Tax practitioners often analogize tax enforcement to a pendulum, slowly swinging back and forth between greater and lesser IRS civil examination and criminal investigation activity. For example, in the mid-2000s, the IRS was recovering from the congressional bashing of the late 1990s, which lowered audit, enforcement, and collection activity, and it then embarked on a major enforcement push against marketed and structured tax shelter transactions. The IRS and the Department of Justice moved aggressively on multiple tracks at once, pursuing criminal indictments, civil promoter penalty examinations, and other initiatives.
In 2007 two top private practitioners reacted to these developments in an article entitled “IRS Enforcement: The Pendulum Has Swung Too Far,” warning that these action could become an “institutionalized way of doing business,” possibly leading to “a state of permanent war” between the IRS and tax professionals. (K. Keneally and C. Rettig, Journal of Tax Practice and Procedure, Apr./May 2007. Ms. Keneally and Mr. Rettig later took hold of the pendulum themselves, the former as Assistant Attorney General for the DOJ Tax Division from 2012-2014, and the latter as current IRS Commissioner.)
Ultimately, however, events overtook their concern. Over the past decade the IRS has faced substantial budget shortfalls, political headwinds, and massive workforce attrition, with the result that except in selected areas, such as unreported foreign accounts and assets, enforcement has waned, and audits, fraud referrals, and criminal investigations have reached historic lows.
Before the onset of the Covid-19 pandemic, the IRS took a number of steps to swing the pendulum back toward more fraud enforcement. Once the IRS and the rest of us are beyond the extraordinary adjustments underway now to our tax administration system and our lives, these actions will begin to take hold. This article will consider these increasingly clear signals from the IRS that when that happens, investigating and punishing fraud will again be a growing focus for the IRS, with important implications for tax practitioners advising clients in audit and collection matters.
Traditional Fraud Enforcement
The IRS has pursued tax fraud as long as there has been an income tax. The Internal Revenue Manual (IRM) instructs examining agents, upon a “firm indication of fraud,” to suspend their audits and refer taxpayers for investigation by the IRS’s vaunted Criminal Investigation (CI) unit, whose special agents conduct the expert forensic accounting and investigative work needed to prove beyond a reasonable doubt that a taxpayer committed a U.S.C. Title 26 or related tax crime. (IRM Section 126.96.36.199.) Tax criminals often go to prison. On the civil side, in a fraud case the IRS will assess civil fraud and fraud-related penalties under the tax code, such as the fraudulent understatement of tax penalty under tax code Section 6663, the fraudulent failure to file penalty under Section 6651(f), and the penalty for the willful failure to file certain information returns such as Form 8300 and FinCEN Form 114 (the “FBAR”).
For many years, IRS examining agents and collections officers have relied on specially trained “fraud technical advisors” (FTAs), who work on the civil side. From the background, these specialists help frame document requests, prepare for taxpayer interviews, and piece together evidence that could support a referral to CI and perhaps the assessment of a fraud penalty. The IRS modified the FTA program in 2018, but FTAs are still a part of the fraud referral process. FTAs have undoubtedly assisted in recent and visible initiatives aimed at specific types of fraudulent conduct, including the involvement of tax professionals in the aforementioned tax shelters in the late 2000s and, more recently, the pursuit of taxpayers who willfully concealed assets and income overseas, and the professionals and banks who enabled such conduct.
IRS budgetary woes and other pressures, however, have resulted in declining fraud enforcement more generally. The audit rate for individual returns was 0.59% in 2018, the lowest rate in 16 years, marking a seventh straight decline. (Wall Street Journal, May 20, 2019.) Fraud referrals from IRS examiners and collection officers have declined dramatically—government panelists at a 2018 UCLA Tax Controversy Conference cited statistics reflecting a decline in referrals to CI from IRS agents and collections officers from 328 in fiscal year 2016 to 206 in fiscal year 2018. This is down from over 500 in fiscal year 2010. (The New Wave of Fraud Referrals: Fact or Fiction, 2018 Annual Tax Controversy Institute, UCLA Extension; TIGTA Report: The Collection Function Develops Quality Fraud Referrals but Can Improve the Identification and Development of Additional Fraud Cases (7/27/12).) The number of prosecution recommendations by CI is down from 3,289 in fiscal year 2015 to 1,893 in fiscal year 2019, and the number of indictments dropped similarly over the same period. (IRS CI Annual Reports Fiscal 2017, 2019 (at Appendix).) Consider that in a nation of over 300 million, the IRS brings such a tiny number of tax fraud cases, and even in a good number of the ones brought, crimes other than tax were the primary focus. Fraud enforcement aimed at pure legal source income tax fraud has indisputably waned. Deterrence has likely suffered.
An Increased Push?
