36 PRACTICALTAX STRATEGIES JULY2009 ANNE MARIE MINOGUE

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2 D Although the odds of being the target of an IRScriminal Investigation are small, the potential penalty can be quite high, so Investigation targets should obtain expert advice. ANNE MARIE MINOGUE any attorneys and accountants are concerned that one of their clients, without their knowledge, could have done something that could cause the client to become the subject of a criminal tax investigation. In this regard, trepidation is a very real element of tax compliance. In fact, the IRS relies on the fear factor as an incentive for most people to file accurate returns. When should a tax advisor be concerned that a client could be the subject of a probe by the Criminal Investigation (CI) division of the IRS? The answer lies within the client, because the single most differentiating characteristic between a civil tax adjustment and a criminal prosecution recommendation is intent or willfulness. Willfulness generally involves a voluntary, intentional violation of a known legal duty. While IRS special agents are well trained in tax, accounting, and law enforcement techniques, they are not trained in mind reading. Consequently, absent an admission from a tar- ANNE MARIE MINOGUE is an associate director in the Business Risk Consulting Practice of Protiviti Inc. in New York. She formerly served as assistant special agent in charge. New York Field Office and interim special agent in charge, Denver Field Office and New Jersey Field Offices of the Criminaiinvestigation Division of the Internal Revenue Service. Anne Marie is experienced in leading and conducting indepth financial investigations focused on tax violations, money laundering. currency crimes, and asset forfeiture. get of an investigation that he or she willfully intended not to pay taxes, the IRSspecial agents must indirectly prove willfulness by gathering and documenting circumstantial evidence of the taxpayer's intent. To this end, special agents will ferret out affirmative acts done by the taxpayer before, during, and after the filing of a return, which demonstrate that the intent was to defeat the payment of taxes. How taxpayers handle their recordkeeping is often indicative of their intentions regarding the reporting of income. Tax evaders often keep duplicate sets of books and records (i.e., one containing the true income and one recording the income they intend to report to the IRS). Needless to say,the discovery of two sets of records would go a long way in satisfying the government's requirement to establish the element of willfulness. Similarly, false or altered entries in the books, and the destruction of records also could be used as circumstantial evidence of the criminal intent of the taxpayer. The act of concealment is also an indication of the taxpayer's intent to evade paying taxes. Concealment of sources of income could be in the form of a different handling of certain transactions to avoid detection or the setting up of separate bank accounts to avoid linkages to the funds. Lies and false statements to IRS agents or accountants also are indicative of the tax- 36 PRACTICALTAX STRATEGIES JULY2009

3 payer's intent to deceive. Assets are often placed in the name of a nominee to avoid detection. Therefore, documentation of acts of concealment also is used to prove willfulness. Consistent patterns of behavior also may demonstrate that the taxpayer sought to deceive the IRS. Repeated omissions of income would indicate a deliberate attempt to evade paying taxes. Likewise,a steady pattern of overstating deductions also may indicate that the taxpayer did so with a calculated purpose. Documenting wilfulness CI special agents employ many overt and covert investigative techniques to document willfulness. The most common technique is interviewing. Special agents will attempt to interview partners, colleagues, and associates in an attempt to document admissions and knowledge of the taxpayer. Key among interviews is the tax return preparer interview in which the special agent will attempt to establish whether the taxpayer withheld information from the return preparer, which resulted in the understatement, or if the return preparer had knowledge of the unreported income or fictitious deductions. Special agents also will seek to interview the taxpayer who is under investigation. The taxpayer has the right to refuse to submit to this interview. If, however, the taxpayer agrees to answer questions, this interview can be extremely grueling and can last several hours. During the interview, the special agent will seek to identify all income, assets, liabilities, and expenses of the taxpayer for the periods before, during, and subsequent to the investigativeyears.the special agents will seekadmissions and confessions, and they will document lies and misstatements. In addition: Corporate records and bank records are subpoenaed and analyzed in an attempt to document selective handling or record alterations. Surveillance may be conducted to identify hidden assets. Mail covers are used to identify unknown bank accounts. A mail cover is a request made to the U.S. Postal Inspector by a law enforcement agent to monitor the mail received by a person who is the target of a felony investigation. In response to the mail cover request, the