How to Survive a Tax Audit as an Entertainment Company When You Blatantly Cheated on your Federal (IRS) or California (FTB) Income Taxes, Payroll Tax (IRS/EDD) or Sales Taxes (CDTFA)

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Imagine that you are getting ready to start your day, excited to unleash your creative talents, and pick up the day’s newspaper to quickly update yourself with the latest developments. The following headline catches your eye:

Movie Producer Arraigned on Charges of Fraudulent Film Tax Credit Applications

The actual headline was about Daniel Adams, a California-based movie director who was indicted for allegedly obtaining $4.7 million in fraudulent film tax credits by claiming inflated expenses for two movies filmed on Cape Cod. The Attorney General’s office alleged that Adams “knowingly defrauded taxpayers by lying about his production costs.” The Grand Jury returned indictments against Adams on the charges of making a false claim against the Commonwealth (2 counts), larceny over $250 (2 counts), procuring the presentation of a false claim to the Department of Revenue (2 counts), filing a false document with the Department of Revenue (1 count) and procuring the preparation of a false tax return (3 counts).

We are here to tell you how you can save yourself from becoming the subject matter of a similar federal or state criminal tax headline. During an “eggshell audit,” the IRS or a California taxing authority is looking for the possibility that you, as a subject of a seemingly civil audit, will make criminal admissions and or sufficient badges of fraud are discovered to provide the criminal investigation division sufficient information to lead to the initiation of a potential criminal tax investigation followed by a criminal tax prosecution. As your dual licensed Criminal Tax Defense Attorney & CPA representing you in an eggshell audit, our goal is extremely clear: the resolution of the audit without a referral by the civil examiner to the IRS’s criminal investigation division (CID). However, as simple as that goal is, reaching it is often cumbersome and perilous. That is where we come in!

We advise you to seek legal guidance from a dually California licensed Tax Attorney and CPA immediately if you or your business entity (S Corp, C Corp, LLC, Partnership, etc.) have received an audit notice from the IRS or a California Taxing Authority, such as Franchise Tax Board (FTB), the California Department of Tax and Fee Administration (CDTFA) and the Employment Development Department (EDD) concerning a tax audit and you know for a fact that you cheated on the return(s) at issue. Depending on what the federal or California auditor finds, an examination of your business and personal tax filings could lead to devastating outcomes, including an unexpected tax assessment, costly accumulated interest, and/or substantial civil penalties—none of which even begins to approach the danger involved in an IRS or California criminal tax investigation. If the government believes that there is strong enough evidence to prosecute you for tax evasion or related offenses successfully, you will be at risk of jail time, in addition to much higher financial fines and criminal restitution and if you have licensing or bonding requirements, potential damage to or complete loss of your career.

Using our experience, we have distilled our approach to four key aspects while we represent you as you undergo an eggshell audit:

Understanding deeply how civil audits arise and the steps that need to be taken as your counsel to prepare you for the audit;

Recognizing when you are facing an eggshell audit and recognizing whether you might have committed criminal tax fraud;

Employing key proprietary techniques when representing an entertainment company going through an eggshell audit and the signals to look for when evaluating whether a civil investigation has turned criminal; and

If all else fails, take steps after a criminal tax investigation has already started to lessen the possibility of a referral for criminal tax prosecution.

Procedures Involved in Examining Your Tax Returns

The IRS and California tax authorities, including the FTB, CDTFA, and EDD understand that even with the exposure to the array of severe civil and criminal negative consequences a taxpayer faces when they get caught cheating, you, as an Entertainment company, will have little incentive to comply with the tax laws if you believe that the authorities will not catch you. To this end, federal and California tax law grants the IRS, FTB, CDTFA and the EDD with authority to investigate your returns and determine whether you owe additional tax, penalties, and interest, at best, and will face criminal tax prosecution, at worst. To exercise this power, the authorities will review your filings and examine or investigate on a deeper level the returns that appear the most questionable.

The first step, administrative review of all your returns, involves scoring the returns and matching them to information returns filed by third parties. The IRS scores returns by applying an algorithm to each return called the Discriminant Index Function (DIF). The higher the DIF Score, the more likely a return will undergo further scrutiny. When the IRS receives a tax return that is inconsistent with third-party information returns, it follows up with the automated underreporter program to resolve the discrepancy. If the problem persists, the IRS will ordinarily contact you to verify certain information.

