Tuesday, February 10, 2009

Is the Civil Audit a Set Up?

The Internal Revenue Manual directs revenue agents conducting a civil examination to refer the case to the Criminal Investigation branch ("CI") of the IRS when there is a "firm indication of fraud." Transfer of the matter to CI means that contact thereafter while there is still fraud investigation potential will be by a CI "Special Agent" who will read the taxpayer the modified Miranda warnings, including the right not to answer questions and the right to consult with an attorney. (Taxpayers are given modified Miranda warnings only because full-blown Miranda warnings are required only if the person is in the potentially coercive setting of custody, which is rarely the case in tax investigations.) Once the Special Agent is on the scene and surfaces, the taxpayer will be on notice that he has rights that he must consider exercising.

Sometimes a civil agent finding such indications of fraud may believe that he should pursue the matter further and either is oblivious to firm indications of fraud or just ignores them. Some civil agents just want to be more involved in the process of nailing the bad guy, and they will be out of the loop once the case is referred. But, for whatever reason, the civil agent may continue on despite firm indications of fraud.

From the taxpayer's perspective, he and his advisors may know that there is some fraud potential in a civil audit, but they are aware of the IRM provision requiring a fraud referral upon firm indications of fraud. The continued civil audit activity by the revenue agent may lead the taxpayer and his advisor to believe that the agent is continuing the civil examination rather than sub silentio conducting a criminal investigation. The continued civil audit activity, as they read the IRM, is an indication that the civil audit continues, and they may read that indication as some type of implicit representation by the revenue agent that the criminal investigation has not begun. The problem then arises when the civil agent develops damning admissions in an interview of the taxpayer without giving them any notice that the investigation has turned criminal -- much less the modified Miranda warning.

When the taxpayer is thereafter criminally prosecuted, the taxpayer may seek to exclude the damning admissions. In some cases, the mere exclusion of that evidence will knock out the Government's case altogether. Generally, of course, where the Government has violated constitutional rights in the process of gathering evidence in an investigation, Courts will exclude the evidence from a criminal trial. Do these exclusionary concepts extend so far to cover a revenue agent who violates the IRM by continuing to conduct the civil investigation when the revenue agent really is pursuing a criminal investigation?

The courts have been troubled by this question. The most extreme case is where the taxpayer or his advisor specifically asks if the investigation has turned criminal and, even though it has (albeit not referred to CI yet because the revenue agent is holding on and conducting his own criminal investigation), the revenue agent denies that it has. That would be an express misrepresentation, and the courts have indicated that suppression may be appropriate for such an express misrepresentation. What about any implicit misrepresentation that a taxpayer or his advisor may infer from continued civil audit activity. The clear trend in the cases is to reject a taxpayer's attempt to exclude the resulting evidence. This is an application of the so-called Caceres rule (United States v. Caceres, 440 U.S. 741 (1979)), which says that the mere failure to follow an internal rule -- here the IRM rule requiring referral upon firm indications of fraud -- does not justify suppression, absent some constitutional consideration.

These rules were announced and applied in a recent case from the Sixth Circuit Court of Appeals in United States v. Rutherford, ___ F.3d ___ (6th Cir. 2009). In Rutherford, the court rejected as dicta a prior Sixth Circuit's panel opinion in United States v. McKee, 192 F.3d 535 (6th Cir. 1999), which in a footnote had held out some possibility of suppressing such evidence. The court held that the mere continuance of the civil audit will not alone suffice for exclusion, absent some other indication of the type of coercion that would constitutionally require some type of warning such as Miranda. Rutherford is the most recent in a series of cases dealing with this issue and is must reading for practitioners as an object lesson in how they and their clients behave in a civil audit.

Bottom line, taxpayers and advisors who are cooperating in a civil audit need to be specially careful in any case with criminal potential. They should never assume that the matter cannot turn criminal, and certainly should avoid doing anything that would shoot the taxpayer in his own foot through damning admissions carelessly made. And, of course, if there is potential criminal potential against the advisor, this will give the advisor increased incentive be proceed cautiously himself.


