REASONABLE CAUSE REALLY EXISTS FOR PENALTY ABATEMENT
By Larry Jones
For several years the taxpayer had been a limited partner in two partnerships. His partnership interest were redeemed in 1996. In prior years the partnerships had generated large losses. Thus">
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REASONABLE CAUSE REALLY EXISTS FOR PENALTY ABATEMENT
By Larry Jones
For several years the taxpayer had been a limited partner in two partnerships. His partnership interest were redeemed in 1996. In prior years the partnerships had generated large losses. Thus, in 1996 the taxpayer was required to recapture earlier losses from the partnerships which resulted in a taxable long-term capital gain. Broker v. United States, __ F. Supp.__ (E.D. Pa., Oct. 26, 2000).
Shortly after his partnership interests were redeemed, and the taxpayer learned that he would incur a gain from one of the partnerships, the taxpayer asked his CPA to estimate his income tax liability and advise as to whether he needed to pay estimated income taxes to the IRS for 1996. The CPA advised the taxpayer that his credit carry forwards and loss carry forwards would offset the recapture income. The taxpayer relied on the advice of the CPA and did not think he had to pay estimated taxes.
In 1996, before learning of the recapture events, the taxpayer sold all of his securities which were marketable and withdrew $234,000 from his Individual Retirement Account ("IRA") to pay for living expenses and obligations. In addition, prior to learning of the recapture events, the taxpayer (who had separated from his wife in 1996 and divorced in 1997) and his soon-to-be wife purchased a new home in 1996 for $585,000 and committed to refurbishing and furnishing their new home. The taxpayer withdrew another $244,288 from his IRA prior to October 1997, to pay living expenses and obligations.
Upon the filing of his 1996 tax return, the taxpayer had total tax liability of $1,150,883, and an unpaid tax liability (after withholding credits of $64,756) of $1,086,127. Taxpayer did not remit any payment with his 1996 tax return. The IRS assessed penalties.
Taxpayer had no liquid assets left in October 1997, other than the balance of money in his IRA, and was unable to pay the tax due for the tax year 1996. The balance in the taxpayer's IRA after the distribution in 1997 was $345,000.34. Taxpayer planned to borrow $1,000,000 from a bank and, if he had no other source, he planned to liquidate his IRA to pay the balance of the tax liability and interest. The taxpayer applied for a loan from a bank, but the loan from the bank was delayed based on certain conditions the bank placed on the loan. On June 25, 1998, taxpayer closed on the loan from the bank in the amount of $1,000,000.43. The following day, on June 26, 1998, taxpayer paid the tax due of $1,086,127.
The Internal Revenue Code imposes a mandatory penalty for the failure to pay taxes when due unless the taxpayer can show that such failure was due to "reasonable cause" and not due to "willful neglect." Section 6651(a)(2). Neither "willful neglect" nor "reasonable cause" is defined in the Internal Revenue Code; however, the Supreme Court has defined "willful neglect" (as that term is used in current context) as a "conscious, intentional failure or reckless indifference." United States v. Boyle, 469 U.S. 241 (1985)
The definition of "reasonable cause" (as it relates to a taxpayer's failure to pay) is found in Treasury Regulation Section 301.6651-1(c)(1), which provides:
A failure to pay will be considered to be due to reasonable cause to the extent that the taxpayer has made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless either unable to pay the tax or would suffer an undue hardship (as described in §§ 1.6161-1(b) of this chapter) if he paid on the due date. In determining whether the taxpayer was unable to pay the tax in spite of the exercise of ordinary business care and prudence in providing for payment of his tax liability, consideration will be given to all the facts and circumstances of the taxpayer's financial situation, including the amount and nature of the taxpayer's expenditures in light of the income (or other amounts) he could, at the time of such expenditures, reasonably expect to receive prior to the date prescribed for the payment of the tax. Thus, for example, a taxpayer who incurs lavish or extravagant living expenses in an amount such that the remainder of his assets and anticipated income will be insufficient to pay his tax, has not exercised ordinary business care and prudence in providing for the payment of his tax liability. Further, a taxpayer who invests funds in speculative or illiquid assets has not exercised ordinary business care and prudence in providing for the payment of his tax liability unless, at the time of the investment, the remainder of the taxpayer's assets and estimated income will be sufficient to pay his tax or it can be reasonably foreseen that the speculative or illiquid investment made by the taxpayer can be utilized (by sale or as security for a loan) to realize sufficient funds to satisfy the tax liability. A taxpayer will be considered to have exercised ordinary business care and prudence if he made reasonable efforts to conserve sufficient assets in marketable form to satisfy his tax liability and nevertheless was unable to pay all or a portion of the tax when it became due.
