An eggshell audit is a civil examination where there is an underlying potential criminal concern. For instance, let us say a taxpayer is audited due to a failure to include a single 1099 income source or simply due to random chance. In most cases the taxpayer would probably only have to pay penalties and correct the seemingly isolated error. However, let’s say the taxpayer has failed to disclose an array of income funneled through similarly undisclosed foreign accounts and trusts. In these circumstances the taxpayer has likely engaged is criminal tax evasion and furthermore potential criminal violations of the Bank Secrecy Act and FATCA. Thus, the audit is referred to as an eggshell audit because one small pull by an auditor at questionable aspects of the filing, and the entire scheme may unravel exposing the taxpayer to potential criminal liability.
However, some taxpayers – typically taxpayers who have utilized an experienced criminal defense tax attorney to provide a buffer between them and the examiner – can make it through the audit unscathed. Unfortunately, they may simply assume that the risk has passed and that the IRS will be statutorily unable to re-open the audit. However, should these individuals decide to continue their fraud in subsequent tax years, there is the possibility of the IRS re-opening the original examination.
In United States v. Titan International, Inc., the IRS sought to obtain the records of a taxpayer’s 2009 tax return. The return had previously been examined by the IRS. The taxpayer argued that turning over the return to the IRS would violate § 7605(b) of the Internal Revenue Code. § 7605(b) states that the IRS is permitted “only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.” Note that the language states that the single inspection is limited to “each taxable year.”
Here, the IRS was seeking the 2009 books and records and not to re-open an examination into the 2009 tax year. Rather, the request for records was part of an inquiry into the veracity of a tax return for 2010 where a deduction related to 2009 was claimed. Per Digby v. Commissioner, the court found that reviewing records previously examined for the purposes of assessing a new tax year is not a duplicative review. Thus, there is a rather large loophole in the IRS’ ability to re-open records previously examined especially for tax years that generated a net operating loss or capital loss carryforward that is being deducted in a subsequent tax year.
However, a plain reading of the above statute illustrates a second exception to the prohibition on the re-examination of previously audited records. The language also states that the Secretary, after conducting an investigation, may also state that a second inspection is necessary. Titan Int’l citing United States v. Powell, 379 U.S. 48, 54 (1964) explores Congressional intent in that the statute was intended to act as a “curb on the investigative powers of low-echelon revenue agents.” Then citing Collins v. Commissioner, 61 T.C. 693, 698-99 (1974), the opinion further elaborates that the Section was not intended to “restrict the Commissioner’s legitimate power to investigate.” Thus, the argument that there was a complete bar on re-examination of books and records was misguided.
Fraud is one situation where previously closed years can be re-opened for re-examination. Taxpayers owe a duty of consistency in their filings. A taxpayer cannot simply wait until the statute of limitations has run out to change historical facts regarding his or her past tax returns to provide a present benefit. In situations where the taxpayer attempts to change the facts regarding a return after the assessment period has seemingly passed, the IRS will not be barred from re-opening the examination.
In an appeal heard by the Ninth Circuit in Estate of Hilda Ashman v. Commissioner of Internal Revenue, the court made its views on such behavior abundantly clear. The court wrote, “The law should not be such a[n] idiot that it cannot prevent a taxpayer from changing the historical facts from year to year in order to escape a fair share of the burdens of maintaining our government. Our tax system depends upon self-assessment and honesty, rather than upon hiding of the pea or forgetful tergiversation.” The simple fact is that for taxpayers who attempt to play fast and loose and attempt to skate on dishonesty or fraud, federal district courts, court of claims and tax courts are more than willing to find exceptions in the rules to hold them accountable.
The above describes the two main means by which the IRS can re-examine previously examined books or records or re-open a seemingly closed tax year. The IRS is also granted broad discretion to re-open examinations where the method of accounting has changed for even a single item on the tax return. Thus, if you have already been audited due to potentially criminal red flags, it is essential to maintain exacting tax compliance going forward.