Tax Audits: IRS and State Tax Audits

The IRS has had its budget reduced by 1.2 billion dollars over the last five years. This has resulted in an 11% loss in its workforce, amounting to 13,000 lost employees. You might be thinking that this would result in a climate where an IRS audit is less likely to morph into a federal criminal tax investigation for federal tax fraud, resulting in a prosecution, because of a reduced likelihood of being chosen for an audit in the first place.

irs tax auditThe federal government and the government of California, by way of example, are in dire straits financially. California has been rumored to be close to declaring bankruptcy as a result of the effects of the 2008 collapse of the housing bubble and the associated problems this created on Wall Street, resulting in the largest bail out in history and over a 14 trillion dollar federal deficit. When the taxpaying public is not making money, tax revenues decline. Worse yet, when they are incurring record losses, tax revenue all but dries up!  Consequently, California’s auditing, criminal investigation and collection efforts have all ramped up in response.

Like the federal government, California also has criminal statutes and criminal investigation departments aimed at quelling fraudulent schemes involving, payroll, income taxes, and the underground economy. In addition California routinely investigates fraud involving sales taxes. California routinely shares information with the federal government regarding the results of its audits and criminal investigations and vice versa so any “fire” lit by an audit or investigation is virtually ensured to spread.

As a combo Tax Attorney and CPA who has handled literally thousands of federal and state audits over my career and has focused the majority of my practice on criminal tax issues over the last seven years, I have observed a steadily increasing amount of criminal tax investigations disguised as plain-Jane civil audits. The U.S. Justice department has just lifted its three-year hiring freeze, and at a recent ABA Criminal Tax Symposium a representative of the Tax Division of the Justice Department made it clear that business was better than ever within the Tax Division and that they were looking to hire.

It is imperative for the federal government to maintain tax compliance when the level of income tax audits is steadily declining. Consequently, it is logical that the federal government would turn to its other mechanism for encouraging tax compliance by more vigorously prosecuting tax offenders for tax crimes. It is well known to the government that a large percentage of U.S. taxpayers file tax returns and remit income tax payments to a great extent out of fear of criminal prosecution and incarceration. It takes a constant stream of highly publicized tax crime prosecutions to maintain the “fear level” within the tax paying public.

In any federal or state income tax audit, there are a few very common reasons for concern when large adjustments are proposed by the government. The first concern is over the sheer financial strain of defending an audit and then coping with the assessed taxes, penalties and interest. The second, and in my opinion much more serious concern, surrounds why the income tax deficiency arose in the first place.

Where the income tax deficiency arose because of willful actions on the part of a taxpayer to intentionally understate their tax liability, an audit can rapidly turn into a taxpayer’s worst nightmare. Imagine the most common of situations where the taxpayer misled their tax professional into understating their tax liability. This is ordinarily accomplished by supplying the tax preparer a “cooked” set of books that support the understated tax liability. The taxpayer is now faced with a situation where they have to produce the “cooked” set of books in order to support the fraudulent position taken on the tax return. As a tax professional, I can tell you from experience that there are always tell-tale signs when a set of books has been “cooked.”  The “cooked” books alone could conceivably support a criminal conviction for a tax crime.

Audits are prove-it-or-lose-it situations. Expenses have to be supported by proof of the method the expense was paid and a receipt from the vendor. Any expense that is fabricated will ordinarily not be supported and thus lost. Additionally, it will become readily apparent where personal expenses were deducted as business expense when the “payees” are examined or where the receipts are examined. Auditors routinely reconcile the cash deposited to a taxpayer’s business accounts and personal accounts and any excess deposits over the revenue reported per the returns will be treated as an adjustment to income unless the taxpayer can prove the income came from a nontaxable source. They also routinely look for fraudulent reporting patterns found in audits within the same industry in the past.

What Happens if You're Suspected of Tax Fraud?

Where tax fraud is suspected in an audit, the government will routinely try and determine whether the taxpayer acted alone or acted in concert with the tax preparer. An inherent conflict of interest thus routinely surfaces where the taxpayer that committed the tax fraud chooses to hire the same tax professional that prepared the return that is being audited to represent them. Ordinarily a tax professional is not under a duty to closely scrutinize a set of books provided by a tax client in order to prepare a tax return. However, It will rapidly become apparent to the tax professional during an audit that their client provided them a cooked set of books where the positions taken on the return relate directly back to the set of books at issue and the positions taken begin to get picked apart by the auditor.

It is also common knowledge amongst tax preparers that where a preparer is proven to have conspired with and/or aided and abetted a client to understate their tax liability, they are a much larger target for criminal prosecution and conviction than the clients he or she serves. It is commonly understood that the government promotes increased tax compliance by taking dirty preparers out of the game and by maintaining a healthy fear of prosecution within the tax preparation industry as a whole. It is also understood that the government can easily obtain a federal injunction to prevent a tax preparer from representing clients in tax controversies or preparing returns without much in the way of due process, making such an action nearly indefensible.

For the reasons discussed above it is a patently bad idea for a taxpayer that knows that he or she cheated on a tax return to hire the original preparer to defend them.  The original preparer is likely to throw their client under the bus in order to protect their reputation and livelihood. The tax preparer is also likely to be forced by the government to be witness number one in any subsequent criminal prosecution of the taxpayer. Moreover, any tax preparer, including an attorney by the way, that preparers and signs a tax return can be compelled to testify as to any communication with a client regarding positions taken on that return.

Taxpayers who have committed tax fraud and find themselves in the terrifying position of being audited need the services of qualified criminal defense counsel from the outset of the audit. Only an Attorney can protect the client communications necessary to mount a proper audit defense. The loss of one’s liberty coupled with the devastating financial ramifications, social embarrassment and shame - and possible loss of professional licensing for being convicted of a felony -  are life altering events that can quite often be avoided with the proper representation.

Tax Law Help | Tax Audit Videos