In this case the Court found that taxpayer's failure to pay his taxes for the tax year 1996 was due to reasonable cause and not due to willful neglect.
The court found that the taxpayer's actions with respect to the payment of the tax due was not conscious, and did not constitute intentional failure or reckless indifference; rather, the evidence shows that once he discovered he owed the tax, the taxpayer made great efforts to procure sufficient funds to pay the tax.
The Court determined that the following constituted reasonable cause for the failure to pay the tax due in 1996:
(1) Taxpayer's reliance on the advice of his accountant that he would owe no federal income tax for 1996;
(2) Taxpayer's decision not to pay any estimated taxes based on the CPA's advice; and
(3) In view of the CPA's advice and taxpayer's understanding that he would not owe any federal income tax with the filing of plaintiffs' 1996 income tax return, taxpayer's sale of his marketable securities, and withdrawal from his IRA for living expenses and to purchase and refurbish a new home with his soon-to-be wife before his learning of his tax liability.
The Court concluded that the taxpayer made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless unable to pay the tax or would suffer an undue hardship. The taxpayer demonstrated that he promptly sought to secure a $1,000,000 loan from the bank upon discovering his tax liability, and then subsequently made diligent efforts to satisfy the requirements set forth by the bank in obtaining that loan. The Court also determined that the circumstances which led to the delay in obtaining the loan were beyond taxpayer's control and that his efforts to procure sufficient assets and monies to satisfy his tax liability were reasonable.
Obviously, the facts in this case were favorable to the taxpayer. But what this case demonstrates is that in requesting penalty abatement a full development of the facts is necessary prior to requesting the abatement.
Taxpayer Rights in Criminal Investigations
by John A. TownsendTax practitioners representing taxpayers in civil tax audits should be concerned about the criminal potential in the audits. Most civil audits have no practical criminal potential. However, some civil audits do have criminal potential. It is often hard to distinguish between the two because practitioners often do not have all of the facts or the experience to assess the relevance of the facts to the criminal potential. In audits where there is criminal potential, the good practitioner can sometimes save the day and the incautious practitioner can do great damage.
Let's look at one facet of the problem highlighted by a recent case. First, I set forth the background. Most practitioners know that a civil audit can turn into a criminal investigation. Civil audits are conducted by revenue agents; IRS criminal investigations are conducted by Special Agents. The presence of a Special Agent will alert all but the most inexperienced practitioners that a civil investigation has turned criminal. Does that mean that, so long as the revenue agent is conducting the investigation without a sign of a Special Agent, the case is a civil audit and not a criminal investigation? Maybe -- maybe not.
The conventional wisdom among practitioners is that continued activity by a revenue agent means that the IRS has not yet spotted the criminal potential in a case, for otherwise the continued activity would be by a Special Agent. Let's take a closer look at this conventional wisdom. The IRM provides that, when a revenue agent has a firm indication of fraud, the revenue agent should cease the development of the audit and refer the case to the IRS's Criminal Investigation Division (referred to as "CI" or "CID"). IRM par. 104.2.2.1; 104.2.3, 104.6.8.5, 9311.85, 9322.1. Thereafter, the investigation will be handled by the Special Agent until it is either declined and returned for completion of the civil audit or referred to the Department of Justice Tax Division. The IRM further requires that, if a Special Agent interviews the target of the investigation (who I shall refer to here as "taxpayer," although targets of criminal investigations may also be others, such as practitioners), the Special Agent must commence the interview by advising the taxpayer that the Special Agent investigates tax crimes and that the taxpayer has certain constitutional rights (right to remain silent and its corollary that statements may be used against him and right to counsel). IRM 9781 300(3)(12)0 Exhibit 300-1 Form 1180 (4-1-87). In the IRM, this process of reading the taxpayer rights is referred to as "Constitutional Advice" or "constitutional rights." E.g., IRM 9.5.8.1.4 Exhibit 8-1. The card setting forth the rights which the Special Agents read to the taxpayer is called the "advice of rights" card. E.g., IRM 9.6.1.4. The IRM further warns: "Department of Justice policy is to decline any case where the special agent * * * failed to properly identify himself/herself, describe his/her function, or fail to give proper advice of rights to the taxpayer on the special agent's first contact." IRM 9783 336 Exhibit 300-1 Subject Investigative Analysis Guide (Form 3714) (5-3-83).
