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Will a Voluntary Disclosure of Unreported Income to the IRS Really Protect You From Criminal Prosecution?

Will a Voluntary Disclosure of Unreported Income to the IRS Really Protect You From Criminal Prosecution?

By Anthony Diosdi

Many tax attorneys tout the benefits of making a voluntary disclosure to the Internal Revenue Service (“IRS”) if you failed to disclose income on previously filed tax returns. Sadly, many professionals neglect to mention the risks of making a voluntary disclosure of unreported income to the IRS. This article will discuss the voluntary disclosure process in detail. A voluntary disclosure is the only administrative remedy that can potentially be utilized to prevent a criminal prosecution for crimes such as tax evasion or the filing of false tax returns. Unfortunately, as will be discussed below in detail, a voluntary disclosure is far from a “sure thing.” Anyone considering making a voluntary disclose to the IRS should know that it had a formal “voluntary disclosure” policy under which a taxpayer who failed to file a tax return or declare his full income and pay the tax could escape criminal prosecution through voluntary disclosure of the deficiency, so long as the voluntary disclosure was made before an investigation was started. The IRS withdrew this formal program in 1952 and efforts to reinstate it have been unsuccessful.

With that said, the spirit of a voluntary disclosure still continues with the IRS as long as an individual makes a true voluntary disclosure. The IRS now considers a true “voluntary disclosure” along with other factors in determining whether or not to recommend criminal prosecution of a tax crime to the United States Department of Justice. The IRS recognizes that an individual may avoid criminal prosecution by voluntarily disclosing a tax violation as long as the disclosure is 1) timely and 2) voluntary. A disclosure means a communication that is truthful and complete and that the individual cooperates with the IRS personnel in determining the correct tax liability. Cooperation includes making good faith arrangements to pay the unpaid tax and penalties to the extent of an individual’s actual ability to pay.

It is the practice of the IRS that a voluntary disclosure will be considered along with all other factors in the case in determining whether criminal prosecution will be recommended. A voluntary disclosure will not of itself guarantee immunity from prosecution. Since the IRS’s application of the voluntary disclosure practice does not automatically result in formal immunity from criminal prosecution, individuals should know that they cannot solely rely on the fact that others may not have been prosecuted who made a voluntary disclosure to the IRS.

Examples of this in United States v. Tenzer, 127 F.3d 222, 226 (2d. Cir. 1997) and Crystal Pools v. United States, 172 F.3d 1141, 1146 (9th Cir. 1999). In Tenzer, an individual attempted to negotiate an installment payment plan with the IRS and filed amended tax returns pursuant of the voluntary disclosure program. The IRS unilaterally determined that the individual did not qualify for the voluntary disclosure program because his offer to settle his back tax liabilities was inadequate. The individual in this case making the voluntary disclosure to the IRS was charged with four counts of failing to file tax returns.

The individual in this case moved to dismiss the charges on the ground that the IRS had violated his due process rights by prosecuting him in violation of the voluntary disclosure program. The district court found that the individual had complied with the voluntary disclosure policy and that the IRS was constitutionally required to comply with its published policies; therefore the charges against the individual were dismissed. The Second Circuit Court of Appeals reversed the district court’s decision, stating that the individual’s due process rights had not been violated because the individual had not paid his taxes or made arrangements to pay his taxes. The Second Circuit also held that the IRS is not constitutionally required to comply with its own published policies.

In Crystal, the individuals, through their attorney, initiated contact with the Criminal Investigation Division (“CID”) of Los Angeles for a voluntary disclosure. The attorney was told that voluntary disclosures were generally handled by the local IRS district office. The attorney confirmed with the CID office for Southern California that the IRS still had a voluntary disclosure program permitting taxpayers to amend past tax returns without the threat of criminal prosecution. Upon further discussion, the IRS told the attorney that the taxpayers’ profiles fit the program’s requirements and that there was no prior IRS investigation underway that would disqualify them. In the meantime, the taxpayers’ attorney faxed the IRS a confirmation letter of voluntary disclosure concerning the individuals’ unreported income. The Los Angeles IRS office thereafter initiated a full investigation of the taxpayers. When the taxpayers argued that they had been misled in making disclosures to the IRS, and that the IRS acted in bad faith, the district court found their voluntary disclosure did not foreclose investigations. In addition, the misrepresentations upon when the individuals in this case could not be imputed to the IRS. The Ninth Circuit Court of Appeals affirmed the case.

The case law points out that regardless of whether a taxpayer actually benefits or suffers detriment from voluntarily disclosing and rectifying faulty tax returns, the disclosure itself does not formally insulate the taxpayer from prosecution under any administrative policy or practice recognized in any court. The Ninth Circuit Court of Appeals took it one step further by stating that “[t]axpayers and their attorneys cannot rely on a long-since abandoned policy of non-prosecution when [a] taxpayer voluntarily discloses [a] violation of the tax laws.” See Crystal Pools 172 F.3d. 1141.

In its current form, the IRS’s voluntary disclosure practice does not appear to formally immunize individuals from criminal investigation by the IRS. In deciding whether or not individuals should avail themselves of the voluntary disclosure program, he or she must weigh the competing probabilities. A factor that would tend to discourage using the voluntary disclosure program could be that an individual is providing evidence that could be used against him that may otherwise be unobtainable by the IRS. In other words, a voluntary disclosure could trigger a criminal prosecution that would never had taken “but for” the disclosure. The factor that would tend to encourage participation in the voluntary disclosure is that it may not be in the best interest of the government to criminally prosecute, or even attempt to impose civil fraud penalties on taxpayers who availed themselves of the voluntary disclosure program.

Anyone considering making a voluntary disclosure to the IRS should consult with a criminal tax attorney to determine if a voluntary disclosure will truly assist them in avoiding a criminal referral to the Department of Justice. A criminal tax attorney should also be able to advise the individual considering making a voluntary disclosure if there are other less drastic measures available to avoid criminal prosecution such as effectively utilizing the statute of limitations.

If it is determined that a voluntary disclosure is the most effective way to avoid criminal prosecution for a tax violation, the individual making the disclosure must understand that the disclosure must be truthful and complete. The individual must be prepared to cooperate with the IRS in determining the correct tax liability. In addition, the individual making the voluntary disclosure must immediately make arrangements to pay the unpaid tax, penalties, and interest. A disclosure should also be “timely.” A disclosure is “timely” if it was received before the IRS has begun its own inquiry into the matter.

Anthony Diosdi is a tax attorney with the firm of Diosdi Ching & Liu, LLP. Anthony Diosdi is a member of the California and Florida bars. He advises clients on tax compliance issues, including criminal tax investigations, sensitive civil audits, and voluntary disclosures. Anthony has represented numerous clients worldwide in matters arising from the IRS and Justice Department’s crackdown on unreported foreign assets and accounts. Anthony Diosdi has written numerous articles and spoken on a number of panels discussing international taxation at continuing education programs. 

Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters 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.