What are the warning signs that a criminal referral has been made out of an IRS Civil audit?

Thank you for joining us and welcome to this installment of David W. Klasing’s clarifying tax situations.

Boy, this is a scary subject. If you’re sitting there in a civil audit and any of the following occur – uh, you should be worrying about whether you’re dealing with a civil audit or whether the government is about to open a criminal tax investigation against you, is the subject of this post.

When is a criminal referral likely to come out of a civil audit? A criminal referral’s likely to come out of a civil audit whenever there are firm indications of fraud that come to exist in the mind of a civil auditor. If he or she is looking at your tax situation and it just doesn’t make sense that the errors, they are discovering are accidents that just happen. It can be a lot of things that tip him or her off. If you’re unwise enough to sit down with the auditor and you’re body language, tells him or her constantly that you are lying, and your words and your actions aren’t lining up, you’re telling a story that doesn’t test out, the evidence doesn’t support what you are saying, and if the auditor finds firm indications of fraud they are likely to start working with a technical fraud advisor (TFA) whose sole job it is to work up your case for potential hand off to the criminal investigation division – I said in an earlier video that there’s two of those in California that I know of and they are rare, but it happens.

The things that are really going to get an auditor excided is when they are looking at “badges of fraud”. “Badges of fraud” are situations that jump out at the IRS as Hey, this wasn’t caused by negligence or an accident. It was caused by purposely misstating information by taking, criminal actions with an intention to deceive and to knock down tax liability.

All it takes is a $10,000 understatement of omitted income on a personal tax return to result in the civil auditor having a conversation with a technical fraud advisor about whether to refer the case for criminal prosecution. There is no such dollar amount with deductions that are claimed that aren’t kosher. Okay? But with $10,000 of underreported income, all of a sudden you have an auditor following the IRS playbook which says “You go talk to a TFA when you see this -$10,000 of unreported income.” A standard audit approach that they use in every audit to find this is: they will grab all of your business bank statements, add up all the deposits, compare the total deposits per your bank statements, also from your credit card deposits from your point of sale transactions or any record ofincoming income. They’re going to compare these external accounting records of income against the income you report on your return. 1099-Ks are being used for this purpose as well. I’ve seen eBay transactions lists examined as well. All of a sudden the IRS hasa record of all of these reported sales on eBay and they look to see if those were reported on your income tax return. 1099s from third parties indicating that there may have been a sale to a third party that wasn’t reported are analyzed as well. They has lots of different ways of looking for unreported income, but if they find firm indications of unreported income, omissions of income – the audit gets scary in a hurry.

If a taxpayer is flat out unable to explain large discrepancies on a return: “Mr. Smith, why is it that, we can see $3,000,000 of income running through your business account, but you’ve only reported $1.9 million worth of income on your tax return?” – that’s a very dangerous question. Or: “Mr. Smith, how is it that we are able to check your books and your books tie out perfectly and they only show $1.7 million of total deductions, but yet I see $3.8 million of deductions on your tax return. How did that happen?” That’sa dangerous issue.

Substantial expense overstatements will do it. If the government come across and actually finds two sets of books. One set of books that you use for your tax return that understates income and one set of books that, supports a loan that you got from the bank and shows a lot more income – that’s a very dangerous situation. I have seen two sets of books be broken out when someone tries to sell their business. The seller provides both set to the potential buyer under a “confidentiality agreement” and they say: “You know, buyer, here are my tax returns for the last five years. Don’t value my business based on those, frankly I’ve been cheating on my taxes for years – don’t look at that set of books and those returns, look at this set of books, this is the set of books that actually accurately represents the income from my business.” That potential buyer can turnthe seller in for tax fraud by the way, violate the “confidentiality agreement” and get a 25% reward of any blood the government squeezes out of you. Its, very, very dangerous to go there, alright?

What else? Fictitious items etcetera: You know, if they are looking at fraud dead in the face of the return, fictitious items would be a bunch of deductions listed that you have absolutely no support for and the cash flow doesn’t support it – that’s very dangerous.

So, if you have a bunch of these situations goingon in your audit and you’re wondering whether a criminal referral has been made, here are the warning signs to look for. Frankly, my job is to get in there and make sure this doesn’t go criminal. If you are already looking at whether a criminal referral has been made, I’m not as well suited to help you – its more damage control at that point thenpotentially avoiding a criminal situation in the first place. Well anyways, here are some warning signs that indicate the audit may be out of the civil auditor’s hands and moved over to the criminal investigation division. The civil audit will be suspended when the civil auditor has firm indications of fraud. In other words, they’re just going to stop auditing at that point and they are going to hand it off to the criminal investigation division. So, if you can tell they weren’t anywhere near done with the audit, you can tell they weren’t happy with the last set of documents that were submitted, you can tell by the type of questions they were asking, your sixth sense is telling you they discovered fraud and they also stopped the audit dead in the process – that’s a very, very good sign it’s moved on. And this can happen with or without your knowledge, but most of the time it happens without your knowledge and without the representative’s knowledge. A lot of times they’ll just punt – they won’t answer questions, they won’t answer their phone, they’ll be unreachable. That leads to the revenue agent becoming unexplainably unreachable. You’ll hear all sorts of excuses – they’ve gone out for training, they went out on maternity leave, it can be really strange as to whether they are actually unavailable or a referrals been made.