A recent series of IRS public statements, personnel moves and other initiatives reflect a far more aggressive and affirmative push to promote more fraud referrals from civil examinations and collection inquiries. Commissioner Rettig has made it a priority to increase fraud referrals. (Bloomberg Tax, “IRS Looking to Refer More Cases to Criminal Investigation Unit,” 6/21/19.) In a rare move, the IRS promoted a Deputy Chief of CI, Eric Hylton, as the new head of an operating division, the Small Business/Self-Employed Division (SB/SE); Hylton has spoken of his interest in encouraging agents in his division to seek out more fraud cases. (IR-2019-137, 7/31/19.) Another former senior CI official, Damon Rowe, has been designated as a new fraud enforcement director, housed also in SB/SE, to supervise a broad based program aimed at increasing high quality fraud referrals, including training for IRS examiners and collection officers; he will also look at practitioner conduct as part of this charter. (IR-2020-49, 3/5/20.)
The agency has designated another senior IRS official as responsible for coordinating IRS enforcement activity against “material advisors” and “promoters” of tax-motivated transactions, and an experienced tax lawyer and law professor was just named the new head of the IRS Office of Professional Responsibility. (IR-2020-41, 2/24/20 .) One can expect that assigning senior executives to promote fraud referrals and to focus on practitioner conduct will result in an institutionalized process aimed at training for and incentivizing such cases, with appropriate monitoring to promote accountability and measure the results.
At the same time, the IRS is quite vocal about its increasingly specialized ability to analyze data in order to help it direct tax enforcement resources and develop criminal cases, touting its use of data analytics programs that can access and search over 9.5 billion records. The global firm Palantir Technologies is under contract with the IRS to develop artificial intelligence, which one can expect will certainly be used to find patterns of fraudulent conduct. The full capability of the IRS’s enhanced data analytic techniques are unknown, but the Commissioner Rettig has said that if the IRS has a name and a phone number of an individual, it can quickly accumulate an extraordinary amount of data. (Wall Street Journal, “AI Comes to the Tax Code,” 2/26/20.)
In addition, early this year, the IRS outlined a new program in which IRS revenue officers will make unannounced visits to high income non-filers. (IR-2020-34, 2/19/20.) Surely these collection officers will be trained on fraud issues and encouraged to make referrals where appropriate. It can be expected that the new push against fraud will entail some coordination with the IRS Whistleblower Office, which conducts initial screening of tips and reward claims by individuals who believe they have spotted tax violations. The IRS also touts its cooperation with foreign tax authorities, and of theirs with the IRS, in pursuing leads on tax evasion throughout the world. (Forbes, “Tax Chiefs Combine Forces in Global Tax Evasion Fight,” 1/23/20.) Finally, the IRS is aggressively hiring new special agents to replenish a large number of retirements and budget-related reductions; this will give CI more capacity to handle more referrals from the civil side. (Accounting Today, “IRS Criminal Investigation Expects to Hire More Agents, Pursue More Crypto Cases
When considered together, these actions suggest an IRS that is going well beyond asking agents to consult behind the scenes with FTAs in developing fraud referrals. Instead, the IRS is engaging in a widespread and pro-active initiative aimed at increasing the number of fraud referrals, and thus fraud cases that are brought, with a corresponding focus on advisors and tax professionals where there are facts to support that. While it will likely take time for these new hires and initiatives to show results, practitioners should understand these combined developments and consider the impact they may have on how we advise clients, especially those who may be the subject of sensitive civil audit or collection activity but who may have potential exposure to allegations of fraud.
Tax Audits and Collection Cases
The IRS’s fraud initiative will affect audits of every type. Practitioners should familiarize or re-acquaint themselves with the 68 specified “indicia of fraud” set forth in the Internal Revenue Manual, as these should be the basis for standard due diligence in discussing an examination with any client. These indicia range from the obvious—cash skimming, the proverbial double set of books, the preparation of false invoices to support business expenses—to the more mundane, such as “intentional under- or over-footing of columns in a journal or ledger” or “recording income items in suspense or asset accounts.” Taxpayer conduct is also an issue. Badges of fraud include the taxpayer’s failure to make full disclosures or follow the advice of an accountant, attorney, or return preparer. The manual instructs examiners to consider even the repeated cancellation and rescheduling of appointments as a marker of a possible fraud case. (IRM Section 188.8.131.52.)
Where any kind of foreign activity is relevant to an examination, tax advisors should by now appreciate that the IRS has access to significant amounts of information from overseas. Such data includes information provided by banks everywhere under the Foreign Account Tax Compliance Act, account data produced by the 80 banks who participated in the Department of Justice Swiss Bank Program, and information from other cooperating financial firms. It also may include information from “spontaneous disclosures” made by foreign tax officials to their U.S. counterparts. As the IRS further ramps up its cooperation with other countries against tax evasion, it seems likely that the application of new data analytic techniques may well lead to yet more enhanced interaction with other tax authorities. Tax advisors should contemplate that if a client also has a potential problem with a non-U.S. tax authority, the client may be just as at risk from a foreign-based investigation as from one directed by CI.
