Audits of Individuals and Small Business

Victoria Eve Kelly, Esq.Victoria Eve Kelly, LLC

www.vekllc.com | victoria@vekllc.comPhone: 240-242-9074

Olney, Columbia, Bethesda, Rockville, DCMailing address:

3407 Olney-Laytonsville Rd., Olney, Maryland 20832

Authority to conduct audits:

IRC Sec. 7602 - Examination of books and witnesses

Authorizes the IRS to examine books, papers, records, or other data, and take testimony to determine the correctness of any return, and the liability of any person for tax.

2

6 STEPS IN AUDIT PROCESS:

1. PREVENTION: address issues in tax return before the Service does

2. PREPARATION: know what the Service knows

3. DISCOVERY: limit issues and disclosure

4. AUDIT RECONSIDERATION/APPEAL

5. CLOSING AGREEMENT: choose form binding on service

6. REFERRAL TO CRIMINAL DEFENSE ATTORNEY

3

Who gets audited?

Lower, middle and upper middle income taxpayers.Returns by Percent of Percent AuditedIncome Total Returns in 2017

All Returns 1.00 0.62No adjusted gross income 0.02 0.03$1 under $25,000 0.36 0.71$25,000 under $50,000 0.23 0.49$50,000 under $75,000 0.13 0.48$75,000 under $100,000 0.09 0.45$100,000 under $200,000 0.12 0.47$200,000 under $500,000 0.04 0.70$500,000 under $1,000,000 0.58 0.02$1,000,000 under $5,000,000 0.26 0.04$5,000,000 under $10,000,000 0.02 0.08$10,000,000 or more 0.01 0.15

IRS Databook 20174

How does the Service select returns for audit?

The Government Accounting Office’s report on IRS RETURN SELECTION, Appendix III: Description of Small Business/Self -

Employed (SB/SE) Selection Methods or Workstreams, GAO-16-103:

Identifies 38 ways of selecting returns for audit

IRS materials on correspondence audits refer to identifying returns “with high potential for a tax adjustment using”:

• Results of prior audits• 3rd party information (data matching)• Entries on the tax return• Referrals from criminal investigation• Preparer/promoter activities• Non-filers

5

AUDIT PREVENTION BEGINS WITH THE TAX RETURN.Not just about correct numbers.

Also about addressing issues before the Service does throughDisclosureDocumentation

Step 1: PREVENTION: address issues in tax return before the Service does

6

Consider attaching explanatory statements for:

So called “Audit flags”Home Office DeductionReal Estate ProfessionalSchedule C for a high cash business like taxi cab service, convenience

stores, gas stations, (etc.)

Large, unusual, or questionable line itemse.g., Unusually high charitable deductionsSchedule UTP (Form 1120), Uncertain Tax Positions, sets forth line items on

Form 1120, U.S. Corporation Income Tax Return, required for corporations with assets equal or greater than $10 million who’ve recorded a reserve for an uncertain tax position in an audited financial statement, or have not, because they expect to litigate the position.

7

Tax Practitioner Guidance: Circular 230, Sec. 10.34, Practitioner Standards

https://www.irs.gov/pub/irs-utl/circular_230_best_practices.pdf

Tax advisors are under no obligation to audit their client’s return.May rely in good faith, without verification, upon information furnished by the client.

BUTTax advisors must advise client of requirements for

adequate disclosure to avoid penalties

Must make reasonable inquiries if information received or assumptions appear incorrect or incomplete

8

Hypothetical tax return client: J. Q. Developer (“J.Q.”)

J.Q. tells me he’s a Real Estate Professional pursuant toIRC Sec. 469(c)(7), Reg. Sec. 1.469-9 and 1.469-5T, CCA 201427016

Allows a taxpayer to offset loss from a passive activity, like real estate rentals, against non-passive income.

Requirements are complicated, and an audit flag.