The rights read by the Special Agent are a modified Miranda warning, based upon but not the same as the warning required by the Supreme Court in Miranda v. Arizona, 384 U.S. 436 (1966). Even if you are not a lawyer with a criminal procedure background, you have undoubtedly been exposed in the movies or the press to the process whereby incident to an arrest a target of a criminal investigation is read his or her rights. The requirement to do so was established in Miranda where the Supreme Court held that, when law enforcement officers interrogate a target of a criminal investigation who is "in custody or otherwise deprived of his freedom of action in any significant way," the law enforcement officer must provide the warning to protect the target's constitutional rights (the Fourth Amendment right to unreasonable searches and seizures, the Fifth Amendment right to not incriminate oneself and to due process, and the Sixth Amendment right to counsel). Usually, interrogations requiring the Miranda warning occur after the target of the investigation has been arrested or has been detained by the law enforcement officer in some significant way. Failing to give the Miranda warning will result in suppression of any inculpatory statements the target may make in the interrogation and fruits of those statements.
The issue in criminal tax investigations has been the relevance of Miranda because interrogations of a target in a criminal tax investigation are almost always in a noncustodial setting. In a criminal setting, the first hint the taxpayer may have that an audit has turned criminal is when the Special Agent shows up unexpectedly at the taxpayer's office or home. The taxpayer is not under arrest nor threatened with arrest if he or she doesn't cooperate. So the threshold issue is whether this Special Agent interrogation involves some type of coercion of the type concerning the Court in Miranda so that some Miranda-type warning or reading of rights may be required. There is no question that the IRM requires that such rights be read to the taxpayer and, I think, that the sensitivity requiring the reading of rights is a similar constitutional sensitivity as in Miranda in a custodial setting. Those rights are that the taxpayer has the right to remain silent and to obtain a lawyer, and that the taxpayer's statements may be used against him in a criminal trial. There is no question that the taxpayer – just as any other potential target of a criminal interrogation – always has those rights. If he or she is aware of those rights and otherwise not subject to intimidation or coercions, he or she can exercise the rights. But, Miranda recognizes that targets of investigations may not always be aware of their constitutional rights or, if they are able, to waive them knowingly and voluntarily in a setting involving some form of coercion or intimidation. The question is whether this modified Miranda warning or some similar warning is required in a noncustodial interrogation an IRS criminal investigation. We have noted that the Department of Justice ("DOJ") allegedly will not prosecute if the Special Agent does not give the warning. Is that policy an exercise of prosecutorial discretion, or is it a constitutional mandate based upon the same considerations as Miranda except extended to a noncustodial IRS investigation?
You will note that I mentioned above two IRM requirements – (1) that the Special Agent give the modified Miranda warning and (2) that the revenue agent conducting the civil investigation refer the case to CI upon a firm indication of fraud. Think of these two in context. The requirement for referral to CI is a protective measure for requirement that a taxpayer be read his rights, because once there is a firm indication of fraud the investigation is really a criminal investigation and, assuming a proper referral, the Special Agent will commence a taxpayer interview with the modified Miranda warning. So the real crux of the issue is whether, in an IRS criminal investigation (either conducted by the Special Agent after referral or the revenue agent before referral but after a firm indication of fraud), the taxpayer must be given some type of Miranda warning – specifically the modified Miranda warning required by the IRM?
Logically, it would seem, if the Special Agent is required to give the warning after the case is referred because of a firm indication of fraud, the revenue agent who fails to refer the case after a firm indication of fraud and conducts a taxpayer interrogation must give the warning. Otherwise, as you can see, there would be a premium upon violating the requirement that the case be referred upon a firm indication of fraud. But this simply asks the question of whether the Special Agent would be required to give the warning, for if the Special Agent would not be required to give the warning, the revenue agent should not be required to give the warning. And, also logically, statements obtained by either the Special Agent or the revenue agent after a firm indication of fraud and the failure to give the warning would be admissible in a criminal trial. So let's look first at the issue of whether the Special Agent would be required to give the warning.
The Supreme Court has never specifically addressed that issue. In Beckwith v. United States, 425 U.S. 341 (1976), the Special Agent interviewed the taxpayer in a noncustodial setting and gave the modified Miranda warning required by the IRM. The issue was whether the modified Miranda warning was not enough and the evidence should be suppressed because the Special Agent did not give the full warning required in Miranda. The Court held that the Special Agent was not required to give full blown Miranda warning. Justice Marshall wrote a separate concurring opinion solely to make the point that, if the modified Miranda warning had not been given, he would not have joined the opinion of the Court. Justice Brennan dissented, urging that the IRS investigation was psychologically as coercive as a custodial interrogation ("peas from the same pod").
