are expressly coordinated.[v]

Language in the IRM states that “a fraud case begins” when an IRS revenue agent engaged in civil examination or collection activities recognizes “affirmative indications and acts of fraud by the taxpayer.”[vi]  The IRM offers extensive guidance to the revenue agents as to how to identify or seek out information that may establish such “affirmative indications and acts of fraud.”  Revenue agents involved in civil examinations are told that the “discovery and development of fraud cases are a normal result of effective investigative techniques” and that their efforts “should be designed to disclose not only errors in accounting and application of tax law, but also irregularities that indicate the possibility of fraud.”  To expedite the process, they are encouraged to seek the assistance of FTA’s in these efforts.[vii]

Only after the revenue agent’s efforts lead to a conclusion that there is a “firm indicator” of fraud, beyond what is depicted by the IRM as “affirmative indications” of fraud, does the IRM state that a criminal referral should occur.[viii]  Until then, what a taxpayer perceives as a typical IRS audit may well involve a revenue agent who is looking to build a criminal case.[ix] The commencement of a criminal investigation still may not stop the civil enforcement efforts, however. Rather than cease the civil process while the criminal investigation goes forward, the efforts may now be more commonly coordinated.

A significant distinction between civil and criminal fraud is the differing burdens of proof. In a criminal prosecution, fraud must be proven beyond a reasonable doubt.[x] In a civil fraud penalty case, however, the government must prove civil fraud by “clear and convincing evidence.”[xi] However, if the government establishes that any portion of an underpayment of tax is attributable to fraud, then the entire underpayment is treated as attributable to fraud, unless the taxpayer establishes by preponderance of the evidence that it is not attributable to fraud.[xii]

The timing of which case proceeds can prove to be crucial. If the criminal case proceeds first, a conviction after a jury verdict or guilty plea under Code Section 7201 essentially precludes the defendant from litigating the issue of civil fraud in a subsequent civil tax proceeding, for the taxable year of conviction.[xiii] The defendant, however, may still litigate the tax deficiency in the civil proceeding.[xiv]   The collateral estoppel doctrine which results in a finding of civil fraud is based on the fact that the willfulness requirement of Code Section 7201 includes the specific intent to evade or defeat the payment of tax, which is the standard for proving fraud for purposes of the civil fraud penalty.[xv] If the Government proves willfulness under Code Section 7201 beyond a reasonable doubt in the criminal case, then that finding necessarily meets the clear and convincing standard of the civil fraud case.  On the other hand, a conviction for only subscribing to a false return under Code Section 7206 does not collaterally estop a taxpayer from contesting the civil fraud penalty since the elements for this offense do not mirror those for the civil fraud penalty.[xvi]

SOME LIMITS EXIST. In the context of parallel civil and criminal proceedings, IRS must remain “mindful” of the decision in United States v. Tweel.[xvii]  In Tweel,  an IRS CI special agent was involved with the civil audit of the defendant, but withdrew.  The accountant representing the defendant at the audit directly asked whether a special agent was involved, and the civil revenue agent responded in the negative.  As the court described, the revenue agent “did not disclose … that this audit was not a routine audit to which any taxpayer may be subjected from time to time,” but rather was being conducted at the specific request of the Department of Justice.  The defendant’s records were subsequently made available to the revenue agent for copying.[xviii]

The Fifth Circuit stated: “It is a well established rule that a consent search is unreasonable under the Fourth Amendment if the consent was induced by the deceit, trickery or misrepresentation of the Internal Revenue agent.”[xix] The court concluded that the revenue agent’s response to the accountant’s inquiry, while the literal truth, “was a sneaky deliberate deception by the agent … and a flagrant disregard” of the defendant’s rights.[xx]  The court suppressed the documents and reversed the conviction. The Tweel decision at one time had sufficient force to make the IRS wary of proceeding with parallel civil and criminal enforcement.  The IRS today goes forward with much less temerity.  The IRS does not suggest, however, that Tweel is not still good law, offering some safeguards to taxpayers.

CI ACCEPTANCE OF A CRIMINAL REFERRAL. What factors are most likely to influence a decision by CI to proceed with a criminal investigation?  A necessary element of every criminal tax felony, including tax evasion, is willfulness. This element is usually proven through evidence of the taxpayer’s conduct. The more egregious the conduct, the more likely it is that the resulting prosecution will be successful. Thus, CI looks for a pattern of understatements of income or non-filing over a period of years (usually three or more) as evidence of willfulness.[xxi]  In contrast,  where a taxpayer understated income for a single year and claims there was a mis-communication with a bookkeeper or gives some other plausible explanation for the income understatement, the government is presented with a more difficult case to prove willfulness.  A mere understatement of income by itself, even if it occurs over several years, is generally not enough to justify a CI investigation.  To buttress its argument for willfulness, the government often looks for other badges of fraud such as acts of concealment, destruction of records, altered documents and other conduct from which willfulness may be inferred.

Another factor CI considers in determining whether to accept a criminal referral is the amount of the tax loss involved.  The IRM section on fraud referrals states that the primary objective of CI is an investigation leading to the prosecution, conviction and incarceration of individuals who violate criminal tax laws and related offenses.[xxii] The IRM further states that since the Federal Sentencing Guidelines tie the period of incarceration to the monetary value of a tax violation, the amount of “tax loss” should be higher than minimum criteria set forth in the government’s internal Legal Enforcement Manual.  Moreover, CI recognizes that United States Attorneys are reluctant to use their offices’ resources to prosecute individuals who could not be sent to prison.[xxiii] The IRM, therefore, instructs persons reviewing a criminal referral to determine whether, based on the tax loss the taxpayer is likely to be incarcerated if convicted.

How much “tax loss” is enough to make incarceration likely? Under the advisory Federal Sentencing Guidelines, the threshold amount for incarceration is actually quite low considering criminal investigations typically cover multiple tax years and all related entities. For those convicted of tax crimes, a tax loss (generally defined as 28% of the amount of unreported income or false deduction) from $30,000 to $80,000 would likely result in a sentencing offense level requiring the defendant to serve a sentence of incarceration. As such, practically all cases investigated for criminal tax violations have the probability of landing the targeted individual in prison.  Since the amount of tax loss is the primary factor in determining the period of incarceration, the tax loss amount often leads a determination to accept a criminal referral.