More than one-half of the personal services the taxpayer performs in trades or businesses during the tax year must be in real property trades or businesses

Hours spent in real property trades or businesses exceed 750 per year

Taxpayer must materially participate in income producing rental activities for >500 hours per year

9

Services, and approximate hours of services, shown “by any reasonable means”, including:

- Daily time reports- Logs- Calendars- Narrative summaries

Reg. Sec. 1.469-5(f)(4)

Good faith reconstruction of time or expenditures: permitted under the Cohan rule. Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930) **

Bare assertion will not suffice. It must be accompanied by corroborative evidence, Vanicekv. Commissioner, 85 T.C. 731 (1985)*

IRS may or may not consider it sufficiently probative to allow deduction

If insufficient, Service may impose penalty for “negligent record keeping” under IRC Section 6662

* When substantiation requires specific documents, as for the Earned Income Credit, good faith reconstruction likely not accepted. See Form 886-H-EIC (October 2017)

10

Guided by Circular 230, I advise hypothetical taxpayer JQ as follows.

1. He has to maintain records of his time, to show:

> ½ is in real property trades and businesses vs. other trades and businesses

> 750 hours in real property trades and businesses

> 500 hours material participation in rental activities

2. If JQ fails to maintain adequate records, and he is audited, the Service may impose penalty for “negligent record keeping” under IRC Sec. 6662.

3. JQ provides a summary of time for each of his activities, and it’s apparently in order. Nothing in his records puts me on inquiry notice, and I’m not required to audit him.

11

Hoping to stave off an audit by showing the Service that JQ understands and satisfies the requirements for being a Real Estate Professional, and for material participation, I attach a summary of JQ’s time to his return.

Let’s say it doesn’t satisfy the Service, and they open an audit

We’ll discuss their procedure for doing so a little later.

For now . . . I need to prepare.

12

STEP 2: PREPARATION: Know what the Service knows

Obtain from client:

Returns for taxpayer and related entities for year in questionReturns for at least three years to look for repeated errorsNotices and correspondence from tax authorities to taxpayerCorrespondence from taxpayer to tax authoritiesRecord of conversations between tax authorities and taxpayerTaxpayer’s credit report

From IRS:File Form 8821, Tax Information AuthorizationObtain tax, account, wage and income transcripts from IRSPrudent if you’ve never met taxpayer

13

Undertake representation by filing Form 2848, Power of Attorney and Declaration of Representative

File request for information under the Freedom of Information Act, U.S.C. 552, as amended

File promptly, since will take time for Service for respondMight not include tax returnsWould include previous examination reports, if any Should contain factual information about taxpayer not exempt from disclosure under the statute, including reports by the Services’ agents, factual information from any studies undertaken by the Service.

14

Request 3rd party contact sheet pursuant to IRC Sec. 7602(c)(2)

Other resources:

Dun & Bradstreet

Transunion TLOxp to search personal and employment information, criminal information, bankruptcies, foreclosures, liens, judgments, assets and professional licenses

Google search

15

Review Internal Revenue Manual

Generally: IRM 4.10.3 Examination Techniques: https://www.irs.gov/irm/part4/irm_04-010-003

Also includes “Handbooks” for specific types of taxes:Employment, Excise, Estate & Gift, Pass-through Entity Handbook, Employee Plans, Exempt Organizations

IRS Audit Technique Guides for specific industries:https://www.irs.gov/businesses/small-businesses-self-employed/audit-techniques-guides-atgs

From Aerospace to Wine industries

Includes Passive Activity Losses Audit Technique Guide, discussing Real Estate Professionals

16

STEP 3: DISCOVERY: Limit issues and disclosure

There are 3 types of audits described in Reg. Sec. 601.105

1. Correspondence Exam

70.8% audits in 2017 https://www.irs.gov/statistics/enforcement-examinationsBy mail or faxLargely automatedResolve limited issues by production of documents

Refundable Tax credits Schedule A, Charitable DeductionsSchedule CNon-filers

17

Takes place at local IRS Offices

Might involve more books and records than can be easily handled during correspondence audit

Might involve discussion with taxpayer or representative to ascertain, for example, circumstances surrounding claim or transaction

Service will try to complete the same business day

Service does not keep statistics on number of office audits performed, or the percentage they comprise of all audits.