The majority opinion focused the issue in the following concluding statement (case citations omitted for readability):
We recognize, of course, that noncustodial interrogation might possibly in some situations, by virtue of some special circumstances, be characterized as one where "the behavior of... law enforcement officials was such as to overbear petitioner's will to resist and bring about confessions not freely self-determined...." When such a claim is raised, it is the duty of an appellate court, including this Court, "to examine the entire record and make an independent determination of the ultimate issue of voluntariness." Proof that some kind of warnings were given or that none were given would be relevant evidence only on the issue of whether the questioning was in fact coercive. In the present case, however, as Chief Judge Bazelon noted, "[t]he entire interview was free of coercion."
The key point, of course, is that the Court did not say or suggest that no warning was required in an IRS noncustodial interrogation; all it held was that, in a case where the modified Miranda warning was given by the IRS in a noncustodial setting, no further warning was required. It is true, of course, that the majority did not specifically state that the modified Miranda warning was required in an IRS noncustodial interrogation, for that was not the issue before it. Nevertheless, given Justice Marshall's concurring opinion where he did state that requirement as a basis for saying something he perceived to be different from the majority, it appears that the majority was at least offered the option to so adopt that position and chose not to, referring instead to a facts and circumstances test as to whether there was any coercion of the type implicating the constitutional values addressed in Miranda.
With regard to the Beckwith Court's reliance on a facts and circumstances test as being one that can vindicate the constitutional values, I note that the Supreme Court recently rejected just such a test in Dickerson v. United States, ___ U.S. ___ (2000). Following Miranda, Congress was not happy with the Miranda blanket rule requiring suppression as a penalty for not advising the target of an investigation of his or her rights. Congress enacted a statute that permitted suppression only if the interrogation was in fact coercive. This statute required a facts and circumstances inquiry. Miranda, by contrast, adopted a bright line rule – either give the warning or the statements and fruits thereof would be suppressed. In Dickerson, the Supreme Court held that Miranda was based upon imperatives to protect constitutional rights and was not based upon the courts' power simply to regulate the conduct of cases before it. As a constitutional imperative, the rule was not subject to change by the Congress. In essence, the prophylactic effect of requiring the Miranda warning in all cases requires that failure to give the warning result in suppression in all cases where the warning is not given. Although not articulated as such, in essence the Court was saying that the benefits to be derived from the blanket rule founded on important constitutional values were just too important to justify the mischief to which a facts and circumstances test might lead. (In this regard, the Court noted that there might be compulsion even where such Miranda warning is given, but that would be the rare case; what it foreclosed was a case-by-case inquiry into voluntariness where the warning is not given.)
Obviously, this same imperative for a bright line test to protect constitutional rights is important in criminal tax investigations, although the setting is quite different from ordinary criminal investigations. Let's address some of these differences just briefly. In tax investigations, the IRS agents (civil and criminal) have coercive power to compel the witness to testify via the summons power, although the witness may invoke his Fifth Amendment privilege. Further, through the civil tax adjustments which might be coupled with severe civil penalties, and through lien and levy powers, the IRS has a range of potentially coercive powers it may take against the taxpayer in order to compel – or give an incentive for – cooperation with the IRS. In the ordinary criminal case (such as bank robbery, drug dealing, etc.), the law enforcement officers have no such dual civil role and coercive powers and are instead limited to either (1) arresting or otherwise confining the target and interrogating him in a setting where Miranda is required or (2) asking him please to cooperate without any real collateral coercive powers or incentives of the type available in IRS investigations. It is for that reason that the IRS itself must have thought some Miranda like values were implicated in its criminal investigations, for it adopted a bright line test – i.e., when the case has turned criminal via a firm indication of fraud requiring that the case be referred to CI, Special Agents will give the modified Miranda warning when they interview the taxpayer in a noncustodial setting. In other words, the IRS itself drew the line based upon the Miranda concerns applied to an IRS criminal investigation setting.