IMPACT OF IRS ENFORCEMENT INITIATIVES. CI enforcement initiatives also play a significant role in determining whether a civil fraud referral is accepted for criminal investigation. “Legal source tax crimes” involve the traditional “garden variety tax criminal” who is involved in a legitimate business, but engages in illegal conduct to divert income, evade filing and payment obligations or assist others in similar conduct.  This tax compliance program is actively focused on abusive trust schemes which are elaborate tax evasion schemes set up to give the appearance of legitimacy through the use of a series of trusts, diversion of unreported income to offshore banks and other foreign financial institutions, health care fraud, employment tax fraud,  non-filer cases, and tax return preparer cases.

PUBLIC AWARENESS & THE SLAM DUNK. It is the government’s objective in criminal tax prosecutions to get the maximum deterrent value from every case that is prosecuted  which may be accomplished, in part, by targeting individuals who are perceived as being “highly visible.” The decision to accept a case for criminal investigation may be influenced by the taxpayer’s occupation, level of education, visibility within a particular community, high standing in a particular industry, either perceived or actual financial success, notoriety in a non-tax field, previous criminal background and other factors that could cause the government to “make an example” of a particular defendant.

During the late 1990’s, CI investigated a number of National Basketball Association referees for criminal tax violations relating to their exchanging of first class airline tickets for lesser priced coach tickets. The government achieved significant deterrence from these cases when an article concerning the investigations and how they affected the lives of the targeted referees was featured in Sports Illustrated magazine.[xxiv]  The government’s goal of maximizing the “deterrent effect” has often been served by pursuing persons in highly visible positions and obtaining publicity of these cases to achieve the broadest possible impact on compliance.[xxv]

FEEL LUCKY? There are many potential outcomes to a sensitive issue IRS civil tax examination. Certainly, very few examinations lead to a criminal tax prosecution and prison. However, some taxpayers go to prison for activities they believed would, at most, result in civil penalties. Those with potential civil or criminal tax fraud issues should immediately consult competent counsel.

[i].Internal revenue Manual (IRM) 25.1.2.1(2)

[ii] IRM 25.1.3.2 Preparation of Form 2797 (01-01-2003).

[iii] IRM 25.1.3.3 Referral Evaluation (01-01-2003).

[iv] Internal Revenue Manual § 38.3.1.8.

[v] E.g., Id.

[vi] Id. § 25.1.2.1(1).

[vii] Id. § 25.1.1.1

[viii] Id. § 25.1.3.2.

[ix] The more aggressive practices by the IRS, the damage to the tax system, and practical guidance for defense attorneys, is set out in a very thoughtful article by Martin A. Schainbaum entitled “The Reverse Eggshell Audit:  the Dangers of Parallel Proceedings,” The Journal of Tax Practice & Procedure (CCH), Dec. 2005 – Jan. 2006.

[x] Holland v. U.S., 348 U.S. 121, 126 (1954).

[xi] Code Section 7454(a); Rule 142(b) of the United States Tax Court Rules of Practice & Procedures; Edelson v. Commissioner, 829 F.2d 828, 832 (9th Cir. 1987) aff’g. T.C. Memo 1986-223; Castillo v. Commissioner, 84 T.C. 405, 408 (1985).

[xii] Code Section 6663(b).

[xiii] Tomlinson v. Lefkowitz, 334 F.2d 262 (5th Cir. 1964), cert. denied, 379 U.S. 962 (1965); McKinon v. Commissioner, T.C. Memo 1988-323 (granting summary judgment against taxpayer for fraud penalties on account of conviction for all years).

[xiv] Delgado v. Commisioner, T.C. Memo 1988-66.

[xv] Code Section 6663.

[xvi] Wright v. Commissioner, 84 T.C. 636 (1985) (“Thus, the crime is complete with the knowing, material falsification, and conviction under Section 7206(1) does not establish as a matter of law that the taxpayer violated the legal duty with an intent, or in an attempt, to evade taxes.”).

[xvii] Wright v. Commissioner, 84 T.C. 636 (1985) (“Thus, the crime is complete with the knowing, material falsification, and conviction under Section 7206(1) does not establish as a matter of law that the taxpayer violated the legal duty with an intent, or in an attempt, to evade taxes.”).

[xviii] Id. at 298.

[xix] Id. at 299

[xx] Id. at 300.

[xxi] Holland v. U.S., 348 U.S. 121 (1954); U.S. v. Magnus, 365 F.2d 1007 (2nd Cir. 1966)

[xxii] IRM 25.1.3.1.1 Background Criminal Referrals

[xxiii] Id.

[xxiv] “Called for Traveling” by Leigh Montville, Sports Illustrated, April 1998.

[xxv] U.S. Department of Justice Criminal Tax Manual, The Federal Tax Enforcement Program, Section 6-4.010, p.2-5.

Posted by: Taxlitigator.com | October 2, 2014

IRS: Common Badges of Tax Fraud

Section 6663(a) provides that, if any part of an underpayment is due to fraud, there shall be added to the tax an amount equal to 75% of the portion of the underpayment which is attributable to fraud. The IRS bears the burden of proving by clear and convincing evidence that: (1) An underpayment of tax exists; and (2) some portion of the underpayment is attributable to fraud.[i]

In the case of a joint return, intent must be established for each spouse separately and the fraud of one spouse cannot be used to impute fraud to the other spouse. Thus, the civil fraud penalty may be asserted on one spouse only.

FRAUDULENT INTENT. To prove fraudulent intent, the IRS must demonstrate that the taxpayer intended to evade tax he believed to be due, by showing proof of conduct intended to conceal, mislead, or otherwise prevent the collection of such tax.[ii] Fraud can not be imputed or presumed – the government must prove by affirmative evidence that an understatement of tax set forth on the return is attributable to fraud.[iii]  Intent is distinguished from inadvertence, reliance on incorrect technical advice, honest difference of opinion, negligence or carelessness.[iv]

RELIANCE AS A DEFENSE. The existence of fraud is a question of fact to be resolved from the entire record.[v] Because direct proof of a taxpayer’s intent is rarely available, fraud may be proven by circumstantial evidence, and reasonable inferences may be drawn from the relevant facts.[vi] Mere suspicion, however, does not prove fraud.[vii] Reliance on a tax professional is a proper defense to the imposition of penalties, as the Supreme Court has observed:

            When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place (citations omitted). “Ordinary business care and prudence” do not demand such actions.[viii]

SENSITIVE ISSUE TAX EXAMINATIONS. In civil tax audits that include potentially sensitive issues, taxpayers often engage a team of representatives, including counsel and a forensic accountant.  Engagement of the accountant by counsel should extend the attorney-client privilege to advice rendered by the accountant pursuant to the engagement.[ix] Although Internal Revenue Code §7525 extended common law protections of confidentiality to tax advice rendered between a taxpayer and a federally-authorized tax practitioner (accountants, etc. to the extent such communications would be considered privileged if they occurred between a taxpayer and counsel), this statutory privilege only applies to non-criminal tax matters before the IRS and non-criminal tax proceedings in federal court.

