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Defense Considerations in an IRS Criminal Tax Investigation- Cooperation Versus Non Cooperation

Defense Considerations in an IRS Criminal Tax Investigation- Cooperation Versus Non Cooperation

By Anthony Diosdi

The Internal Revenue Service (“IRS”) selective program to utilize criminal sanctions is part of an overall system of collecting taxes. It is part of an overall system that will send the best and the brightest to prison as a public reminder to file correct tax returns. When the IRS refers a case to the United States Attorney for criminal prosecution, in most cases, the United States Attorney will do so without compassion. Criminal tax cases are different then other criminal cases. A criminal tax case is the nearest thing to an inquisition in modern times. Unlike most other criminal cases, the question is not whether an individual did something wrong. The question in a criminal tax case is whether an individual targeted by the IRS did anything wrong. Consequently, criminal tax investigations are typically detailed and lengthy. This article will discuss the advantages and disadvantages of cooperating with the IRS in a criminal tax investigation. It will also discuss the different types of cooperation that can be utilized in such cases.

Cooperation, as we will use the term in this article, means the voluntary production by the taxpayer of material for inspection by the IRS that is not otherwise available to the IRS by lawful process. Turning over corporate records is not “cooperation” under this definition because they are subject to production by the lawful issuance of a grand jury subpoena or an IRS summons. Turning over personal records or making statements to an IRS special agent, neither of which is mandatory, because of the Fifth Amendment privilege, is cooperation.

During the course of an IRS criminal investigation, the individual being investigated will be confronted at regular intervals with the question of whether he or she ought to cooperate with the IRS special agent. When an IRS special agent first contacts an individual being investigated, he or she will ordinarily request that the individual being investigated cooperate in the investigation by answering the agent’s questions, and by permitting the agent to inspect his business books, records, bank statements, and any other records considered relevant in the investigation. If such assistance is at first refused, the IRS special agent will typically request the assistance of the individual being investigated in resolving various issues that have emerged during the investigation, both by supplying documentation and giving explanations.

Whether an individual being criminally investigated by the IRS should or should not comply with these requests is not merely an intellectual decision. Decisions made under great pressure are emotional as well as intellectual. The original resolve not to cooperate may weaken after the individual’s banks have been contacted, his or her business associates have been visited by an IRS special agent, and the individual’s most recently fired employee has been interviewed by the IRS special agent. The impulse to cooperate is usually based both on a desire to terminate an IRS criminal investigation before it is widely publicized, and an emotional impulse to set the record straight even if it cannot be set straight exactly.

It is true that cooperation, insofar as turning over records is involved, is becoming less and less of a real question. Court decisions have expanded the range of documents subject to subpoena or summons. More sophisticated investigation techniques and widespread use of indirect methods of proof have enabled the IRS to make criminal cases without the taxpayer’s personal records. Many more records are available to an IRS special agent from third parties, such as banks. Nevertheless, there are records beyond the reach of lawful process and unavailable from third parties. And, of course, no individual being criminally investigated by the IRS is obligated under law to incriminate himself or herself by testimony under oath or “informal” explanations to an IRS special agent. These rights are still vital and they are especially vital in a IRS criminal tax evasion case.

Whatever statements and documents the special agent might procure without the individual being investigated for cooperation, he or she must find elements of intent and knowledge. The special agent must find evidence to indicate the personal state of mind of the individual being investigated when the taxpayer filed the tax return in question. The closer the evidence gets to the individual being investigated, the more likely that acceptable proof of “intent” and “knowledge” for criminal prosecution purposes will emerge. There is seldom better proof of an individual targeted in an investigation’s state of mind than what he or she says to a IRS special agent in direct explanation of how a transaction was handled. Records which were actually prepared by an individual are more indicative of what he knew and what he was doing than third party records. Notations in an individual’s handwriting on an original document are also highly probative in criminal tax evasion cases and can be the ruin of an individual targeted in a criminal investigation. For example, the author’s firm represented an individual who delivered his personal records to an IRS special agent thinking that they could not hurt him, only to discover that one of the folders contained negotiations which contradicted the income reported on his tax return.

Whatever the emotional pressures may be on an individual being criminally investigated by the IRS, cooperation or noncooperation is a large question in criminal tax fraud cases, and it must be handled with judgment and scrupulous attention to detail. The simple truth is that the pressure will not abate if the cooperation is a disaster.

Advantages of Cooperation

Cooperation can be advantageous at any stage of a potential or actual tax fraud investigation. It can be particularly advantageous in cases where no criminal criminal investigation has commenced but questionable returns have been scheduled for audit by an auditor or when a special agent is conducting a limited inquiry based on a specific suspicious circumstance such as allegations of certain transactions or specific dealings with one or two associates, suppliers, customers or clients. However, even under these circumstances, the tax attorney representing the taxpayer must endeavor to limit the response to only the specific questions asked and be very careful not to give information which will open up other areas of inquiry. In such circumstances, cooperation may forestall a full scale investigation, provided that the cooperation presents material that satisfactorily explains the potential fraud items.

Cooperation during a full scale criminal investigation may be advantageous because: 1) the act of cooperation itself is evidence of candor, openness, and lack of guilty knowledge, and is admissible evidence tending to prove the above; 2) the act of cooperation forestalls possible adverse inferences of evidence of noncooperation; 3) it may persuade the investigating agent of the individual’s good faith, and thereby potentially viewing the case in a non prosecutorial way; and 4) the material supplied by the act of cooperation may prove a defense or disprove faulty conclusions.

