While the government tactics in the KPMG tax shelter indictments have caused a stir in the legal community, they are indicative of a larger government effort to crush advocacy and deprive citizens of due process. Examples of this increased aggressiveness include changes to the bankruptcy code, the recent revisions to Treasury Circular 230, and the treatment of KPMG’s assertion of the attorney-client privilege as non-cooperation under the federal sentencing guidelines. In the case of KPMG, the government essentially treated the assertion of due process rights like the attorney-client and Kovel privileges and the refusal to extend the statute of limitations, as criminal conduct. Attorneys practicing before the government must be both careful and courageous in the face of this aggressive wielding of government power as rule changes have raised the specter of personal liability for attorneys who don’t toe the government line.
Increasingly aggressive government tactics have been directed at taxpayers and their practitioners as well. In recent years, the parallel investigation, or reverse eggshell audit, has become a favorite tool of the IRS. A reverse eggshell audit is essentially a criminal tax investigation disguised as a civil audit. The benefit to the government of such an investigation is that it allows the government to use the investigative tools of a civil audit, like administrative subpoenas and examinations of tax records, without the invocation of due process or fourth, fifth and sixth amendment rights. These benefits to the government are similarly grave dangers to taxpayers and their practitioners: under the mistaken belief that they are complying with a civil audit, taxpayers may waive the attorney-client privilege and the right against self-incrimination and other due process if their counsel is not careful.
This material only addresses administrative reverse eggshell audits and does not discuss grand jury investigations. (IRM §188.8.131.52) Reverse eggshell audits/joint investigations occur either after a referral from an examiner to CI, or upon a request by CI that an examiner be assigned to an ongoing criminal investigation. (IRM §184.108.40.206) In either situation, the taxpayer comes under investigation by both the civil and criminal arms of the IRS without necessarily being notified of the criminal investigation. Thus, an audit may be suspended, referred to CI and recommenced while a concurrent criminal investigation continues unbeknownst to the taxpayer.
Administrative summonses are a powerful tool that the IRS can use for either civil or criminal investigations, so long as those investigations are carried out within the IRS. Once a case has been referred to the Justice department, the IRS may no longer issue or enforce administrative summonses against the taxpayer or third parties (banks, title companies, credit card issuers, etc.). (I.R.C. §7602(c)(3)-(d)) In a criminal investigation, the IRS is not required to notify a taxpayer of the issuance of third party summonses. (I.R.C. §7602(c)(3)(C)) Thus, if a civil audit is referred to CI without the taxpayer’s knowledge, third party summonses may also be issued without the taxpayer’s knowledge and the IRS has an incentive to keep the investigation in-house rather than refer it to the Justice Department and lose the administrative summons power.
In a reverse eggshell/joint investigation, the examiner’s primary concern is supposed to be determining civil tax liability, while a special agent (criminal investigator) is concerned with gathering evidence to prove criminal violations. (IRM §220.127.116.11.1) This does not mean, however, that information supplied to an examiner will not be used in a criminal investigation. Because a special agent is required to advise the taxpayer of his constitutional rights against incrimination and the availability of an attorney prior to an interview, such interview will often be delayed, to avoid giving notice while the examiner continues to collect information and conduct interviews with the taxpayer.
Another dangerous situation for a taxpayer is the parallel investigation, in which certain entities or tax years are subject to a criminal investigation while related entities or other tax years are the subject of a simultaneous civil audit. Any information collected by the civil examiner in this circumstance may be used in a criminal referral, again without the taxpayer’s knowledge. (IRM §18.104.22.168.4) Thus, a taxpayer may be under criminal investigation while his closely held corporation is the subject of a civil audit, or he may be under criminal investigation for certain tax years and be the subject of concurrent civil investigation for others.
An eggshell audit is a civil audit in which the auditing revenue agent is unaware that the taxpayer has filed one or more fraudulent tax returns. In this situation, the taxpayer and his practitioner must walk a fine line between cooperating with the auditing revenue agent to avoid suspicion and remaining silent to protect the taxpayer from self-incrimination or consenting to a search. The practitioner’s primary goal in an eggshell audit is to prevent the examiner from referring the case to the criminal investigation unit of the IRS.
A reverse eggshell audit, (also called a “joint investigation” or a sub rosa criminal proceeding) is an audit where the examiner collects information in an apparently civil audit with the intent of contributing the information to a simultaneous criminal investigation of which the taxpayer is unaware. So, rather than the examiner operating in the dark about the taxpayer’s criminal conduct, it is the taxpayer who is in the dark about the auditor’s actual intentions. The practitioner’s role is also different in a reverse eggshell audit: where in an eggshell audit the practitioner seeks to avert a criminal investigation, in a reverse eggshell audit, the practitioner’s primary objective it to discover the criminal proceeding and protect the taxpayer from prosecution and from cooperation which might be used against him.
