Tax Audits - Referral to IRS Criminal Investigations

The majority of tax returns that the IRS selects for audit are not immediately identified as being flagged for criminal investigation. For instance, the IRS conducts random audits on a certain number of taxpayers from all income levels. Audits also occur when the IRS receives information from a taxpayer that does not match other records from employers or other income-generating sources. Should a taxpayer have any business relations with another taxpayer who is being audited, the related taxpayer may be audited as well (See IRS will increase audits of Flow Thru Entities). Of course, the IRS may audit a taxpayer for raising one of the red flags that the IRS keeps secret. And finally, a tax audit will be triggered if it appears that the taxpayer is attempting to underpay taxes, the IRS may begin a civil audit.

However, during any audit process, if an IRS employee finds that “affirmative acts” (also known as “firm indications”) of fraud or willfulness exist, in addition to the meeting of other criminal criteria, the IRS auditor is instructed to refer the case to the IRS’ Criminal Investigation Division (“CID”). General IRS procedures then require the IRS tax auditor to suspend the “normal” audit process in these cases, without disclosing to the taxpayer that the referral has been made or reason for suspension (in our practice, some suspension last as long as a year). CID then either accepts or declines the referral. If CID declines the referral, the civil tax audit or collection process resumes.

While a civil audit may have involved a detailed review of a taxpayer’s financial papers and possible financial penalties, a criminal investigation entails much more. As the law enforcement arm of the IRS, CI investigates potential criminal violations of the Internal Revenue Code and other financially-related crimes. Thus, an investigation by CI may include interviews, surveillance, monitoring, search warrants, and arrests. Should prosecution be initiated, it may then include asset seizure and forfeiture, a court trial, financial penalties and/or prison time.

Several situations may give rise to a Criminal Investigation referral. “Affirmative acts” or “firm indications” include actions showing that something was done purposefully to deceive, conceal or make things look different than they really are. Examples of such actions include unreported income or undisclosed assets, evidence of structuring amongst bank accounts), evidence that business income was not deposited into business accounts, a covering up of income sources, or the intentional omissions or certain items even when other similar items were not omitted (for example, the use of trusts to purposely avoid tax obligations). Thus, even if it is later determined that technically no tax crime is involved, a tax related criminal investigation may be initiated by the IRS due to various financial discoveries.

As you can see, IRS tax audits have a way of reaching into every corner of an individual's or entities’ life. The advice of a respected and trusted tax attorney is a necessity.

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Moreover, if your tax audit stays civil or if tax attorney is successful in limiting the tax audit to the civil matters only, the IRS may open up additional tax years to audit as part of the originating audit (this is very common, and the IRS is targeting 3 – 6 years with audits now). Furthermore, the result of the audit may impact the amount of taxes you pay going forward by setting an unkind precedent:

Investigating and Auditing Additional Years

The IRS attempts to audit returns soon after they are filed, if they are to be audited at all. However, once an audit is started for one tax year, the IRS will likely include information from returns of the past three tax years and may decide to include those in the audit as well. Fortunately for many taxpayers, the statute of limitations for an IRS audit is three years from either the filing due date or, if the taxpayer filed late, the date of the actual filing date. However, if the IRS finds a substantial error in a tax return, it may go back six years to audit. This six-year allowance is controversial and while some federal appellate courts have declined the IRS’ ability to reach back more than three years, at least one appellate court has allowed it. Therefore, a taxpayer may be audited for returns filed for the past three, or even six years.

Precedent Setting for Future Tax Filing

Some civil audits may be very simple and include little to no change requests from the IRS. However, even a minor change agreed upon by a taxpayer may set a poor precedent for the taxpayer’s filing in future years. For example, if a self-employed taxpayer agrees to exclude certain expenses for the year being audited, the IRS may become biased against the inclusion of similar expenses for a subsequent year even if they are legal and appropriate. It is imperative that taxpayers analyze and discuss even minute changes with a professional in order to determine whether it will cause financial harm to the taxpayer in subsequent years.

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