Enter Taxman

Failure to do so may result in the taxpayer getting hit with additional taxes, interest and penalties if the IRS audits the return and the taxpayer concedes his position or loses in court. Accuracy related penalties in these situations are 25 percent of the understated tax; civil fraud penalties can be as high as 75 percent. The stakes are even higher in criminal tax disputes: tax evasion is a felony punishable by a maximum sentence of five years in prison.

To prove tax evasion, the government must show that the taxpayer has deliberately misled the government or concealed wrongdoing. Such conduct includes: substantial omissions of income, substantial amounts of personal expenditures claimed as business expenses and backdating documents to obtain a favorable tax result. Because tax fraud is intentional, not negligence, the taxpayer’s good faith reliance on the advice of a tax professional will often get the taxpayer off the hook—provided that the taxpayer hasn’t misled the tax professional. The standard of proof in a criminal case is higher than in a civil one. In the latter, the government must only prove its case by “clear and convincing evidence.” But to put a taxpayer in prison, the government must prove its case beyond a reasonable doubt.

How do civil audits become criminal investigations? They frequently start as an examination conducted by a civil tax examiner called a “revenue agent” before being referred to the Criminal Investigative Division. Unfortunately for taxpayers, a revenue agent is under no obligation to advise the taxpayer that the case has been referred to the Criminal Investigative Division. CI agents—somewhat ominously called special agents—are the ones who recommend that the tax division of the Department of Justice prosecute a taxpayer.

Once a special agent comes on the scene, the taxpayer should hire experienced criminal tax counsel immediately. That’s not just because the attorney has specialized expertise; the relationships between the participants have suddenly changed. First, there is no accountant-client privilege in criminal tax matters; the taxpayer’s own accountant can be forced to testify against him. Second, the original tax return preparer may now have interests divergent from the taxpayer’s. The preparer’s advice and actions may provide a defense for the taxpayer, but this defense might expose the preparer to sanction for malpractice and/or violation of Treasury Department rules.

This newly adversarial relationship potentially complicates the situation immensely. For example, the special agent may request to interview the preparer outside of a grand jury and subpoena his work papers. Under the laws of most states, those papers belong to the preparer, not the taxpayer. If the relationship between the preparer and the taxpayer has grown hostile, the preparer may withhold what he provided to the special agent from the taxpayer’s counsel.

Tax attorneys often retain a forensic accountant to investigate the facts, review financial documents, assist in the interpretation of tax issues and make exculpatory reports and presentations to the IRS. To ensure secure communications with the forensic accountant, he must be placed under the attorney’s privilege. The tax attorney does this through a so-called Kovel letter, named after a 1961 New York case exploring the issue.

Criminal tax investigations are very complicated matters and formalities must be followed so that the taxpayer retains all possible defenses against the government’s serious claims.