Take the right steps to advise your client and to protect yourself during a tax fraud investigation.
By James H. Schlesser, CPA
Your client just called and left the following message: “I answered the door at my home today, and an agent who said he was from the IRS Criminal Investigation Division wanted to ask me some questions. What should I do?”
While you may never get a call from a client exactly like this, it is important to know that taxpayers may reach out to their adviser, such as a CPA, during the initial stages of an IRS investigation that could result in allegations of criminal misconduct. How you handle this call and other situations like it is important in providing your client with quality service and defining your role in a tax fraud investigation.
As a practicing CPA, you should be alert to a taxpayer’s possible exposure to allegations of fraud or other criminal misconduct. The consequences to the taxpayer from conviction are generally imprisonment and substantial monetary penalties. While CPAs may provide valuable advice concerning tax liability and IRS administrative procedures, once a client’s actions appear potentially to constitute fraud or another crime (see sidebar, “How the IRS Defines and Prosecutes Tax Fraud,” below) CPAs should refer that client to an attorney experienced and skilled in this area. If the CPA is not also an attorney, he or she must avoid acting in a way that could be considered practicing law. However, knowing criminal tax fraud legal definitions and IRS investigative procedures can help CPAs avoid inadvertently complicating or hampering legal representation of the client.
SOURCES OF CRIMINAL INVESTIGATIONS
Investigations conducted by the IRS’ Criminal Investigation Division (CI) are generated from various sources, but the largest source is IRS civil examinations. Because the IRS cannot criminally prosecute every taxpayer suspected of having a willful intent to violate the IRC, other factors are often evaluated in deciding whether to pursue a criminal prosecution. Generally, single instances of wrongdoing will not result in criminal prosecution; rather, the government looks for multiple years of ongoing wrongful behavior before it charges a taxpayer with a crime, as opposed to civil penalties. Part 25 of the Internal Revenue Manual (IRM) gives examples of indicators of fraud that, if uncovered during an examination, can trigger a criminal investigation or the assertion of a civil fraud penalty. They include:
* Omissions of entire sources of income.
* Substantial unexplained increases in net worth, especially over a period of years.
* Substantial amounts of personal expenditures claimed as business expenses.
* Keeping two sets of books or no books.
* Amounts on return not in agreement with amounts in books.
* Backdating of applications and related documents.
* Assets placed in others’ names.
Because an IRS field agent conducting a civil examination is under no obligation to inform a taxpayer when a case has been referred for criminal investigation, the first indication that a taxpayer is under criminal investigation may come when an IRS special agent requests an interview with the taxpayer. A taxpayer who is interviewed before he or she has obtained representation by a criminal attorney may make incriminating statements that can later be used against him or her in a criminal prosecution.
Once a special agent has been assigned to the client’s case, the CPA should cease representation of the taxpayer. Representing a taxpayer in a criminal tax investigation requires specific knowledge and expertise that most tax advisers do not possess. Moreover, the tax adviser may be considered a witness in the criminal investigation and be subpoenaed to testify against the taxpayer.
ACCOUNTANT-CLIENT PRIVILEGE LIMITED TO NONCRIMINAL MATTERS
Section 7525 extends the common-law attorney-client privilege to tax advice furnished by a federally authorized tax practitioner; however, it may be asserted only in noncriminal tax matters. The IRS takes the position that the accountant privilege does not cover communications that took place in the context of a civil proceeding that later becomes a criminal matter.
Furthermore, at least one court has held that statements made by taxpayers during a civil examination can later be admitted as evidence in a criminal case, even where IRS agents fail to follow the IRM’s instructions to suspend the examination and refer the case to the criminal division once a firm indication of fraud has surfaced. In U.S. v. Rutherford, docket no. 06- 20207, E.D. Mich. (2007), rev’d and remanded, 555 F.3d 190 (6th Cir. 2009), a civil examination into a nonprofit’s tax-exempt status quickly turned into an investigation of potential tax fraud by the nonprofit’s officers. Although the court agreed that the IRS civil agents probably should have made a criminal referral sooner (which would have had the effect of putting the defendants on notice that the investigation was now a criminal one), it did not bar the use of interview statements the defendants made after that point but before it officially became a criminal investigation. The defendants were represented by a CPA when the interviews were conducted.