Unfortunately, this statutory privilege is not available when it is truly needed the most – when a civil tax proceeding moves into the criminal arena.  It also may not be available in certain state-related tax proceedings, or non-tax civil litigation. However, if the accountant is appropriately engaged by counsel, the common law attorney-client privilege should apply to all communications rendered in furtherance of the legal services being provided to the client, both during the investigative stages of the audit and, if necessary, during any subsequent civil or criminal litigation. This privilege does not extend to the actual return preparation.

Counsel’s engagement of the accountant should be in writing, and should indicate that the accountant is acting under the direction of counsel in connection with counsel’s rendering of legal services to the client, communications between the accountant and the client are confidential and are made solely for purposes of enabling counsel to provide legal advice; the accountant’s work-papers are held solely for counsel’s use and convenience and subject to counsel’s right to demand their return; and the accountant is to segregate their work papers, correspondence and other documents gathered during the course of the engagement and designate such documents as property of counsel.

The critical inquiry is often whether counsel should retain the taxpayer’s prior accountant or a new accountant. Many practitioners prefer to engage a new accountant to avoid the necessity of delineating between non-privileged communications (communications prior to counsel’s engagement of the accountant), and privileged communications (communications following counsel’s engagement of the accountant).

In an IRS civil tax fraud examination, the IRS will follow up on all leads identified as fraud indicators (signs or symptoms); securing copies of all relevant data relating to indicators of fraud; and noting from whom and when obtained. Original documents obtained from the taxpayer or third parties should not be marked, indexed, hole punched, or in any way altered by the compliance employee. Also, it is critical that the compliance employee attempt to secure the taxpayer’s explanation(s) for any discrepancies.

Most civil fraud cases involve individual and business taxpayers with poor or nonexistent internal controls and/or where there is little or no separation of duties. When these occur, there is a greater potential for material misstatement of taxable income than in cases involving individuals earning salaries and wages. However, fraud may be present in any type of tax return. In cases where a return has not been filed and fraud is suspected, the IRS representative is instructed not to demand a return from the taxpayer.

Unusual, inconsistent or incongruous items should alert the IRS examiner to the possibility of fraud and the need for further investigation. Taxpayer misconduct is an early warning sign of possible fraudulent conduct. The method of operating a business (i.e., lack of internal controls, dealing in cash, etc.) may be indicative of improperly filed tax returns.

The initial contact by the IRS examiner provides the opportunity to obtain valuable information, which may not be readily available later. Indications of fraud may be disclosed in discussions, financial activities and nonresponsive answers. Questions asked should be recorded verbatim. Similarly, nonresponsive answers are to be noted verbatim and the IRS examiner will exercise their judgment in deciding what information is relevant (affidavits may be used). Examination work papers should be noted as to the tax year, the date of the contact, who was present during the contact, and the author of the examination work papers. IRS examination work papers will include the following information:

  • Who prepared the information used to complete the tax return,
  • Who approved and classified expense items,
  • Who deposited business receipts, and
  • How business gross receipts, per the tax return, were determined. 

“BADGES OF FRAUD.” Over the years, various courts have developed a list of “badges of fraud” from which fraudulent intent might be inferred. These badges of fraud generally include: (1) understatement of income; (2) inadequate books and records; (3) failure to file tax returns; (4) implausible or inconsistent explanations of behavior; (5) concealing assets; and (6) failure to cooperate with tax authorities.[x] The IRS Fraud Handbook sets forth a non-exclusive list of various indicators of potentially fraudulent conduct, including:[xi]

The IRS examiner will typically search behind the books and to probe beneath the surface to validate and determine the consistency of information provided and statements made to evaluate the credibility of evidence and testimony provided by the taxpayer. If fraud is discovered, it is important for the IRS to determine who is responsible for the fraudulent act(s) – the taxpayer, the tax return preparer or both.

If the taxpayer is not responsible, then neither criminal and/or civil fraud penalties should apply to the taxpayer although some courts have attributed fraud by the preparer to the taxpayer in the context of the civil fraud penalty and extending the unlimited statute of limitations associated with a fraudulent return.

Indicators of Fraud – Income

  • Omitting specific items where similar items are included.
  • Omitting entire sources of income.
  • Failing to report or explain substantial amounts of income identified as received.
  • Inability to explain substantial increases in net worth, especially over a period of years.
  • Substantial personal expenditures exceeding reported resources.
  • Inability to explain sources of bank deposits substantially exceeding reported income.
  • Concealing bank accounts, brokerage accounts, and other property.
  • Inadequately explaining dealings in large sums of currency, or the unexplained expenditure of currency.
  • Consistent concealment of unexplained currency, especially in a business not routinely requiring large cash transactions.
  • Failing to deposit receipts in a business account, contrary to established practices.
  • Failing to file a tax return, especially for a period of several years, despite evidence of receipt of substantial amounts of taxable income.
  • Cashing checks, representing income, at check cashing services and at banks where the taxpayer does not maintain an account.
  • Concealing sources of receipts by false description of the source(s) of disclosed income, and/or nontaxable receipts.

Indicators of Fraud—Expenses or Deductions

  • Claiming fictitious or substantially overstated deductions.
  • Claiming substantial business expense deductions for personal expenditures.
  • Claiming dependency exemptions for nonexistent, deceased, or self-supporting persons. Providing false or altered documents, such as birth certificates, lease documents, school/medical records, for the purpose of claiming the education credit, additional child tax credit, earned income tax credit (EITC), or other refundable credits.
  • Disguising trust fund loans as expenses or deductions.

Indicators of Fraud—Books and Records

  • Multiple sets of books or no records.
  • Failure to keep adequate records, concealment of records, or refusal to make records available.
  • False entries, or alterations made on the books and records; back-dated or post-dated documents; false invoices, false applications, false statements, or other false documents or applications.
  • Invoices are irregularly numbered, unnumbered or altered.
  • Checks made payable to third parties that are endorsed back to the taxpayer. Checks made payable to vendors and other business payees that are cashed by the taxpayer.
  • Variances between treatment of questionable items as reflected on the tax return, and representations within the books.
  • Intentional under- or over-footing of columns in journal or ledger.
  • Amounts on tax return not in agreement with amounts in books.
  • Amounts posted to ledger accounts not in agreement with source books or records.
  • Journalizing questionable items out of correct account.
  • Recording income items in suspense or asset accounts.
  • False receipts to donors by exempt organizations.