2. Office exam

18

Field exam

At taxpayer’s place of business or representative’s office

Larger businesses

Examiners are usually highly trained

May be accompanied by other IRS personnel with specialized training in finance, engineering, (etc.)

Exams can take months

19

Audit begins with a LETTER notifying taxpayer his or her return has been selected for examination

For JQ, our Real Estate Pro, letter might refer to “Schedule E real estate loss after passive limitation”

Letter asks JQ to contact the IRS

IRM 4.10.3 Examination Techniques emphasizes personal contact with taxpayers as a way of gathering evidence

Passive Activity Loss Audit Technique Guide, p. 2-6 Guidance for auditing Real Estate Professional advises during the initial interview, question the Real Estate Pro regarding time spent in all activities (personal, business, civic, family, hobbies, and so forth).

20

As a rule, taxpayer should not speak directly to serviceTaxpayer can be asked to appear

Can only be compelled to speak pursuant to a summons, enforced by court (more detail later)

Options as a substitute for personal interview:

Offer documentation or other written response (chart, summary)

Postpone client interview pending review of documentation.

If Service seems determined to summons taxpayer

Negotiate with the Service to reduce the number of interviews and to limit the interviews to certain persons or specific subject areas

Negotiate with the Service to obtain, in advance, the questions that will be asked

Deny the interview request and see whether the Service issues a summons.

If the taxpayer agrees to the interview request, or is summoned, the taxpayer should be informed of what to expect.

21

LETTER accompanied by DOCUMENT REQUEST

Audits requesting more complicated information may include an Information Document Request (“IDR”) on Form 4564.

IDRs are informal means of gathering information. Not enforceableIf taxpayer does not respond, the IRS may summons the same information

under IRC Sec. 7602If taxpayer does not respond to summons, IRS may enforce summons by

court order

22

Along with letter, Service sends document request asking for JQ’s time logs- to see if JQ qualifies as a Real Estate Professional &- materially participated in his rental activities

Recall that, if both are true, JQ may offset rental losses against non-passive income

Passive Activity Loss Audit Technique Guide, p. 2.6, instructs examiners to “[r]equest and closely examine the taxpayer’s documentation of time utilized for material participation in each activity.

Contemporaneous daily records not required, but may be requested if taxpayer’s participation cannot otherwise be reasonably established

The courts have repeatedly taken a dim view of self-serving guesstimates of time. See Scheiner, Tax Court Memo 1996-554, 72 T.C.M. (CCH) 1532 “We are not bound to accept the unverified, undocumented testimony of taxpayers.” Hradesky v. Commissioner [Dec. 33,461], 65 T.C. 87, 90 (1975), affd. per curiam [76-2 USTC ¶ 9703] 540 F. 2d 821 (5th Cir. 1976)

23

For simpler audits, generally:Support numbers on tax return with the documentation needed to persuade Service to accept tax return as filed.

Drafting responses to document requests of any type:Ensure adequate time frame for doing so Discuss with client after receipt Confirm time for response with Service

Track documents submitted Spreadsheets useful Don’t submit original documents If you must, obtain Form 2725, Document Receipt

24

Ensure discovery observes appropriate parameters

Communication

After filing Form 2848, Power of Attorney and Declaration of Representative, communication should only be through you as representative

Scope of Audit

From Service’s perspective, IRM 4.10.3.2.1 (02-26-2016):

Goal of examination to determine the "substantially correct" tax liability. Examiner considers facts and circumstances, evaluation of internal controls (in business examinations), use professional

judgment to determine whether scope should be expanded or contracted. Examiners must document reasons for expanding or contracting the examination on Lead Sheet 110 [Revenue Agent

Audit Plan], or workpaper, or Form 9984 [brief summary of actions taken] indexed to Lead Sheet 110.

