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Introduction to the Internal Revenue Service's "Parallel" Investigations

Insights, Willamette University, Autumn 2013
October 1, 2013

Overview

The nature, purpose, and impact of an Internal Revenue Service (the "Service") audit investigation are not always apparent to the taxpayer or the taxpayer's representatives (e.g., attorney or accountant). This discussion summarizes the Service's criminal investigation capabilities and techniques, and it provides guidance regarding the Service's recent practices in "parallel" civil and criminal tax investigations.

Introduction

The government's goals in a civil tax examination are (1) to determine the correct amount of tax and (2) to assess tax, penalties, and interest. The taxpayer's goals are (1) to minimize the taxpayer's tax liability and (2) to eliminate the assessment of penalties, if at all possible. In many instances, the taxpayer's goals may be best served by cooperating with the government in order to minimize monetary costs.

Unlike a civil tax examination, a criminal tax investigation has little to do with the assessment of additional tax. The purposes of a criminal investigation are (1) to detect suspected criminal tax offenses and (2) to refer those offenses for criminal prosecution. The government's goal is to obtain a conviction that results in imprisonment, fines, and/or restitution.

The taxpayer's goal is to avoid a plethora of potentially disastrous consequences, including going to prison, loss of assets, loss of the taxpayer's reputation and forfeiture of the taxpayer's professional licenses and ability to earn a living.

One of the dangers in not knowing or understanding the purpose and goal of the Service's inquiry is that a taxpayer may be irreparably prejudiced in a criminal case if the taxpayer is forced to defend a civil examination while the taxpayer is secretly under criminal investigation. For reasons discussed below, the possibility of a secret criminal investigation during a civil audit has recently increased significantly. The determination of the civil and/or criminal nature of the government's inquiry at an early stage is important to the protection of taxpayer rights.

Criminal Tax Investigations

Among the several types of investigations that are conducted by Treasury agents are (1) joint investigations and (2) parallel investigations. Each of these types of investigations is discussed below.

Joint Investigations

Joint investigations are criminal investigations in which civil Revenue Agents (civil examiners or "auditors") assist Special Agents from the Criminal Investigation Division (CID), who control the investigation. The civil Revenue Agent interviews witnesses, reviews and analyzes tax returns and financial records, and provides accounting and auditing services, in a supporting role. In a joint investigation, although the civil Revenue Agent may be involved, the criminal process is the government's primary focus. This fact is usually disclosed and apparent to the taxpayer.

Parallel Investigations

Parallel investigations are simultaneous civil and criminal investigations, with both tax assessment and criminal prosecution purposes and goals. The criminal process is not predominant, but any proposed civil enforcement plan must be coordinated with CID in order to protect the criminal case. For example, during the course of an investigation civil Revenue Officers (tax collectors) may not undertake enforced tax collection actions against the taxpayer or enter into any agreement to resolve a civil tax liability.1

The "Rule of Two"

Revenue Agents and Revenue Officers do not commonly travel in pairs. However, Special Agents almost always conduct their interviews in pairs. One of the Special Agents is very likely the chief investigator on the case. The other Special Agent usually serves:

  1. as a witness for purposes of recording statements,
  2. to be available later on to verify the information provided during the interview, and
  3. to attest to the fact that the witness was not threatened or intimidated by the interviewing agent during the course of the interview.

Because Special Agents most often travel in pairs, until recently the common guidance was that, if you are visited by a single agent, the investigation is probably not criminal in nature. The fact that a single agent appeared generally means that the examination was civil in nature, and probably pertained only to the examination and possible assessment of additional tax.

A visit by two agents indicated that the Service was probably investigating the possible commission of a crime, with the purpose of imposing criminal penalties, including incarceration.

For the reasons described in this discussion, taxpayers can no longer rely upon the "Rule of Two" as a general proposition or procedure.

The History of the Parallel Investigation Issue

Prior to 1977, the civil and criminal investigation divisions of the Service freely shared and exchanged information during an investigation or audit of a taxpayer. In the face of expanding Service abuses in this area, case law developed over time that caused the Service to change its practice and procedure.

In 1970, in U.S. v. Kordel,2 the U.S. Supreme Court permitted parallel civil and criminal investigations. The Kordel decision stated that requiring the government to pursue criminal investigations separately from civil examinations would "stultify enforcement of federal law."

The Supreme Court held that using evidence obtained in a civil investigation for subsequent criminal prosecution is permissible where there is no "violation of due process or a departure from proper standards in the administration of justice." The Supreme Court also indicated that there may be specific limitations on that ruling, stating "we do not deal here with a case where the Government has brought a civil action solely to obtain evidence for its criminal prosecution or has failed to advise the defendant in its civil proceeding that it contemplates his criminal prosecution." 3

In 1973, in U.S. v. Robson,4 the defendant cooperated with a civil audit, but was not informed when the Service's focus turned to criminal issues. The Ninth Circuit found no constitutional violation. This was because the Service agent had not affirmatively misled the taxpayer into believing that the investigation was exclusively civil in nature and would not lead to criminal charges.

