Additional Issues – Civil vs. Criminal Audit

Additional Issues – Civil vs. Criminal Audit

Additional Issues – Civil vs. Criminal Audit can arise quickly which is yet another reason why a CPA that represents cannabis industry businesses should have an active relationship with a tax attorney that can handle a criminal case should one develop.

Warning signs of criminal referrals include:
  • The Revenue Agent goes AWOL (the United States v. Tweel, 550 F.2d 297 (5th Cir. 1977))
  • The Revenue Agent starts to focus on the “intent” of the client toward sensitive issues
  • The Revenue Agent focuses on net worth analysis or bank records

    Additional Issues - Civil vs. Criminal Audit
    Additional Issues – Civil vs. Criminal Audit
  • The Revenue Agent makes excessive copy requests
  • The Revenue Agent makes contact with third parties
  • The Revenue Agent obtains search and seizure warrants
  • Your client receives summons or subpoenas for records

Additional Issues – Civil vs. Criminal Audit

Privileges to Consider
  • Attorney-Client Privilege
  • Federally Authorized Tax Practitioner Privilege (only applies to tax advice in non-criminal tax matters per IRC §7525)
  • Fifth Amendment Privilege
  • Joint Defense Privilege
  • Spousal Privilege

An auditor is supposed to protect your rights as a taxpayer. However, an auditor is unlikely to inform you if the examination escalates from a civil examination to a criminal investigation. In fact, there can be an ongoing criminal investigation being carried out in conjunction to the audit and the auditor is collecting evidence for the criminal investigation. This is a reverse eggshell audit. Even if there is no concurrent criminal investigation, an auditor may nonetheless be conducting an examination with the objective of gathering evidence to establish proof of fraud without your knowledge. A tax attorney can intervene at any stage of the audit, ensure that the audit is conducted properly, and limit your future exposure.

Differences Between Civil Tax Fraud and Criminal Tax Fraud

Technically, the difference is the degree of proof required. Civil fraud cases require the Government to prove fraud by clear and convincing evidence. Criminal tax fraud cases require the Government to present sufficient evidence to prove guilt beyond a reasonable doubt. Clear and convincing evidence must prove that something is highly probable or reasonably certain, whereas evidence that is beyond a reasonable doubt can leave no doubt that would cause uncertainty in the mind of the person examining the evidence.

Civil fraud results in remedial action taken by the government such as assessing the correct tax and imposing fraud penalties such as fines. These civil fraud fines are generally greater than those associated with a tax deficiency and are owed in addition to the deficiency penalties. Furthermore, interest accrues on the penalty from the due date of the return. If convicted, criminal tax fraud includes the possibility of imprisonment in addition to the unpaid taxes, interest, and penalties. A tax fraud offense may result in both civil and criminal penalties.

Additional Issues – Civil vs. Criminal Audit

Involvement of Counsel

If there are potentially sensitive issues, the taxpayer should be interviewed by counsel in order to determine whether there is a need to fully preserve potentially privileged information. In turn, counsel should consider engaging the accountant to coordinate the audit on behalf of the taxpayer. Under the doctrine of United States v. Kovel, 292 F.2d 18 (2d Cir. 1961), the investigative accountant may be clothed with an extension of the attorney’s privilege. Further, and of significant importance to the accountant, the accountant might become the subject of a malpractice action if not engaged by the taxpayer’s counsel in the event information revealed to the accountant during or in preparation of an audit is ultimately required to be unnecessarily disclosed to others.

Due Diligence Required

Effective representation of a taxpayer during an audit requires a thorough review of the taxpayer’s general financial activities not otherwise set forth on the returns. Section 7602(d) has been added to the Internal Revenue Code to prohibit the use of “financial status” or “economic reality” examination techniques to search for unreported income unless there is a “reasonable indication” that there is a likelihood of unreported income.1 Under the financial status approach, a taxpayer’s total financial situation is evaluated to assure that the tax return accurately reflects reportable income. It is an approach designed to compare information set forth on a return with the taxpayer’s financial lifestyle or business activities. It is also an attempt by the IRS to increase compliance and search out potentially fraudulent situations.

Additional Issues – Civil vs. Criminal Audit

Indirect Methods of Determining Income

 Historically, conventional audit techniques have been discovered to be grossly inadequate for the purpose of demonstrating an understatement of taxable income. In such event, the government has often resorted to one or more indirect methods of detecting unreported income (often including a Bank Deposits Analysis, Expenditures Analysis, Net Worth Analysis and/or Mark-Up Analysis). Indirect methods may generally be pursued, even though the taxpayer’s books and records appear reliable. In fact, the indirect method often provides strong evidence that the taxpayer’s books and records are otherwise unreliable. In Holland v. the United States, the Supreme Court stated:

“To protect revenue from those who do not render true accounts, the government must be free to use all legal evidence available to it in determining whether the story told by the taxpayer’s books accurately reflects his financial history.”

Further, indirect methods as a basis for providing reliable estimates of the taxpayer’s taxable income have been consistently affirmed on that basis.

Chicken, Eggshell – Reverse Eggshell

Kovel Doctrine – Expanded Privilege

Additional Issues – Civil vs. Criminal Audit

Internal Revenue Manual – Badges of Fraud