Indicators of Fraud—Allocations of Income

  • Distribution of profits to fictitious partners.
  • Inclusion of income or deductions in the tax return of a related taxpayer, when tax rate differences are a factor.

Indicators of Fraud—Conduct of Taxpayer

  • Testimony of employees concerning irregular business practices by the taxpayer.
  • Destruction of books and records, especially if just after examination was started
  • Transfer of assets for purposes of concealment, or diversion of funds and/or assets by officials or trustees
  • Pattern of consistent failure over several years to report income fully.
  • Proof that the tax return was incorrect to such an extent and in respect to items of such magnitude and character as to compel the conclusion that the falsity was known and deliberate.
  • Payment of improper expenses by or for officials or trustees.
  • Willful and intentional failure to execute pension plan amendments
  • Backdated applications and related documents.
  • False statements on Tax Exempt/Government Entity (TE/GE) determination letter applications.
  • Use of false social security numbers.
  • Submission of false Form W–4.
  • Submission of a false affidavit.
  • Attempt to bribe the examiner.
  • Submission of tax returns with false claims of withholding (Form 1099-OID, Form W-2) or refundable credits (Form 4136, Form 2439) resulting in a substantial refund.
  • Intentional submission of a bad check resulting in erroneous refunds and releases of liens.
  • Submission of false Form W-7 information to secure Individual Taxpayer Identification Number (ITIN) for self and dependants.
  • False statement about a material fact pertaining to the examination.Attempt to hinder or obstruct the examination. For example, failure to answer questions; repeated cancelled or rescheduled appointments; refusal to provide records; threatening potential witnesses, including the examiner; or assaulting the examiner.
  • Failure to follow the advice of accountant, attorney or return preparer.
  • Failure to make full disclosure of relevant facts to the accountant, attorney or return preparer.The taxpayer’s knowledge of taxes and business practices where numerous questionable items appear on the tax returns.

Indicators of Fraud—Methods of Concealment

    • Inadequacy of consideration.
    • Insolvency of transferor.
    • Asset ownership placed in other names.
    • Transfer of all or nearly all of debtor’s property.
    • Close relationship between parties to the transfer.
    • Transfer made in anticipation of a tax assessment or while the investigation of a deficiency is pending.
    • Reservation of any interest in the property transferred.
    • Transaction not in the usual course of business.
    • Retention of possession or continued use of asset.
    • Transactions surrounded by secrecy.
    • False entries in books of transferor or transferee.
    • Unusual disposition of the consideration received for the property.
    • Use of secret bank accounts for income.
    • Deposits into bank accounts under nominee names.
    • Conduct of business transactions in false names.

[i] IRC § 7454(a); Rule 142(b); DiLeo v. Commissioner, 96 T.C. 858, 873 (1991), aff’d. 959 F.2d 16 (2d Cir. 1992).

[ii] See Recklitis v. Commissioner, 91 T.C. 874, 909 (1988).

[iii] See Beaver v. Commissioner, 55 T.C. 85, 92 (1970); Senyszyn v Commissioner, T.C. Memo. 2013-274.

[iv] Internal Revenue Manual 25.1.6.1 (10-30-2009)

[v] See Gajewski v. Commissioner, 67 T.C. 181, 199 (1976).

[vi] See Spies v. United States, 317 U.S. 492, 499 (1943); Stephenson v. Commissioner, 79 T.C. 995, 1006 (1982).

[vii] See Cirillo v. Commissioner, 314 F.2d 478, 482 (3d Cir. 1963); Katz v. Commissioner, 90 T.C. 1130, 1144 (1988); Shaw v. Commissioner, 27 T.C. 561, 569-570 (1956).

[viii] United States v. Boyle, 469 U.S. 241, 251 (1985); Henry v. Comm., 170 F. 3d 1217, 1220 (9th Cir. 1999).

[ix] United States v. Kovel, 292 F.2d 18 (2d Cir. 1961).

[x] Bradford v. Comm’r, 796 F.2d 303, 307 (9th Cir. 1986).

[xi] Internal Revenue Manual (IRM) 25.1.2.3 Indicators of Fraud

Posted by: Taxlitigator.com | September 22, 2014

IRS Interviews of Taxpayers and Return Preparers

Requests to interview the taxpayer and/or return preparer during an otherwise normal IRS examination have become somewhat common. During the examination, the examining agent is auditing the return for accuracy and the taxpayer’s representative is typically trying to determine the nature and scope of the examination, gather responsive documents and information, etc.

It is nearly impossible for the representative to be able to determine why an examination commenced but a good starting point is to simply ask the examining agent. A typical response may be that the return was randomly selected for examination. However, there are actually few random audits. Examinations are typically focused on issues, areas, or industries having a historically high rate of non-compliance. Other examinations begin because the IRS received information from a related examination of another taxpayer or, perhaps, someone purposely provided information to the IRS relating to the taxpayer. Informants usually include disgruntled employees, ex-spouses or business partners, competitors or financial mercenaries seeking a whistleblower reward.

Interviews of the taxpayer serve a dual purpose: (i) to further the tax examination and (ii) to identify potential violations by a tax return preparer.  During the initial interview and throughout the examination process, the examiner can be expected to ask questions regarding the return preparation as appropriate to the case and issues being developed. Whether through the interview process or other documentation, the examiner will also be determining whether return preparer penalties might be appropriate to the situation.

QUESTIONS WHICH MAY BE ASKED. Interview questions are often tailored to the individual taxpayer and situation. Did you meet with the preparer? What documentation was provided to the preparer? Did you receive a copy of the return or claim? How was the preparer compensated? Are you aware of any errors, omissions or mistakes on the return under examination? Did you disclose this transaction on your tax return? Why? Why not? Were there any concerns about how the transaction was reported? What sort of process is used to address those concerns and on what basis are decisions made? Was there any discussion regarding potential penalties? Was there any discussion regarding whether the transaction is subject to disclosure?

When interviewing the taxpayer or preparer the agent may ask if any other services have been provided by the return preparer’s firm and how long the preparer has been preparing returns for the taxpayer? These questions provide insight into the extent of the preparer’s knowledge regarding the taxpayer’s financial situation/status and may alert the agent to the applicability of penalties. A tax return preparer who has been preparing a client’s return for a number of years is more knowledgeable than a firm that is preparing a client’s return for the first time.

