What is an Eggshell Tax Audit?

An Eggshell Audit is an audit of a return, either by correspondence audit or office audit or field audit where there have been material statements within that return that if the governments discovered them they can possibly be viewed as criminal in nature.

Errors happen in returns for two reasons: either somebody’s got something wrong in the preparation of that return, could have been the preparer.Somebody got something wrong in the accounting underlining that return – that could have been the client or the client’s staff. Or, there is a purposeful mistake in the return designed to understate tax liability. That’s a crime. It’s called income tax evasion, and if you have a return where income tax evasion has taken place, and that returns under audit – that’s an eggshell audit.

That’s a term of artcoined by criminal tax defense attorneys. I’ll read you the definition here: An eggshell audit is a civil audit in which the returns under examination contain a material understatement of income. Now, what would I consider material? Well, let’s say you have $20 million worth of income on a return, a million bucks is material in relation to 20 million – especially if that million bucks can be traced back to that one account that didn’t get included into the books at all. Some sort of slush account. It really depends on the underline badges of fraud that are apparent within the fact pattern. The badges of fraud are something the IRS is going to look at and say: “That is indicative of fraud. We’ve seen it in the past. We see it now. We believe the return is understated due to fraud, not due to negligence.”

A material overstatement of deductions has occurred. You’ve got somebody deducting their country club membership, you got somebody deducting their rent. Every personal expense that they have for existing on this planet they deducted as a business expense. That’s fraud, or credits claimed that taxpayer is not entitled to. A credit is a dollar for dollar offset against tax. How about a childcare credit claim where you don’t have children. That might be indicative of fraud. The end result of all this is that the taxpayer showed less tax liability then they would havehad a true accurate and complete return been filed. That’s an Eggshell Audit.

Again, these audits can be caused by mere negligence – in which case only a 20% negligence penalty would apply and nobody would go to jail. Or these actions can be viewed as caused by willful intent and that indicates a criminal situation where the taxpayer or his representative, if his representative actually committed the tax fraud, could do three to five years in jail and pay a 75% fraud penalty.

Let me give you an example to illustrate a 75% fraud penalty: $1,000 of tax liability is discovered, the government hits you with a 75% fraud penalty, you pay $1,750 rather than the $1,000 because they ramped it up by a 75% fraud penalty. In a negligence situation, now they are going to ramp it up by 20%: $1,000 tax liability – you have to pay $1,200 plus interest back to the original filing date of the return.

Here’s the ultimate definition that I like on Eggshell Audits: An eggshell audit is one in which the client and the representative are aware of a potential indication of civil fraud or criminal tax violations that have not yet come to the attention of the revenue agent or other examining officer. The part of this definition that doesn’t always make sense to me is:a lot of the time the original representative, and frankly, this is what makes these audits so dangerous,may not know that fraud has occurred. The client handsthe original preparer, let’s say a CPA a set of books. Those books are cooked all to hell. There’s deductions claimed that they are not entitled to, there is income left off the return that the preparer’s not aware of, the preparer takes the client in for an audit and all of a sudden the preparer becomes aware that things are not adding up and the IRS agent becomes aware things are not adding up and the scary part is the preparer can actually work against the client by trying to defend their honor for their role in preparing the tax returns. Which could put the client in jeopardy.

Anyways, if you have an egg shell audit situation chances are you know it, and you know deep down in your heart you played games in preparing that return and frankly you should get as far away from the preparer as you can. Hire someone that has attorney-client privilege. The only one that does is a tax attorney, and then flat out in the first meeting with the tax attorney say “Mr. Klasing, I’m under audit. What I’m worried about is I left income off my return. I claimed personal expenses that I shouldn’t of on my return. I pulled numbers out of thin air and threw them down on my return, because I didn’t have the money to pay my taxes. Or, I claimed a bunch of credits I was not entitled to. And I did soknowingly and willfully, and I’m afraid of going to jail for it.” At least you and the representative are on the same page and there will be no surprises in the audit representation phase. Frankly, it should be an attorney that takes you through that situation. Only an attorney can keep that secret in perpetuity because of the attorney client privilege and represent you in that situation. The idea is to try and keep it civil and not let it go criminal.

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