Making a Federal Case?

On Oct. 26, 2009, Internal Revenue Service Commissioner Douglas Shulman, speaking at the annual meeting of the American Institute of Certified Public Accountants (AICPA), announced the IRS' creation of a new audit unit, the Global High Wealth Unit (GHWU).1 Comm. Shulman stated that the GHWU's purpose was to audit very wealthy individuals who hold an interest in investments and businesses through complex

On Oct. 26, 2009, Internal Revenue Service Commissioner Douglas Shulman, speaking at the annual meeting of the American Institute of Certified Public Accountants (AICPA), announced the IRS' creation of a new audit unit, the Global High Wealth Unit (GHWU).1 Comm. Shulman stated that the GHWU's purpose was to audit very wealthy individuals who hold an interest in investments and businesses through complex domestic and international structures, including corporations, trusts, partnerships and other flow-through entities.2 The key question now is whether the IRS is hoping to develop federal fraud cases from this audit unit.

Based on the activities that the IRS suspects may be occurring¸ it's apparent that the IRS believes that some of the planning for extremely wealthy individuals, including the use of international structures, may have crossed the line between aggressive tax planning and tax fraud.

GHWU Basics

The GHWU audits very wealthy individuals. Including “global” in the name of the group indicates that the IRS isn't interested only in those individuals with domestic investments and businesses, but also is interested in wealthy taxpayers with international investments and businesses held through a variety of global entities and structures. The GHWU will initially audit those individuals with tens of millions in assets or income.3

The group is part of the IRS' Large Business and International (LB&I) group4 and staffed with some of the IRS' most seasoned agents. LB&I agents typically audit large companies, so they possess the skills to deal with sophisticated global organization structures.5 The GHWU conducts comprehensive, coordinated examinations of all the wealthy individual's entities, including entities owned by related parties, when warranted.6

This represents a dramatic shift in the IRS' approach to auditing wealthy individuals with multiple businesses and investment vehicles. In the past, the IRS may have audited a 1040, corporate or other return of an entity owned by a wealthy individual, but it rarely coordinated audits of the individual and the entities owned by the individual. In this new approach, the IRS assembles a team of case agents to examine a wealthy individual and the entire group of entities and investments he holds (and, perhaps, entities owned by family members and business partners). This allows the IRS to obtain a more complete picture of the wealthy individual's entire economic interests and to review transactions among related entities owned by the wealthy individual, which may involve shifting of income or the transfer of income and assets to avoid U.S. income or estate and gift taxes.

Additionally, the IRS employs specialists to conduct the audits, including international agents, economists, financial products specialists and flow-through specialists, when warranted.

Exposing Wealthy Tax Cheats?

I'm not suggesting that the GHWU will be doing anything nefarious to entrap wealthy individuals during these new comprehensive audits: Any civil investigation can shift into a criminal investigation if the IRS agent uncovers indications or “badges” of fraud.

However, certain factors indicate that the IRS at least suspects that some very wealthy individuals may be using complicated tax structures and foreign entities in aggressive tax schemes designed to shift, hide or remove income and assets from the U.S. tax net altogether.

First, the formation of the GHWU came quickly on the heels of the UBS scandal, in which the United States discovered that many citizens and taxpayers were using foreign bank accounts to hide income. That scandal resulted in the IRS' implementation of the foreign account voluntary disclosure program, which allowed U.S. taxpayers with undisclosed foreign bank accounts to come clean with reduced penalties (or in some cases no penalties, depending on the circumstances).7 The UBS case and related foreign bank investigations have already resulted in a number of high profile tax fraud prosecutions.8

Although the response to the IRS' voluntary disclosure program was overwhelming (with nearly 15,000 people coming forward to disclose foreign bank accounts), the IRS rightfully suspects that there are many more U.S. taxpayers who didn't come forward because they have significant unreported income.

In addition to the IRS' suspicion that a substantial number of U.S. taxpayers have yet undisclosed foreign accounts¸ comments by Comm. Shulman and others with the IRS indicate that the agency suspects that some of the tax planning for wealthy individuals has crossed the line.

For example, in his speech to the AICPA announcing the GHWU, Comm. Shulman stated:

Rooting out individuals hiding their money in foreign jurisdictions is very different from the IRS and Treasury creating ground rules for multinational corporations operating in a global environment. Now for individuals with overseas income and assets, it's straightforward. If you are a U.S. individual holding overseas assets, you must report and pay your taxes, or we will be increasingly focused on finding you.

