TAX FRAUD INVESTIGATIONS – A PROCEDURAL ROADMAP Part I

I. Introduction

An IRS fraud investigation is a harrowing experience, not only for the corporate officers, directors and employees who are the subject of the investigation, but for the corporation’s legal advisors as well. The process many begin innocuously with a routine civil tax examination, or with the jolting arrival of a grand jury subpoena. The investigators may not know exactly what (or who) they are after, and will be very guarded in what they tell corporate representatives about the basis, nature, scope and direction of their investigation. Without a thorough understanding of how and why tax fraud matters are investigated and prosecuted by the IRS and the Department of Justice, it is likely that the corporation’s representatives will lose forever numerous opportunities to protect their clients from prosecution. Even worse, ill-advised statements and disclosures may materially assist the government in its prosecutorial efforts. The purpose of this article is to familiarize corporate officers and legal representatives with the policies and procedures applicable to such cases so that this hazardous road need not be travelled in the dark.

The article will be presented in two parts, with the first part focusing on the initiation and processing of a tax fraud investigation by the IRS Criminal Investigation Division. The second part of the article, to be published in the next issue of the Corporate Criminal Liability Reporter, will discuss the review procedures applicable to such cases as they journey from the Criminal Investigation Division, through IRS District Counsel and the Tax Division of the Department of Justice, to the U.S. Attorney’s Offices throughout the country where tax fraud cases are indicted and tried.

Information is the key to the successful defense of any criminal tax case. The investment of substantial time, effort and ingenuity is required, since the true facts can never be determined by a few cursory interviews with company personnel about whether they “know of anything that was done wrong.” At a very early stage of the investigative process, it will be necessary for the corporation’s representatives to determine whether the government’s request for the voluntary production of voluminous records and for ready access to company employees will be honored. It is impossible to respond appropriately to these requests without having done everything possible to collect all relevant facts. Understanding the process utilized by the government in investigating these cases will help mold and channel the corporation’s own efforts to gather the facts needed to respond effectively throughout an investigation.

II. In the Beginning….

A. Referrals from the Examination Division

How do criminal tax investigations begin? Answering this question in any given case is seldom easy, and is sometimes impossible. In practice, tax fraud investigations arise from a variety of sources. About half result from information sent to the Criminal Investigation Division by other departments of the IRS. The most frequent source of these “referrals” is the Examination Division, which conducts civil tax audits. Its examiners, or “Revenue Agents,” have the most contact with taxpayers, and it is not uncommon for an astute Revenue Agent conducting a routine corporate examination to unearth facts that hint at the presence of fraud. The Internal Revenue Manual, the Agents’ bible, states that “when the examiner discovers a firm indication of fraud, the examination should be immediately suspended without disclosing to the taxpayer or representative the reason for the action.”1

Revenue agents are instructed to look for evidence of fraud whenever they audit income, estate or gift tax returns.2 Not surprisingly, the examiner often obtains his first hint of possible presence of fraud from the corporate taxpayer’s own officers and employees.3 Dealing with a “routine” civil tax audit when corporate officers are already aware of potential “problem” areas is thus one of the most difficult dilemmas corporate counsel can face.4

Once a Revenue Agent determines that the facts constitute a “firm indication of fraud,” he prepares a Referral Report for Potential Fraud Cases (Form 2797). This report is directed to the Criminal Investigation Division, and contains all of the information the agent has gathered which leads to the suspicion that tax fraud has been committed.5 It takes some time to prepare one of these reports, particularly in a complex case. Thus, experienced practitioners know that when an aggressive auditor who has been badgering the company for documents and information on a daily basis suddenly disappears with no explanation, it is not necessarily cause for celebration.6

B. Referrals from Other IRS Divisions

Other offices within the Internal Revenue Service also refer cases to the Criminal Investigation Division, though none with the frequency of the Examination Division. Revenue Officers, employees of the Collection Division, sometimes refer cases involving alleged intentional failure to file federal income or employment tax returns, or cases involving willful attempts to defeat IRS levies or rescue seized property. The Employee Plans and Exempt Organizations Division also refers a few cases to CID, such cases generally involving misuse of pension fund assets or fraudulent claims of tax exempt status.

