Tax Crimes: Part I

How the Criminal Tax Investigation Starts and When You Should Worry

In case you did not know, you can go to jail for cheating on your taxes. Although the odds of being convicted of a tax crime are extremely low, the IRS does conduct a number of criminal investigations each year in an effort to directly influence the American public’s confidence and compliance with tax laws. In 2020, the IRS initiated 1598 investigations. Of those, 945 prosecutions were recommended, and 593 people were convicted. For reference, there were nearly 170 million individual income tax returns filed in 2020. Accordingly, roughly 0.000003% of all taxpayers were convicted of tax crimes. Nevertheless, this article will focus on the initiation and processing of tax fraud investigations by the IRS.

Since first being offered in 2012, the Streamlined Procedures have been expanded to include both Streamlined Foreign and Domestic Offshore Procedures. Both sets of Procedures will be explored in greater detail in later articles.

How do criminal tax investigations begin?

To begin, it is important to understand that criminal investigations are not conducted by Revenue Agents – those responsible for conducting civil audits of income, estate, or gift tax returns – or Revenue Officers – those responsible for collecting any taxes, penalties, or interest you owe to the IRS. Rather, criminal tax fraud investigations are conducted by the IRS Criminal Investigation Division (“CID”).

Next, it is important to understand how criminal tax investigations are initiated. In practice, there are multiple referral sources to the CID to initiate an investigation on a particular taxpayer. For example, approximately half of the investigations are initiated based on referrals from Revenue Agents. Additionally, Revenue Officers, other federal, state, and local investigative agencies, and whistleblowers will refer cases to the CID. Each of these will be discussed in turn. Lastly, the CID itself may initiate its own investigations.

Before diving into each referral source’s process for recommending a CID criminal investigation, we must define fraud. Fraud is defined in Internal Revenue Manual (“IRM”) § 25.1.1.2 as the “deception by misrepresentation of material facts, or silence when good faith requires expression, which results in material damage to one who relies on it and has the right to rely on it.” Moreover, under IRM § 25.1.1.2, tax fraud is often defined as an intentional wrongdoing, on the part of a taxpayer, with the specific purpose of evading a tax known or believed to be owing. Therefore, tax fraud requires both:

See Fiscal Year 2020 Annual Report, I.R.S. Pub. No. 3583 (Nov. 16, 2020)

See Filing Season Statistics for Week Ending Dec. 11, 2020, I.R.S. Newsroom

Referrals by Revenue Agents and Revenue Officers

As previously stated, Revenue Agents are the number one referral source to the CID to initiate investigations into possible tax crimes. Revenue Officers will also refer potential fraud cases to CID; however, those cases typically involve intentional failure to file federal income tax returns or employment tax returns, or cases involving willful attempts to defeat IRS levies or rescue seized property. Under IRM § 25.1.2.2, Revenue Agents and Revenue Officers (collectively “compliance employee”) must follow a specific fraud development procedure. Fraud is substantiated by establishing “affirmative acts or firm indications of fraud.” Affirmative acts of fraud are actions taken by the taxpayer, return preparer, and/or promoter to deceive or defraud. See IRM § 25.1.1.3. Fraud cannot be established without affirmative acts of fraud. Id. Although there is a distinction between an “indicator” of fraud versus an “affirmative act” of fraud, indicators of fraud versus affirmative acts will be discussed in greater detail in a separate article. For purposes of this article, example indicators include:

These indicators are often uncovered during the initial contact with the taxpayer. The compliance employee may attempt to glean information through an informal discussion, but the taxpayer’s answers (or lack thereof) pertaining to financial activities, expense items, and return preparation may be extremely valuable information to the Revenue Agent or Officer.