From Taxpayer’s perspective:

Confirm issues under audit with Service Taxpayer Bill of Rights: Service should not lie or misrepresent See IRC Sec. 7803(3) IRS should provide notice if it expands issues under audit

25

Information Document Request (IDR) should not exceed permissible scope of discovery.

IDRs can seek evidence that“may be relevant or material” to issues under audit IRC Section 7602“might . . . throw . . . light upon” the correctness of the return under examination.U.S. v. Arthur Young &Co., 465 U.S. 805, 813 n. 11 (1984)

IDRs may not be overbroad or burdensomeNo fishing expeditions. U.S. v. Richards, 631 F.2d 341, 345 (4th Cir. 1980)e.g., “All emails pertaining to services for the rental activity claimed as a loss”

An IDR concerning charitable donations during the audit of my hypothetical Real Estate Pro should prompt question about whether this is appropriate.

Cannot require creation of new documentsProvide a chart . . .Provide a summary . . .

But consider whether generating the document might address and satisfy issues in a particular instance

26

Only 1 exam/year

IRC Sec. 7605 limits exams to 1 per year, and prohibits “unnecessary examinations or investigations”

Unless taxpayer requests otherwise• Requests a private letter ruling

Or Service deems necessary • Circumstances where Service can reopen limited under Regs. Sec. 601.105(j) (discussed later)

Actions the Service does not consider an examination under 4.03 of Revenue Procedure 2005-32.31; Rev. Proc. 2005-32; 2005-1 C.B. 1206.

Contacts and communications with taxpayer that do not involve inspections of books and accountsCorrection of a math errorAdjustment resulting from an information-return matching programVoluntary issue-resolution programs like a technical adviceRecalculation carry-backs and carry-forwards based on adjustments in other years

27

Statute of limitations

IRC Sec. 6501, Limitations on assessment and collection •The statute of limitations generally expires three years after the return is filed •Various exceptions for fraud, failure to file a return, omissions from gross income in excess of 25%, failure to report foreign transfers

Not unusual for IRS to request extension if it appears 180 days before statute runs that the audit will not be finished.

IRM 25.6.22.3 (02-09-2018) Notification of Taxpayer's Rights directs examiners to notify the taxpayer that•Taxpayer has the right to refuse•Request the extension be limited to particular issues/•To particular period of time

Information also provided in Publication 1035, Extending Tax Assessment Period28

Other considerations for extending statute:

Has the exam proceeded fairly, suggesting a fair result, or does taxpayer intend to file a protest with appeals?

Do concerning issues remain, that the IRS has not explored?

IRM 25.6.23.6.6. “If the taxpayer does not consent to extend the statute, the examiner will initiate action, as necessary, to issue a statutory notice of deficiency or initiate other means to assess tax deficiencies before the statute expires.”

29

Privilege:

Is the material requested by the Service privileged?

Should the privilege be waived?

What are the consequences of waiving privilege?

30

Attorney – client privilege

Confidential communication from client to attorney for purpose of obtaining legal advice, or

From attorney to client, containing the client’s confidential information which is the subject of that advice

The privilege does not apply to documents intended to be disclosed to third parties, like a tax return. United States v. Lawless, 709 F.2d 485, 487 (7th Cir. 1983);

Also, tax return regarded as more of an accounting than a legal function. See Olender v. United States, 210 F. 2d 795 (9th Cir. 1954), and cases cited therein.

- But advice relating to a tax return position may be covered -

31

IRC Sec. 7525 - Confidentiality privileges relating to taxpayer communications

(tax practitioner privilege)General rule: With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.

Significant Limitations:

o Only applies in federal tax proceedings, • not to any proceeding outside the federal tax system

o Does not apply to advice given to promote tax shelters

o Does not apply to criminal proceedings

• Accountants and other consultants offering advice in the context of criminal proceeding may be brought within the ambit of attorney-client privilege if employed by an attorney to assist that attorney in rendering legal services to the client. United States v. Kovel, 296 F.2d 918, 921 (2d Cir. 1961)

• To ensure communications with an accountant will be protected by the privilege, the accountant should be directly retained by the attorney.