And, just to repeat the logical loop between the Special Agent interrogation and the revenue agent interrogation after a firm indication of fraud, you can immediately spot the problem. If the same rule (warning or suppression) does not apply to a revenue agent interrogation after a firm indication of fraud, there will be a premium for a revenue agent to conduct that interrogation after a firm indication of fraud rather than refer the case to CI whose Special Agent must give the warning as the first item of business upon interrogating the taxpayer. The rule requiring referral upon the firm indication of fraud is simply a corollary to the rule that the Special Agent must give the modified Miranda warning at the inception of a taxpayer interrogation.
Now, lets turn to the recent case. In United States v. Kontny, ___ F.3d ___ (7th Cir. 2001), the taxpayer implemented a wage scheme for its employees whereby the wages for overtime were not reported as taxable income (the benefit to the employees because payroll taxes were not withheld) and the taxpayer did not pay overtime at 1.5 times compensation (the benefit to the taxpayer). One of the workers informed an IRS Special Agent. The Special Agent apparently was not then interested based on the information supplied and turned the matter over to the civil audit division of the IRS rather than pursuing a criminal investigation. (Just for context, although not detailed in the court's opinion, IRS Special Agents are informed often of alleged or potential fraud but, unless the informant lays out a compelling criminal case at the beginning (most unlikely), the matter will usually be referred for civil examination; most of these cases simply do not ultimately have criminal investigation potential and will be disposed of civilly.) The civil examination in Kontny then began. The civil agent initially represented to the taxpayers that the audit was simply a civil audit. The civil agent interviewed employees and, as the court stated:
concluded that despite their disgruntlement over the labor dispute, they might well be telling the truth. In that event the Kontnys had committed a fraud; and tax fraud is criminal, though more often handled on a civil than on a criminal basis.
The civil agent then requested an interview with the taxpayers (husband and wife). They agreed. At the interview, the civil agent advised that he was investigating their failure to withhold payroll taxes on the overtime payments. One of the taxpayers asked whether they needed an attorney, and the civil agent "replied that this was 'a civil exam' and it was up to [the taxpayer] to decide whether [the taxpayer] needed to have a lawyer present." He added, however, that, if he [the revenue agent] did discover fraud, he would refer the case to CI. The taxpayers then made inculpatory statements in that interview and a follow-up telephone call. The civil agent did not have a firm indication of fraud until the follow-up call, at which time he referred the case to CI.
The Court (through Judge Posner, one of the country's leading judges, writing for the panel) concluded that there was no basis for suppressing the statements in the interview and telephone call. The Court said that confessions could only be suppressed if involuntarily obtained by threats or promises. The Court said summarily, without explanation, that "The Miranda rule is not in play here since the interrogation * * * was not custodial," citing Beckwith. The Court further noted, however:
Virtually all cases involving coerced confessions involve the questioning of a suspect who is in police custody, an inherently intimidating situation in which people find it difficult to stand up for their rights or even to think straight. The situation is different when a person who does not even know that he is a criminal suspect (that is a premise of the [taxpayer's] appeal) is being interviewed in his home, and by a civil rather than a criminal investigator to boot. [The civil agent] was unarmed, un-uniformed, unaccompanied. The [taxpayers] were at no disadvantage in dealing with him. They were under no pressure to answer his questions. Any answers they gave were voluntary.
Similarly, the Court rejected the taxpayers' argument that their cooperation was really obtained by trickery or deceit – the false representation of the audit as one civil rather than criminal in focus. The Court reasoned that law enforcement officers frequently use trickery and deceit to obtain confessions or incriminating information – e.g., sting operations, statements that colleagues in crime have confessed when they have not, etc. Indeed, the latter genre of misrepresentations are allowed even in custodial situations. With these analogs, the Court held (citations omitted for readability):
So even if [the revenue agent] was pretending to be conducting a civil investigation but was really, as the appeal argues, conducting a criminal one, this would not, under the rules that govern the admissibility of incriminating statements (written or oral) made to government officers even by a suspect who is in custody, make the statements inadmissible. The circumstances did not remotely prevent the [taxpayers] from making a rational decision about whether to play ball with [the revenue agent]. We might have a more difficult case had [the civil agent] gone further and promised the [taxpayers] they would not be prosecuted if they played ball with him, for that conceivably is the kind of false promise that might induce a rational person to rely. [The civil agent] did not do that. On the contrary, he as much as warned the [taxpayers] that any evidence they provided of fraud would lead to a criminal investigation. As we have said, he didn't have to go further and give them Miranda warnings.