Granted, Comm. Shulman wasn't explicitly speaking about the GHWU at that point in his speech, but it discloses the IRS' belief that a significant number of U.S. taxpayers are hiding overseas accounts and assets, including the very wealthy taxpayers who will come under audit by the GHWU.

With respect to the GHWU audit program, Comm. Shulman said:

For a variety of reasons — including valid business reasons — many high-wealth individuals make use of sophisticated financial, business and investment arrangements with complicated legal structures and tax consequences. Many of these arrangements are entirely above board. Others mask aggressive tax strategies.9

While Comm. Shulman stated that some of the planning for high-wealth individuals was “above board,” his comments indicate that the IRS suspects that some of the planning is not above board and instead “masks aggressive tax strategies.” There's a fine line between aggressive tax planning and improper tax evasion and fraud.

Donna C. Hansberry, who heads the GHWU, participated in a panel discussion of the program at the American Bar Association's (ABA's) Tax Section's Fall meeting in Toronto. The panel, in its materials, made the following observations:

  • Opportunity: Higher income or wealth often leads to aggressive tax planning.
  • Integrity: Combat perception that those with the greatest wealth/income pay the least tax.
  • Tax shelters.
  • Offshore tax evasion (emphasis added).10

Similar to Comm. Shulman's statements, the materials indicate that the IRS (or the ABA panel, in this case) suspects that high-wealth U.S. taxpayers may be utilizing aggressive tax planning and may in fact be engaging in offshore tax evasion or utilizing foreign entities to shelter income from U.S. taxation.

The IRS may confirm some of its suspicions through the GHWU audit program, which may result in a number of high-profile criminal tax prosecutions.

Badges of Fraud

The IRS Internal Revenue Manual (IRM) lists a number of indications or “badges” of fraud that its agents should be aware of while conducting civil audits. When an IRS agent finds sufficient badges of fraud, the agent is required to make a fraud referral to the IRS Criminal Investigation Division (CID). After receiving a fraud referral, the CID determines whether a criminal tax fraud investigation is warranted. If no investigation is warranted, the CID recommends whether the civil fraud penalty should be asserted against the taxpayer.

The IRM Fraud Handbook includes a comprehensive list of badges of fraud that include transferring assets, shifting income, hiding accounts, hiding assets and fraudulent or sham transactions.

It's apparent that the IRS at least suspects that wealthy individuals are employing some of these techniques in “offshore tax evasion,” such as improperly shifting income and assets to foreign entities, hiding foreign bank accounts or improperly transferring assets to foreign entities and using them to avoid reporting income in the United States. If any of these activities are uncovered during a GHWU audit, they would constitute badges of fraud that could result in a referral of criminal fraud and an initiation of an IRS criminal investigation.

IRS Civil Audits Gone Bad

If you're representing someone involved in a GHWU audit, the key question is how to determine if the civil audit is taking a turn toward a criminal investigation. As mentioned above, the civil IRS agent is instructed to suspend the civil audit and make a referral to the IRS CID if the agent uncovers “firm indications of fraud.” The agent is also instructed to use examination techniques to develop the firm indications of fraud. Thus, the agent may take steps to obtain firm indications of fraud after the agent has found badges of fraud.11

You may be able to tell that the agent is moving toward a criminal referral if indications exist that tax fraud may have occurred during the year or years under examination. Signals that the taxpayer may have committed tax fraud include: (1) the high-wealth individual has a substantial amount of unreported income that can't be explained; (2) a substantial amount of expenses were deducted on corporate or entity returns that may be personal in nature; or (3) hidden income or assets were uncovered during the examination.

The agent's examination techniques may also provide clues that the tenor of the investigation has moved toward a criminal inquiry. The agent is instructed to obtain an explanation from the taxpayer outlining any significant unexplained discrepancies.12 The agent's request to interview the taxpayer toward the end of an audit or after the discovery of some unexplained sources of income or unexplained deductions may indicate that the agent is attempting to establish firm indications of fraud.13

In addition, the agent may request to interview employees or third party recordkeepers to develop a fraud case. The agent may also issue a summons for the taxpayer's records from companies that the taxpayer owns and from third party recordkeepers such as banks and brokers with whom the taxpayer has accounts. This is likely in cases in which the agent suspects that the taxpayer has failed to disclose or report bank accounts or other investment assets.

If an agent makes a referral to the CID, the agent will suspend the civil audit while the fraud referral is pending. The agent is instructed not to disclose the reason for suspending the examination to the taxpayer or his representative.

If a criminal investigation is initiated, an IRS special agent will contact the taxpayer. The agent will provide the taxpayer with a modified Miranda warning and will inform the taxpayer that he's the subject of a criminal investigation.