A greater focus on fraud will also affect the process of an examination. More intrusive demands for evidence can be expected. As one element of proving fraud is often a pattern of activity, an agent’s effort to obtain information in an information document request (IDR) or a summons may extend over multiple years. Certainly such a request (especially into years that at least facially may appear closed under the three year civil statute of limitations) should raise the obvious concern that the agent believes a fraud issue may be present. Agents may seek to interview relevant professionals, employees, family members or others more than in the past and earlier during the course of an exam. Third party contacts in general are apt to increase, and the IRS may be quicker to pursue summonses and refer cases for summons enforcement. On the other hand, as has always been the case, a prolonged period of inactivity in an examination may signal that the fraud referral is already underway.
The routine request to interview the taxpayer—often a touchy issue—will become even more problematic in an era where agents are looking to increase criminal referrals. A taxpayer who has engaged in any kind of fraudulent activity faces a difficult dilemma when facing a request for an interview in a civil examination. Any admission of wrongdoing can be used against the taxpayer, even in a subsequence criminal proceeding, but any false statement or material omission will just add another “badge of fraud” to whatever list the agent is accumulating. Such a lie or omission would also likely be a separate criminal offense.
A taxpayer may decline to answer questions, and when pressed for a reason why (or in defending a summons case), the taxpayer may have no choice but to invoke the Fifth Amendment privilege against self-incrimination; it is hard to imagine, though, a brighter “red flag” regarding the existence of possible fraud. If the facts, or even comments from the agent, suggest a risk of a criminal referral, however, declining the interview may well be the “less bad” of two bad choices.
Privilege becomes a greater concern. An agent may pursue the question whether the taxpayer used the services of a professional advisor to engage in fraudulent conduct. A summons to an advisor may, in the face of a claim of privilege by the taxpayer, generate an IRS effort to penetrate the privilege through a showing that the taxpayer’s communications were in furtherance of a fraud, or even a crime, even where the advisor was unaware of a client’s potential wrongdoing. Communications with non-lawyers that might be protected in a civil examination under the “federally authorized tax practitioner” privilege (Section 7525) may later be at risk—that privilege does not apply in criminal cases. More broadly, one important recent case found that no privilege at all attached to documents reflecting transactions as to which “a significant purpose, if not the sole purpose…was to avoid or evade federal income tax.” (United States v. Microsoft Corp., No. 2:15-cv-00102, Order Following Court’s In Camera Review (W.D. Wash., 1/17/20).)
Efforts to incentivize fraud referrals will acutely impact certain types of examinations known as “eggshell audits.” In these audits, a taxpayer is selected for examination on what looks to be a fairly mundane or routine issue—travel and entertainment, charitable contributions, asset depreciation or the like. The taxpayer and his or her advisor, however, are aware that lurking elsewhere, and possibly unknown to the agent, are potential fraudulent or criminal issues such as a hidden foreign account or the accumulation of unreported income through a sham or nominee entity. The objective is to walk “across the eggshells” in the examination to get to an agreed case without “cracking” a criminal referral.
Traditional “eggshell audit” practice has consisted of numerous, well known tactics: specialized criminal tax counsel stays behind the scenes, the front line tax professional affirmatively works to ease the analytical burden on the agent, issues are conceded perhaps more quickly than normal, the advisor attempts if possible to limit the scope of the interview of the taxpayer, and generally there is an overall effort to steer the examination toward a faster conclusion. This all must be accomplished, of course, without anyone making false representations or engaging in any kind of willful concealment. Indeed, practitioners in some “eggshell audits” will simply disclose even the underlying fraud issue, in a manner and at a time when it may still be possible to conclude the examination without a referral.
Achieving a civil resolution in these types of cases always has been difficult. It may now become impossible. Tax professionals should assume that the training material used in these new fraud initiatives will include a lesson on these time-worn practice techniques, and on how an agent should examine the taxpayer so that whatever fraud issues have yet to be revealed, eventually revealed they will be, with a greater institutional encouragement to the examining agent to refer the case to CI.
Collection cases will also present special issues. As noted above, fraud issues can certainly arise as the IRS undertakes outreach to high income non-filers; a visit from a revenue officer may place a non-compliant taxpayer in the same position as one whose interview is requested in a sensitive audit—often nothing good can come of answering questions.
Also, “evasion of payment” cases under Section 7201 appear to be increasingly favored as a tax prosecution theory. In these cases, the taxpayer’s liability has already been determined. The criminal conduct occurs when the taxpayer takes affirmative and fraudulent steps to avoid paying the liability. Such steps often include undisclosed and gratuitous asset transfers, the use of nominee entities or individuals to hold assets, or the filing of false collection statements (Form 433.) Professionals are often involved in advising the taxpayer during the collection process, and their conduct may also come under scrutiny. One can expect that revenue officers will be more likely to consider a fraud referral where a taxpayer’s post-assessment conduct suggests a deceptive effort to evade payment, especially where a professional may have been involved in advising or executing a transaction.