Judge Posner seems to sanction even express misrepresentations about the nature of an investigation. In a leading case, the Fifth Circuit much earlier had held that the taxpayer's reliance upon a revenue agent's misrepresentation as to the nature of the examination (specifically whether it had a criminal focus) would result in suppression. United States v. Tweel, 550 F.2d 297 (5th Cir. 1977). Judge Posner distinguished Tweel on the basis that it had been decided before the Supreme Court's decision in United States v. Caceres, 440 U.S. 741 (1979), which had held that IRM requirements are general internal procedural rules that grant no affirmative rights to taxpayers. Hence, Judge Posner held that the IRM requirement that the case be referred upon a firm indication of fraud simply conferred no rights on the taxpayer and thus it was OK for the agent to lie about the nature of the audit which had been the problem in Tweel.
Similarly, Judge Posner rejected the argument that the taxpayer had relied upon the IRM requirement that the case would be transferred to CI upon discovery of a firm indication of fraud. The taxpayers gave no proof that they were even aware of the IRM requirement, much less that they relied upon it. Further, there was no allegation of a level of other deceit implicating constitutional concerns. The Court concluded:
A failure to terminate a civil investigation when the revenue agent has obtained firm indications of fraud does not without more establish the inadmissibility of evidence obtained by him in continuing to pursue the investigation. There is nothing more here.
In so holding, Judge Posner rejected the dicta in cases such as United States v. McKee, 192 F.3d 535 (6th Cir. 1999). In McKee, while holding that the agent did not have a firm indication of fraud, the Court did address the issue as follows: "We are satisfied that the Manual's rule, requiring suspension of a civil investigation once the revenue agent has a 'firm indication of fraud,' is the type of rule that is designed to protect the taxpayer's constitutional rights."
I have several concerns about the Kontny decision:
First, and most importantly, Judge Posner fails to grasp the nuances of the IRS noncustodial interview incident to a civil tax audit. In a civil tax audit, the IRS has various weapons easily deployed to encourage cooperation and thus the situation is different from the policeman simply questioning someone on the street that he has not arrested. Short of the arrest or threat of arrest (i.e., the custody or similar setting), the policeman has no effective power over the life or welfare of the interviewee. By contrast, the IRS whose civil agent is conducting the interview has a broad range of incentives or coercions or intimidations to induce cooperation of the taxpayer and to induce an environment that the taxpayer may feel he or she has to cooperate. In this setting, the taxpayer may not even know that he has constitutional rights he or she could invoke and certainly could feel intimidated into waiving the rights. Indeed, it is for that reason that, based on Miranda, the IRS adopted the requirement for modified Miranda warning in the first place – to insure that the taxpayer knew his or her rights and waived them voluntarily. The IRS itself drew the line. The Court never asks nor answers the question of why the IRS would have such a requirement in the IRM if the IRS had not thought they were constitutionally based.
Second, Judge Posner treats the IRM requirement for referral upon a firm indication of fraud as being somehow separate from the requirement that the Special Agent give the modified Miranda warning. As I have reasoned above, the two requirements work in tandem, for together they insure (when honored) that, after a firm indication of fraud at which time the audit has a criminal focus, the taxpayer will receive the modified Miranda warning. If, instead, the civil agent having a firm indication of fraud undertakes a taxpayer interview, the taxpayer will not receive the modified Miranda warning and his constitutional rights will be compromised.
Third, Judge Posner's reasoning means most critically that even Special Agents are not constitutionally required to give the modified Miranda warnings in a noncustodial setting – required in the sense that the taxpayer will have a remedy for violation of the requirement. Special Agents can lie and misrepresent to their hearts content to trick, intimidate, coerce or otherwise influence the taxpayer into cooperating and, better still, confessing, so long as they simply do so without arresting the taxpayer.
Finally, Judge Posner's sweeping statements illustrate much of the dangers of dicta. The facts recited by Judge Posner show that the agent did not have a firm indication of fraud, hence the essential factual predicate to arguing that constitutional values were implicated was missing. Yet, Judge Posner went beyond the facts to announce a sweeping rule that no warning is required in any event and it is wholly acceptable for revenue agents – and by extension, Special Agents – to lie to taxpayers about what they are up to. Moreover, had Judge Posner paid more careful attention to the facts, he would have seen that the civil agent did come fairly close to giving the modified Miranda warning. The civil agent did tell the taxpayers that they could engage an attorney to represent them and that the information they disclosed could result in a criminal referral. He may not have used the precise words "used against them" but he came close and I am not sure lay persons would have thought that the concepts were different. To leap from these facts where the equivalent of the some of the critical warning was given to the sweeping holding that no Miranda warning – modified or otherwise – is required in IRS noncustodial criminal investigations is a stretch indeed.