32

Attorney Work Product Privilege

Codified by Federal Rules of Civil Procedure, Rule 26(b)(3)

Protects “documents and tangible things that are prepared in anticipation of litigation”, or in other words “because of” the prospect of litigation by or for a party or its representative.

Whether an administrative proceeding before the Service that could lead to litigation supports the privilege may vary depending upon jurisdiction.

Privilege can be overcome by sufficient showing.

33

5th Amendment privilege against self-incrimination

The privilege granted by the 5th Amendment of our Constitution allowing an individual the right to refuse to answer questions or otherwise give testimony against him- or herself.

Taxpayer must present him or herself for questioning and elect whether to raise the privilege as to each question.

The federal district court may then determine whether, for each question, the claim of self-incrimination is appropriate

In a civil context, the finder of fact is allowed to take a negative inference against the person asserting the privilege

34

Acknowledgement of Facts

At the end of discovery in simpler audits, the IRS may send a notice proposing adjustments to the tax return, followed by an “examination report” or other form, and request taxpayer’s signature.

For more complex audits, the Service may seek agreement with the taxpayer on relevant facts before forwarding a notice proposing adjustments.

This may take the form of a Written Acknowledgment of the Facts (AOF) IRM 4.46.4.9 (03-09-2016).

Purpose:

Ensures all relevant facts considered before a notice of a proposed adjustment issues.

Defines issues for appeal.35

Acknowledgement of Facts (continued)Enforceability:

Not enforceable by summons

Recall that IRC Sec. 7602 authorizes the Service to examine books and records, and take testimony to determine the accuracy of a tax return. An AOF is, in effect, document request that doesn’t actually request documents. An AOF is more in the nature of an interrogatory (request for information) under Rule 33 of the Federal Rules of Civil Procedure, or perhaps a Request for Admission under Rule 36.

Response:

Remove misstated facts

Supply relevant and favorable facts

Consider re-writing the facts in a counter-statement

Qualify response for good faith errors, further investigation, changes in law and IRS theories of adjustment, and so forth.

36

Conclusion of Audit

NO CHANGE: Service agrees no change is warranted.o Letter issues stating no changes made to the taxpayer’s return.o Audit is closed.

AGREED: Taxpayer accepts changes to the tax return by the Service.o Form issues stating adjustments to the return.o Taxpayer signs form agreeing to assessment of additional tax.

PARTIALLY AGREED: Taxpayer agrees to some, but not all adjustmentso Adjustments agreed to:

Listed on Form 886-A, Explanation of Items Those issues will be closed

o Adjustments not agreed to: 30 day letter issued permitting protest to Office of Appeals If insufficient time for administrative and judicial appeal, and taxpayer has not agreed to extend

statute of limitations, Statutory Notice of Deficiency, known as a 90 day letter, will issue, permitting petition to U.S. Tax Court

Generally, if case not considered by Office of Appeals beforehand, it can be referred for administrative appeal from Tax Court

37

STEP 4: AUDIT RECONSIDERATION/APPEAL

Audit Reconsideration, IRM 4.13.1, Pub. 3598

If the taxpayer disagrees with the IRS’ adjustments, may ask for reconsideration under specific circumstances.

Taxpayer has new information not previously considered Taxpayer did not appear for the original audit Taxpayer moved, and did not receive the correspondence from the IRS Taxpayer disagrees with an assessment created under the authority of IRC Sec. 6020(b), Substitute for

Return (SFR). Taxpayer has been denied tax credits such as earned income credit (EITC) claimed, during prior

examination. There was an IRS computational error

Consider this option if retained after audit terminated, particularly if material facts were not presented to the original examiner.