However, cooperation must be viewed realistically. An IRS special agent knows the difference between an intelligent act of cooperation and an unthought, impulsive act based on emotions. So does a federal district court jury. If the material turned over is damaging and if the cooperation appears impulsive, the IRS is more likely to conclude that “cooperating taxpayer” is a fool than the individual was candid, open, and honest. Even an apparent good faith disclosure to an agent will not persuade the IRS not to forward a case to the United States Attorney for criminal prosecution.

The primary advantage of cooperating with the IRS must be in the evidence itself. In other words, the evidence provided to the IRS establishes a defense, explains transactions which on their face appear questionable, or present a close question of fact capable of genuinely conflicting interpretations that may persuade the IRS that there is no reasonable probability of a criminal conviction.

Disadvantages of Cooperation

The two primary disadvantages of cooperation are that 1) it will give the agent information he or she otherwise could not obtain which will be of assistance in proving the charge; and 2) it will permit the agent to set aside the defensible transactions from the case and focus on items or transactions which establishes criminal tax fraud. Thus, cooperation not only can be a form of suicide, it can also make an IRS criminal tax ase more solid to the extent it becomes more selective and targeted.

Adverse Inference from Non Cooperation

When an individual being investigated by the IRS refuses to turn over books and records which would be helpful in determining his or her true tax liability, he or she must realize that he or she runs the risk of creating an adverse inference that he or she is withholding vital information. The courts traditionally have found a way to permit the introduction of evidence of noncooperation and the use of such evidence as evidence of willfulness to defraud the IRS. However, whatever adverse inferences may result from the failure to turn over books and records, it is far better to deal with an adverse inference than with specific proof that those records might contain.

Cooperation Can be Selective

An individual being criminally investigated by the IRS is not obligated in law or as a matter of strategy to commit himself absolutely to a program of cooperation or non cooperation. Because an individual permits the inspection of his or her books and records, it does not follow that he or she must or should supplement the information with his or her personal explanations. Because an individual being criminally investigated by the IRS turns over his or her bank statements, he or she is not required to turn over his or her personal business ledgers and journals. There are obvious limitations on the capacity to be selective and the strategy of being selective. It will be of limited assistance to an individual to turn over every other month of his or books and records for one year of a three year investigation. That will only tend to highlight the real problem areas. Such behavior may also be disastrous if present to a jury. For example, in Beard v. United States, 22 F.2d 84, 95 (4th Cir. 1955), a federal district court approved an instruction authorizing a jury to infer willfulness from a defendant’s failure to produce his books and records. In support of that instruction, the court commented that it was:

“Especially pertinent in this case where the defendant, although availing himself of his undoubted right to remain silent nevertheless put in evidence fragmentary portions of the records of his business, admittedly within his possession, but, nevertheless withheld the writings which could have given a complete picture of his gambling operations.”

Selective cooperation should be utilized as a means of answering specific questions or pointing out specific problems of proof to the agent. When selective cooperation is employed to answer specific questions, it should be complete. That is not to say that the answers given must always present a complete defense, but they should include all of the relevant documents necessary to fully address the question presented. For example, if a special agent asks a lawyer that is being criminally investigated for tax fraud if he received cash fees from client X that was not disclosed on a tax year and the defense wishes to present evidence of the receipt of checks from client X on the payment of fees, some presentation may have to be made regarding services performed and their relation to the fees represented by checks. It will not be convincing to present a bookkeeping entry reflecting payment in the sum of $5,000 if the payment was made to the attorney during the course of an extended litigation. If, however, a bookkeeping entry was for $5,000 and the attorney can present a file indicating a routine divorce, it will be a substantial indication that no additional cash fees were received.

If an answer is given to a particular question with selective cooperation, it should be done so with reasonable completeness. Selective cooperation in indirect methods of proof cases is usually not as helpful as in specific item cases. Completeness of information is vital to indirect methods of proof such as the net worth method, cash expenditure less cash available methods, etc. Such methods depend upon having all of the relevant (or obtainable) records regarding particular assets or particular accounts. Specific limited questions are less likely to arise, except, perhaps, in the area of prior-accumulated funds or nontaxable sources of funds. Limited or selective answers in those two areas can be dangerous. They may be construed as “leads” and limit the obligation of the IRS to check out possible sources of nontaxable or prior accumulated funds.

Selective cooperation is best used in answering specific questions about specific transactions. Its use may be extremely dangerous in an area where completeness of information is vital or where selective cooperation is insufficient to fully answer the question or questions asked. 

Do Not Rush to Cooperate

Criminal tax evasion or tax fraud cases may last for years. At the very least, they will last long enough to permit the individual being investigated to select a good tax attorney who can evaluate the case fully. No commitments should be made as to cooperation until the advantages and disadvantages of cooperation can be intelligently assessed by a tax attorney. When an individual is involved in a full-scale criminal tax investigation, the decision to cooperate should be postponed until the issues have crystallized to some extent. The decision to cooperate can be more intelligently assessed after the method or probable method of proof has been decided on by the special agent, e.g, net worth, etc. 

Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi represents clients in tax audits, civil tax litigation, criminal investigations, and voluntary disclosures throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.