When the IRS Comes Calling

November 01, 2011
Criminal Tax Investigations and the CPA

By Kip Dellinger, CPA
It might happen this way: “Good morning, CPA, we are from the IRS Criminal Investigation Division. We’d like to ask you some questions about your client, John Smith, for whom you’ve prepared numerous federal income tax returns.”

Or, how about a phone call or voice mail from a client stating, “Oh, my gosh, two people from the IRS Criminal Investigation Division showed up at the house this morning and wanted to speak to me about my tax returns! What should I do?”

These are but two of the ways that CPAs can find out that their client is the subject of a criminal inquiry by the IRS (or the FTB criminal investigation arm).
Though most CPAs will not encounter such criminal tax investigators, it’s still wise to know how to respond if it occurs.

The Client Informs the CPA
Follow these steps if the initial discovery of a criminal investigation of a client comes from the client:
  • Emphatically recommend that the client immediately seek legal counsel experienced in handling criminal tax matters.
  • Do not allow the client to begin any discussion of the matter—even if merely to relate the client’s conversations with the criminal investigators. It’s tempting for CPAs to want to know what happened, but the client could reveal information that may compromise the client with the tax authorities. The client’s communication with his or her CPA in a criminal tax matter at this point is not privileged. Thus, CPAs could be placed in the position of being a government witness against a client. The ramifications to a CPA’s reputation and possible malpractice claims for failing to exercise a known duty not to allow the client to waive privilege could be damaging.
  • Contact your malpractice (errors and omissions) insurance provider and inform them of the matter. Also, the risk management and liability personnel at the company may be able to offer suggestions concerning the CPA’s future course of action.
  • Bring in legal counsel experienced in criminal tax matters. Persons at the insurance carrier may offer suggestions about qualified legal counsel if the CPA is not aware of counsel that works in this area of tax law. Counsel can provide invaluable guidance in anticipation of the inevitable interview of the CPA by the criminal investigators.
The CPA is Confronted by Criminal Investigators
If approached by criminal investigators, CPAs should politely inform the investigators that they recognize they are a witness and will answer questions—after first consulting with legal counsel.

Surprise visits can be stressful and CPAs will be tempted to appear that you have nothing to hide. However, CPAs should insist on the opportunity to confer with legal counsel, assure the investigators of full cooperation and, if possible, set a date to continue the matter.

CPAs should then contact legal counsel for advice—prior to engaging in any contact with the client under investigation—and contact their malpractice insurance carrier.

Where a summons is part of the process, CPAs should comply. Generally a summons requires a future production of records, so there is time to confer with counsel with regard to the matter. If a summons is issued, the client generally also will be notified of its existence (pursuant to “third-party record keeper” rules in the Internal Revenue Code) and will be able to assert any privilege claims to which the client is entitled.

Finally, if the investigators arrive to serve a search warrant and to seize records, CPAs must cooperate. In such situations, it’s common for the client to be served a warrant simultaneously. Again, the investigators will often attempt to interview the CPA. And, again, CPAs should insist on the opportunity to confer with legal counsel before submitting to an interview. This is of paramount importance when a seizure occurs as it may indicate the possibility that the investigators believe the CPA may evolve from status as a witness to becoming a criminal target at some future point in time.

Telltale Signs?
Generally, when records are seized, it’s an indication that the investigation is prompted by some third-party information provided to the tax investigators (e.g. referrals from an angry family member, an employee whistleblower, from some public documents such as court filings that contradict tax return reporting, etc.).

However, in many situations, a tax examiner has reviewed the records, and believed that he has discovered a potential fraud case in the course of an otherwise routine examination and is coordinating the examination with a fraud referral specialist operating in the background.

A telltale sign that this may be occurring in an examination is a lengthy suspension of the examination by the auditor; however, lengthy delays in the examination process are routine and should not—in the absence of some other factor, such as discovery of third-party contacts—raise undue concern that an otherwise normal examination has become a fraud referral situation.

A Potpourri of Crimes
Generally, the standard of proof to convict under a criminal statute is very high (i.e. a willful act proven beyond a reasonable doubt). There are many possible tax-related crimes that may be asserted against taxpayers.

Common crimes assessed under the Internal Revenue Code include tax evasion (omitted income, false deductions, et al.) and false returns, willful failure to file, aiding and abetting (which can reach the tax professional who assists in a crime), and submission of altered or false documents.

The statute of limitations for criminal offenses under the Internal Revenue Code is generally six years and begins at the time the offense is committed or completed (e.g. the due date of filing of a false return). The six-year period for filing a false document begins at the time the document is filed. It should be noted that there is no statute of limitations for assessing taxes and penalties arising from civil fraud (which generally also requires a lower standard of proof than a criminal charge).