Role of Practitioners
The new initiatives are likely to focus also on the conduct of tax advisors and professionals. The IRS has its traditional weapons against professionals, including return preparer and promoter penalties and injunctions, OPR sanctions for the violation of Circular 230, and even criminal charges under conspiracy or other statutes. The IRS and the Justice Department’s Tax Division view actions against tax professionals as especially useful in deterring tax violations. In the tax shelter enforcement push in the late 2000s, the IRS focused on tax professionals, and their firms, who created, marketed, and issued opinions on fraudulent shelters, and more recently, the IRS and the DOJ have pursued civil and criminal actions against tax return preparers who “find” fraudulent deductions for their clients.
Various other special tax code provisions impose list maintenance, reporting, and other obligations on “material advisors,” with substantial penalties imposed for violations. One of the new senior positions in the IRS will entail the coordination of examinations and penalty assessments across the IRS where these material advisor rules may be in play. One can expect that there will be an increased push to look for cases in this area against professionals who engage in fraudulent or willful misconduct. Indeed, IRS officials have openly discussed looking for fraud referrals in micro-captive insurance and conservation easement cases. (Forbes, “IRS Suggests Criminal Referrals To Be Made In Abusive 831(b) Captive Tax Shelter Cases,” 11/17/19; Wall Street Journal, “IRS Pursues Criminal Cases on Land-Tax Donation Deals,” 11/12/19.) (The IRS means business when it comes to micro-captives and conservation easements—even with the administrative forbearance being exercised in a number of areas due to the pandemic, the IRS has made it clear that work will proceed apace in both areas though without in person contact. (LB&I Memorandum, 04-0420-0009, April 14, 2020.)) Both types of transactions might previously have drawn only civil scrutiny, and both entail the work of tax, valuation, and financial professionals. Agents are also likely to make more referrals to OPR where disciplinary violations are suspected.
Tax practitioners might consider the implications of the new fraud initiative on their own conduct in representing a client in an examination. Additional fraud-related due diligence is essential before the IRS interviews any client or a practitioner makes any factual representations to an examining agent. Conflicts of interest may become a heightened concern. Professionals involved in the subject under examination—such as by having recommended a structure for a transaction, prepared a return, or given an opinion—should be mindful that in a new, more enforcement oriented environment, they may soon be witnesses, either for the government as to the facts, or for their client who seeks to defend allegations of fraudulent conduct by arguing reliance on professional advice as a defense. To comply with ethics rules and Circular 230, such professionals may have to obtain conflict waivers, step back from any representation in connection with the examination, or even have their firm withdraw entirely. Overall, it might make sense to recommend, earlier than in the past, separate counsel for other involved individuals or entities, such as spouses or employees.
Other issues are likely to emerge. Practitioners should pay increased attention to privilege waiver issues, because waiving an attorney client privilege in an audit likely means the privilege is gone for purposes of any resulting criminal referral and investigation. Current year tax returns due while the taxpayer is under examination could be particularly problematic. Those returns, of course, must be timely, accurate, and complete, presenting challenges to a taxpayer and a return preparer if potentially fraudulent conduct continued into the most recent tax year. The taxpayer’s dilemma is similar to responding to an interview request—complete disclosure may equate to a confession, whereas a selective assertion of the Fifth Amendment privilege on the return—permitted by decades of case law—would provide a clear signal that might prompt a fraud referral.
Practitioners should be mindful that although it may take some time for the system to gear up, especially as we get through the current health crisis, all signs point to the IRS engaging in an agency-wide push aimed at finding and punishing taxpayers who have engaged in fraudulent conduct, and if appropriate, the advisors who helped them. Tax professionals may not be happy assuming that every new or existing client is a criminal or a fraudster, and the vast majority in fact are not. Yet enhanced due diligence on fraud issues will become prudent in every IRS examination or collection matter. This new IRS focus on fraud also will put stress on what in the past have been generally accepted audit defense practices. The obvious Hippocratic principle of “first do no harm” should clearly come into play, with the highest priority being protecting a client from indictment, if possible. Beyond that, strategic decisions and judgments will have to be made in potentially a much higher-pressure environment with greater risk. Caution is warranted. The tax enforcement pendulum is swinging again.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Scott D. Michel is a member of Caplin & Drysdale in Washington and New York. He has practiced for nearly 40 years in the area of tax fraud and criminal tax cases, including sensitive civil examinations, voluntary disclosures, and criminal tax investigations, representing individual and corporate clients from around the world.