If the revenue agent is focusing heavily on the intent of the tax payer taking positions on the return, asking: “What were you thinking when you did X?”, “Why did you do Y?” The “Why” question – very, very dangerous! Now all of a sudden they are trying to get direct evidence on tax fraud right out of the tax payer’s mouth. That’s a dead clue as to this thing is about to go criminal. If they start doing a net worth analysis and subpoena bank records – you’ve got a problem. Let me explain what a net worth analysis is: if over the past five years you show $80,000 of income a year and all of a sudden they realize you are living a block from the beach, you have an $8 million mansion, you’re driving a Maserati, you have five kids in private school, you got a butler, the auditor’s going to think “You know, their net worth and their reported income aren’t lining up. This doesn’t make sense!” That’s very dangerous! Okay? As a matter of fact, the net worth method is quite often presented at criminal trial to show criminal intent in a tax evasion case. Okay, so the revenue agent starts gathering excessive amount of documentation and makes excessive copies. If all of a sudden, the auditor disappears into your copy room, hires a company to roll out a copy machine and brings out three employees from the IRS to start making a copy of every document supporting your business – their building a criminal investigation against you and you need to move fast!

How about this? If the revenue agent has made undisclosed contact with third parties. In a civil audit their supposed to tell you when they are reaching out to third parties – they don’t have to, but the courtesy says they’ll tell you. They are reaching out to your bank and collecting documents, they’re going to the guy who sold you the business and requesting a copy of the contract from him,they are going out to your venders and they are asking: “You know, what did you actually sell this guy in the way of inventory over the last five years? Because I see reported sales of $100,000, how is it when they have reported sales of $100,000 when you’ve sold them $5 million worth of inventory? That indicates the inventory that they sold for cash is not reported on the return.” You receive a summons for records or for an appearance. If the government actually summons records they are using the power of the court to make you produce something. if they actually summons you to appear, in other words they don’t ask you to show up and submit to an interview, they summons you via legal procedure – you know you should start to worry about it at that point. And if you show up for that summons and there are two revenue agents at the table, there is someone from district council, there’s a court reporter writing down everything that you said – if the hair on the back of your neck doesn’t stand up at that point then you’re just not getting the situation.

Okay, there are three more typical clues: More than one revenue agent, the agent and manager or worst yet – two revenue agents and attorney of chief counsel office, a court reporter to attend a client interview. That’s a bad sign. Okay? I have had that happen to me a couple of times. They are creating an actual record of every word that comes out of the client’s mouth, they are doing that for a reason. If the auditor breaks out a tape recorder and puts it on the table, if the auditor sets up a video cameraand starts videoing the interview of the client. You know, these are all things that should really bother you.

Okay. So, I kind of touched on this earlier, the typical eggshell audit is said to reverse, remember we talked about an egg shell audit where there is an underlined criminal issue in an audit, that the client or the representative may or may not know about it. The IRS doesn’t know about it. It reverses from an egg shell audit to a reversal egg shell audit, in other words a referrals been made, when all of a sudden the auditor cancels the next appointment and all of a sudden you can’t reach them, they won’t return your phone calls – you should start to suspect a referral to CI at that point. Now, this isn’t to say the IRS wont drag out an audit for years, and they’ll get super busy especially with the budget cuts that are going on right now, The IRS has lost 15,000 personal over the last five years nationwide. There has been a hiring freeze on. It’s getting harder and harder for them to be efficient in audits situations. So, I’m not necessarily saying panic if they’re too busy to get to you, but you know, you look at the proceeding events that lead to the disappearance of the auditor and it should make sense to you. Well, they punted because they found criminal actions have taken place, their out and the criminal investigation division’s in and there’s a big pause while CI gets up to speed on the case. It can be two years before CI comes knocking on your door.

Okay, so here is the most obvious example that you are under criminal investigation. An officer of the IRS wearing a gun and badge approaches you. Well, first of all the only agents in the IRS that wear guns and badges, well, there’s two of them, there are agents out of TIGTA – they are not usually involved with investigating clients for tax evasion, their usually involved with going after prepares that hold themselves out as CPA’s when they are not. You know, they go after people that are committing identity theft and stealing people’s refunds, they monitor the IRS personnel themselves and make sure the IRS agents aren’t extorting income out of the people they are auditing. They wear guns and badges, but it’s a different gig. You’re looking for somebody with a badge that says “Criminal Investigation Division” on it and they have a gun strapped to their side. Usually they will show up in teams of two and they’ll be an agent of the Criminal Investigation Division, and they’ll be a revenue agent assigned to them with a pad of paper that’s writing down everything that’s said. If somebody from the IRS with a gun and badge hands you three years’ worth of tax returns and starts asking you questions about them, and someone’s writing down what you say, you’ve got a problem. You’ve got a big problem and you need to call me. First of all, you need to understand that you have the right to terminate that impromptu investigation. They will show up, out of the blue, at 7 o’clock on a Friday morning – they’ll know your habits, they’ll know when you are leaving for work, they’ll try to catch you off guard and they’ll try and get you try to explain your way out of the problem. What they are looking for is to get you to lie on the record to be able to show that there was criminal intent for what you did on that tax return. What you need to tell them is: “I demand to have an attorney present before I answer your questions. I’m terminating this conversation right now until I can have my attorney present.” That’s the only safe thing to say. They’re going read you Miranda warnings that’s going to say something along the lines of: “Their conducting a criminal investigation, anything you say can be used in the prosecution of tax crimes.” Choose your right to remain silent. Even if they arrest you, yes… they have the power to arrest you, if they pull you into a room and won’t let you leave, you remain silent for as long as it takes until counsel is present because nothing you say is going to help you.

Thank you so much for watching this video – scary stuff. I’m always here to take questions on these issues.

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