What is Eggshell and Reverse Eggshell Tax Audit?

Navigating Eggshell and Reverse Eggshell Tax Audits: A Comprehensive Guide for Taxpayers

Tax audits are a routine part of the IRS’s efforts to ensure compliance with federal tax laws. However, certain audits—known as eggshell and reverse eggshell audits—present unique challenges due to their delicate nature and potential for severe consequences, including civil penalties or criminal prosecution. For taxpayers and their representatives, understanding these audits is critical to managing risks and protecting their interests. This tax lawyers guide explores the intricacies of eggshell and reverse eggshell tax audits.

What is an Eggshell Tax Audit?

An eggshell tax audit is a civil IRS audit that becomes precarious because the tax return(s) under examination contain material inaccuracies that understate the taxpayer’s true tax liability. These inaccuracies may include:

• Material Understatement of Income: Failing to report significant income, such as cash payments, offshore accounts, or unreported business revenue.
• Material Overstatement of Deductions: Claiming deductions for expenses that are not allowable under the tax code, such as personal expenses disguised as business costs.
• Improperly Claimed Credits: Taking tax credits for which the taxpayer is not eligible, such as exaggerated refundable credits.

These errors result in the taxpayer reporting less tax liability than they would have owed had they filed a true, complete, and accurate return. The term “eggshell” reflects the fragile nature of the tax audit: the taxpayer must tread carefully to avoid triggering penalties or escalating the matter to a criminal investigation.

Causes and Consequences of Errors in Eggshell Tax Audits

The errors in an eggshell tax audit may arise from either negligence or willful intent:

1. Negligence:
   • Negligent errors occur when a taxpayer fails to exercise reasonable care in preparing their return, such as overlooking income or misinterpreting tax rules.
   • If the IRS determines negligence, the taxpayer may face a 20% accuracy-related penalty on the additional tax owed, as outlined in Internal Revenue Code (IRC) Section 6662. This penalty applies to underpayments attributable to negligence or disregard of rules and regulations.
2. Willful Intent (Tax Fraud):
   • Willful errors involve intentional acts to evade taxes, such as deliberately underreporting income or fabricating deductions.
   • If the IRS establishes fraud, the consequences are severe. Under IRC Section 6663, a 75% civil fraud penalty may be imposed on the portion of the underpayment attributable to fraud. In more serious cases, the IRS may refer the matter to its Criminal Investigation (CI) Division, potentially leading to criminal prosecution.
   • Criminal tax fraud convictions can result in 3 to 5 years in prison for tax evasion (IRC Section 7201) or up to 7 years for filing a false return (IRC Section 7206), along with substantial fines.

Navigating an Eggshell Tax Audit

Eggshell audits are high-stakes because the taxpayer is aware of the inaccuracies in their return but must avoid disclosing them in a way that alerts the IRS to potential fraud. Key strategies include:

• Engage Experienced Tax Counsel: A tax attorney with expertise in IRS audits can help manage communications with the auditor, ensuring responses are accurate without inadvertently admitting to wrongdoing.
• Assess the Risk of Criminal Exposure: Tax Attorney should evaluate whether the errors suggest negligence or fraud and advise on whether to pursue voluntary disclosure programs, such as the IRS Voluntary Disclosure Practice, to mitigate criminal risks.
• Maintain Consistency: Providing incomplete or inconsistent information can raise red flags, prompting the auditor to dig deeper or refer the case to a Fraud Referral Specialist.
• Prepare for Potential Penalties: If inaccuracies are discovered, taxpayers should be ready to negotiate penalties or challenge them through IRS appeals or litigation if appropriate.

What is a Reverse Eggshell Tax Audit?

A reverse eggshell tax audit is an even more complex and covert scenario where a civil audit is conducted alongside a parallel criminal investigation, but the taxpayer and their representative are unaware of the criminal component. In essence, the IRS disguises a criminal tax investigation as a routine civil audit, creating a minefield for the taxpayer.

How Reverse Eggshell Audits Arise

Reverse eggshell audits typically originate in one of two ways:

1. Referral from a Civil Auditor:
   • During a standard civil audit, a revenue agent may uncover evidence of potential tax fraud, such as significant unreported income or falsified records.
   • The auditor refers the case to a Fraud Referral Specialist, whose role is to develop the case for potential handoff to the IRS Criminal Investigation Division. The specialist may continue the civil audit to gather additional evidence without alerting the taxpayer.
2. Request by the Criminal Investigation Division:
   • The CI Division, already investigating the taxpayer for potential criminal tax violations, may request that a civil auditor be assigned to the case to assist in gathering evidence.
   • The civil audit serves as a facade, allowing the IRS to collect information under the guise of a routine examination while building a criminal case.