C. Cases Initiated by CID

The Criminal Investigation Division generates many of its own cases without referrals from other divisions of the Service. Its agents constantly monitor newspapers for articles about prominent local citizens, criminal activities, evidence of unexplained affluence, or other items which seem to suggest possible avenues of investigation. Often the Special Agents in the IRS District will divide up the district geographically and assign responsibility for monitoring local newspapers from small towns within the district. Of course this does not mean that appearing in the paper is a guarantee of being subjected to either an IRS audit or a criminal investigation, but agents do check to see whether a corporations’s financial success as described in the newspaper is similarly reflected in the company’s tax returns. In fact, it is not unusual for agents to find that the local business or businessman being described in such glowing terms in the press has somehow neglected to even file tax returns. Agents also design and implement district, regional or national “projects,” including some undercover projects, focusing on particular industries or business types.7 These kinds of preliminary inquiries lead with some frequency to the initiation (or “numbering”) of active criminal cases.

Agents also follow leads obtained in a given investigation in order to develop cases on related parties. Thus, a seemingly unrelated investigation of one of a corporation’s employees, suppliers or customers can easily lead to an investigation of the corporation itself. Cases against corporations have even resulted from investigations of union officials involved in representing the firm’s employees.

D. Cooperation with Other Investigative Agencies

Special Agents also spend time conversing with their colleagues in other federal, state and local investigative agencies. In fact, CID agents are assigned to maintain liaison with specific law enforcement agencies in hope of developing cases from information gathered from these agencies. Thus, a corporation which is having difficulties with a particular federal or state regulatory agency may come under the scrutiny of the IRS Criminal Investigation Division because of information exchanged by investigators on an informal basis over a friendly cup of coffee.

In addition to these informal relationships with other investigators, the IRS Criminal Investigation Division participates in formal programs of cooperation with other federal agencies. Numerous tax fraud cases result each year from the ongoing cooperation between the IRS and the Drug Enforcement Agency.8 Of more interest to corporate officers and legal representatives is the long history of cooperation between the IRS and the Securities and Exchange Commission. A few years ago when the SEC was actively investigating questionable foreign payments by U.S. companies and was asking those companies to make “voluntary disclosure” of their past misdeeds, the information collected was turned over by the SEC to the IRS Criminal Investigation Division. Indeed, IRS Special Agents were invited by the SEC to attend the meetings during which corporate representatives made the disclosures, and a number of criminal tax fraud prosecutions resulted.9 The Service also has agents who maintain close working relationships with staff members of the major stock and commodities exchanges, and who are always interested in stories of unusual trading activities. The unproven suspicions of any one of dozens of other federal, state and local law enforcement and regulatory agencies can set a criminal tax investigation in motion.

E. Tips from Informants

The IRS also receives information from the general public, and in fact encourages it with a generous reward program.10 The Service receives hundreds of calls each day from citizens who want to provide information on the misdeeds of their friends, neighbors, employers, competitors, ex-lovers and former (or present) spouses. All of these calls are routed to the Criminal Investigation Division, and each caller speaks with a Special Agent or Tax Fraud Investigative Aide who dutifully records the information provided, trying to elicit as much detail as possible. If warranted, follow-up meetings are arranged, and the relevant IRS files are pulled for review. Many of these calls are of mere entertainment value, but more than a few result in full scale tax fraud investigations. The confidentiality of these informants is jealously guarded by the IRS, and many taxpayers are investigated, tried, convicted and incarcerated without ever knowing that the process began with a tip from a former employee or spouse.

III. Staffing of Tax Fraud Investigations

A. Special Agents

Successful football teams study the opposing players with great interest, and it is no less important for corporate officers and their representatives to know who is on the other side in an IRS criminal investigation. As noted above, these investigations are conducted by Special Agents from the IRS Criminal Investigation Division.11 The agents involved in these cases are a relatively well trained group. The recruiting standards are the highest for any non-lawyers position in the Service, and indeed many Special Agents are lawyers or Certified Public Accountants. The Criminal Investigation Division has a far lower turnover rate than the Examination or Collection Divisions, and the typical Special Agent stays with the IRS until retirement. Many have previously worked as Revenue Agents in the Examination Division, and at one time such experience was required.12

Unlike Revenue Agents, who are under a great deal of pressure to close civil tax audits as quickly as possible, Special Agents have the luxury of time. Often a tax fraud investigation takes twelve to twenty-four months to complete, with 1,000 to 2,000 staff hours being devoted to the case. In appropriate circumstances, an entire team of agents will be assigned to a large corporate criminal investigation, and the resources they are permitted to devote where the case appears to have good prosecution potential will be virtually unlimited.