  1. Excellent analysis!

    I wholeheartedly agree with the Caceres doctrine.

    I would, out of an abundance of caution, suggest that where an advisor (especially an attorney) knows or has any reasonable cause to suspect that either there are "criminal aspects" or that the IRS believes that there is any indication of fraud, the taxpayer and his or her advisor should, at a minimum, audio record all official communications (in-person and telephonic) in accordance with applicable law.

    Further, at the commencement and resumption of official communications, the IRS's official(s) should be clearly, directly, distinctly and expressly asked those questions that the advisor believes are necessary to finitely establish that: (1) the IRS has taken any kind of formal or informal position (at any level(s) including those short of a "formal institutional position") regarding the existence or nonexistence of any indication(s) of fraud; and, (2) the IRS's official(s) is (are) accurately, correctly, completely, timely and fairly conveying such position to the taxpayer directly or through his or her advisor; (3) the IRS's official(s) is (are) acutely aware that the taxpayer and the advisor intend to rely on the statements (and perhaps allude to those statements being amenable to a full range of evidentiary use as "admissions by a party opponent" in accordance with the Federal Rules of Evidence); (4) the IRS's official(s) is (are) fully aware that the taxypayer and hos or her advisor would not knowingly and voluntarily participate in such official communications without such clear, distinct, direct, and express official representations; (5) the IRS's official(s) is (are) aware that he/she/they have had a factually-concrete and realistic opportunity to reflect upon the official representation(s), including but not limited to an ample opportunity to consult counsel of their choice (members of the IRS's Office of Chief Counsel, one or more Assistant United States Attorneys, and one or more trial attorneys or supervising attorneys at the US DOJ's Tax Diviison in Washington (or the closest regional office).

    While I believe that the foregoing could (when done early, often, and consistently) go a long way toward establishing a taxpayer's and his or her advisor's reasonable reliance upon official government agents' representations, I would certainly hasten to caution that it is, by no means, a clear substitute for invoking one's Fifth Amendment right and privilege, especially, where a taxpayer or taxpayer's advisor has any reasonable cause to believe that the taxpayer is a subject, let alone, a target of an official inquiry that could have potential penal consequences.

    One more thing: Although I firmly believe that there are many fine, intelligent and rather upstanding nonattorney taxpayer advisors (CPAs, EAs, etc) throughout this country, there are a number of cogent legal reasons, including, especially the attorney-client privilege, which I believe weigh in favor of a taxpayer having the guiding hand of an experienced white collar defense attorney. This is all the more critically important where there is any potential for incrimination (regarding any federal or state tax or non-tax offense(s)) associated with federal, state or local tax compliance. Compare FRE 502 with section 7525.

    PS: If anyone is interested in a discussion about taxpayer (or any witness or deponent, for that matter) handling of in camera evaluations of Fifth Amendment claims or immunity/compulsion order issues, please post.

  2. Anonymous,

    Yet another excellent discussion by you. I hope the readers, particularly my students, will learn from you. Thanks,

    Jack Townsend

  3. Jack,

    You are very welcome.

    I also hope the readers and, especially, your students....the leaders of the next generation of tax professionals, will learn from what I have offered.

    I would welcome the opportunity to exchange ideas on these topics and other topics with your readers, particularly, your students.

    Please tell your students that this Anonymous poster firmly believes that your Tax Procedure Book has, for several years, rivaled one of the best resources on federal tax procedure -- IRS Practice and Procedure by Michael Saltzman.

    I have read Mr. Saltzman's book since he authored the first edition in 1981. I hold him and other leaders of the tax/white collar defense profession such as Mort Caplin and Scott Michel, in very high regard. However, I think your edge over such fine gentlemen is that you are a better communicator.

    Thanks, again, for allowing me to offer input to your readers, and particularly, to your students.


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