The Deceptive Nature of Reverse Eggshell Audits

In a standard civil audit, the revenue agent is typically unaware of any criminal issues at the outset. In contrast, during a reverse eggshell audit, the auditor or Fraud Referral Specialist is fully aware of the potential for criminal violations but does not disclose this to the taxpayer or their representative. This lack of transparency puts the taxpayer at a significant disadvantage, as they may provide information or documents that could later be used against them in a criminal prosecution.

Risks and Consequences

The stakes in a reverse eggshell audit are extraordinarily high because the IRS is actively investigating potential criminal conduct. If the taxpayer or their representative is unaware of the criminal investigation, they may inadvertently:

• Provide incriminating evidence during the civil audit.
• Make false statements to the auditor, which could lead to additional charges under 18 U.S.C. § 1001 for lying to a federal officer.
• Waive important constitutional protections, such as the Fifth Amendment right against self-incrimination.

If the IRS builds a sufficient case, the taxpayer could face criminal charges for tax evasion, filing false returns, or other tax-related crimes, in addition to civil penalties.

Strategies for Handling Reverse Eggshell Tax Audits

Navigating a reverse eggshell audit requires extreme caution and the guidance of a skilled tax attorney. Key steps include:

• Identify Red Flags: Certain indicators may suggest a reverse eggshell audit, such as an unusually aggressive auditor, requests for sensitive financial records, or inquiries into lifestyle expenses that seem unrelated to the audit’s scope. A sudden shift in the audit’s tone or the involvement of a Fraud Referral Specialist may also signal criminal interest.
• Invoke Legal Protections: Taxpayers have the right to consult with counsel and, in some cases, may need to assert their Fifth Amendment rights to avoid self-incrimination. An attorney can help determine when and how to exercise these protections without antagonizing the IRS.
• Limit Disclosures: Providing only the information required by the auditor and avoiding voluntary disclosures that could incriminate the taxpayer is critical. Counsel can help craft responses that comply with IRS requests while minimizing risk.
• Monitor for Criminal Referral: If there is evidence of a criminal investigation, such as contact from a CI special agent, the taxpayer’s attorney should immediately shift to a criminal defense strategy, potentially exploring voluntary disclosure or negotiating with the IRS to resolve the matter civilly.
• Engage a Kovel Accountant: In some cases, hiring an accountant under a Kovel agreement (named after United States v. Kovel, 296 F.2d 918 (2d Cir. 1961)) can shield accountant-client communications under attorney-client privilege, providing an additional layer of protection.

Key Differences Between Eggshell and Reverse Eggshell Audits

IRS Procedures and Safeguards

The IRS has established procedures to balance its civil and criminal enforcement roles, as outlined in the Internal Revenue Manual (IRM). For example:

• IRM 25.1.3: Governs fraud referrals from civil auditors to the CI Division, requiring evidence of a “firm indication of fraud” before a referral is made.
• IRM 4.10.6: Outlines the responsibilities of revenue agents in identifying potential fraud during civil audits and coordinating with Fraud Referral Specialists.
• Taxpayer Rights: The IRS must adhere to the Taxpayer Bill of Rights, including the right to be informed, the right to quality service, and the right to challenge the IRS’s position. In reverse eggshell audits, however, taxpayers may not be fully informed of the criminal investigation, complicating their ability to exercise these rights.

Practical Advice for Taxpayers

Whether facing an eggshell or reverse eggshell audit, taxpayers should take proactive steps to protect themselves:

1. Retain Experienced Counsel Early: A tax attorney with expertise in IRS audits and criminal tax matters is essential. Avoid relying solely on a CPA, as accountant-client communications are not privileged in criminal investigations unless covered by a Kovel agreement.
2. Review Tax Returns Thoroughly: Before an audit begins, review the returns in question with counsel to identify potential inaccuracies and assess the risk of negligence or fraud.
3. Document Compliance Efforts: Demonstrating reasonable care in preparing returns (e.g., relying on professional advice or maintaining accurate records) can help mitigate negligence penalties.
4. Consider Voluntary Disclosure: If errors are discovered before an audit, the IRS Voluntary Disclosure Practice may allow taxpayers to correct their returns and avoid criminal prosecution, provided they act before the IRS initiates an investigation.
5. Stay Calm and Cooperative: While cooperation with the IRS is important, taxpayers should avoid providing unnecessary information or making statements without consulting counsel.

At Tax Lawyers Group, we understand the complexities of these audits and are committed to guiding our clients through every step of the process. Our experienced criminal tax attorneys work diligently to protect your rights, minimize penalties, and achieve the best possible outcome, whether through strategic audit management, voluntary disclosures, or robust defense in criminal tax matters. If you are facing an IRS tax audit or suspect inaccuracies in your tax filings, contact us today for a confidential consultation.