What are the implications of Kontny? As noted, the holding would apparently mean that there is no requirement that IRS Special Agents give the modified Miranda warning and are licensed by the courts to lie and mislead taxpayers. That just can't [or ought not] be the law. But, a noted jurist – Judge Posner of the 7th Circuit – has held that it is the law. (In this regard, Judge Posner's decision had been preceded by a similar opinion by 7th Circuit Judge Easterbrook, also a respected jurist, expressed in a concurring opinion in United States v. Peters, 153 F.3d 445 (1998), so at least 4 judges in the 7th Circuit agree with the analysis.)
What are some protective measures practitioners representing taxpayers can take? If Judge Posner and his ilk are correct in the sweeping propositions that there is no remedy for lies and misrepresentations by IRS agents to taxpayers and no requirement for the modified Miranda warning in any noncustodial IRS interrogation, the only practical remedy may be for taxpayers and their practitioners simply never to cooperate with the IRS in any setting where there is even the slightest possibility of the investigation turning criminal. That would be virtually every audit, unless the practitioner has conducted a fraud potential audit prior to undertaking the civil audit representation. In the past, Tweel taught (and still teaches in the Fifth Circuit, at least until reversed by the Supreme Court or the Fifth Circuit en banc) that affirmative misrepresentations about the criminal focus of the investigation could result in suppression. However, even practitioners in the Fifth Circuit should not rely upon this rule because, as noted, it can be reversed.
This noncooperation stance raises a number of practice issues. Does the practitioner adopt this stance only in cases where the practitioner perceives some criminal potential in the audit? Would noncooperation be a signal to the revenue agent that there is some criminal potential that he or she then must investigate? Should the practitioner adopt the noncooperation policy in all cases, whether there is criminal potential or not? This approach may hurt innocent clients with no criminal potential where cooperation may be in their best interests. But often the practitioner may not have perfect knowledge about the client's situation and thus cannot exclude the possibility that the investigation might turn criminal. Obviously, the practitioner should discuss the matter in some detail with each client and tell him or her the advantages and disadvantages of these strategic choices. At a minimum, discussing the matter with the client on the front-end may help flesh out early on whether the case has some criminal potential. If there is criminal potential in the case, your whole approach in representing the client will be powerfully influenced.
In all events, Judge Posner's analysis requires that the competent practitioner adopt some level of noncooperation that would not be mandated if the practitioner could rely upon the IRM requirements that the case be referred upon a firm indication of fraud and that the Special Agent interview begin with a reading of the taxpayer's rights. I question whether systemically that is a good thing for the IRS or its taxpayers/citizens. I think that, rather, the opinion in McKee is closer to the mark that our constitutional values mandate. It must be the courts that stand as the guardians of those values, for ultimately law enforcement will respond only as it feels it will be required to respond. I hope that Judge Posner sweeping dicta in Kontny will be rejected.
Postscript:
Subsequent to Kontny, a different panel of the Seventh Circuit (although each panel contained one common judge, Judge Evans) decided United States v. Utecht which involved a related issue. The issue in Kontny was whether the IRS had delayed the discontinuance of the civil investigation and referral to CI, thus potentially misleading the taxpayer in order to obtain cooperation and admissions the IRS could not have otherwise obtained. The issue in Utecht was whether the IRS had improperly used the IRS summons power after it had institutionally determined to recommend prosecution of the taxpayer, so that its further investigation was solely criminal in focus.
The background for the issue addressed in Utecht was the Supreme Court's decision in United States v. LaSalle Nat'l Bank, 437 U.S. 298 (1978). In LaSalle, the Supreme Court held that § 7602 did not authorize the IRS to issue a summons in an investigation which was solely criminal in nature. LaSalle offered fertile ground for taxpayers to fight distracting battles in the investigation process and in prosecution, if one ensued, over the IRS's alleged abuse of the summons power. Accordingly, Congress enacted § 7602(b) which provides that the summons may be used for "the purpose of inquiring into any offense connected with the administration or enforcement of the internal revenue laws" and § 7602(d) which provides that the IRS summons may not be used when there is a "Justice Department referral" ("DOJ referral") is in effect. Procedurally, the DOJ referral is made by IRS CI after it has completed its criminal investigation and recommended, in the referral, that the taxpayer be either prosecuted or that there be further investigation by the grand jury. Some had thought that these amendments foreclosed the LaSalle issue, but that was not definitively decided. See United States v. Michaud, 907 F.2d 750, 752 n.2 (7th Cir. 1990) (en banc) (discussing views on whether a LaSalle-type inquiry survives these amendments, but declining to resolve issue); United States v. Berg, 20 F.3d 304, 309 n. 6 (7th Cir. 1994) (taxpayer "correctly notes that the Service cannot use its summons authority if its only purpose is to gather evidence for a criminal investigation, (i.e. if it has no civil purpose whatsoever and [it] has abandoned any institutional pursuit of civil tax determination," but citing only Michaud which did not resolve the issue) [Internal quotations omitted for clarity].