Once the indicators (often referred to as “badges”) of fraud are uncovered, the compliance employee must document the potential fraud indicators and discuss these with their manager and a fraud technical advisor (FTA). If the manager and FTA agree with the compliance employee, the compliance employee will then prepare a Fraud Development Recommendation. At that point, the case will be placed in Fraud Development Status and the compliance employee, if they have not already collected them, will request the taxpayer’s original tax returns. What the compliance employee is attempting to do is prove an act of fraud. If after consultation with the FTA, it is determined that the compliance employee has successfully established affirmative acts of fraud, then the compliance employee will suspend the audit immediately and notify their manager along with the FTA. At that point, the compliance employee will prepare Form 2797, which is the Referral Report for Potential Fraud Cases that will be sent to the CID. The report includes all the information the Revenue Agent has gathered to show that tax fraud has been committed. See IRM § 25.1.3.2. From there, the FTA will refer the case to the CID.

If you or your return preparer have been handling a civil audit to this point and you suddenly stop hearing from the Revenue Agent assigned to your case, it could be a sign of things to come. You may contact the compliance employee to ask whether a fraud referral is being considered or whether CID is involved. Under IRM § 25.1.3.2, the compliance employee is prohibited from giving a false or deceitful response. However, we recommend that you contact an experienced tax controversy attorney immediately.

Referrals by Other International, Federal, State, or Local Investigative Agencies

Aside from compliance employees, the CID often partners with other international, federal, state, or local enforcement agencies to develop cases from information gathered by such agencies. With an increase in information exchanges, the CID can initiate tax fraud cases each year from the ongoing cooperation between agencies. For example, in the IRS’s CID 2020 Annual Report, example partnering federal agencies include:

According to the 2020 Annual Report, through partnerships with international, federal, state, and local law enforcement agencies, the CID has seized over 500 assets worth an estimated value of $511 million and forfeited approximately $134 million as of July 31, 2020. These CID-led investigations focused on international financial entities, ultra-high net worth individuals, and tax fraud promotors. Two of the most notable forfeitures obtained by the CID in 2020 include $71,850,000 from a Swiss bank and a nearly $19,000,000 forfeiture from two pharmaceutical company owners committing tax evasion.

Referrals from Whistleblowers

Though most of the investigations initiated by CID come from established referral sources, such as law enforcement agencies or employees of the IRS’s Examination and Collection Divisions, the CID also initiates investigations based on information gathered from the general public, often referred to as whistleblower claims. Under Internal Revenue Code (“IRC”) § 7623, the IRS is permitted to award up to 30% of the proceeds collected in cases in which the IRS determines that the information submitted by the whistleblower “substantially contributed” to an administrative or judicial action. Under IRM § 25.2.2.1.4, the term “proceeds” includes criminal fines, civil forfeitures, penalties, interest, and additions to tax among others. Given the severity of the award, people from all walks of life regularly contact the CID to blow the whistle on the indiscretions of others.

Investigations Initiated by the CID

CID has a long history of generating many of its own cases without referrals from other divisions within the IRS, international, federal, state, and local law enforcement agencies, or whistleblower claims. Special Agents within the CID are constantly monitoring news sources at the international, federal, state, and local levels. Additionally, it is not uncommon for related parties or co-conspirators to be investigated by the CID based on information obtained in a separate investigation. Not only that, but the CID also uses undercover techniques to investigate tax crimes. In 2020 alone, undercover Special Agents conducted nearly 300 undercover operations. The purpose of these investigations was to initiate contact with individuals potentially conducting tax crimes to gather the evidence needed to prosecute those crimes.

A common theme in the investigations initiated by undercover Special Agents of the CID is the arrest of business owners who keep two sets of books, one which often lists the total cash generated from sales and the other which includes underreported cash sales. According to the IRS’s CID 2020 Annual Report, in February 2020, a business owner and his wife were convicted of submitting false income tax returns and were ordered to pay restitution of over $820,000 because they kept two sets of books for their business and were underreporting income on their returns by providing their return preparer with the false set of books.

In Part II of Tax Crimes, we will continue to examine the criminal investigation process, but take a deeper dive into the IRS’s definition of fraud, the badges of fraud, and what leads compliance employees or CID Special Agents to the belief that indicators of fraud have become affirmative acts of fraud. In the meantime, if you or someone you know has been contacted by a Revenue Agent, Revenue Officer, or Special Agent, contact The Wilson Firm immediately.