38

Appeals

Office of Appeals

If the taxpayer does not agree with one or more adjustments following the exam, the taxpayer may appeal. See Reg. Sec. 601.105(d)(1))

Office of Appeals is part of the IRS, but separate and independent from the division that conducts exams

Goal to resolve disputes without litigation

Success rate said to be about 80%, though IRS does not have numbers

Appeals shorter, more informal, cheaper than formal litigation

39

Purview of Appeals Office

Cannot consider criminal cases

Cannot develop issueso If new issues arise, must send back to exams

Can consider hazards of litigation

40

Appeals strategies

May settle some issues on appealTake others to court

Can appeal some issues while others still in examo Early referral program under IRC Sec. 7123(a)o Roughly comparable to interlocutory appeal under the FRCP Section 1292o Fast Track Settlement allows expedited appeal of specific issues even while others are still under exam

On appeals, emphasize hazards of litigationo Demonstrate to Appeals that taxpayer’s position is correct ANDo Service is unlikely to prevail on appeal

Necessary to exhaust administrative remedies if taxpayer hopes to get attorneys fees in court under IRC Sec. 7430, IRM 8.7.15.1

If taxpayer seeks a refund, and a significant issue remains unexplored after exam, it may be best to forego administrative appeal, consider paying the disputed tax, and pursuing a refund claim in district court just before the statute of limitations expires

41

Timing of appeal30 day letter

Notifies taxpayer of the right to appeal exam within 30 days Accompanied by Publication 5 describing the appeals process

90 day letter, “Notice of Deficiency” Notifies taxpayer of right to file petition in Tax CourtIssued after exam if not enough time to accommodate an administrative appeal and an appeal to Tax Court, andTaxpayer has not agreed to extend statute of limitations by signing Form 872, Consent to Extend the Time to Assess TaxTaxpayer should file the petition with Tax Court

• Generally, if case not before Office of Appeals beforehand, Tax Court will refer to appeals• Taxpayer may also request that the IRS attorney assigned to their Tax Court petition transfer

their case to IRS Appeals

42

Form of Appeal

Appeal commenced with “Protest” See Reg. 601.105 (d)(2) and Publication 5

Protest may be short or long depending on complexity issues

Cases under $25,000• File “small case request” on Form 12203, Request for Appeals Review• Or brief letter

Protest for larger dollar amounts requires written letter as described in Publication 5

May file protest meeting minimal requirements and amplify later• If retained late• If new facts/law comes to light

43

Discovery (or further discovery) before appeal

FOIA RequestFile promptlyIf need be, file more than one

The Service is under no continuing obligation to update previous responses

44

FOIA should request Administrative File

File should include:Correspondence and notifications from IRS

Notice of AuditInformation Document RequestsNotices of proposed adjustments30 day letter90 day letter (Statutory Notice of Deficiency)

Internal IRS documentation

Form 5402, Appeals Transmittal and Case MemoExaminer’s workpapers and notesExaminer’s rebuttal to any protest previously filedInformants’ reportsMemoranda of interviews with taxpayer and third partiesInformation from other taxpayers’ returnsPreviously filed protest/tax court petition

45

STEP 5: CLOSING AGREEMENT: choose form binding on service

Service and Taxpayers may enter into so called “closing agreements” under IRC Sec. 7121 and Reg. 301.7121-1(a).

IRC Sec. 7121, Closing Agreements authorizes an agreement with any person or estate as to any type of tax liability.

Reg. 301.7121-1(a) only recommends a closing agreemento “where there appears to be an advantage in having the case permanently and conclusively closed”,

and no disadvantage accrues to the Serviceo “or if good and sufficient reasons are shown by the taxpayer for desiring a closing agreement”

Closing agreements require approval of personnel above examiners.

Using the language of contract law, the statute describes these agreements as: o Finalo Except for fraud, malfeasance, misrepresentation of material fact

46

Use the correct form

Form 866, Agreement as to Final Determination of Tax Liability used to close conclusively the total tax liability for a taxable period ending prior to the date of

the agreement. Reg. Sec. 601.202

Form 906, Closing Agreement as to Final Determination Covering Specific Matters finally determines one or more separate items affecting the taxpayer's liability used when agreement has been reached as to the disposition of one or more issues and a

closing agreement is considered necessary to insure consistent treatment of such issues in any other taxable period. Reg. Sec. 601.202

this type of closing agreement does not bar the IRS from subsequently determining that a taxpayer is liable for additions to tax

47

Combined Agreement

Neither Form 866 nor Form 906 is specifically designed for closing agreements which determine both tax liability and specific matters.

