In the Emmy award-winning “Regular Show” episode Eggscelent, Mordecai had to eat a 12-egg omelet in under an hour to win a funny-looking trucker hat for his good friend Rigby. Lawyers often face their own eggscelent challenge, but the stakes are quite a bit higher. My colleague Larry A. Campagna, who is a partner at a Houston law firm which represents people accused of financial crimes, introduced the concept of the “eggshell audit” in a series of articles first published in the summer of 2012. His tips for dealing with these situations are every bit as insightful today as they were two and a half years ago.
As a preliminary matter, an eggshell audit is an event at which the client and representative are aware of red flags that may draw the attention of government investigators and lead to possible criminal charges, but said investigators are still in the dark. The pre-investigative audit is something akin to preemptory damage control, as both the client and representative work together to delicately avoid possible criminal sanctions. Eggshell audits are quite common at firms that have any overseas assets or deal in similar transactions.
Getting Ready
First up is the relationship between the lawyer, accountant and client. While the attorney-client privilege means that an attorney does not have to repeat any incriminating statements from the client, and typically does not even have to turn over incriminating documents, accountants are not similarly protected. But frank exchange of information between the client and accountant is essential in any circumstance, particularly an eggshell audit. The answer may be a Kovel Agreement. Essentially, the accountant becomes the lawyer’s subcontractor, and any information that the accountant learns is protected by the attorney-client privilege.
The Kovel Agreement is not a panacea. It is not retroactive and is not applicable to all tax professionals. If you, or your accountant, even catch a fleeting glimpse of a red flag, contact an attorney straightaway. Early legal intervention typically means that more information can be protected under the attorney-client privilege.
The Shadow Audit
In the same way that the practice squad on an NFL team is charged with mimicking next week’s opponents to get the team ready, the shadow audit has the lawyer and accountant temporarily don black hats and assume the guise of IRS investigators. These professionals will be looking for illegal activity, and your accountant and lawyer should do the same thing. This activity may lead to some rather uncomfortable conversations, but it is the only way to identify potential problem areas before the government finds them.
The shadow audit should obviously include tax returns, bank statements, P&L reports and other documents. If the client has ever filed bankruptcy, review the schedules with a magnifying glass. The exercise should also include an interview with the tax preparer, in-house accountant and all other financial professionals. The attorney-client privilege applies, so encourage people to bare their souls, at least in terms of the company’s dollars and cents.
The worst thing that can happen is that the attorney discovers something illegal, and it’s much better for your lawyer to find it than for the government auditor to gleefully announce “look what I found.”
The Big Day
After all the background work is complete, it’s time to take a deep breath and ask the government auditor to examine the books. Understand that there are certain things that the revenue agent can and cannot do. For about the last thirty years, United States v Tweel has set limits on revenue agents. The thumbnail version is that they can do almost anything short of intentionally make misleading statements. Once auditors discover a “firm indication of fraud,” they are instructed to suspend the civil audit in favor of a criminal investigation.
If the field auditor finds indication of fraud, the files are forwarded to a manager for an initial evaluation and then to the criminal section of the IRS. In other words, fraud does not necessarily mean a criminal indictment. The attorney can still do damage control before the U.S. Attorney becomes involved.
Remember the entire point of this exercise is to minimize potential criminal liability. If there are some civil fines or penalties, so be it. If there is no indictment, the process has been a success.