U.S. Postal Inspector will send to the law enforce- ment officer a list of all mail received by the target of the investigation during a 30-day period. "Dumpster diving:' a term used to describe the retrieval of trash for analysis, may be employed to retrieve documentation that has been discarded. Computer forensics may be conducted to locate deleted documents. When traditional investigative techniques are not realistic, financial search warrants may be employed for IRSspecial agents to locate concealed records and executed to seize the second set of books and records or receipts reflecting unreported income. Co-conspirators may be convinced to cooperate and wear electronic monitoring devices to document admission. Undercover operations are sometimes initiated to locate evidence and document admissions of knowledge and willfulness. Documenting unreported income CI special agents document evidence of unreported income directly or indirectly. In the specific items method, direct evidence is obtained by identifying specific items of unreported income and obtaining testimony from the source of the income. The special agent then demonstrates which specificitems were reported on the income tax returns, and which items were not reported on the tax returns. Three indirect methods of documenting income may be used: 1. Net worth method. 2. Bank deposits method. 3. Expenditures method. In the net worth method, the taxpayer's net worth is calculated at the beginning of the period and at the end of each tax year. An increase in net worth, less any nontaxable sources of funds, is calculated as income. In the computation of income via the bank deposits method of proof, unreported income is documented through illustration of the extent to which the taxpayer's bank deposits exceeded his or her reported income. Similarly, in the expenditures method, the special agent determines unreported income by demonstrating that the taxpayer spent more than he or she earned. DTHE SPECIAL AGENT WILL AnEMPT TO ESTABUSH WHETHER THE TAXPAYER WITHHELD INFORMATION FROM THE RETURN PREPARER. CRIMINAL INVESTIGATION JULY2009 PRACTICALTAX STRATEGIES 37

4 D IT IS ESSENTIAL THAT THE SUB.JECT OF AN INVESTIGATION BE REPRESENTED BY AN ATTORNEY. NOT AN ACCOUNTANT. SO THAT COMMUNICATIONS ARE PROTECTED UNDER THE ATTORNEY-CLIENT PRMLEGE. Targets of investigation Virtually anyone who files an income tax return or anyone who fails to file an income tax return could find himself or herself the target of a criminal tax investigation. CI classifies its investigations into programs and emphasis areas of fraud. Program areas include: Abusive return preparer enforcement. Abusive tax schemes. General tax fraud. Money laundering. Narcotics-related investigations. Non-filer enforcement. Questionable refunds. Areas of emphasis include the following: Telemarketing fraud. Bankruptcy fraud. Corporate fraud. Employment tax enforcement. Excise tax enforcement. Financial institution fraud. Gaming. Health care fraud. Insurance fraud. Public corruption. Often otherwise-law-abiding citizens are lured into tax crimes by unscrupulous tax return preparers or promoters of abusive tax schemes. The IRS often warns, "If it sounds too good to be true, it probably is." That is good advice in these times. Also, it is essential that every taxpayer carefully review and understand every item on their returns. Even if willfulness is established and the taxpayer is not prosecuted, he or she could be subject to hefty fines, interest, and penalties. Although most criminal tax investigations target individuals, increasingly corporations as well as the responsible individuals are prosecuted for evasion of corporate taxes. However, the elements of proof are the same. Evenin large corporations, fictitious books, false statements, and concealment are what demonstrate the willfulness that supports a criminal prosecution. Likelihood of becoming the target. The IRS encourages individuals to inform on those that they know to be tax cheaters. In fact, legislation signed into law on 12/20/06 by President Bush authorized the IRS to pay higher rewards to many informants in cases involving large amounts of money. Rewards could be as much as 30% of what the IRS collects.' Lawmakers hope this and other incentives in the legislation will encourage more people to step forward with valuable tips that will help the IRS collect additional revenue. Tax cheaters have a much greater chance of being detected and investigated if others are aware of their noncompliance with the lawand are enticed to come forward by the hefty reward. Still, tax prosecutions must be recommended by CI special agents of the IRS. The IRS employs approximately 2,600 special agents nationwide. Only 3,794 investigations were initiated and 2,785 prosecution recommendations were made by IRS special agents during fiscal year 2008 (10/1/07-9/30/08). Thus, statistically,the odds are small that a client would become the subject of a criminal investigation. Yet,the penalty is stiff if a client is one of the select few who become the subject of a criminal tax investigation. During fiscal year 2008,81 % percent of those recommended for prosecution received jail time.2 Whattodoifa clientistargeted Prior to agreeing to be interviewed by CI special agents, the target of an investigation is strongly encouraged to seek the advice of an