ANATOMY OF A CRIMINAL TAX CASE: PART TWO
Before tackling a criminal tax case, one needs to know a little about the inner workings of the IRS, Department of Justice Tax and your local Assistant US Attorney.
A man with a badge claiming to be a CID Agent is at the front door, what do I do?
Like all criminal confrontations with law enforcement the first answer to the clients question is do not say anything until you have had time to talk to an attorney. However, how the CID agent got to the clients front door and what you do now is very different from most criminal investigations.
A CI investigation typically begins with the receipt by CI of information concerning potential criminal violations of one or more of the statutes discussed previously. This information can come from the general public, another division of the IRS, a US Attorney’s office, another law enforcement agency, or another CI investigation.
Once the office approves the opening of the case, a CID agent will conduct an investigation and prepare a Special Agent Report (SAR) that the agent’s superiors will use to decide whether to refer the case to the Department of Justice (DOJ). If the DOJ decides to prosecute and brings charges against the target, the CID agent becomes the AUSA’s case agent.
An IRS referral:
A case works its way from a civil audit to a criminal investigation through the IRS’s long-standing fraud referral program. When a revenue agent or revenue officer investigates a case and identifies “firm indications of fraud” the agent must suspend the civil audit and transfer or refer the case to the IRS CI division.
There are sections of the IRS in the civil audit and collections divisions that are set up to detect fraud that have fraud referral specialists. Tax protesters, gambling enterprises, drug dealers, dubious tax deduction schemes and overseas shelters are all examples of the type of activity that will alert the fraud referral specialists.
When you have a client that is being audited by the IRS and there is the reason to suspect he or she has some criminal exposure there is a difficult decision to make. To what extent, if any, you want to allow your client to be interviewed by the civil revenue agent?
U.S. Attorney referral:
Often the US Attorney will refer a matter to the IRS for criminal investigation. Other State and Federal agencies investigating criminal activity will usually make the referral to the U.S. Attorney who then notifies the IRS. Because of its ability to crunch numbers and its arsenal of tax laws, the DOJ and US Attorney’s will often use the IRS in drug conspiracies, political corruption, organized crime and a host of money heavy criminal investigations.
A number of referrals come from outside information. Sometimes the IRS receives a tip that someone is cheating on their taxes. The more common of these referrals include confidential law enforcement sources, whistle blowers, competitors and unhappy spouses (at one time the largest source of outside referrals came from ex and soon to be ex wives).
If the case is referred to the IRS CI division it usually follows the administrative procedures of the Internal Revenue Service and the Tax division of the Department of Justice, but that is not always the case. Sometimes a criminal tax case can be indicted by a Grand Jury that bypasses all the administrative steps that are normally required.
Once the civil division turns the case over to the criminal division, the CID agent has the power to issue an Administrative Summons. The summons will force a tax payer to appear before the agent, give testimony and produce books and records. 26 USC §7602 (IRC – Examination of books and witnesses). The Agent designates the time and place of examination. And failure to obey the summons is enforceable by a contempt action. 26 USC §7210 (IRC – Failure to obey summons).
Often the taxpayer receiving this Summons (on his front porch at 7:00 AM) is when we first become aware of the criminal investigation. The issuing of the Summons is usually followed by an interrogation from the Agents (they always come in pairs). And this interrogation is fraught with peril for your client. While the Agent will talk to you, briefly and usually over the phone, any additional communication will require the attorney to fill out a signed power of attorney (POA) form from you and your client (Form 2848 provided by the IRS). This is necessary to protect the confidentiality of the taxpayer’s financial information.
The tax payer has the right to contest the Summons in District Court, via a motion to quash, but has very limited legal grounds that would allow him to prevail.
Once the CID agent has put together his case the taxpayer, through his lawyer, has the right to appear before the local IRS attorneys (Area Counsel) who have to approve the criminal case through the DOJ Tax Division in Washington. You should always request a hearing from Area Counsel. They will tell you what years are in question, how much money they are alleging is involved and what statues they are pursuing. You do not have to say a word or you can challenge their case at this point. They will notify you in writing of their decision and if it is to go forward you get another bite at the apple in Washington.