The Ninth Circuit gave the government great leniency, finding no requirement of affirmative disclosure, stating only that "the IRS agent must not affirmatively mislead the taxpayer into believing that the investigation is exclusively civil in nature and will not lead to criminal charges."5

The climate began to change in 1977 in the Fifth Circuit's Tweel case.6 In Tweel, the Service continued a criminal investigation of a taxpayer after evidence was obtained through the civil examining agent's deception of the taxpayer's representative regarding the true nature of the investigation. Briefly, in Tweel:

  1. The Service had concluded an audit of Tweel's 1958–63 income tax returns. That examination was referred to CID for investigation. The Service subsequently dropped the investigation and the civil case was settled.
  2. The Service subsequently began an audit of the taxpayer's 1966, 1967, and 1968 income tax returns. Tweel's certified public accountant (CPA) contacted the Revenue Agent and asked whether the 1966–68 audit was being coordinated with CID. The Revenue Agent replied that it was not.
  3. In fact, the Revenue Agent was conducting the examination specifically at the request of the Organized Crime and Racketeering Division of the United States Department of Justice (DOJ). While it was true that the Revenue Agent's examination was not linked to a Service investigation, it was a part of a federal criminal investigation.
  4. In fact, the agent knew that the DOJ's criminal division requested the audit, and also knew that the evidence he gathered during the audit would be turned over to the DOJ and could lead to Tweel being prosecuted.
  5. Relying on the Revenue Agent's statement, the CPA provided a large number of documents to the Service. The government used those documents to prosecute and convict Tweel of tax evasion and other charges.

Tweel appealed. The Fifth Circuit reversed and remanded the case, finding that the Revenue Agent intentionally failed to disclose to the CPA or to the taxpayer the criminal nature of the tax examination. The Fifth Circuit found that the Revenue Agent's conduct was a "sneaky and deliberate deception."

The Fifth Circuit also found that the Revenue Agent's conduct violated Tweel's Fourth Amendment Rights as an "unreasonable search." The Fifth Circuit stated that it could not condone the Service's conduct, suppressed the evidence, and ordered the Service to correct its procedures.

As a result of those and other court decisions, the Service adopted procedures directing agents who discovered "firm indications of fraud" or "badges of fraud" during a civil examination to cease the audit and refer the case to CID. From that time forward, danger signs arose if the Revenue Agent conducting the civil audit "disappeared."

For this reason, under the "Rule of Two" discussed above, the continuing presence and involvement of a Revenue Agent has been commonly accepted as an indirect indication that no criminal investigation is in progress. One agent indicated a civil audit or tax collection action, while the presence of two agents (or more) may indicate a criminal investigation. This general rule continued to apply until recently, as discussed below.

Subsequent Case Law Developments

Over time, some courts began to exercise leniency in the treatment of other investigative agencies conducting simultaneous and concealed civil and criminal investigations.

In U.S. v. Stringer,7 the Securities and Exchange Commission (SEC) and DOJ conducted a joint criminal investigation into alleged fraudulent accounting practices. The defendants cooperated with the SEC investigation, unaware that the SEC was coordinating with the DOJ.

The defendant's lawyer specifically asked the SEC agent whether a criminal investigation was underway. Rather than replying directly, the SEC agent merely referred the lawyer to Form 1662, which states that information obtained in a civil investigation may be used in a criminal prosecution. The agent did not mention the fact that the DOJ had considered the filing of a criminal indictment from an early stage in the examination.

The District Court found that the government's actions were "so grossly shocking and so outrageous as to violate the universal sense of justice" and dismissed the criminal case.

The government appealed. The Ninth Circuit reversed the trial court, stating that the government may not affirmatively mislead taxpayers to hide the existence of a criminal investigation. However, the government is under no obligation to inform targets about a criminal investigation so long as the defendants are generally aware that prosecution is a possibility.

The Ninth Circuit found that the SEC made no "affirmative representations," and it did not advise the defendants of the possibility of criminal prosecution. The Ninth Circuit found that it engaged in no tricks to deceive the defendants into believing that the investigation was exclusively civil in nature.

The Ninth Circuit stated that, where a civil examination precedes a criminal investigation, the criminal investigators may help guide the civil examiners to assist in developing evidence for use in the criminal case. Thus, the Stringer case provided a basis for the Service to revise the investigation practices and procedures it had adopted in the wake of the Tweel decision.