Examining agents are aware that, no matter how important the question, it is irrelevant if the response is not accurately understood. As such, they are to demonstrate an interest in the responses from the taxpayer and make sure that their non-verbal communication contributes to a comfortable atmosphere. If they appear overly relaxed and are not looking at the taxpayer, the taxpayer may believe they are not interested and will respond accordingly. Agents are not to interrupt the taxpayer and should allow a brief pause at the end of a response.

IRS INTERVIEW AUTHORITY. A taxpayer has the right to resist an examining agent’s request for an interview. Code Sec. 7602 authorizes the IRS to examine books and records and to take testimony under oath. Pursuant to Code §7521(c) the taxpayer’s representative may represent the taxpayer before the examining agent and is not required to produce the taxpayer for questioning, unless an administrative summons is served on the taxpayer. There are several considerations that the taxpayer’s representative should weigh before allowing the taxpayer to submit to an interview, especially if potential fraud issues are involved.

A question often presented is whether the taxpayer and others should consent to interviews,force the issuance of Summonses or invoke various Constitutional protections. There are several considerations that the taxpayer’s representative should weigh before allowing the taxpayer to submit to an interview, especially if potential fraud issues are potentially involved.

TIMING OF THE INTERVIEW. Agents usually seek to conduct an initial interview as soon as possible after opening a case and schedule subsequent interviews if all requested information is not provided, more detailed explanations are required or to review the progress of the examination.  The representatives pre-audit analysis should include preparation for the taxpayer interview. The representative should attempt to obtain as much information about the issues, the information within the agent’s possession, and the agent’s position with regard to the issues, before agreeing to submit the taxpayer to an interview.  Ideally, the interview should occur toward the end of the audit, possibly with an understanding that if the taxpayer submits to an interview and answers the questions, the agent will proceed to close the audit.  However, the representative must take extreme caution, since such an understanding is probably not a basis for challenging the use of statements from the interview in a subsequent civil or criminal proceeding.

PREPARATION FOR THE INTERVIEW.  The representative should try to obtain actual questions, or areas that the agent will question, in advance of the interview.  This will substantially assist the representative in preparing the taxpayer for the interview, especially for the “hard questions.”  The taxpayer should be strongly cautioned about making truthful responses, not speculating if the taxpayer is uncertain about a particular response, etc.

PLACE OF THE INTERVIEW.  The location of interviews will typically be set by the examining agent. The taxpayer’s representative should attempt to have the interview at the representative’s office. This is a much more supportive environment for what could be an extremely agonizing experience for the taxpayer.  Conversely, the taxpayer should be less intimidated and should hold up better under the pressure of the agent’s questioning if the taxpayer is not in the unfamiliar confines of an Internal Revenue Service office.  Also, the representative should in most instances attempt to keep the interview from occurring at the taxpayer’s place of business, to help ensure the taxpayer is better focused for the interview and also to avoid the intrusion in the taxpayer’s daily activities.

RECORDING THE INTERVIEW. All participants must consent to the recording of the interview.  Taxpayers may request to tape record an interview proceeding as long as 10 calendar days advance notice of intent to record is provided to the IRS. In addition, the taxpayer must supply his recording equipment. The IRS has the right to simultaneously produce its own recording and has the right to reschedule the interview if the IRS does not or will not have equipment in place. The IRS can initiate an audio recording provided it notifies the taxpayer 10 calendar days in advance of the interview. The Field Territory Manager must approve all IRS initiated recordings.

TYPES OF INTERVIEW QUESTIONS. The types of questions should be varied to establish a conversational atmosphere. When developing questions, agents are to focus on four types of questions: open-ended, closed-ended, probing, and leading described as:

  1. Open-ended questions are framed to require a narrative answer. They are designed to obtain a history, a sequence of events, or a description and are often asked regarding the taxpayer’s business, employment, education, and sources of income which may not be reflected on the return. The advantage of this type of question is that it provides a general overview of some aspect of the taxpayer’s history. The disadvantage is that this type of question can lead to rambling;
  2. Close-ended questions are specific and direct intended to identify definitive information such as dates, names, and amounts. They are frequently asked for personal background information such as the number of dependents or current address and are useful to help focus the taxpayer when they have difficulty giving a precise answer. They are also useful to clarify a response to an open-ended question. The disadvantage to close-ended questions is that the response is limited to exactly what is asked and can make the taxpayer uncomfortable;
  3. Probing questions combine the elements of open and close ended questions and are used to pursue an issue more deeply. For example, when questioning a taxpayer’s travel expense, the agent may ask “How many miles is it from your residence to your practice and where do you first travel to in the morning?” The advantage of this type of question is that the taxpayer’s response is directed, but not restricted;

Leading questions suggest that the interviewer has already drawn a conclusion or indicate what the interviewer wants to hear. Agents are to limit the use of leading questions and typically will only use them when looking for confirmation, since the answer is stated in the form of a question. For example: “So you did not keep a log or other written record of your auto expenses?

COMMON INTERVIEW TECHNIQUES — IRS examining agents have been instructed on various interview techniques. These interview techniques are generally designed to put the person being interviewed at ease but to also ask pointed questions as the interview progresses. Many of these techniques include:

  1. Make eye contact.
  2. Put the taxpayer at ease.
  3. Use appropriate types of questions (probing, leading, open-ended, etc.).
  4. Use “silence” appropriately.
  5. Paraphrase or restate.
  6. Listen.
  7. Pace the interview.
  8. Know when to move on to the next question.
  9. Maintain a calm manner.
  10. Have the taxpayer demonstrate the flow of transactions.
  11. Read the taxpayer’s non-verbal language (body language).
  12. Be aware of the Examiner’s non-verbal language.
  13. Be conscious of note taking so as not to distract the taxpayer.
  14. Use humor when appropriate.
  15. Be courteous, business-like, and firm.
  16. Consider issues in the proper order (volatile vs. non-volatile).
  17. Schedule the interview at a convenient time and allow adequate time for completion.
  18. Appear interested.
  19. Control the interview.
  20. Appear confident.
  21. Maximize the value of what you know.  (Audit Technique Guidelines – ATGs)
  22. Adapt your appearance to be appropriate for the circumstances.
  23. Give feedback to the taxpayer.
  24. Be observant.
  25. Feign when appropriate (act dumb).
  26. Be prepared.
  27. Use spontaneous follow-up questions (react when you receive new information).
  28. Be yourself.
  29. Know yourself and your limitations.
  30. Read the taxpayer (know when you have lost their attention).
  31. Read the taxpayer’s perception of you.
  32. Dispel any negative image.
  33. Be on time.
  34. Use appropriate small talk.
  35. Use easily understood language.
  36. Don’t anticipate answers.
  37. Clarify responses.
  38. Use reflection.
  39. Ask for examples.
  40. Recognize your biases.
  41. Be assertive and persistent.
  42. Avoid debate or argument.
  43. Give the taxpayer an opportunity to ask questions.
  44. Express appreciation.
  45. Verbally pin down the taxpayer when appropriate.
  46. Have an open mind.
  47. Maintain composure.
  48. Adapt questions to the situation.
  49. Have the taxpayer explain their terminology.
  50. Be precise, come from a position of knowledge.  (MSSP Guidelines)
  51. Work to establish rapport with the taxpayer.
  52. Respect the taxpayer’s views.
  53. Know your authority.
  54. Make a positive first impression.
  55. Maintain an inquisitive mind.
  56. Contain your excitement (and surprise).
  57. Note unusual hostility or irritability on the part of the taxpayer.
  58. Consider the need to question both spouses.
  59. Don’t interrupt the taxpayer.
  60. Be methodical.
  61. Refresh the taxpayer about important points in prior interviews.