B. Joint Investigations with Cooperating Revenue Agents

Criminal tax cases are usually conducted as “joint investigations,” in which one or more Revenue Agents from the Examination Division are assigned to assist the Special Agents with the case. If the investigation results from a referral from an examiner who detects indications of possible fraud during a civil audit, often this examiner is assigned as the “cooperating agent.” In other cases, the cooperating agent will be one of a small cadre of the most senior and experienced Revenue Agents in the District. These agents, like their Special Agent counterparts, have often testified in numerous criminal trials, and make extremely effective government witnesses. During the investigation, the cooperating Revenue Agents are responsible for making all computations of the actual tax consequences of the fraudulent conduct alleged, and provide invaluable assistance to the criminal investigators in the more complex and technical areas of tax law and accounting often encountered in large corporate investigations.13

IV. Classification of IRS Criminal Investigations

A. Administrative vs. Grand Jury Investigations

Criminal tax fraud cases are either handled as “administrative” or “grand jury” investigations. In the former, the Service conducts the investigation on its own, utilizing the administrative summons to compel the production of documents and testimony, while in grand jury investigations the Special Agents work in conjunction with the local U.S. Attorney’s Office and/or the Department of Justice Tax Division, and utilize grand jury subpoenas to obtain the documents and testimony they seek.

The Service’s stated policy is to utilize administrative investigations when possible, and to request that an investigation be conducted by a grand jury only where the IRS is experiencing particular difficulty obtaining the evidence it needs through the use of administrative summonses, where an investigation would be facilitated by the ability to grant immunity to key witnesses,14 or where the investigation be more efficient if integrated with a probe already being conducted by a grand jury in conjunction with the U.S. Attorney’s Office:

Investigations of particular cases or projects may be conducted by means of the administrative process, or by seeking a grand jury investigation. The administrative process is the preferred alternative and all investigations shall be by means of the administrative process unless… seeking a grand jury investigation is necessary and appropriate in the circumstances where:

(a) It is apparent that the administrative process cannot develop the relevant facts within a reasonable period of time, or

(b) Coordination of the tax investigation with an on-going grand jury investigation would be more efficient, and

(c) The case has significant deterrent potential. IRM 9267.21.

An IRS request that a matter be handled by grand jury investigation is directed to the Department of Justice, where authority to approve such requests has been delegated to the Deputy Assistant Attorney General in charge of the Criminal Section of the Tax Division.15

U.S. Attorney’s Offices throughout the country also initiate tax-related grand jury probes when investigations being conducted by their offices reveal evidence of possible tax crimes. As with requests initiated by the IRS, such grand juries may be utilized only with the approval of the Department of Justice Tax Division.

There are numerous procedural differences between grand jury and administrative cases. One such difference relates to the method of compelling the production of documents or testimony. As noted above, agents conducting administrative investigations use the statutory power of the Commissioner’s Summons.16 Administrative summonses may be used for any civil tax purpose, or in connection with a criminal tax matter until the case is referred out of the IRS to the Department of Justice. The summons is served personally on the person or organization whose testimony is sought. The Internal Revenue Manual directs that a summons to a corporation be served “upon a corporate officer, director, managing agent, or other person authorized to accept service of process for the corporation.”17

A summons may be made returnable at any time and place reasonable under the circumstances.18The place specified will usually be the Special Agent’s office. The time must be at least ten days from the date of service of the summons.19 The period is somewhat longer if the summons is served on a “third-party recordkeeper.”20 In this case, notice of the issuance of the summons must be furnished to the taxpayer within three days of such service, and the return date may not be less than twenty-three days from the date of the notice. The purpose of the period of delay is to allow the taxpayer to challenge the summons and halt compliance therewith by a third-party recordkeeper.21

Disputes over the enforcement of administrative summonses are handled by U.S. District Courts. Willful failure to obey a summons is a misdemeanor violation of IRC 7210, and a person convicted thereunder may be imprisoned for up to one year and/or fined up to $1,000.22 In order to contest a summons, it is necessary for the taxpayer to file a motion to quash within twenty days of notice of the issuance of the summons.23 Both the IRS and the party receiving the summons are notified of the filing of the motion to quash, but the party summoned nevertheless has an obligation to assemble the records demanded by the summons and have them available for production on the date specified.24

In a grand jury investigation, administrative summonses are not used. Instead, grand jury subpoenas are issued in coordination with an Assistant U.S. Attorney. Unlike IRS summonses, no notification of the issuance of a subpoena is given to the subject of the investigation. Furthermore, there is no statutory delay period to facilitate challenges, and subpoenas can be made returnable on very short notice.