Although assigning a DIF score is not a full examination, the scoring process still changes the calculus for you if you are considering the likelihood of getting caught cheating. A one percent audit rate amounts to a one percent likelihood of getting caught only if the IRS chooses the returns for audit at random. The mere fact that the selection process is not random skews the likelihood of getting caught. The fact that the DIF score is highly sophisticated and undergoing continuous improvement skews the likelihood of getting caught even more over multiple tax years. Unfortunately, a probable outcome becomes a complete unknown when considering that the DIF score algorithm undergoes frequent calibration (i.e., the IRS continuously improves it).

The second step in the IRS’s tax determination is to examine returns that it suspects have underreported tax liability. To do this, the IRS must select returns, obtain information from taxpayers by legal compulsion, if necessary, address their responses to its requests for information, and, if an examiner concludes that a taxpayer owes more tax, propose adjustments to the returns at issue.

The final step is for the IRS to issue a final determination via an audit report. If the taxpayer is unwilling to voluntarily sign off on the report the IRS will eventually issue a statutory notice of deficiency or 90-day letter. If a taxpayer signs off on the audit report, they give up all appeal rights and the IRS can immediately begin collection action.

The taxpayer’s only recourse if they disagree with a 90-day letter is to file a tax court petition which starts the IRS appeals process in motion. The IRS has a 98% settlement rate, and we are ordinarily successful in improving our client’s audit results where we are of the opinion that the law and facts are squarely in our client’s corner and are willing to go to tax court if necessary to prove it.

Types of Audits

There are three primary types of audits. The first type is the correspondence audit. A correspondence audit takes place by mail. As a general matter, this type of audit is rather narrow in scope. The IRS sends a letter by mail requesting documentation for one or more return items it chooses to challenge. According to the IRS’s regulations, if you receive a notice that the IRS has initiated a correspondence audit, you may alternatively request to meet with an examiner in person, we however do not recommend that.

Please be aware that in a correspondence audit, you have a limited amount of time to respond to the IRS’s inquiries. From our experience, if you do not respond within the allotted time, the IRS, rather than resorting to its summons power, may disallow the item at issue and notify you that the disallowance may be appealed through the IRS’s internal appeals process.

The second type of audit is the field audit. A field audit shall often be requested to take place on your business premises or within your home. This type of audit is often broad in scope. The IRS will seek information about numerous issues and pursue new issues as they arise. During a field audit, the IRS seeks information on an informal basis by issuing Information Document Requests (IDRs). If you refuse or fail to respond to such a request, the process becomes formal, and the IRS turns to its summons authority. The IRS shall issue a summons to you that describes the documents or records the IRS desires, which gives you a second opportunity to respond to the IRS’s request. If you still refuse or fail to respond, the IRS may refer the summons to the Department of Justice for enforcement in federal district court under the court’s contempt power. You can be sequentially and incrementally fined or indefinitely jailed under a court’s contempt power, until you comply.

The third type of audit is the office audit. An office audit takes place in the IRS’s offices. An examiner shall request you to bring documents to the IRS’s office to talk with an agent face-to-face. The typical office audit is broader than a correspondence audit but narrower than a field audit.

How Does the IRS Specifically Target Entertainment Companies?

The IRS is very thorough in its approach and has a deep understanding of all vulnerable areas related to the tax filings of those in the entertainment industry. The IRS audits entertainment companies so frequently that it has even developed an Entertainment Audit Technique Guide to assist its IRS Revenue Agents during audits by providing insight into the issues, accounting practices, and methods unique to the entertainment industry. In general, the guide identifies issues unique to the entertainment industry of which the Revenue Agents should be aware. It directs Revenue Agents to look for certain vital sources of information and outlines steps and techniques to be taken in conducting effective and focused audits/investigations of entertainment companies.

However, using our extensive experience, we use the same tools to the advantage of our clients. In other words, we know what weapons and strategies the other side will likely employ, making us ready, willing, and able to defend every blow that might come your way. For instance, we know that the IRS and California taxing authorities are aware of the fact that, historically, taxpayers in the entertainment industry tend to be aggressive or abusive when deducting expenses that may or may not be related directly to their business activities (i.e., personal expenses). The IRS has stated as one of its goals to bring the allowable deductions back within the internal revenue code’s strict legal confines. It is working to ensure that the distinction between ordinary/necessary and extravagant must be clearly drawn.