Instead, typed combined agreement should be used. oFormat described in Rev. Proc. 68-16, Exhibit F.oLast page of combined agreement same as last page of Form 906

48

Consequences for not using correct form: Hinkle et al. v. U.S.,No. 1:16-cv-01048 KG/SCY, Consolidated with No. 1:16-cv-01051 KG/SCY, No. 1:16-cv-01052 KG/SCY, United States District Court, D. New Mexico., June 15, 2018

At the conclusion of audit, the IRS sent Form 4549, Income Tax Examination Changes, with a letter stating that, if Plaintiffs signed the form, they would not be assessed an accuracy penalty under IRC Sec. 6222.

IRS later sent written notice that it was considering a penalty under IRC Sec. 6707A for failure to disclose a listed transaction under Reg. 1.6011-4(b((2), referring to transactions the IRS considers consistent with tax avoidance schemes.

Thereafter, Plaintiffs received a Form 4549-A, Income Tax Discrepancy Adjustments assessing a civil penalty under Sec. 6707A

Both before and after receipt of Form 4559-A, Plaintiffs received correspondence from the IRS, including the North Atlantic Area Director, stating that there would be no penalty.

The court held that the Service had waived the penalty under Sec. 6662, but not 6707A. "As a Revenue Officer, Roberts was not authorized to enter into a binding agreement with the Meyers. The Meyers were charged with knowing Roberts' limited authority so they cannot demonstrate that their reliance was reasonable. Since only a private letter ruling or a closing agreement by authorized agents bind the government, and because the Meyers did not obtain such documentation, their estoppel claim fails". Footnote 9

49

STEP 6: REFERRAL TO CRIMINAL DEFENSE ATTORNEY

Criminal matters are handled differently than conventional civil audits

Do not cooperate or disclosePrivileges claimedPursuant to summonsValidity of claims decided by federal court

Do not agree to extend statute of limitations

Consequences may include jail

50

3 scenarios where question of referral to criminal defense attorney should be evaluated:

1. No substantiation for expenses . . . o Will IRS simply disallow with penalties and interest?o Or see a willful and criminal attempt to evade tax?

2. Non-filers . . . IRS distinguishes non-filers with badges of fraud from non-filers without.

o Pursue voluntary disclosure? IRM 9.5.11.9., Voluntary Disclosure Practiceo Make a “soft disclosure” by filing past due or amending previously filed returns?o Refer to criminal attorney?

3. Signs of fraud/examiner considering referral to criminal division during audit . .

51

How to handle these 3 scenarios:

Two fold analysis, based on -

LAW

IRS PRACTICE AND POLICY

Interplay not always straightforward

52

Law

Two statutes particularly relevant:

IRS Sec. 7201 - Attempt to evade or defeat taxAny person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.

IRS Sec. 7203 - Willful failure to file return, supply information, or pay taxAny person required under this title to pay any estimated tax or tax, or required by this title or by regulations made under authority thereof to make a return, keep any records, or supply any information, who willfully fails to pay such estimated tax or tax, make such return, keep such records, or supply such information, at the time or times required by law or regulations, shall, in addition to other penalties provided by law, be guilty of a misdemeanor and, upon conviction thereof, shall be fined not more than $25,000 ($100,000 in the case of a corporation), or imprisoned not more than 1 year, or both, together with the costs of prosecution

53

Law (Continued)

Case Law:

Was taxpayer’s conduct willful? Cheek v. United States, 498 U.S. 192 (1991)o Willfulness is “an intentional violation of a known legal duty.” o Taxpayer may claim a good faith belief that s/he did not have a legal duty, and belief

need not be objectively reasonable.o“ [C]laimed good-faith belief [need not] . . . be objectively reasonable if it is to be

considered as possibly negating the Government's evidence purporting to show a defendant's awareness of the legal duty at issue.”

o In effect, ignorance of the law is a defense to prosecutions or penalties based on willfulness.

