Tax Representation in Sensitive Audits and Investigations
Representation of Clients' interests before the Internal Revenue Service in a tax audit or investigation may involve the Client's concern that "sensitive" matters will be exposed to scrutiny. This is only natural. Whenever some impropriety of action is insinuated against an individual by any agent of government, but most especially at an early stage of an "inquiry," a point of tension is reached. An IRS Agent's request for production of documents or for answers to questions projects no good consequence to the client. Performance (production of requested evidence) is often delayed. When more demands and more probing questions follow within a timeframe seen by the Client to be unreasonable, the Client naturally feels hostility. In these situations, to be effective, I must be aware of all of the facts and any limitations of evidence, including evidence which may seriously prejudice the Client's case during an audit or investigation process. Responses to an agent must be truthful. It is my duty as lawyer and advocate for my Client to present all evidence available in support of the Clients position on tax issues in the most favorable light possible, often with reference to arguments from reported cases. It may be desirable to invoke privileges or other defenses in avoidance of production of evidence, especially where evidence is not fully understood, is too extraordinary to be believed, or requires further investigation before it might be presented in a light favorable to the Client.
The Client is an integral part of the decision making after discussion of evidence, privileges, defenses and so forth. These discussions take place in the context of the case in various stages of development and run to what the Client did, how it was done and if not done right, and how one will go about fixing it. If a case cannot be put right with the government on the facts and evidence at hand, the question becomes how ought it be defended to the point of some result favorable to the Client? Often it is on the horns of a dilemma that a government's demands for information and the pressures of an audit or investigation are addressed.
It is clear that all client evidence, whether a document produced or a statement made by the client or a third party, will be seen by an examining agent to carry a certain weight. In order for a finding of fact to be made by an agent, there must be a foundation in evidence to support that finding. Evidence which is authentic is the foundation upon which facts are stated to be knowable or known. This process is called "making findings of fact." In "sensitive" cases there may not be a sufficiency of persuasive evidence available to the Client to defeat a finding by the government that claims made by a client on income tax returns are false. An agent may in this context of a finding of fact form an opinion during an examination that the evidence upon which the facts are found so contradicts claims made on income tax returns that fraud may have formed some part of the basis of reporting. If so, there is a civil fraud context or a criminal fraud context to the finding or opinion of the examining agent.
In the civil context, the government must rely on evidence which is "clear and convincing" as a demonstration that a client violated a known legal duty and did so willfully. In the context of criminal tax fraud, the evidence must prove beyond a reasonable doubt that the taxpayer violated a known legal duty and did so willfully. The word "willfully" therefore means different things in the civil and criminal contexts. The difference as can be seen is one of degree. Again, it is the weight of evidence in support of a finding that a taxpayer violated a known legal duty which determines how willful that violation is seen to have been, i.e., civilly willful or criminally willful. Adding to the complexity of the analysis is the observation that evidence is very rarely direct. It is virtually always circumstantial. In the context of signing a tax return for example, evidence of a taxpayer's knowledge of a material misstatement or omission or willful blindness to obvious or material errors is virtually always circumstantial. Most, if not all adjustments, accusations or prosecutions proceed upon inferences from the evidence. The line between the threat of a proposed civil fraud penalty and of a criminal tax prosecution recommendation is often based upon mere attenuated subtleties in the compilation of proof.
It can be seen from the foregoing that there is a fine balance between clear and convincing proof and proof beyond a reasonable doubt. Criminal exposure can be based on items misrepresented on a return, unreported income, improper deductions, or false statements made on a return or before government agents. Most methods by which unreliability of information presented by a Client on a return or in any supporting documentation is proved are based on circumstantial rather than direct evidence.
Often, when it is determined that a Client's original return or returns as filed were erroneous in material matters presented, preparation and presentation of an amended return or returns may be advisable. Although an amended return will often be an admission against the Client's interest, it is usually done to present good faith changes to reflect honest error or omission on the original(s). When and if I must consider engaging a certified public accountant on behalf of the Client I will consider the doctrine of United States v. Kovel, 292 Fed. 2nd 918 (2nd Cir. 1961). I must do so to protect the client where a third party where a third party return preparer is advisable to present admissions of errors or omissions. The latter case holds that an accountant employed by the client's attorney is clothed with the same privileges as the attorney.
An interview with the Client at or near the time at which an audit letter or criminal investigation letter is received will be requested by an agent. Effective representation requires a thorough review of the Client's financial activities. Indeed, all issues of concern to the Client which might be raised in the context of the audit or investigation must be thoroughly reviewed before such a meeting ever takes place, if it does. During the information gathering stage of an audit or criminal investigation, the IRS agent may or will issue administrative summonses requiring the Client or a keeper of records for the Client and any third parties to provide relevant books, records and testimony to him or to her at an appointed time. It can be anticipated that after the information sought has been obtained by the revenue agent or special agent, the agent's focus upon a method for reconstructing a Client's income will commence.
A source and application of funds method may be used. This method compares all known expenditures during a taxable year with all known receipts of income for the same year and challenges the Client to explain sources of funds for expenditures which exceed documented sources.
Another method is the bank deposits method. This method is based on the premise that a Client's bank deposits most frequently represent income. The total of deposits is computed for the tax year in question to determine gross receipts. Adjustments proposed by the IRS agent are up to the Client to prove. The bank deposits method is generally used where the client's books and records are inadequate to support the correctness of the receipts and expenditures reported on the return, or where the Client refuses to make records available after consultation.
Another method is the net worth method. This is the best known of the circumstantial methods of proof of evasion. It is not regularly applied to routine cases where other methods of proof are sufficient and involve less substantial analysis. Again, this method might be used when the Client is unable or refuses to produce books and records.
All of the circumstantial methods used by the IRS to reconstruct a Client's income are used to support the government's burden to prove an understatement which is an agent after review has concluded may have been due to the fraud. In practice, one must move affirmatively to prove the contrary of government assertions or insinuations during an investigation by production of evidence [after evaluation], with limitations on the scope of production negotiated as far as possible.
Agents for the government maintain a record of all conversations during an investigation. It is part of an agent's job to attempt to obtain admissions concerning all relevant facts. A Client has the right to resist an agent's request for an interview pursuant to Internal Revenue Code Section 7521(c) unless an administrative summons is served on the Client to appear and to testify. Even then, the constitutional right to remain silent is an absolute right. If potential criminal fraud issues are made manifest in the facts of a case, the Client's answers to questions about transactions could incriminate him or her [a corporation possesses no right to assert the privilege against self-incrimination]. Where self-incrimination is evident where testimony will be given, I must consider having my Client assert the Fifth Amendment privilege not to make statements "from his own lips." Invoking the privilege may increase the potential for further investigation and risk initiation of a criminal prosecution recommendation to the Department of Justice. Not invoking may appear to make conviction more probable. However, indeed, it appears to be more the case than not in criminal audits or investigations that a Client will prefer to testify, and will seek aggressively to remove any onus of wrongdoing. The Client will be cautioned against making false or misleading statements in such cases. The Client makes the final decision on how he wishes to proceed after having been advised concerning risk. No one knows the future, after all. One can only hope to influence it in a positive way. Production of evidence, limitation of the scope of inquiry, persuasive argument, explanation even of "sensitive" matters in good faith may, in the end, avoid criminal prosecution and conviction, or, if not, ameliorate hardship which might have been the case had the client asserted his right to have the government prove its case, but had lost. Such potential for harm as may in any difficult conflict be seen at the beginning is quite often not realized in the end. This is indeed what I have persevered to achieve throughout my career as a criminal tax defense attorney.
Theodore L. Craft, Esq., L.L.M.