When I was a young, fresh-faced criminal defense attorney, there was an aged judge on one of the local benches. Courthouse rumor persisted that this gentleman, whose name I cannot recall, was a finalist to serve as Alf Landon’s running mate in 1936. The judge would occasionally say that his particular fiefdom should be called “County Dumb Court” instead of “County Criminal Court.” While his rhetoric was a bit overblown, at least in my humble opinion, his underlying point was valid. Almost all the defendants who approached the bench were there not because they had done something malicious, but because they had made a poor decision under pressure, misunderstood the law or been trapped on a technicality.

In a way, tax court is much the same. The petitioners are certainly not “dumb” in any way, shape or form. But people are people. Many of us take shortcuts to meet a deadline, do not understand all the nuances of that scroll we call the tax code, or receive a letter that opens with the words “Dear Taxpayer,” closes with something about a “penalty,” and contains a lot of gibberish in between.

At the same time, there is a widely-held belief that serious tax problems only happen to “other” people. And while it is true that the number of examinations is nearly at an all-time low and criminal prosecutions are quite rare, people do get audited and they do go to jail. How can you avoid being one of them?

File and Pay

It’s very simple. The IRS wants your money and not your liberty. Even if the filing deadline has already passed, and even if you’re already receiving letters, submit your return. Nobody likes scofflaws and everybody likes reformed sinners.

The Lauryn Hill episode is an excellent reminder that it’s never too late to pay. Two years ago, the Grammy-award winner faced a minimum 24 months for failing to file returns between 2005 and 2007. She made a restitution agreement almost literally on the courthouse steps, and the judge reduced her sentence to four months. Unfortunately, just a few months after she was released, the IRS filed seven tax liens totaling about $877,000 against the troubled singer. On her Tumblr account, she claimed she was a “victim[] of institutional terror.” Good luck with that defense.

Shadow Audit

If the Service begins rummaging around, be ready to fight back. Retain an independent accountant – preferably a former IRS revenue agent – to review your financial records and look for red flags. If you know what the government is looking for, it will be much easier for you and your attorney to prepare a response.

Cooperate

If the situation progresses, and it almost certainly will, cooperate during the audit and the investigation. Note that “cooperate” is not synonymous with “rolling over and playing dead,” and your attorney can help you understand the difference between the two, because the distinction is very fine.

Be Consistent 

Most people file both federal and state returns, and possibly even returns for a foreign country. If push comes to shove, the IRS has access to all these records. Any inconsistency is simply a nail in your coffin. The same is true for multiple years. If you claimed a huge business loss three or four years in a row, the IRS will almost certainly ask questions.

Be Familiar with the Process

There is a certain rhythm to the audit process, and it’s a very scary beat. It’s much easier to go through this with a good attorney who is also a good advisor.

Upon completion of an examination, the revenue agent may determine that a deficiency exists. A deficiency is defined as the taxpayer’s correct liability, as determined by the IRS, less the amount reported on the return. Assuming there is a deficiency, the revenue agent will prepare a “Revenue Agent Report” (RAR). Included in the RAR will be a cover letter and a settlement agreement.

A taxpayer who disagrees with the revenue agent’s findings may request a conference with the IRS Appeals Division, but must do so within 30 days. It is for this reason that the cover letter is known as a “30-day letter.”

If the taxpayer requests an Appeals conference but the parties do not come to an agreement, or if the taxpayer simply ignores the 30-day letter, the IRS will send the taxpayer a notice of deficiency (i.e., a “90-day letter”).

The notice of deficiency provides the taxpayer with two options: (1) pay the asserted deficiency and follow the refund procedures (thus brining the matter to a close) or (2) petition the tax court to contest the claimed deficiency within 90 days of the date the notice was mailed.

The mailing of the notice of deficiency begins a period during which the IRS is prohibited from assessing tax.

What if the taxpayer does not file his tax court petition in the time provided? In that case, the IRS will make an assessment. Once an assessment is made, it becomes a debt of the taxpayer. If the taxpayer refuses or neglects to pay the tax after notice and demand for payment, the amount of the tax liability becomes a lien on all of the taxpayer’s real and personal property until it is paid.

Let’s talk about what happens if the taxpayer timely files a tax court petition. First, the IRS is prohibited from assessing tax until the tax court’s decision is final. Second, what issues can be raised? The taxpayer can challenge the deficiency claimed by the IRS along with any overpayment that he or she individually claims.

Contrary to popular belief, the IRS is not represented by a revenue agent in tax court. Instead, the IRS is represented by an attorney from IRS Chief Counsel’s Office.

As a rule of thumb, these individuals are more likely to make some concessions to reach an out-of-court settlement than the revenue agents are. First, they are less emotionally invested in the case than the original auditor. Second, their dockets are extremely full, and every case they resolve is one less case they have to try. Third, they are quite familiar with the hazards and costs of litigation, and they factor these variables into their negotiations.

When there is no agreed resolution, the matter proceeds to a bench trial. Only a very small number of cases make it this far, because it is essentially the bottom of a funnel. If the taxpayer loses, he may appeal the resulting decision to the Court of Appeals for the circuit in which he resided at the time he filed the petition.

A Nightmare on Elm Street

However unlikely it might be, there are still times when an audit that starts out innocent enough turns into an indictment. We’ve seen this happen time and time again with respect to public figures, such as Lauryn Hill, Wesley Snipes, and most recently, Mike “The Situation” Sorrentino. There is a good reason why the IRS begins to salivate when they have a Hollywood actor on the ropes.

Because these individuals are constantly in the public eye and are worshipped by a torrent of adoring fans, they are just the type of people that the IRS would love to sink their teeth into. The idea is that they be scorned and ridiculed by their criminal convictions in the same way that Hester Prynne from Nathaniel Hawthorne’s “The Scarlet Letter” was scorned by being forcing to wear a prominent scarlet letter “A” for the rest of her life after being convicted of the crime of adultery (yes, this was actually a crime back in Hawthorne’s day in Salem, Massachusetts (1850)).

In this way, the Department of Justice is able to maximize the deterrent effect of the criminal tax enforcement system by sending a strong message to those who might be thinking about underreporting their income or engaging in some other form of tax “hanky panky”: “Don’t even think about it!” Not surprisingly, press releases of Hollywood stars going down in flames for tax evasion are often timed to coincide with the tax reporting season.

What happens if a similar fate befalls you? Of course, let’s hope it doesn’t happen. But if it does, then take a page out of the survival playbook: stay calm and do not panic. Evidence gathered over centuries of natural disasters reveal that the cause of death is not the disaster itself but instead the panicked reaction to the disaster.

All hope is not lost. There are a number of defenses that can be raised, some more popular than others.

Some of the more common defenses include the following:

• • Unclaimed Deductions: If the taxpayer-defendant offers evidence of offsetting costs, then the government has the burden of persuading the jury that the costs are not allowable.
  • Statute of Limitations: As the civil lawyers like to say, if you miss the SOL, then you’re SOL. Typically, the government has three years to begin a prosecution, but there are so many exceptions, and so much fine print, that it’s not even funny.
  • Willfulness: Basically, the government has to prove that the taxpayer knew the requirement and intentionally violated that requirement. That’s obviously not possible in all cases.

In a future post, we’ll examine these defenses, and other ones as well, in considerable detail. Be sure and tune in tomorrow for the next episode of “As The Stomach Churns.”