PROTECTING DOCUMENTS AND OTHER MATERIALS
A CPA should take steps to protect any materials related to services rendered with respect to a client with a potential criminal matter. The taxpayer’s attorney will find it helpful to know what documents have already been provided to the IRS, as well as the substance of any interviews. If the CPA has a document retention policy that calls for disposal of materials related to the matter, the CPA should consider extending the retention period for the materials. To the extent the CPA is performing services for the client through a Kovel arrangement, the CPA should look to the attorney who has engaged him or her for direction regarding maintaining and retaining any materials related to the potential criminal matter. In a Kovel arrangement (named for U.S. v. Kovel, 296 F.2d 918 (2nd Cir. 1961)) an accountant works directly for an attorney, assisting the attorney as an interpreter of technical tax issues, enabling the attorney’s rendering of legal advice (see “Attorney-Client Privilege: CPAs and the E-Frontier,” JofA, April 2004, page 64).
ENCOUNTERING POTENTIAL FRAUD
Having effective client acceptance policies and procedures is an important part of the CPA’s practice management. These policies and procedures should include that, when a CPA screens a new client, if any potentially criminal matters come to light, the CPA should request that the prospective client engage the services of appropriate legal counsel before beginning the engagement. Screening of a client may include procedures such as background checks and other information searches that would bring to the attention of the CPA relevant information concerning the prospective client’s business and personal affairs. To the extent the prospective client is unwilling to engage the services of legal counsel, the CPA should consider whether establishing the business relationship is appropriate.
AICPA Statement on Standards for Tax Services (SSTS) no. 6, Knowledge of Error: Return Preparation and Administrative Proceedings, provides that if a CPA believes a taxpayer could be charged with fraud or criminal misconduct, the CPA should advise him or her to consult with an attorney before the taxpayer takes any action. Additionally, you may need to consider whether to withdraw from the performance of further tax (or other) services for the client and whether to continue a professional or employment relationship with the client. The client should be aware of the need to retain legal counsel and the potential lack of protection that is provided with respect to communications between you and the client. When you advise the client of the need to engage legal counsel, you should be aware that any communication made between you and the client could be subject to an investigative summons or grand jury subpoena.
A CPA may become aware of circumstances such as an error on a previously filed tax return of the client or of the client’s failure to file a required tax return. Such circumstances or others (see the indicators of fraud in the IRM) can arouse the suspicion of examining agents. Under SSTS no. 6, in these circumstances, a CPA should inform the client of the error or failure to file and recommend that corrective measures be taken. If the CPA believes the client could face possible exposure to allegations of fraud or other criminal misconduct, the CPA should advise the client to consult legal counsel before taking any other action.
A client who has committed tax fraud may be able to avoid criminal liability by making a voluntary disclosure before the IRS has discovered the fraud. However, such a disclosure should be approached with caution and after obtaining the advice of legal counsel, since it can backfire and lead to criminal prosecution (see “Voluntary Disclosure to the IRS: A Viable Option,” JofA, March 2008, page 40). The CPA may not inform the taxing authority of the error or failure to file without the taxpayer’s permission, except when required by law. If the client does not correct the error, the CPA should consider whether to continue a professional relationship with that client. If the CPA decides to maintain the client relationship and prepare a return for a year subsequent to that in which the error occurred, the CPA should take reasonable steps to ensure the error is not repeated. If the subsequent year’s return cannot be prepared without perpetuating the error, the CPA should consider withdrawing from the return preparation.
CPA LEGAL LIABILITY
Generally speaking, when a CPA is providing advice on behalf of a client with respect to a potential criminal matter, the CPA would not necessarily need his or her own legal representation. In some instances, however, based on the nature of the services the CPA previously performed for the client, it may be advisable for the CPA to engage separate legal counsel. The CPA should analyze the services that have been performed, along with understanding the provisions of the arrangement with the client as well as other business arrangements, such as insurance coverage the CPA may have, when considering seeking the advice of legal counsel.
Editor’s note: Portions of this article are adapted from Client Criminal Matters and the CPA: Practice Guide, developed by the author for the AICPA Tax Division, January 2011. The full guide is free to members of the AICPA Tax Section.
