Sensitive Issue Tax Examinations – the “Eggshell Audit”
Representation of clients involved in an audit or dispute with the Internal Revenue Service require the exercise of considerable judgment, discretion, and caution. There are often unknown, potentially sensitive issues that might unexpectedly arise during the course of any audit. Throughout, the representative must balance their duties to their client with the representative’s ethical and legal obligations. Effective representation requires that the representative understand the inherent limitations involved at each level of the administrative process. Further, and most important, the representative must be able to acknowledge their own limitations.
A practitioner is often faced with the issue of whether a taxpayer can possibly prevent a criminal tax prosecution by making a voluntary disclosure of past misconduct to the Internal Revenue Service. Resolving this issue properly is of great importance as it can mean the difference between a taxpayer being excused of filing a fraudulent return or failing to file a return, and possibly being convicted of a tax crime on the basis of admissions derived from the disclosure to the IRS.
Within the complex world of tax administration, we should all be reminded of the following comments of Judge Learned Hand:
. . . the words of such an act as the Income Tax *** merely dance before my eyes in a meaningless procession: cross-reference to cross-reference, exception upon exception – couched in abstract terms that offer no handle to seize hold of – leave in my mind only a confused sense of some vitally important, but successfully concealed, purport, which it is my duty to extract, but which is within my power, if at all, only after the most inordinate expenditure of time. I know that these monsters are the result of fabulous industry and ingenuity, plugging up this hole and casting out that net, against all possible evasion; yet at times I cannot help but recalling a saying of William James about certain passages of Hegel: that they were, no doubt, written with a passion of rationality; but that one cannot help wondering whether to the reader they have any significance save that the words are strung together with syntactical correctness. *** [Hand, “Thomas Walter Swan”, 57 Yale L. J. 167, 169(1947).]
The Audit Letter. Against this background it must be acknowledged that an Internal Revenue Service civil audit letter may, in some cases, also signal the beginning of a potential civil or criminal fraud investigation. The potential fraud/criminal exposure could be based on items set forth on a return such as unreported income, improper deductions or some other false or inaccurate statement on the return. The taxpayer’s representative must immediately adopt a defensive posture with respect to the “areas of sensitivity,” especially given the “Indirect Method / Financial Status” audit techniques being utilized by Internal Revenue Agents.
Involvement of Counsel? If there are potentially sensitive issues, the taxpayer should be interviewed by counsel in order to determine whether there is a need to fully preserve potentially privileged information. In turn, counsel should consider engaging the accountant to coordinate the audit on behalf of the taxpayer. Under the doctrine of United States v. Kovel, 292 F.2d 18 (2d Cir. 1961), the investigative accountant may be clothed with an extension of the attorney’s privilege. Further, and of significant importance to the accountant, the accountant might become the subject of a malpractice action if not engaged by the taxpayer’s counsel in the event information revealed to the accountant during or in preparation of an audit is ultimately required to be unnecessarily disclosed to others.
Due Diligence Required. Effective representation of a taxpayer during an audit requires a thorough review of the taxpayer’s general financial activities not otherwise set forth on the returns. Section 7602(d) has been added to the Internal Revenue Code to prohibit the use of “financial status” or “economic reality” examination techniques to search for unreported income unless there is a “reasonable indication” that there is a likelihood of unreported income.1 Under the financial status approach, a taxpayer’s total financial situation is evaluated to assure that the tax return accurately reflects reportable income. It is an approach designed to compare information set forth on a return with the taxpayer’s financial lifestyle or business activities. It is also an attempt by the IRS to increase compliance and search out potentially fraudulent situations.
Indirect Methods of Determining Income. Historically, conventional audit techniques have been discovered to be grossly inadequate for the purpose of demonstrating an understatement of taxable income. In such event, the government has often resorted to one or more indirect methods of detecting unreported income (often including a Bank Deposits Analysis, Expenditures Analysis, Net Worth Analysis and/or Mark-Up Analysis).2 Indirect methods may generally be pursued, even though the taxpayer’s books and records appear reliable. In fact, the indirect method often provides strong evidence that the taxpayer’s books and records are otherwise unreliable.3 In Holland v. United States, the Supreme Court stated:
“To protect revenue from those who do not render true accounts, the government must be free to use all legal evidence available to it in determining whether the story told by the taxpayer’s books accurately reflects his financial history.”4
Further, indirect methods as a basis of providing reliable estimates of the taxpayer’s taxable income have been consistently affirmed on the basis that:
“To require more would be tantamount to holding that skillful concealment is an invincible barrier to proof.”5
A better-equipped IRS has been able to ferret out potentially sensitive issues in a manner often compromising the relationship between a taxpayer and their non-lawyer tax practitioner. Is the IRS now somewhat prevented from applying various indirect methods to determine if there is a “reasonable indication” of unreported income? Historically, a more in-depth investigation did not occur until there was otherwise an inability to reconcile a taxpayer’s income. Calculations based on an indirect method have always required corroboration through proper and competent evidence, including interviews with the taxpayer, records furnished by the taxpayer, and third-party sources. As such, legislative efforts have not had a significant impact on the use of indirect methods of proving a taxpayer’s income.
