Friday, February 6, 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.

Tuesday, February 3, 2009

Bank Secrecy Act /Money Laundering Manual

A Bank Secrecy Act/Anti-Money Laundering Examination Manual has been published.

The manual can be found at:

Can you claim a tax benefit inconsistent with the contract you signed?

It is not uncommon for parties to a contract to be dissatisfied with something they agreed to in the contract. When the provision involves tax consequences to the contracting parties, an unhappy party may seek some self help relief from the IRS by claiming a tax position that is inconsistent with the provision of the contract. The classic case is a sale of a business where the seller and buyer have opposing tax positions as to whether to allocate a portion of the purchase price to covenant not to compete or to good will. Assuming buyer and seller are in roughly the same tax sitution: (1) the buyer preferring more rapid tax benefit from payments to the seller will prefer to allocate to covenant not to compete; and (2) the seller preferring no tax cost (return of capital) or lower tax cost (capital gain) will prefer allocating to good will. In their contract they will negotiate and make an allocation, which in theory should be consistent with the economics and their relative bargaining positions. The expectation then is that they will report and pay tax consistent with the allocation. (Of course, if the parties are not in the same tax position (such as a buyer having a tax picture that makes him indifferent as to whether he gets a current tax benefit or future tax benefit), the situation is ripe for tax gamesmanship.)

The issue raised here is whether one of the parties can achieve a tax result inconsistent with his agreement. The general principle of tax law is that the realities govern the tax treatment. Under this principle, one might think, if an amount allocated by the parties to covenant not to compete (or consulting) is really for good will, the parties cannot make it so by contract and the real deal should prevail for tax purposes. On the other hand, administrative considerations suggest that the IRS should have not to go behind tax related provisions of a contract to discover the real deal and, thus, that tax consequences should be governed by the contract, at least where the IRS does not assert otherwise; it certainly does not offend notions of fairness to require a party to report and pay tax consistent with the deal he described in the contract he signed. So, balancing these considerations, courts have created a judicial principle requiring a party seeking to disavow his own contract to prove entitlement to do so by "strong proof." Strong proof is well beyond the normal civil tax standard of preponderance of the evidence, and at least one court has described "strong proof" as generally the same as "clear and convincing evidence," which is a standard used in the law generally and also in the tax law (i.e., the IRS must prove civil fraud for purposes of the fraud penalty and unlimited statute of limitations by clear and convincing evidence). There are various formulations of what precisely that party must proof to that heightened proof level. Some courts say that the party must prove facts sufficient that, in a law suit between the parties to the contract to reform the contract, the contract could have been reformed. Other courts say that the party must prove that there was a meeting of the minds between the contracting parties that is not consistent with the words they used in the contract. (This latter standard obviously suggests some manipulation by the parties and potentially criminal conduct in doing so.)

This strong proof rule applies only to a party seeking a tax benefit inconsistent with the contract. The IRS is not bound by the strong proof rule, may determine that the contract provision is not the real deal and may seek additional tax from one of the parties accordingly.

Jack Townsend has recently supplemented his Tax Procedure Book to deal with this issue in more detail. Readers interested in further discussion and citation of authority may download that portion of the Tax Procedure Book by clicking here.