Warning Signs of an IRS Criminal Tax Prosecution Referral
Posted by Hochman Salkin Toscher Perez P.C. 
Posted on Monday, November 03, 2014
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.