The foregoing list is not to be followed in every interview. However, it provides insight into the nature of “humanizing” the interview process. Representatives must always remember that the interview is designed to elicit statements and understandings directly from the person being interviewed. There are no “off the record” comments and even casual conversations can provide information that would have been better provided or explained in a more thoughtful environment.

 

Posted by: Taxlitigator.com | September 15, 2014

Bankruptcy (Tax) Law Must Apply Equally to the Rich and Poor Alike . . .

Generally, subject to certain statutory exceptions, a debtor is permitted to discharge all debts that arose before the filing of his bankruptcy petition.[1] With respect to tax debts, the Bankruptcy Code provides that a debtor may not discharge any tax debts “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” [2]

Today, the Ninth Circuit Court of Appeals “reversed and remanded” a district court’s earlier affirmance of the bankruptcy court’s judgment that a chapter 11 debtor’s tax debts should not be discharged on the basis of his alleged “willful attempt to evade or defeat taxes” under 11 U.S.C. § 523(a)(1)(C).[3]

The Rich Are Different . . . They Have More Money. In a somewhat colorful opinion, the Ninth Circuit Majority stated “F. Scott Fitzgerald observed early in his career that the very rich ‘are different from you and me,’[4] to which Ernest Hemingway later rejoined, ‘Yes, they have more money.’[5] As with many bankruptcy cases involving the wealthy, our saga reads like a Fitzgerald novel, telling the story of acquisition and loss of the American dream, and the consequences that follow.”

In association with various “tax shelter” transactions, the IRS made aggregate assessments against the underlying taxpayer for tax years 1997–2000 totaling $21 million and the California Franchise Tax Board also made assessments which totaled $15.3 million. With overall limited financial resources, the taxpayer ultimately found himself attempting to resolve these debts in a bankruptcy proceeding. The bankruptcy court opinion determined that the taxpayer (and his wife) “did very little to alter their lavish lifestyle after it became apparent in 2003 that they were insolvent and that their personal living expenses exceeded their earned income.”

Changing direction, the Ninth Circuit noted that the taxpayer “sold his primary residence and paid the entire $6.5 million net proceeds to the IRS. A month later, the FTB seized $6 million from various financial accounts. In September of that year, the [taxpayer] filed a Chapter 11 bankruptcy petition, which the bankruptcy court found was for the primary purpose of dealing with their tax obligations. Shortly after filing, the [taxpayer] sold the La Jolla condominium for $3.5 million and paid the proceeds to the IRS. Even after these payments and the seizure by the FTB, the IRS filed a proof of claim for $19 million and the FTB filed a claim for $10.4 million.”[6] To settle the remaining IRS liability, the taxpayer submitted an offer in compromise of $8 million, which was rejected.

The Ninth Circuit deemed it important that most of the expenditures by the taxpayer along the way “were made consistent with [taxpayer’s] past spending practices, and investments were made in property that would be subject to tax liens. As far as the record discloses thus far, there were no financial transfers into nominee accounts or concealment of assets, although the government claims that some funds ordered paid into trust by the family court were done so with the intent of tax evasion.” It also appears the taxpayer was investing funds improving or preserving property encumbered with tax liens that would ultimately accrue in a benefit to be received by the government when the property was sold.

The IRS and FTB alleged that the assessed liabilities could not be discharged in bankruptcy pursuant to 11 U.S.C. § 523(a) (1) (c), which excludes from discharge any debt “with respect to which the debtor . . .  willfully attempted in any manner to evade or defeat such tax.” (Emphasis added).  The primary, but not exclusive, theory of the IRS and FTB was that the [taxpayers] maintenance of a rich lifestyle constituted a “willful attempt to evade taxes.”

The bankruptcy court rejected most of the other government theories, but stated that the [taxpayer’s] personal living expenses from January 2004 to September 2006 were “truly exceptional.” The bankruptcy court estimated that the couples’ personal expenses exceeded their earned income by $516,000 to $2.35 million during the years at issue. Given these facts, the bankruptcy court concluded that, as to the Taxpayer-Husband, the tax debts were excluded from discharge; the district court affirmed and the appeal to the Ninth Circuit followed.

Specific Intent Required? The Ninth Circuit noted that “The key question in this case is the meaning of the word ‘willful’ in the statute. Unfortunately, the plain words of the text do not answer that question because, as the Supreme Court has observed, ‘willful . . . is a word of many meanings, its construction often being influenced by its context.’ Spies v. United States, 317 U.S. 492, 497 (1943). Context matters in this case. The Bankruptcy Code is designed to provide a “fresh start” to the discharged debtor. [Citation omitted]. As a result, the Supreme Court has interpreted exceptions to the broad presumption of discharge narrowly. See Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998). As we have observed ‘exceptions to discharge should be limited to dishonest debtors seeking to abuse the bankruptcy system in order to evade the consequences of their misconduct.’ [Citation omitted].”

Further, “[t]hus, the ‘fresh start’ philosophy of the Bankruptcy Code argues for a stricter interpretation of ‘willfully’ than an expansive definition. . . . The structure of the statute also supports a narrow construction of ‘willfully.’ The discharge exception at issue, § 523(a) (1), lists tax and customs debts warranting exception in three categories. Under § 523(a) (1) (A), numerous types of debts are excepted from discharge on a strict liability basis. Under § 523(a) (1) (B), tax debts for which a return was not filed or was filed late may not be discharged. Section 523(a) (1) (C) is the grouping at issue here: no discharge is permitted for tax debts “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” 11 U.S.C. § 523(a) (1) (C). The grouping of the fraudulent return offense with the evasion offense in subsection (C)—rather than with the other offenses involving tax returns in subsection (B)—suggests that it is more akin to attempted tax evasion than to failing to file a timely return. If a willful attempt to evade taxation requires mere knowledge of the tax consequences of an act, and no bad purpose, then it is difficult to see how such acts resemble the filing of a fraudulent return. By contrast, if a willful attempt requires bad purpose, then such acts are naturally grouped with other acts requiring bad purpose, such as filing a fraudulently false return.” (Emphasis added).       