Deductions

To deduct meals and entertainment expenses, the IRS expects you to establish that the expenses are directly related to the active conduct of your trade or business and ordinary and necessary to your business or profession. For example, knowing that you can only deduct 50 percent of the allowed expense, and regarding meals specifically, there is a limitation that it be “not lavish or extravagant under the circumstances,” we anticipate the issues that might arise and structure our strategy accordingly. In our experience, business deductions claimed by entertainers, either as employees or independent contractors on the entertainer’s individual income tax return, are subject to more scrutiny and more frequent challenge by the tax authorities.

Royalties and License Fees

A particular focus for IRS is Royalties and License Fees as they are a common form of income received by people in the entertainment industry. These are periodic payments received by copyright owners, such as songwriters, recording artists, and authors. They are paid by those who perform, exhibit, run, or otherwise distribute copyrighted works for a prescribed time period or purpose. It is important to remember that royalties are portfolio income and are considered non-passive. The IRS might look to see whether you included royalties on forms that improperly permit deductibility of passive losses and credits. This is because passive losses and credits are generally deductible only to the extent of passive income. There is a single exception only for royalties derived in the ordinary course of a trade or business of licensing intangible property, which permits royalties to be treated as passive income. This exception is highly restrictive and rarely seen.

What if I Know I Cheated on My Taxes and the IRS or California CDTFA FTB or EDD Wants to Speak with Me?

If you know you cheated on your tax returns, the biggest mistake you can make is to consult the original preparer. The reason is that they are likely to become the primary witness against you if the government decides to initiate criminal proceedings. They would have absolutely no incentive to protect you and are likely to reveal everything, including the information that you thought was confidential. A CPA, EA, or CTEC certified preparer generates most of his income from tax accounting and preparation; thus, they are strongly motivated to protect their reputation with the taxing authorities at the expense of your reputation. As uniquely qualified and extensively experienced Criminal Tax Defence Tax Attorneys & Kovel CPAs, our firm provides a unique platform to efficiently achieve the optimal and predictable results that simultaneously protect your liberty and your net worth.

You would think that a forensic accountant may be able to spot issues or identify explanations for your failures. You may also think an accountant may be able to identify additional deductions or characterizations of income that reduce the potential deficiency in tax. However, you should know that the privilege provided by the Internal Revenue Code for certain communications between an accountant and a taxpayer does not exist in the context of a criminal case. Thus, communications between you and the third-party accountant would be subject to IRS discovery and potentially admissible evidence in the event of a criminal trial. That is why you need us and the unique solutions we provide, because David Klasing is a former public auditor and dual-licensed Tax Attorney and CPA with over a decade of specialized training in criminal tax defence and has a full staff of Kovel Accountants that he trained personally to assist him.

You should be aware that the IRS and California taxing authorities have a keen insight into the working of the entertainment industry. It has trained its agents, so they are equipped with the knowledge of all the issues and terminology pertinent to players in the entertainment industry. The goal is simple—the IRS and the California taxing authorities want to ensure that their examiners are fully equipped to catch any irregularity, big or small, while they examine your tax returns.

Therefore, it is crucial that you are thoroughly prepared for an audit. While representing you, we strive not to be surprised by anything raised by the IRS or a California taxing authority conducting the audit or by information that may be inadvertently disclosed by you during the audit. That is where our years of experience comes in. Once we determine that you might be facing potential criminal liabilities, our primary goal becomes the prevention of initiation of a criminal investigation, and we do whatever we legally can to achieve that. Consequently, attempting to prevent the taxing authority from interacting directly with you goes a long way towards that goal.

If you have failed to file a tax return for one or more years or have taken a position on a tax return that could not be supported upon an IRS or state tax authority audit, eggshell audit, reverse eggshell audit, or criminal tax investigation, consider hiring the Tax Law Offices of David W. Klasing. Hiring our firm can make all the difference between paying the proper amount of income taxes due, as opposed to doing jail time, paying a hefty penalty, and paying for the cost of a long and ardous prosecution.

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