How the IRS Defines and Prosecutes Tax Fraud
The most familiar tax offense is tax evasion under IRC § 7201. Tax evasion is a felony, with a maximum sentence of five years in prison. The elements of tax evasion are (1) a deficiency in tax, (2) an affirmative act or attempted act of evasion, and (3) willfulness. An affirmative act of evasion means something more than a failure to perform a duty, such as file a return. An affirmative act of evasion is conduct that has the likely effect of misleading or concealing wrongdoing. Willfulness requires the intentional violation of a known legal duty, as opposed to a careless disregard for the truth or negligence. The test for willfulness in tax evasion is subjective rather than objective, and good faith reliance on the advice of a tax practitioner (after complete factual disclosure to the practitioner) is a defense to the crime.
Where it may be difficult to prove the element of a tax deficiency beyond a reasonable doubt, the government will often bring charges under section 7206(1), for willfully making and subscribing to a false return, statement or other document, which also is a felony. Section 7206(1) sets forth the following elements for this offense: (1) the willful making and subscribing to a return, statement or other document under penalties of perjury and (2) not believing it to be true and correct with respect to every material matter. The IRS also has authority to investigate crimes arising under Title 18 of the U.S. Code, sections 1956 and 1957, which deal with money laundering, and Title 31 U.S.C. sections 5311 and following, the Bank Secrecy Act.
To successfully prosecute a criminal tax case, the government must prove its case beyond a reasonable doubt, whereas in a civil case, the IRS has to prove the case only by clear and convincing evidence. From a factual proof standpoint, the element of willfulness can be the hardest to establish.
Civil penalties. However, civil penalties may also arise from a case that is investigated as potential fraud, particularly the fraud penalty of section 6663. The penalty amount is 75% of the portion of an understatement of tax attributable to fraud, but note that if any part of an underpayment of tax is due to fraud, the entire underpayment is presumptively attributable to fraud, and the taxpayer bears the burden of proving otherwise (section 6663(b)).
Criminal investigations. The IRS’ Criminal Investigation Division (CI) conducts an investigation and may recommend a case for prosecution. The case is then reviewed by the Tax Division of the Department of Justice (DOJ). If the Tax Division authorizes prosecution, the prosecution will usually be handled by the local U.S. attorney’s office. Once the case is referred to the Tax Division, the IRS may not issue or enforce an administrative summons with respect to the taxpayer for the same tax and the same taxable period. In circumstances where CI either cannot complete its investigation or otherwise determines that it cannot effectively gather information through the administrative process, it may request that the Tax Division authorize a grand jury investigation.
Taxpayers may be subject to criminal prosecution for felonies including tax evasion under IRC § 7201 and filing false returns under section 7206. CPAs with clients with a possible exposure to criminal fraud allegations require appropriate advising and consultation, usually including a referral to an attorney experienced in such matters.
In addition to criminal investigation, the IRS may also pursue civil penalties, including the section 6663 fraud penalty. The penalty amount is 75% of the portion of a tax understatement attributable to fraud, with the taxpayer bearing the burden of proving that any part of an underpayment is not attributable to fraud.
Criminal cases are typically investigated by the IRS’ Criminal Investigation Division. Cases are reviewed by the Department of Justice’s Tax Division, which may authorize a prosecution by a local U.S. attorney’s office or grand jury investigation.
Criminal investigations often begin as civil examinations in which omission of sources of income or substantial personal expenditures claimed as business expenses are “red flags” that may trigger a criminal referral. IRS field agents conducting a civil examination are not obligated to inform the taxpayer when a case has been referred for criminal investigation, and incriminating statements from a civil examination can be used in a criminal prosecution.
The tax practitioner privilege of client confidentiality does not extend to criminal matters, and at least one court has held admissible in a criminal case taxpayer statements made before a civil examination became a criminal investigation, even though examiners should have made the criminal referral sooner.
CPAs should have a document retention policy to preserve evidence helpful to a criminal defense. CPAs may also assist an attorney representing a client through a Kovel arrangement, interpreting technical tax issues to better inform the attorney’s legal advice.
Through their client acceptance policies and procedures, CPAs should screen new clients for any possibility of criminal exposure. The AICPA Statements on Standards for Tax Services provide guidance for AICPA members in such situations. In some situations, the CPA may also need legal representation.
James H. Schlesser (firstname.lastname@example.org) is managing director of Deloitte’s U.S. India tax practice and a former member of the AICPA Tax Practice Responsibilities Committee.