Tax-related crimes under the Criminal Code that may be prosecuted include conspiracy, false statements, false claims, mail and wire fraud (including all variety of electronic communications), money laundering, and perjury (which often trips up taxpayers and sometimes related parties and advisers).

There are also tax-related crimes that may be prosecuted under the Bank Secrecy Act, such as failure to file Form 90.22.1 (the FBAR form) and currency transaction reporting forms (e.g. Form 8300, Report of Cash Payments over $10,000 Received in a Trade or Business). Generally, the statute of limitations with respect to Criminal Code and Bank Secrecy Act violations is five years (with the exception of conspiracy, which is six years and runs from the last date an act of commission in furtherance of the conspiracy occurs).

Eggshell Examinations
Briefly, an “eggshell audit” is a civil examination in which the auditing revenue agent is unaware that the taxpayer has filed one or more tax returns that may be considered fraudulent. In this situation, the taxpayer and tax advisers 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 IRS criminal investigation unit.
Tax attorneys can best handle these examinations. Sometimes they prefer to operate in the background because of what their presence in an examination of a return prepared by CPAs may signify. However, CPAs have no privilege and should tread very carefully.

First, because information that he is aware of is not privileged; and second because there is the possibility that the IRS may conclude that the CPA is engaged in aiding and abetting a tax crime. Consequently, the CPA is advised to seek advice from the CPA’s own independent legal counsel (it’s important to remember that counsel for the client has a duty to the client and none to the CPA).

Expect to be Replaced
Don’t expect to keep a client under investigation for fraud. In most cases, it’s just not a good idea because of the privilege concerns previously described with regard to any examination that involves criminal tax charges, or where there is significant potential that a civil examination may give rise to criminal tax charges. Some CPAs mistakenly believe that they can be insulated with respect to privilege issues by means of obtaining Kovel protection.

In a Kovel arrangement, the CPA is engaged to assist the client’s attorney in providing tax advice to the client and, consequently, client communications with the CPA are subject to the broad, attorney-client (and related workproduct) privilege.

However, a Kovel arrangement does not shield communications prior to being put in place, nor does it shield tax workpapers pertaining to earlier returns prepared by the CPA. Moreover, while information discovered by the CPA regarding the taxpayer’s financial affairs during the discovery process in the criminal investigation may be protected by the attorney-client privilege, it may be very difficult—if not impossible—to conclusively prove what was known by the CPA before and after the preparation of the original return(s) and after entering into the Kovel arrangement.

Indeed, the Tax Division of the U.S. Justice Department views with skepticism such arrangements with the preparer of the original return(s), particularly where the CPA has a longstanding professional relationship with the client-target of the criminal inquiry.

It should be noted that not all potential criminal investigations—whether initiated by IRS as a direct investigation or incident to a grand jury proceeding—lead to criminal charges. And often the client has a lengthy, comfortable and trusted relationship with a CPA or CPA firm. Moreover, many tax attorneys will replace the longstanding CPA with a Kovel CPA for the duration of the criminal inquiry and clients will be returned (if they choose) to the original CPA at the end of the criminal inquiry—particularly when no charges are ultimately asserted.

A Word About Offshore Financial Accounts
The IRS in 2009 and 2011, under Offshore Disclosure Initiatives, provided taxpayers insulation from criminal prosecution if the taxpayer complied with stated guidelines and requirements and disclosed previously unreported foreign financial accounts required to be filed by the Bank Secrecy Act (Treasury Form T.D. 90.22.1), and if the taxpayer reported and paid taxes attributable to previously unreported earnings. Specified penalties were also imposed.

Because the IRS provided miscreant taxpayers two opportunities to disclose without facing the possibility of criminal charges, there is reason to believe that it may well deal harshly with taxpayers who simply file amended or original income tax returns with a Service Center and hope they are processed routinely without inquiry).

Consequently, to protect every possible right of the taxpayer, CPAs are advised to cease the conversation and refer the client to an attorney who deals with civil and criminal tax matters when a taxpayer raises the issue of foreign reporting requirements or the possibility of unreported income in earlier periods. The last thing CPAs should do is continue to listen to communications that may result in them becoming a government witness against the client— no matter how remote either the client or the CPA believes that possibility.

Hopefully, the only encounter a CPA will have with federal or FTB criminal tax investigators is at periodic professional liaison meetings or conferences. However, if the moment does arrive when investigators confront CPAs regarding a client matter, they should take a deep breath, keep their wits about them and calmly protect themselves and their clients.
Kip Dellinger, CPA is senior tax partner at Kallman & Co. LLP CPAs.
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