In Utecht, the taxpayer sought suppression of evidence, arguing that during the IRS investigative phase (prior to the DOJ referral) "the IRS circumvented his constitutional rights by using civil summonses" because the investigation had a criminal focus. The Court started its reasoning by acknowledging some validity to the general argument that the use of an IRS summons when the investigation has turned criminal could constitute a constitutionally impermissible involuntary seizure requiring exclusion of the evidence if the summons were issued without probable cause. The Court concluded: "the government's use of civil subpoenas (or other kinds of administrative measures that do not require probable cause) principally to further a criminal investigation could undermine the Fourth Amendment's probable cause requirement." The Court cited prominently Abel v. United States, 362 U.S. 217 (1960), which, it said, "contemplates applying the exclusionary rule to evidence obtained through the bad faith use of administrative warrants (which includes the IRS's civil summonses)." Bad faith for this purpose exists "if 'the decision to proceed administratively . . . was influenced by, and was carried out for, a purpose of amassing evidence in the prosecution for crime.'" (citing Able). The Court thus concluded that "if the IRS uses civil subpoenas without establishing the probable cause necessary for criminal cases after having made an institutional commitment to recommend prosecution of the defendant, evidence obtained through these subpoenas possibly could be suppressed at a criminal trial." The Court then rejected the taxpayer's LaSalle/Able argument because, it held, the taxpayer had not made a predicate prima facie showing sufficient to put the issue in play. In so doing, the Court said that the taxpayer's only predicate showing was that the IRS had deferred action on the civil tax liability while the criminal investigation proceeded and that that was not sufficient. (The Court's cryptic paragraph dismissing the force of this argument is so obtuse, that I shall not even attempt to explain it; it seems to me that the fact does show the primacy of the criminal investigation over the civil investigation and is thus quite probative of the type of purpose that would require probable cause.)
The key point of Utecht is that, by suggesting that the LaSalle issue implicates constitutional concerns, the Court seems to suggest that the carefully crafted dividing line – the DOJ referral – in § 7602(b) & (d) does not solve the problem (i.e., a statute cannot solve a constitutional infirmity). True, the Utecht court does not even cite § 7602(b) & (d), so that issue may not have been joined. But the Court was clear in its suggestion (arguably dicta) based on Able that constitutional guarantees were implicated. Hence, constitutionally the LaSalle/Able arguments are alive and well, at least in the Seventh Circuit.
Moreover, even if one were to assume that § 7602(b) & (d) does mean something, it is clear that the plain meaning of the statute is that the civil summons cannot be used while a DOJ referral is in effect. (I think everyone thought that was the case even before and after LaSalle) That does not answer the more subtle issue in LaSalle (that the Seventh Circuit also found in Able) that a DOJ referral can be unreasonably delayed so as to continue an IRS criminal investigation – and use of the summons – where it would otherwise be statutorily denied.. That issue also is live and well because the plain language of the statute simply does not address that type of abuse which, if the DOJ referral dividing line is to be meaningful, must be policed by the courts.IRS Reads Newspapers As Audit Initiation Technique
The New York Times reported on 3/20/01 that the IRS is using news reports of judgments and settlements in large litigation cases to begin an inquiry the persons receiving recoveries are properly reporting the recoveries. The IRS says that the project so far has netted over $43 million in taxes and penalties. The persons receiving the recoveries were taking the return reporting position that their recoveries were excludable personal injury damages under section 104. Those who have watched the developments in the law related to excludable personal injuries know that the courts and congress have narrowly circumscribed the damages that can be excluded. But, those who practice in the area know that taxpayers take aggressive positions in this area and just hope that they will not be audited. Often the IRS has great difficulty having this type of recovery hit its radar screen. This project mines a handy source -- newspaper articles -- to put these recoveries on the IRS's radar screen.
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