Article: Voluntary Disclosure Can Ease Criminal Tax Liability

June 2003

Voluntary disclosure can ease criminal tax liability

To head off prosecution for tax crimes, a taxpayer’s only realistic option is to come clean … the right way

When you misreport your taxable income, the IRS may view your error in one of two ways: as an innocent mistake, or as a willful attempt to evade your tax obligation. If it’s the latter, you may face a criminal investigation.

By the time you appear on the radar screen at the IRS Criminal Investigation Division (CID), a simple “I’m sorry, how much do I owe?” will be insufficient repentance. The Justice Department may get into the act, and when they’re through with you your willingness to confess your sins may do little more than shorten your prison sentence.

But let’s say your tax problems have not quite reached the point of criminal investigation, and you decide to come clean about your underreported income or other potentially fraudulent acts. What are your options? Can filing an amended return and admitting your misdeeds before the IRS starts an investigation eliminate the threat of criminal prosecution?

You have three basic choices:

You can do nothing, but you’ll regret it. Letting a “sleeping dog lie” is a bad idea, since the IRS doesn’t sleep.
You can quietly pay up; without explanation or amending your return, you send the IRS a check for the taxes, penalties and interest that you owe. This is another bad idea; while it may clear up your civil tax liability, it does nothing to reduce your criminal liability.
You can make a voluntary disclosure. Although this won’t guarantee immunity from prosecution, it may be a major factor for the IRS in determining whether to prosecute the case.

Voluntary disclosure. A qualified voluntary disclosure is a complete, truthful, and timely disclosure to the IRS of the correct tax liability. For years, the IRS had a vague policy that left taxpayers and tax professionals scratching their heads over whether to make a voluntary disclosure.

Recently, that policy has been clarified. It’s still not ideal – i.e., it doesn’t guarantee that the taxpayer is safe from prosecution – but a voluntary disclosure can reduce the likelihood that you will face criminal penalties for your actions. If you make a qualified disclosure before the IRS begins an investigation, the revised policy will apply.

A qualified voluntary disclosure must satisfy three requirements.

First, the disclosure must be complete and truthful. Holding anything back may undermine your efforts to disclose, and, worse, it may result in additional criminal charges.
Second, you must cooperate with the IRS and make good-faith arrangements to pay the tax due, along with any interest and penalties. In most cases, these requirements are fairly easy to meet, particularly since the policy doesn’t actually require the taxpayer to pay the tax, but rather to arrange to pay the tax (an interesting distinction).
Third, the disclosure must be timely. This is where most of the controversies occur.

A qualified voluntary disclosure is timely if it is received by the IRS before the IRS:

notifies the taxpayer that it intends to commence an examination or a criminal prosecution;
receives information from a third party alerting the IRS that the taxpayer may have committed tax evasion;
initiates an audit or criminal investigation directly related to the taxpayer’s liability (e.g., an audit of a corporation from which he or she has been skimming); or
obtains tax liability information as part of a criminal enforcement action, such as a grand jury subpoena or a search warrant.

Timing is crucial in a qualified voluntary disclosure. Once an audit or investigation has begun, the opportunity to make a voluntary disclosure has passed. However, the IRS may consider a voluntary disclosure made in response to a public announcement, provided that an audit or investigation of the taxpayer hasn’t begun.

Example. Let’s say you belong to a barter club and haven’t reported any income from your barter exchanges. On Monday you read in the local newspaper that the IRS is going to start clamping down on barter clubs. (This is news to you, as neither you nor your barter club has received notice that you’re the subjects of an audit or criminal investigation.) On Wednesday you file accurate amended returns and pay all back taxes, penalties and interest.

The IRS will likely treat your actions as a voluntary disclosure because you met all of the requirements. The fact that the IRS had launched a broadly based enforcement effort is not treated as a specific examination of you or your barter club. However, if on Tuesday the IRS had sent a notice of examination to the barter club, your disclosure wouldn’t be considered voluntary.

Legal muscle needed. It is extremely important to meet all of the requirements and to get solid legal assistance from an attorney skilled in criminal tax law. Your conversations with your tax accountant are probably not protected (i.e., your tax professional can probably be compelled to reveal the content of your discussions), but your conversations with your lawyer are protected by attorney-client privilege.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.