The Ninth Circuit Majority. Given the structure of § 523(a)(1) as a whole, the Ninth Circuit Majority concluded that declaring a tax debt nondischargeable under 11 U.S.C. § 523(a)(1)(C) on the basis that the debtor “willfully attempted in any manner to evade or defeat such tax” requires a showing of specific intent to evade the tax. Specifically, “[t]herefore, a mere showing of spending in excess of income is not sufficient to establish the required intent to evade tax; the government must establish that the debtor took the actions with the specific intent of evading taxes. Indeed, if simply living beyond one’s means, or paying bills to other creditors prior to bankruptcy, were sufficient to establish a willful attempt to evade taxes, there would be few personal bankruptcies in which taxes would be dischargeable. Such a rule could create a large ripple effect throughout the bankruptcy system. As to discharge of debts, bankruptcy law must apply equally to the rich and poor alike, fulfilling the Constitution’s requirement that Congress establish ‘uniform laws on the subject of bankruptcies throughout the United States.’ U.S. Const., art. I, § 8, cl. 4.”

The Dissent. With obvious passion, the dissent noted, in part,: “I respectfully dissent. I agree with the majority that the rich are different in many ways, but that difference should not include an unfettered ability to dodge taxes with impunity. . . . The majority’s conclusion, in my view, creates a circuit split and turns a blind eye to the shenanigans of the rich. . . . . Providing a fresh start under the Bankruptcy Code should not extend to aiding and abetting wealthy tax dodgers. I respectfully dissent.”

Conclusion. What mental state is required in order to find that a bankruptcy debtor’s federal tax liabilities should be excluded from a bankruptcy discharge under 11 U.S.C. § 523(a)(1)(c) because he “willfully attempted in any manner to evade or defeat such tax”? Consistent with similar provisions in the Internal Revenue Code, the Ninth Circuit Majority concluded that “specific intent . . . to evade or defeat such tax” is required for the tax debt to not be discharged in a bankruptcy proceeding and remanded the underlying case to the district for a re-evaluation under that standard.

The result in this case might seem obvious to most – to “willfully evade tax” it should be clear that the debtor took some actions with the specific intent of evading taxes, i.e., financial transfers into nominee accounts or concealment of assets, etc. Continuing to mostly live life as they had before the underlying debts accrued, selling assets such that all proceeds are distributed to the government, making investments in assets already subjected to the tax liens, etc. would not seem to support the requisite “specific intent . . . to evade or defeat such tax.

In tax nothing is obvious until various levels of courts and sometimes even the U.S. Supreme Court have had a chance to evaluate and re-evaluate potentially relevant events. Rich or poor, the tax code (and the bankruptcy code) apply to the taxpayer (debtor) and, at least in this situation (although the dissenting opinion certainly disagrees) the Ninth Circuit seems to have gotten it exactly right.

 

[1] 11 U.S.C. § 727(b) and 11 U.S.C. § 523

[2] 11 U.S.C. § 523(a)(1)(C) (emphasis added).

[3] See William M. Hawkins, III, aka Trip Hawkins, Appellant, v. The Franchise Tax Board of California; United States of America, Internal Revenue Service, Appellees (9th Circuit No. 11-16276; September 15, 2014).

[4] F. Scott Fitzgerald, The Rich Boy, in The Short Stories of F. Scott Fitzgerald: A New Collection 317  Matthew J. Bruccoli ed., Scribner 1989) (1926).

[5] Ernest Hemingway, The Snows of Kilimanjaro, in The Snows of Kilimanjaro and Other Stories 23 (Scribner 1961) (1936). (Hemingway, quoting the critic Mary Colum without attribution, used Fitzgerald’s name in the original magazine version of the short story, but altered the name to “Julian” in the later published book. See Eddy Dow, Letter to the Editor, The Rich Are Different, N.Y. Times, November 13, 1988, available at http://www.nytimes.com/1988/11/13/books/l-the-richare- different-907188.html.)

[6] The Ninth Circuit also noted that the IRS received a $3.4 million distribution pursuant to a  liquidating plan of reorganization, which was confirmed by the bankruptcy court.

 

Voluntary Disclosure. Practitioners often struggle with the issue of whether a taxpayer can avoid a criminal tax investigation by making a disclosure to the IRS.  A “voluntary disclosure” is generally the process of voluntarily reporting previously undisclosed income (or false deductions) through an amended return or the filing of a delinquent return. A taxpayer’s timely, voluntary disclosure of a significant unreported tax liability is an important factor to the IRS in considering whether the matter should be referred to the U.S. Department of Justice for criminal prosecution.

A voluntary disclosure must be truthful, timely and complete, and the taxpayer must demonstrate a willingness to cooperate (and must in fact cooperate) with the IRS in determining the correct tax liability. Further, the taxpayer must make good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable. Additionally, the policy only applies to income earned through a legal business – so called “legal source” income.

IRS and JOJ Voluntary Disclosure Practice. Importantly, the IRS Voluntary Disclosure Practice describes a voluntary disclosure to include: (6) Examples of voluntary disclosures include: a. a letter from an attorney which encloses amended returns from a client which are complete and accurate (reporting legal source income omitted from the original returns), which offers to pay the tax, interest, and any penalties determined by the IRS to be applicable in full and which meets the timeliness standard set forth above. This is a voluntary disclosure because all elements . . . above are met.” See Internal Revenue Manual (IRM) 9.5.11.9. If this process is pursued, it is important that all the appropriate “bells and whistles” set forth in the IRM are followed, exactly.

The Department of Justice maintains a voluntary disclosure policy that provides: “Whenever a person voluntarily discloses that he or she committed a crime before any investigation of the person’s conduct begins, that factor is considered by the Tax Division along with all other factors in the case in determining whether to pursue criminal prosecution. If a putative criminal defendant has complied in all respects with all of the requirements of the Internal Revenue Service’s voluntary disclosure practice, the Tax Division may consider that factor in its exercise of prosecutorial discretion. It will consider, inter alia, the timeliness of the voluntary disclosure, what prompted the person to make the disclosure, and whether the person fully and truthfully cooperated with the government by paying past tax liabilities, complying with subsequent tax obligations, and assisting in the prosecution of other persons involved in the crime.” Section 4.01, Criminal Tax Manual, U.S. Department of Justice (2008).