Handling a Criminal Investigation

An in-depth discussion on defending an IRS criminal investigation is beyond the scope of this article. Nevertheless, it's important for you to recognize the potential for a criminal investigation and to take steps to avoid a criminal referral, if possible, or to limit the risk that the client will be indicted and prosecuted for a tax crime if the IRS agent makes a criminal fraud referral.

If you suspect that GHWU agents are moving the investigation toward a criminal referral, your tactics and goals must change. If you're not an attorney, instruct the client to hire a criminal tax attorney immediately. Having an attorney represent the client will make it more likely that the communications and documents prepared in the defense of the potential criminal case will be subject to the attorney-client privilege or the work product doctrine. If you're a tax attorney who doesn't specialize in criminal tax defense, you should instruct the client to hire a criminal tax attorney experienced in defending IRS criminal investigations and tax fraud prosecutions.

The goal in a potential criminal tax investigation is to prevent the IRS from moving forward with a criminal case against the client.

The attorney in a potential criminal tax matter may want to hire a forensic accountant.14 This is particularly true if the GHWU has uncovered apparent unreported income or undisclosed assets. The forensic accountant may be able to determine explanations for the alleged unreported income or hidden assets and should be hired under a Kovel agreement (that is, a letter used to make a non-attorney subject to the attorney-client privilege), to ensure that the forensic accountant's work product and communications will be privileged.15

The attorney will also want to control the flow of information to the IRS by reviewing all documents that are subject to IRS information requests or summonses and determining whether any such documents are subject to privilege. Even if the documents aren't privileged, the attorney will want to review all documents being turned over to the IRS to have a complete understanding of the potential criminal case against the client.

The attorney will also want to conduct interviews of possible witnesses to develop a defense to the potential criminal case and to determine if there's damaging evidence or testimony that the witnesses may provide to the IRS.

The Justice Department has sanctioned prosecution guidelines that take into account various factors, such as the education, age and health of the defendant.16 For example, the Justice Dept. is less likely to prosecute an individual who's elderly, has a health problem or has a low education level. It's likely that a wealthy taxpayer being audited by the GHWU will have a higher level of education than the average American, so the education factor may not benefit the wealthy individual in a criminal tax matter. The attorney should document the age of the wealthy individual as well as any health problems, including any mental health issues, as such problems might be helpful in preventing the Justice Dept. from pursuing a criminal tax case.

To mount a successful defense to a potential criminal tax matter, it's necessary for the attorney to become involved early in the process to assess the case and develop defenses. In a potential criminal matter being developed by the GHWU, the case may involve complex structures and foreign entities, and there's likely to be a substantial amount of documentary evidence that the attorney will need to review.

  1. Speech by Douglas H. Shulman, Commissioner, Internal Revenue Service, at the American Institute of Certified Public Accounts National Conference on Federal Taxation, Oct. 26, 2009 (Shulman Speech).
  2. For further information on planning for and defending Global High Wealth Unit audits, see “New IRS Holistic Audit Program” in Trusts & Estates, (July 2010) at p. 26.
  3. Shulman Speech, supra note 1.
  4. In 2010, the IRS reorganized and renamed the Large and Mid-Size Business examination to the Large Business and International group to reflect changes in its international tax enforcement.
  5. Shulman Speech, supra note 1.
  6. Ibid.
  7. See IRS Memoranda released March 23, 2009 [2009 TNT 57-32, 57-33, 57-34].
  8. The IRS website, www.irs.gov [5], lists 16 U.S. residents and former UBS clients who were prosecuted for tax fraud.
  9. Shulman Speech, supra note 1.
  10. American Bar Association Administrative Practice Committee Fall Meeting 2010, Toronto. The panel materials may have been prepared by one of the other panelists and thus, the comments shouldn't be attributed specifically to Donna C. Hansberry. Furthermore, the reader shouldn't assume that Hansberry supports or endorses the specific comments made in the panel materials.
  11. See Internal Revenue Manual (IRM)
  12. IRM
  13. Ibid.
  14. See Michael Saltzman, IRS Practice & Procedure, Warren Gorham & Lamont (2d. Ed. 2002) 12.09.
  15. See United States v. Kovel, 296 F.2d 918 (2d Cir. 1961).
  16. Saltzman, supra note 14.

Kevin Johnson is a shareholder in the Philadelphia office of Chamberlain Hrdlicka White Williams & Martin. He was previously an IRS revenue agent and also worked in IRS Appeals