Recent Amendments to IRS Procedures

After Stringer and other decisions pertaining to other governmental agencies, the Service has revised its own procedures over time, to the point where tax practitioners and criminal defense lawyers can no longer rely upon the "Rule of Two."

In 2009, and apparently in reliance upon the Ninth Circuit's decision in Stringer, the Service quietly amended its Internal Revenue Manual (IRM) to authorize the use of parallel civil and criminal investigations when fraud is suspected during a civil tax audit.

Under the revised procedures, while criminal investigators are not permitted to "direct the actions" of the civil examiners, they may conduct criminal investigations before, during, and after civil audits of the taxpayer. Moreover, auditing Revenue Agents are instructed to share information gathered in the civil examination with CID.

Since revision in 2009, the IRM provides instructions to agents in areas including the following:

  1. How to commence a parallel investigation
  2. Coordinating investigative tactics
  3. Sharing evidence between civil and criminal agents
  4. How to respond to questions posed by the taxpayer or the taxpayer's representative

The IRM's parallel investigation provisions specifically refer to "revenue officers," but other provisions subject other civil examiners like Revenue Agents and tax compliance officers to the same parallel investigation rules.8 The IRM instructs agents to use parallel investigations for trust fund recovery penalty cases, levies, liens, and summons enforcement proceedings.

The revised Service procedures require the civil agent to inform the criminal Special Agent in advance of all meetings with the taxpayer. While the Special Agent cannot "direct the actions" of the revenue agent, it seems clear that the CID can make suggestions to the Revenue Agent regarding documents to be gathered and questions to be asked, which may otherwise be well beyond the scope of a normal civil audit.

Regular meetings between the civil and criminal agents during the course of the parallel investigation are required.9 The purpose of the regular meetings is to "communicate the case developments and to facilitate information sharing. . . ."10

Meeting participants must include a criminal special agent, the revenue agent, respective group managers, and area counsel and criminal tax attorneys. The civil agent must make the civil audit file accessible to the criminal investigator.11

The Service takes full advantage of recent court decisions that hold that the mere fact that the Service has been "sneaky" is not enough to save the taxpayer. The Service is only prohibited from "affirmatively misleading" the taxpayer.

This standard requires a showing that the Service tricked or deceived the taxpayer into providing evidence that was later used against the taxpayer criminally. Mere concealment of the existence of a parallel criminal investigation during the course of a civil audit is no longer sufficient to cause suppression of evidence in a criminal case.

In the wake of these developments, tax preparers, tax advisers, and taxpayers will do well to modify their application of, and reliance upon, the "Rule of Two." In this environment all taxpayers and taxpayer representatives must act out of an abundance of caution, suspecting and planning for the worst while hoping for the best.

Recent Amendments to the Federal Rules of Evidence

In addition to the recent revisions of the Service's examination and investigation guidelines, the Federal Rules of Evidence (FRE) have been amended in a way that increases the usefulness of parallel investigations. Before 2006, statements made in the course of settlement negotiations, even if made by a taxpayer to a governmental agent or representative, were not admissible into evidence.

The reason for this rule was that public policy should encourage settlement of disputes without litigation. Accordingly, parties attempting to negotiate a settlement should be able to speak freely without fear that their statements made during settlement negotiations would be used against them at trial, should settlement efforts fail. Prior to amendment, FRE 408 stated, in part:

Evidence of (1) offering or promising to furnish, or (2) accepting or offering or promising to accept, a valuable consideration in compromising or attempting to compromise a claim which was disputed as to either validity or amount, is not admissible to prove liability for or in validity of the claim or its amount. Evidence of conduct or statements made in compromise negotiations is likewise not admissible.

This rule of evidence was repealed, effective December 2006. The rule now provides that statements made by a taxpayer in the course of settlement negotiations with governmental agents are specifically admissible in evidence in a criminal case. Accordingly, any concession or admission made by the taxpayer during settlement negotiations regarding a civil tax examination, assessment or liability may now be brought into evidence against the taxpayer in a criminal case.

FRE 408 now provides, in pertinent part:

(a) Prohibited uses. Evidence of the following is not admissible—on behalf of any party—either to prove or disprove the validity or amount of a disputed claim or to impeach by a prior inconsistent statement or a contradiction:

(2) conduct or a statement made during compromise negotiations about the claim— except when offered in a criminal case and when the negotiations related to a claim by a public office in the exercise of its regulatory, investigative, or enforcement authority [emphasis added].

Under the FRE 408, as amended, evidence derived from settlement negotiations between private parties is still not admissible in evidence. However, the Advisory Notes on this rule state:

Where an individual makes a statement in the presence of government agents, its subsequent admission in a criminal case should not be unexpected.