You must request a hearing in writing at the DOJ Tax level in Washington. They will grant the request and you can do the hearing in person or over the phone. These lawyers review the case from a trial lawyer’s perspective and this is an excellent opportunity to convince the government they have a civil fraud case and/or it should be reduced to a lesser charge. If they authorize prosecution the case usually goes down to the AUSA in the district it originated from to be indicted and prosecuted.
Direct Grand Jury:
Sometimes a case will forgo all the administrative steps of the IRS and go directly to the Grand Jury for indictment. These cases are most often associated with an ongoing criminal investigation that happens to uncover additional criminal tax violations. Speed and secrecy are considerations and thus the US Attorney will request an expedited approval from DOJ Tax so they can indict and prosecute. We are talking drug cartel, organized crime, state security type cases here.
A direct grand jury tax case is like any other criminal case that is in the pre indictment stage. The only real difference is that DOJ Tax has become involved. If Washington has approved an indictment, there are not many local AUSA’s that are willing to try and reverse that decision. If a local US Attorney refuses to go forward on a DOJ approved criminal tax case, the Justice Department will send their DOJ tax lawyers from Washington to try the case.
PROVING TAX FRAUD
Criminal tax fraud focuses on two necessary factors:
- A solid and substantial tax deficiency.
- The badges of fraud; provable, sneaky behavior usually (but not always) concerning the tax deficiency.
Most but not all of the big five criminal tax offenses require a tax due and owing. However, even for those that do not require a tax deficiency, as a practical matter it is a tax case and the case becomes stronger for the government as a tax deficiency increases and becomes more evident. The government’s case also, of course, strengthens with the more badges of fraud it can uncover.
Proving the tax deficiency:
The government proves a tax deficiency in different methods both direct and indirect. Not surprisingly many of these methods come from the world of accounting. At one time the IRS “unofficially” required a tax deficiency of at least $40,000 before they would approve a criminal case.
- Specific items method consists of direct evidence of the items of income received by a taxpayer in a given year. This is just what it sounds like. The Defendant received dollars from his business, a kickback, gambling, extortion, the lottery etc. … and the income does not appear on the return.
- Bank deposits method, an indirect method of proof, reconstructs income by analyzing bank deposits by a taxpayer who has an income-producing business and makes regular and periodic deposits to bank accounts.
- Net worth method, another indirect method that reflects increases in the taxpayer’s wealth, as contrasted with reported income. This is often the undoing of many a drug dealer.
- Expenditures method (a variation of the net worth method) reflects the expenditures made by a taxpayer. Excessive money spent for consumable items such as vacations, entertainment, food, drink, and the like.
- Cash method, a variation of the expenditures method, compares the taxpayer’s cash expenditures with the known cash sources.
Remember that interview by the CID agent of your client early one morning? One of the first questions asked will be how much cash do you keep on hand and where did it come from?
Proving Intent: Badges of Fraud
- Classic Spies Badges of Fraud:
In Spies v. US, the Supreme Court in 1943 listed the classic set of badges of fraud that provide circumstantial evidence of a tax fraud:
Keeping a double set of books,
Making false entries, invoices or documents,
Destruction of books or records,
Concealment of assets or covering up sources of income,
Handling of one’s affairs to avoid making the records usual in transactions of the kind and
Any conduct, the likely effect of which would be to mislead or to conceal.
Spies v. US, 417 US 492, 498 (1943).
- And Much More.
The Internal Revenue Manual and the DOJ Tax, Office of Chief Counsel’s “Tax Crime Handbook” has expanded greatly on the original 1943 list. The Badges of fraud are now much more numerous and fall under six different categories of badges:
- Expenses or deductions
- Books and records
- Allocations of income
- Conduct of taxpayer
- Methods of concealment
Remember that 7:00 AM interview of your client, at his front door before he had his cup of coffee, by the CID Agent? If your client makes a false statement in response to a question such as: “why haven’t you filed your taxes the last few years?” Client, “Oh I meant to but we had a fire at my office and it has delayed me.” His little ‘white lie’ has elevated a misdemeanor Failure to file his taxes into a felony Tax Evasion charge! And this rise to a felony is all under the legal nomenclature of a badge of fraud.