Another significant difference between administrative and grand jury investigations, especially when the taxpayer under investigation is a corporation, is access to witnesses interviews. In an administrative investigation, witness interviews are conducted by Special Agents, usually at the IRS offices or at the offices of the witnesses. A friendly witness, such as a corporate employee, may request that counsel for the corporation be present during the interview. Although the agent won’t like it, he is required to accede to this request. In a grand jury investigation, witness interviews often take place either informally in the U.S. Attorney’s Office, or under oath in the grand jury. Not even counsel for the witness himself is permitted to be present in the grand jury room during the witness’ testimony, and whereas a witness in an administrative investigation has the right to record an interview conducted by a Special Agent25, the testimony a witness gives to a grand jury will be available to the defense, if at all, only pursuant to the rules of discovery after indictment. The opportunity to attend and even record witness interviews during an administrative investigation is of great benefit to defense counsel trying to understand where the government is going and what information it has amassed along the way. Although witnesses can (and should) be debriefed after they come out of the grand jury room, it is a poor substitute for actually having counsel for the corporation present during the interviews.

B. General Enforcement vs. Special Enforcement Cases

Criminal investigations are classified within the Internal Revenue Service as “General Enforcement Program” or “Special Enforcement Program” cases. The latter category includes efforts to identify and prosecute those who “derive substantial income from illegal activities and violate the tax laws or other related statutes….”26 Cases involving narcotics dealers, corrupt politicians, organized crime figures and labor racketeers are typical of those covered

V. The Purpose of IRS Criminal Investigations

Why does the IRS devote so much time and money to criminal investigations? Many corporate and individual taxpayers, when faced with the overwhelming onslaught of full scale tax fraud investigation, question whether it makes sense for the government to spend so much time and effort trying to collect taxes from them. Unfortunately, this question misses the point. Although the primary job of the Internal Revenue Service is to collect money, it is not the purpose of a criminal investigation to secure the payment of taxes from the individual or corporation under investigation. Indeed, when a criminal tax case is initiated, the “civil features” of the case, such as collecting taxes, are placed in suspense. [27] The sole purpose of a criminal tax investigation is to obtain sufficient evidence to prosecute the individual taxpayer or responsible corporate officials under scrutiny. [28]The objective is to foster “voluntary compliance” among other taxpayers who observe the pain and suffering of their peers, and who therefore choose to follow the straight and narrow path to avoid the same fate:

The federal tax enforcement program is designed to protect the public interest in preserving the integrity of this nation’s self-assessment tax system through vigorous enforcement of the internal revenue laws. The purpose of a criminal tax prosecution is to expose the wrongdoer, thereby deterring other potential tax violators. [29]

All actions taken by a corporation and its representatives during a criminal tax investigation must proceed from a thorough and realistic understanding of the Service’s objectives in these cases. Taxpayers unfamiliar with the process are often tempted to think that if they just admit their mistakes and pay the tax the agent will go away. These are not civil tax examinations, and the same approach which might lead to the rapid conclusion of a civil audit will merely bolster the Service’s criminal case and provide valuable evidence which will later be used in the prosecution of the corporation and its officers. Special Agents enjoy nothing more than dealing with a taxpayer or representative who does not understand the important differences between a civil audit and a criminal investigation. The investigation will end only when in the view of the agent “sufficient evidence to convict has been obtained and there are no reasonable grounds to expect that further investigation may produce significant results in relation to the available evidence and to the additional time and investigative effort involved.” [30]