attorney. He or she should obtain a criminal defense attorney who specializes in representing individuals in U.S. district court and who has experience in defending individuals accused of criminal tax violations. Attorneys experienced in defending criminal tax allegations are familiar with the unique methods employed in criminal tax investigations and are well equipped to navigate the bureaucracy of the IRS, Department ofjustice Tax Division, U.S. Attorney's Office, and federal judicial system. Experienced criminal tax defense attorneys are also knowledgeable of the sufficiency of evidence necessary to prove income and willfulness. The proper legal representation can protect the individual's legal rights, and ensure that the individual does not provide false information or submit a confession. A good defense counsel can assist the individual in preparing the best possible defense. It is essential that the subject of an investigation be represented by an attorney, not an accountant, so that communications are protected under the attorney-client privilege. The attorney may also enlist the services of a forensic accountantlfinancial investigator who is experienced in fraud investigations and criminal tax investigations. If the forensic accountant/financial investigator is engaged 38 PRACTICALTAX STRATEGIES JULY 2009 CRIMINAL INVESTIGATION

5 through the defense attorney or through a "Kovelletter" communications with the forensic expert and his or her work products will be protected under the attorney-client privilege. A Kovelletter is a form letter that is used by lawfirms to place an accountant under the attorney-client privilege. It stems from the landmark case, Kovel,3 in which a former IRS agent and accountant had been hired by a law firm to help advise its clients. Kovel met with and received information from a client under IRS investigation for tax fraud. When subpoenaed by a grand jury, Kovel refused to answer questions about the client and was sentenced to a year in prison for contempt of court. The Second Circuit reversed the contempt citation. It ruled there was no reason in the case to exclude accountants from the list of those who assist lawyers in providing legal services. The forensic accountant/financial investigator can gather financial documents and predict the findings of the special agents. He or she can uncover defenses and gather the necessary evidence to support them. This can be invaluable in interactions with the government and in the overall defense strategy. Becausethe person who prepared a taxpayer's returns also may become the target of an investigation,it is not in the taxpayer's best interest to enlist the assistance of the accountant who prepared the returns when the taxpayer is the subject of a criminal investigation. The accountant also may have exposure to criminal charges. He or she may have given poor advice to the taxpayer and will have a vested interest in protecting himself or herself rather than the taxpayer. Finally,a taxpayer must be extremely patient if he or she is under a criminal investigation by the IRS. Investigations may last up to two years and probe every cent spent by the taxpayer. Avoid becoming a CI subject A tax advisor whose client believes he or she may have committed a tax violation may want to consider advising the client to make a voluntary disclosure. Prior to making a voluntary disclosure, a taxpayer should consult with an attorney and, if he or she decides to go forward with a voluntary disclosure, it should be made through an attorney. The IRS CI division has established procedures for the handling of voluntary disclosures that are designed to encourage individuals to come forward and pay their tax liabilities. A voluntary disclosure will be considered by the IRS, along with all other factors in the investigation, in determining whether to recommend criminal prosecution. Although a voluntary disclosure will not guarantee immunity from prosecution, it may result in prosecution not being recommended. This practice does not apply to taxpayers with illegal-source income. A disclosure is only considered voluntary by the IRS if it truthful, timely, complete, and when the taxpayer shows a willingness to cooperate (and does in fact cooperate) with the IRS in determining his or her correct tax liability. The taxpayer also must make good-faith arrangements with the IRS to pay in full the tax, interest, and any penalties determined by the IRS to be applicable. A disclosureis timelyif it is receivedbefore the IRS has initiated or obtained information that would lead to a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation. In addition, to be considered timely, the IRS must not have received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer's noncompliance. Most clients will not become the target of a criminal investigation by the IRS, as long as they do not willfullyevade the payment of taxes. However, should they receive a visit by CI special agents, it is in their best interest to obtain advice, counsel, and assistance from criminal defense attorneys and forensic experts who have experience in the area of criminal tax law.. NOTES 1 Section 7623(b). 2 Statistics taken from the IRS CID website at irs. gov I com p Iia n cel en fo rc e men tl art ic Ie/ F.2d AFTR2d 366 (CA ). CRIMINAL INVESTIGATION JULY 2009 PRACTICALTAX STRATEGIES 39