Accordingly, statements made to a revenue agent, revenue officer, appeals officer, or other governmental agent are now admissible in a criminal case, even when made during the course of settlement negotiations. Taxpayer concerns during the course of a civil audit include the possibility that, through inadvertence, the taxpayer may compromise valuable rights without even knowing of the existence of an actual or potential criminal investigation.

Taxpayer concerns also include the following:

  1. Is the taxpayer fully apprised of his/her constitutional rights, and potential effects of either invoking or waiving those constitutional protections?
  2. Is the taxpayer in a position to effect a "knowing" (i.e., fully informed and intentional) waiver of his or her constitutional protections?
  3. Does the taxpayer understand the full scope of the investigation?
  4. Does the taxpayer understand the full nature and scope of potential allegations as to what he or she did?
  5. Does the taxpayer have all of the relevant documents and evidence?
  6. May the taxpayers' statements or cooperation with the Service be used to expand testimony or admissible evidence in future proceedings?
  7. Does the taxpayer possess information that may be valuable or of use to the government in other investigations or prosecutions? If so, should the taxpayer seek immunity or reduction of charges in exchange for cooperation?

Each of these concerns should be carefully considered before the taxpayer takes any action in response to government requests for production of information and documents, especially in instances in which criminal investigation is even a remote possibility.

The New Rules of Thumb

While taxpayers may no longer rely on the "Rule of Two," there are certain precautions that taxpayers should consider in trying to determine whether a taxpayer may be the subject of a parallel civil and criminal investigation. If the Revenue Agent shows disproportionate interest in understanding the circumstances of a specific transaction or activity, rather than merely verifying that the transaction took place and was reported in the income tax return, it may indicate an investigation beyond the scope of the civil examination.

Other indicators may include the following:

  1. The Revenue Agent focuses on the taxpayer's motivations or intent regarding a transaction or activity, rather than just on what happened.
  2. The Revenue Agent focuses on whether the taxpayer knew, understood, or appreciated a specific legal duty or requirement, and the potential consequences of violating that duty or requirement.
  3. The Revenue Agent repeatedly requests to interview the taxpayer.
  4. The Revenue Agent declines to answer whether he or she is conducting a simultaneous parallel investigation under the new IRM provisions.
  5. The Revenue Agent states that any evidence gathered can be shared with CID.
  6. The Revenue Agent requests copies of voluminous records or documents, rather than just reviewing them.

There are certain procedures that a representative can use to attempt to protect the taxpayer, including the following:

  1. Permit the Revenue Agent to review requested documents, but do not provide copies.
  2. Try to resolve the civil matter as quickly as possible, and without extending any applicable statute of limitations periods.
  3. If the Revenue Agent indicates that the Service is not conducting a parallel civil or criminal investigation, document that information in writing.
  4. If in doubt, do not permit the taxpayer to meet directly with the Revenue Agent. The Revenue Agent has no authority to compel the taxpayer's attendance at an interview unless an administrative summons is issued. If a summons is issued and the taxpayer fails to appear, the Service may bring a summons enforcement proceeding in court. At any hearing to enforce the summons, the taxpayer can bring to the attention of the judge the taxpayer's concerns regarding the possibility of a pending or ongoing criminal investigation.

Conclusion

Dealing with the Service is an inherently risky business, regardless of whether the proceedings are civil or criminal in nature. In light of recent developments, taxpayers, their advisers, and representatives can no longer rely on the "Rule of Two." Nor can they rely on the representations of agents.

Only through continuing diligence and review of all indicators provided by the Service may the taxpayer and the representative determine the true nature of, and motivations for, the investigation.

Notes:

1. IRM 5.1.5.2(8), IRS Policy Concerning Parallel Investigations (August 31, 2010).

2. U.S. v. Kordel, 397 U.S. 1 (1970).

3. Id. at 11.

4. 477 F.2d 13 (9th Cir. 1973).

5. Id. at 18.

6. U.S. v. Tweel, 550 F.2d 297 (5th Cir. 1977).

7. 521 F.3d 1189 (9th Cir. 2008).

8. IRM 4.32.2.6.6, Interviews (by examiners in abusive tax shelter examinations) (Sept. 23, 2011) and IRM 25.1.3.2, Preparation of Form 2797 (criminal referral where fraud is suspected) (Dec. 27, 2011).

9. IRM 5.1.5.5(1), Coordination Meetings (Aug. 3, 2009).

10. IRM 5.1.5.5(3), Coordination Meetings (Aug. 3, 2009).

11. See e.g., IRM 5.1.5.8, Information Sharing (Aug. 3, 2009).

As printed, Insights, Willamette University, Autumn 2013

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