VI. The Special Agent’s Report

The final product of the IRS criminal investigation is the Special Agent’s Report. [31] This report bears about as much resemblance to the typical Revenue Agent’s Statement of Audit Changes as a Reader’s Digest story bears to a James Michener novel. The hundreds, or thousands, of documents collected by the Special Agent during his or her investigation will be assembled, labelled, organized, scheduled and explained. The fraudulent transactions will be explained in narrative form, with extensive cross-references to the documents and to transcripts of the testimony of the witnesses. All contacts with the taxpayer or the taxpayer’s representatives, no matter how innocuous, will be documented by contemporaneous memoranda. Particular attention is paid to those items of evidence which demonstrate that the misstatements on the returns or other inaccuracies were the product of willful intent, and not innocent mistakes or inadvertence. A computation of the tax consequences of the alleged fraudulent transactions, i.e. the omitted income or the false deductions, will be prepared by the cooperating Revenue Agent and included in the report. Finally, all defenses raised or even suggested by the taxpayer, no matter how outlandish, will be set forth, and where possible refuted, with documents and the testimony of witnesses.

The purpose of the Special Agent’s Report is to synthesize and present all of the evidence to be used in the various stages of review and in the ultimate prosecution of the case. [32] Reports are also written when the agent concludes that the facts do not warrant prosecution, although these “withdrawal” reports don’t contain the same degree of detail and documentary support found in a “prosecution” report. The agent, who has typically developed a deep personal commitment to the case by this point, prepares the report to speak for him in the review process which follows, and to forcefully convey his conclusion that the case is one which the government can successfully prosecute. Although intended as a straightforward presentation of the facts, it is inevitable that the agent’s personal sense of commitment to the case reflects itself in the interpretation of the facts and the conclusions drawn therefrom. [33] The Special Agent’s Report follows the case throughout its subsequent administrative life, and all reviewer who deal with the case later will have had their opinion of the case formed in large measure by this document.

VII. To Be Continued….

In the next issue of the Corporate Criminal Liability Reporter, we will examine the processing of the Special Agent’s prosecution recommendation as it is reviewed first within the Criminal Investigation Division, the by IRS District counsel, and finally by the Criminal Section of the Department of Justice Tax Division, before finally being sent to the U.S. Attorney’s Office in the appropriate district for indictment and trial. At each stage of this review sequence defense opportunities are presented, and a knowledge of the process is essential if corporate counsel is to effectively utilize the opportunities which the process provides.

[1] . IRM 4231, Audit Guidelines for Examiners, ’981(1).

[2] . The Audit Guidelines for Examiners advises Revenue Agents “(t)he discovery and develop­ment of fraud cases is a normal result of effective examinations. Auditing techniques employed by examiners, if thy are to be effective, should be designed to disclose not only errors in accounting and application of tax law, but also irregularities that indicate the possibility of fraud.” IRM 4231, ’961(1).

[3] . “The Audit Guidelines for Examiners” states that (t)he first symptom alerting the examiner to the possibility of fraud will frequently be provided by the taxpayer. Conduct during the examination and method of doing business may be indicative of the filing of improper returns. IRM 4231, ’962(1).

[4] . See Marvin J. Garbis, “Handling the Eggshell Audit.”

[5] . IRM 4565.

[6] . Sometimes an enthusiastic Revenue Agent will follow the road too far before referring the case to the Criminal Investigation Division, and a few agents have engaged in outright deception to gather this information prior to preparing the referral. In a few cases, this has resulted in suppression of the evidence gathered. U.S. v. Toussaint, 456 F.Supp. 1069 (S.D. Texas 1978), but see U.S. v. Caceres, 440 U.S. 741 (1979).

[7] . For example, a project might seek to identify well drillers from city or county permits or funeral directors from death certificate records. This information is then cross-checked against returns, giving preliminary indications of failure to file or understatement of income. In a particularly interesting recent effort, the “Business Opportunities Project,” the Service sought and found businessmen who had cheated on their taxes by the device of using Special Agents posing as prospective buyers of their companies. Often a “second set of books” was produced to substantiate income higher than that shown on the tax returns, and to thus justify a higher value for the business being sold. See Jones v. Berry, 722 F.2d 443 (9th Cir., 1983), cert. den., 104 S.Ct. 2343 (1984).

[8] . A formal agreement has been in place for almost ten years between the IRS and the Drug Enforcement Agency, under which the DEA provides to the IRS names and other information on DEA “Class I” violators. See IRM 4566.52 et seq.