The Interview. Agents often seek testimonial evidence through interviews of the taxpayer and third parties. A question most often presented is whether the taxpayer and others should consent to interviews by the Revenue Agent or force the issuance of Summonses or invoke Constitutional protections. Certainly, if there are extremely sensitive (i.e., potentially criminal) issues, the taxpayer should not consent to an interview and should invoke their Fifth Amendment privilege against self-incrimination. It is preferable for a taxpayer to avoid providing incriminating information when compared with the possibility of propelling a civil tax examination into a criminal tax investigation/prosecution.
Agents often seek to interview taxpayers near the commencement of an audit. Unfortunately, near the commencement of the audit, the representative typically does not have sufficient information to determine whether there are potentially sensitive issues that might arise during an interview of the taxpayer. If possible, it is often preferable to postpone a taxpayer interview if the representative is otherwise able to provide prompt responses to relevant inquiries. Also, representatives should consider their client relationships in agreeing to have the client interviewed. Clients often engage a representative believing the representative is capable of appropriately interacting with the government agents. When requested to submit to an interview, some clients believe the agent has requested the interview because the representative might not have been appropriately or fully cooperating with the government agents.
If a taxpayer interview is necessary and otherwise unavoidable (it is always avoidable in a potentially criminal sensitive issue case), the interview should occur far into the audit process such that the representative can appropriately assist the taxpayer in preparing for the interview. Under any situation, the representative must prevent presentation of false or misleading information or the presentation of false statements by the taxpayer or the taxpayer’s representative. Presentation of false statements or documents significantly enhances the potential for penalties and a possible criminal investigation/prosecution (that may include an investigation of the representative).
Prior to a taxpayer interview, the representative should attempt to obtain the actual questions or determine areas that the government agent desires to examine. An interview at the representative’s office provides the taxpayer with a more supportive environment for what might be an extremely agonizing experience. The taxpayer should be less intimidated and should feel more comfortable than in the unfamiliar confines of an IRS office.
All relevant information must be closely scrutinized to determine plausible and supportable explanations for any potentially sensitive audit issues, whether or not such issues are set forth on the return. Although there may be plausible explanations for potentially sensitive issues that arise during the course of an audit, responsive statements by the taxpayer should not merely be repeated to an government agent. Any potential explanation should be supported by credible evidence.
Information Gathering by the Government. During the information gathering stage of an audit, a government agent may either ask for information verbally, or may issue an informal Information Document Request (“IDR”). If responses to an IDR are not forthcoming or are clearly insufficient, the government agent may issue an administrative Summons. The IRS has broad authority to summons books and records, the taxpayer, or any person having custody of records in order to ascertain the correctness of the taxpayer’s return, to make a return, or to determine the liability of a taxpayer.6
The Summons will set forth the date, time and place, where the summoned party is to appear, although at least ten (10) days’ prior notice of appearance is required.7 Compliance with the Summons may take the form of a formal question-and-answer session under oath, an informal interview, or the submission of (or providing access to) the records being summoned. The witness summoned is entitled to decline to produce documents or to answer particular questions if a good-faith basis exists for an objection to compliance.8
If a taxpayer fails to comply with a Summons, the IRS may decide to proceed with Summons enforcement. To succeed in enforcing a Summons, the IRS must demonstrate: (1) that the investigation is being conducted pursuant to a legitimate purpose; (2) that the inquiry is relevant to that purpose; (3) that the information sought is not within the possession of the IRS; and (4) that the IRS has followed the administrative steps required by the Internal Revenue Code.9 Jurisdiction to enforce a Summons is in the United States District Court for the District in which the summoned person resides.10 A District Court Judge has the power to imprison anyone required to respond to a Summons. Typically, if the IRS proceeds to issue a Summons, it intends to enforce compliance with the Summons through a District Court proceeding, if necessary.
Applicable Privileges. Although the IRS Restructuring and Reform Act of 1998 extended common law protections of confidentiality to tax advice rendered between a taxpayer and a federally-authorized tax practitioner (to the extent such communications would be considered privileged if they occurred between a taxpayer and counsel), the statutory privilege only applies to non-criminal tax matters before the IRS and non-criminal tax proceedings in federal court.
The 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.11 On the contrary, if the accountant is appropriately engaged by counsel (see United States v. Kovel, 292 F.2d 18 (2d Cir. 1961), 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.