54

IRS POLICY

Badges of fraud” as evidence of willfulness

o A consistent pattern over several years of underreporting taxable incomeo False Statements or False Recordso Accounting irregularities o Failure to cooperate with the examinero Concealment of assetso Inadequate records; Dealing in cash

Significant multi-layered review within the Service and Justice Department before bringing criminal proceedings to determine likelihood of:

o Proving defendant guilty beyond a reasonable doubto Significant jail timeo Publicity which will achieve substantial deterrence

Typical targets are educated/financially successful taxpayers with substantial misstatements over several years

55

Non-filers:

IRS handles non-filers differently depending on whether if there are “badges of fraud”.

Taxpayers’ representatives should as well.

If fraud, Service will develop case pursuant to guidelines in IRM 25.1.7, Fraud Handbook –Failure to File

If no fraud, Service will solicit returns IRM 4.12.1.7.2.1 (10-05-2010)

Enforcement usually limited to 6 years. Longer or shorter periodsRequires management approval Depends on variety of factors How much tax is due relative to time and effort to collect Badges of fraud Illegal income Taxpayers history of noncompliance/evasion of withholding requirements Special circumstances relating to taxpayer, industry, or type of tax

56

Voluntary Disclosure (domestic)https://www.irs.gov/compliance/criminal-investigation/how-to-make-a-domestic-

voluntary-disclosure

Voluntary disclosure for non-filer • If there’s fraud: consider referral to criminal defense counsel

Made by forwarding taxpayer’s identifying information to the IRS criminal division Prior to any enforcement action by IRS Income must be legally obtained

Taxpayer must cooperate with IRS in Determining amount of tax due and Paying it

IRS does not guarantee voluntary disclosure will avoid criminal prosecution, but it typically does

If non-filer has committed further crimes of fraud and evasion Voluntary disclosure may enable them to avoid prison Should be handled by attorney experienced in criminal defense

57

“Soft disclosure”

Another option for a nonfiler is “soft disclosure” byForwarding unfiled returnsAmending previously filed returns to report unreported income

Accompany with an explanation why taxpayer’s failure to file or report was not accompanied by badges of fraud

If failure to file or report was accompanied by badges of fraud, consider referral to defense counsel

(Historically, soft disclosure made in the hope that the IRS would accept the returns, and refrain from prosecuting failure to report/file as “willful”. If fraud is present, this procedure exposes taxpayer to the risk of prosecution without protection by defense counsel.)

Conversation with one Taxpayer’s advocate suggests the IRS prefers voluntary disclosureOne would suppose that’s especially the case where there’s no good explanation

58

Signs of fraud/possible criminal referral by Service during audit

So called “eggshell audit” Representative knows there’s fraud, but IRS doesn’t Consult experienced criminal defense attorney

o Do so behind the scenes o Refer with discretion

Long period of silence during audit Conventional wisdom: long period of silence where auditor is out of touch and unresponsive may

indicate a referral to criminal division You can consider asking whether such a referral has been made, but risk alerting IRS to possibility it

may not be considering Consider having criminal defense attorney available, but in background, to avoid alerting Service

59

-End of review-

6 STEPS IN AUDIT PROCESS:

1. PREVENTION: address issues in tax return before the Service does

2. PREPARATION: know what the Service knows

3. DISCOVERY: limit issues and disclosure

4. AUDIT RECONSIDERATION/APPEAL

5. CLOSING AGREEMENT: choose form binding on service

6. REFERRAL TO CRIMINAL DEFENSE ATTORNEY

60

Volunteer for MVLS!

Janice Shih and MVLS network are wonderful to work with.

61