[9] . See Fink, Tax Fraud, p.5-19 (1986).

[10] . IRC §7623 and IRM 4569.1. The reward can be as high as 10% of the taxes collected as a result of the information furnished.

[11] . Practitioners frequently deal with clients who have been contacted by IRS employees but do not know whether these generic IRS “agents” were Revenue Agents, Revenue Officers or Special Agents. Corporate employees should be instructed that in any official encounter with an employee of the IRS they should record the name, title and office affiliation of the person by whom they are contacted. In addition, it is crucial to keep good notes and contemporaneous memos on what is said by and to an IRS agent and what documents are furnished to him.

[12] . A novice trial attorney in his first criminal tax case is reported to have opened his cross examination of the Special Agent by reaching for a little humor, asking, “Agent Smith, just what is it that makes you so special?” Neither the young lawyer nor his client recovered after the agent listed for the jury’s benefit his various academic degrees, business and accounting courses, extensive government training, numerous major investigations, and the series of awards he had received for his successful cases. Corporate counsel should never underestimate either the expertise or tenacity of the Special Agents assigned to an investigation.

[13] . The cooperating Revenue Agent in a joint investigation is responsible for the “examination features” of the case, including “reconciliation of the taxpayer’s records with his/her tax returns, test-checking book entries, inspecting canceled checks, reconciling control accounts with subsidiary accounts, determining and substantiating tax and accounting adjustments having no significant effect on the criminal features of the case, and computation of the basis for tax and the tax liabilities, including such computations in those instances when the taxpayer has no books and records.” IRM 4564.31.

[14] . In the last few years, the IRS has been making more use of administrative immunity. The IRS, with the concurrence of the Department of Justice, can grant immunity to a witnesses without the intervention of the US Attorney’s Office or the Courts.

[15] . Department of Justice, Manual for Criminal Tax Trials, p.1-9; IRM 9267.22.

[16] . IRC §7602.

[17] . IRM 4022.7 (5).

[18] . IRC §7205(a).

[19] . Regs. ’1.301.7605-1(a).

[20] . IRC §7609.

[21] . Regs. ’301.7609-1 provide that notice is not required if the person summoned is an employee of the taxpayer.

[22] . “Any person who, being duly summoned to appear to testify, or to appear and produce books, accounts, records, memoranda, or other papers, as required under ” 6420(e)(2), 6421(f)(2), 6427(j)(2), 7602, 7603 and 7604(b), neglects to appear or to produce such books, accounts, records, memoranda or other papers, shall, upon conviction thereof, be fined not more than $1,000, or imprisoned not more than 1 year, or both, together with costs of prosecution.” IRC §7210.

[23] . IRC §7609(b)(2).

[24] . IRC §7609(i)(1).

[25] . IRM 9353(3).

[26] . IRM 9781-50, Handbook for Special Agents, ’311(2)(a).

[27] . Controls are placed on all related tax modules in the IRS computer system for the taxpayer under investigation so that all activity on such accounts is routed directly to the Special Agent. The Special Agent controlling the case must even be consulted before payments are posted to the taxpayer’s account.

[28] . The Special Agent’s Handbook states that “(t)he purpose of a special agent’s investigation is to obtain facts and evidence. His/her primary aim is to determine whether the person under investigation has committed a criminal violation, and, if the facts disclose violations subject to criminal or civil penalties within the jurisdiction of the Criminal Investigation Division, to obtain whatever evidence is required to sustain criminal proceedings of the assertion of civil penalties.” IRM 9781, Special Agent’s Handbook, ’313(1).

[29] . United States Attorney’s Manual, ’6-2.010.

[30] . IRM 9781, Special Agent’s Handbook, ’313(4).

[31] . In a grand jury investigation the Special Agent’s Report is abbreviated in form and content because the Department of Justice and the grand jury have already been involved in the case, often from its inception.

[32] . The Special Agent’s Handbook, IRM 9781, explains that “the purpose of a report is to present in suitable form all the pertinent facts relating to a matter in order that appropriate action may be taken.” See generally IRM 9781, ’610 et seq.

[33] . It is difficult to address this editorial license, however, because the Special Agent’s Report is never disclosed in its entirety, and even those parts which may be obtained by the defense are surrendered by the government only as part of post-indictment discovery.

Check out Part II here. 

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