Id.; US v. Brooks, 174 F.3d 950, 954-56 (8th Cir. 1999); US v. Meek, 999 F.2d 776,779 (10th Cir. 1993).
The Defense Attorney has his strategy and arsenal of weapons as well and the sooner we are involved in the case the better the chances of success.
By having the Form 2848 Power of Attorney filled out and signed by lawyer and client, the lawyer stops the bleeding of information to the CID Agent. You are now the authorized agent for the target and pursuant to IRS regulations all communication must go through you.
Still give your client the speech about not talking to anyone unless it is in the presence of his attorney. But you have at least shielded him from additional contact from the CID investigators.
- Hire a CPA:
The weakest link in the IRS case is often proving the tax deficiency. There are a lot of good forensic fraud CPA’s and former IRS CID agents that know where and how to attack the numbers that the case is based on. Hire this accountant and use a contract that spells out the purpose of his employment. He is being hired to help you prepare a defense for this client. The agreement gives the accountant a Kovel privilege [US v. Kovel, 296 F.2d 918, 922 (2d Cir. 1961)]. Kovel sets out the parameters of the privilege and they are a little different from hiring an investigator/accountant in your typical case. However, the primary difference would occur if the Kovel accountant files a return or amended return because tax preparation files are never privileged.
Interview the CPA that the client used to prepare his taxes. Make sure your Kovel accountant is at the interview as he is going to know more about taxes than you are.
The CPA who prepared the taxes is referred to as the historical CPA and does not have a privilege. His information and conversations are fair game for government investigators. There is usually a race for the defense attorney to try and interview the historical CPA before the CID Agent gets there.
- Ignorance of the law:
The intent element of most all tax offenses is Willfulness … the voluntary, intentional violation of a known legal duty. Cheek v. US, 498 US 192 (1991). But because the tax laws are complex, and often used by lay people, the courts have softened the concept that ignorance of the law is no excuse. A good faith belief that one is following the law, even if unreasonable, will excuse criminal willfulness if honestly held by the tax payer. Id.; Razlaf v. US, 510 US 135 (1994).
The Cheek instruction as it is known allows the defense attorney to argue good faith to Area Counsel, DOJ Tax and a jury. Although everyone may know better, and what the Client did was improper he still did it out of an honestly held belief that it was the proper way to treat his taxes. The court in Cheek held that this instruction has its limits and will not aid a so called tax protestor who holds an erroneous belief the tax laws are unconstitutional and he does not have to pay taxes at all.
- Beyond a reasonable doubt:
Besides the obvious burden of proof in all criminal cases, the reasonable doubt standard has significant repercussions in a criminal tax case. When your Kovel accountant is preparing the taxes for your case he is not burdened with the fact that the IRS may not accept his method or deductions. Questionable methods may not be accepted by the IRS in a civil case but here there is a beyond a reasonable doubt standard. Vague and unsettled law can be an advantage to a client and reasonable doubt about a deduction or a tax method goes to the Defendant. US v. Harris, 942 F.2d 1125, 1131 (7th Cir. 1991); US v. Heller, 830 F.2d 150, 154-55 (11th Cir. 1987); US v. Garber, 607 F.2d 92, 100 (5th Cir. 1979); US v. Critzer, 498 F.2d 1160, 1162 (4th Cir. 1974).
While the accountant cannot go wild with his methodology he does have an advantage that is seldom seen in the tax courts. This can, once again, give the defense attorney powerful arguments at the administrative level for a civil tax fraud and/or a lesser charge.
- File or amend a tax return:
Sometimes an early filing or amending a tax return can convince a CID agent or his superiors to turn the case back over to the civil division. The IRS does have a voluntary disclosure policy. However, this is a risky move because reveling undisclosed income has the potential of making a de facto confession to the IRS of filing incorrect returns. Like putting your client before a Grand Jury this move requires some warm and fuzzy input from the government and a leap of faith on your part.
At the end of the day a federal tax fraud case is just another fraud case with a few more legal twists and turns. The defense attorney, by paying close attention to these unique twists and turns, can do things for his client that we cannot do in any other criminal case.