According to the IRS Fraud Handbook, once a civil examiner discovers “firm indicators” of fraud, he must suspend his audit and refer the case to the Criminal Investigation section of the IRS (“CI”). (IRM §§22.214.171.124, 126.96.36.199) A “firm indicator” of fraud, also called and “affirmative act” is an action that establishes taxpayer intent to defraud. Absent a showing of intent, a criminal prosecution is doomed to failure. (IRM §§188.8.131.52, 184.108.40.206) A firm indicator is not to be confused with an “affirmative indication” of fraud, a sign or symptom which is not actual evidence of taxpayer fraud and which does not automatically trigger a referral. (IRM §220.127.116.11)
In an eggshell audit, once an examiner discovers affirmative indications of fraud, he will consult with his manager and a “fraud referral specialist” to develop a plan of “fraud development,” the purpose of which is to document affirmative acts/firm indicators of fraud, and refer the case for criminal investigation. Thus, even before any criminal investigation has begun, the civil arm of the IRS begins developing evidence for use in a criminal prosecution, and, unbeknownst to the taxpayer and his attorney, the eggshell audit is reversed. (IRM §18.104.22.168)
In an eggshell audit, examiners have been known to continue collecting information without making a referral after the discovery of a firm indicator of fraud, thus conducting their own personal reverse eggshell audits. Such continued investigation by an examiner, absent notification to the taxpayer that information he provides might be used for a criminal prosecution, is a violation of the taxpayer’s 4th, 5th and 14th Amendment rights, and all information collected subsequent to the discovery of the “firm indications” is suppressible under U.S. v. Tousaint, 456 F.Supp. 1069 (1978). However, the reverse eggshell audit is a very dangerous area, because if the examiner’s conduct is a mere deception in violation of IRS procedure but does not violate the Constitution or federal statute, there will be no suppression of the evidence collected by the auditor. U.S. v. Caceres, 440 U.S. 741 (1979).
The best protection for taxpayers is provided by U.S. v. Tweel, 550 F.2d 297 (5th Cir., 1977), which held that while intentional deception of the taxpayer is implicit in a reverse eggshell audit, the deception can only be tacit and cannot be affirmative. If an examiner fraudulently asserts that there is no parallel criminal investigation, or if he continues a civil investigation after the discovery of firm indicators of fraud which is supposed to trigger a criminal referral, any subsequently documents produced by the taxpayer are suppressible in a criminal prosecution. This is a difficult situation for the practitioner, however, because it may be difficult to prove the exact moment at which an examiner becomes aware of firm indicators of fraud for purposes of suppression. Furthermore, if a rule violation does not rise to the level of a constitutional violation, or if the violation is unintentional and does not prejudice taxpayer, there will be no suppression. U.S. v. Caceres, 440 U.S. 741 (1979), Crystal v. U.S. 172 F.3d 1141 (9th Cir., 1999) (where a civil examiner mistakenly told a taxpayer that there was no parallel criminal investigation because he didn’t know about it).
Prior to answering a summons or turning over documents, the practitioner should ask the revenue agent the magic question: “is there is a parallel or sub rosa criminal investigation?” This question serves different purposes depending on whether the audit is eggshell or reverse eggshell. If the audit is eggshell, the question serves to protect the taxpayer, but the practitioner must exercise extreme tact when asking so as not to give rise to suspicion. If the audit is reverse eggshell, the question can rescue the taxpayer, because it will either expose the existence of the criminal investigation or, if the examiner denies the existence of a criminal investigation of which he is aware, any information produced thereafter is suppressible under Tweel.
Another indicator that an eggshell audit has reversed is a temporary suspension of a civil audit. Civil Examiners may suspend an audit or merely cancel an appointment and fail to contact the taxpayer for several weeks while the referral process continues. Thus, not only should the practitioner be on the lookout for suspensions of the audit, he may have to ask the magic question again, as the answer might change. Again, the practitioner must exercise extreme caution here so as not to arise suspicion in the examiner.
The practitioner should ask herself whether the examiner has discovered any firm indicators of fraud. Familiarize yourself with IRM §22.214.171.124,(available here) which lists the indicators of fraud that the examiner is searching for, and put yourself in the examiner’s shoes. Has the examiner encountered one or more of the fraud indicators? What was his reaction to the discovery? Be particularly wary of the methods of concealment by the taxpayer, as they may constitute firm indicators of fraud. Know your case. Pay close attention to the examiner’s question and areas of interest, such as income probe, bank deposits, and net work analysis.
Finally, DON’T BE AFRAID TO TAKE THE FIFTH. If a civil investigation has some telltale signs of a criminal investigation, or if you think the examiner has discovered some firm indicators of fraud but not revealed that discovery, the taxpayer can refuse to answer a summons on the ground that he might incriminate himself. This is another area that might give rise to suspicion in the examiner, but failure to invoke taxpayer’s fifth amendment privileges can be even more damaging to a taxpayer as information gathered by an examiner can be used against the taxpayer in a criminal prosecution. Further, turning that information over to a civil examiner might constitute waiver of the taxpayer’s 4th, as well as 5th Amendment constitutional protections.
Both “eggshell” and “reverse eggshell” audits/examinations are sensitive proceedings. The practitioner must be ever vigilant to protect taxpayer rights. Failure to ask the right questions at the sensitive juncture in the process may result in loss of taxpayer constitutional rights and privileges. Therefore, know your case prior to embarking on the examination process, always be careful and attentive to the areas of IRS inquiry, and walk the courageous and careful line.