Further, the Department’s Policy Directives and Memoranda provides: “. . . the Service’s voluntary disclosure policy remains, as it has since 1952, an exercise of prosecutorial discretion that does not, and legally could not, confer any legal rights on taxpayers. If the Service has referred a case to the Division, it is reasonable and appropriate to assume that the Service has considered any voluntary disclosure claims made by the taxpayer and has referred the case to the Division in a manner consistent with its public statements and internal policies. As a result, our review is normally confined to the merits of the case and the application of the Department’s voluntary disclosure policy set forth in Section 4.01 of the Criminal Tax Manual.” Section 3, Policy Directives and Memoranda, Tax Division, U.S. Department of Justice (02/17/1993).

A practitioner should always advise a client seeking advice about a potential voluntary disclosure that the client must comply with the next set of filing requirements. Any suggestion to the contrary by the practitioner could subject him or her to potential criminal liability for aiding or assisting in the failure to file a return or the filing of a false return. This precept becomes important because many clients express a fear that a current filing may trigger scrutiny of their prior conduct, and some change their minds about making a voluntary disclosure prior to actually filing. Thus, the practitioner should always advise the client of the legal requirements for the current filing season and memorialize in the file that such advice was given.

Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution.  A timely voluntary disclosure will not guarantee immunity from criminal prosecution, but a true voluntary disclosure will normally result in the IRS not even recommending a criminal prosecution to the Department of Justice.

Timely? To be timely, the disclosure must generally be received before: (i) the IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation; (ii) the IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance; (iii) the IRS has initiated a civil examination or criminal investigation which is directly related to the specific liability of the taxpayer; or (iv) the IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena).

Any taxpayer who contacts the IRS regarding voluntary disclosure may be directed to IRS-CI for an evaluation of the disclosure. To determine whether the disclosure is truly voluntary, IRS will review the actual status of any prior interest in the taxpayer, the taxpayer’s potential knowledge of such interest, and the taxpayer’s fear of some potential trigger that could have alerted the IRS.  A voluntary disclosure cannot be made anonymously. Any plan by a taxpayer, or their representative, to resolve a tax liability, file a correct return, or offer payment of taxes for an anonymous client is not likely to be considered a voluntary disclosure.

A voluntary disclosure does not occur until IRS has actually been contacted.  As such, it is imperative that the disclosure occur as quickly as possible.  Since returns filed pursuant to a timely voluntary disclosure have significant audit potential, they should be “bulletproof” in correctly reflecting the taxpayer’s income and expense items.

Fed-State Information Sharing. Due to various federal-state information sharing agreements, any applicable state returns should be contemporaneously filed or amended with the federal returns. Returns for related entities should also be contemporaneously filed or amended. Questions or doubts should likely be resolved in favor of the government. If a return filed pursuant to a voluntary disclosure is less than accurate, the taxpayer is compounding – not helping the problem.

Qualified Amended Return (QAR). Under certain situations, a timely  filed amended return may reduce or eliminate accuracy-related penalties. The “amount shown as the tax by the taxpayer on his return” not subject to penalties includes an amount shown as additional tax on a QAR, except that such amount is not included if it relates to a fraudulent position on the original return. See Treas. Reg. § 6664-2(c).  A QAR effectively eliminates accuracy-related penalties by removing amounts shown on the amended return from the penalty calculation. Significantly, even if timely, an amended return does not qualify as a QAR if the tax deficiencies that are corrected in the amended return relate to a fraudulent position on the original filed return.

How many returns must be filed or amended?  While there is certainly no well-established rule as to how many returns must be filed in making a voluntary disclosure, the general consensus is probably six tax years since the applicable statute of limitations for most tax related crimes is six years.  The disclosure should eliminate any government concern that there might be any potential issues with respect to a particular tax year for which the applicable statute of limitations for criminal prosecutions has not already expired. Additional returns could be in order since the statute of limitations for a criminal prosecution is tolled for the period of time a taxpayer is outside of the United States or is a fugitive from justice.

Typically, in a civil context, it is also the IRS policy to enforce the filing of returns for the prior 6 tax years.  In considering whether shorter or longer periods should be civilly enforced, the IRS will determine the prior history of non-compliance, the possible existence of income from illegal sources, the effect on voluntary compliance, the anticipated revenue in relation to the time and effort required to determine the tax due, and special circumstances existing in the case of a particular taxpayer, class of taxpayer, or industry, which may be particular to the class of tax involved.

Should IRS be Contacted Directly? Counsel must determine whether to contact the IRS before submitting a voluntary disclosure and actually filing the delinquent or amended tax returns. Some practitioners prefer to submit a Freedom of Information Act (FOIA) request seeking income information already in the possession of the IRS before filing the returns.  Some simply choose to file the delinquent or amended returns, with payment of tax and interest, with the appropriate IRS service center (now referred to as a “campus”) by certified mail, return receipt requested.  Such filings occur during the typical tax return filing season (around April 15 and October 15 for individual returns).

Some prefer making the voluntary disclosure in a meeting with the Special Agent in Charge of the local IRS-CI where the investigation would be conducted.  At this meeting, the potential voluntary disclosure would initially be discussed in a hypothetical format.  Counsel would generally outline the facts in hypothetical form (probably in writing) and would request whether IRS-CI would consider the return filing to be a voluntary disclosure in order to avoid recommendation of a criminal prosecution.

Counsel may also attempt to secure an IRS waiver of all applicable penalties before revealing the taxpayers identity.  In the event that IRS-CI responds affirmatively, counsel would then disclose the client’s identity and taxpayer identification number. However, IRS will assert that there has not been the requisite “disclosure” until the taxpayers information has been provided to the IRS.Properly resolving these issues can mean the difference between a taxpayer being subjected solely to civil tax adjustments (and possibly civil penalties), criminally excused of a tax crime or being convicted on the basis of admissions derived from the voluntary disclosure itself.

Certainly, the IRS has a somewhat limited capacity to perform criminal investigations. However, a significant amount of time is not required to criminally investigate and seek to prosecute a non-filer, particularly one who files delinquent or amended returns following an IRS inquiry. Without adequate representation, the perceived light at the other end of the voluntary disclosure tunnel . . . may be the IRS train coming straight at the taxpayer!

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