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UNITED STATES v. PETERS

October 21, 1996

UNITED STATES OF AMERICA, Plaintiff,
v.
FLORENCE L. PETERS, Defendant.



The opinion of the court was delivered by: LINDBERG

 Defendant, Dr. Florence L. Peters, is the subject of a five count indictment for tax fraud. She now moves to suppress records and statements that she offered to IRS auditors in the months between April, 1990 and January, 1992. Dr. Peters claims that the IRS obtained this evidence in violation of her Fourth and Fifth Amendment rights by telling her that they were conducting a routine civil audit when in fact they were carrying out a criminal investigation. For the reasons set forth below, defendant's motion to suppress is denied.

 Tax Investigations

 This case unmasks the investigative techniques employed by the Internal Revenue Service. Its principle players are the Criminal Investigation Division and the Examination Division of the IRS, two organizations charged with enforcing the nation's tax laws. A brief introduction to these institutions sets the stage for the factual recitals to follow.

 As its name suggests, the Criminal Investigation Division (CID) ferrets out criminal violations of the tax code and related federal statutes. A criminal tax offense generally entails a substantial level of underpayment paired with some intent to defraud the government. See 26 U.S.C. § 7201 et seq. Due to the nature of its investigations, the CID wears the raimants of a criminal law enforcement agency. CID operatives are called special agents, and they carry guns and badges. Moreover, special agents must read the following administrative warning before they solicit information from taxpayers:

 
As a special agent, one of my functions is to investigate the possibility of criminal violations of the Internal Revenue laws, and related offenses. ... Under the Fifth Amendment of the Constitution of the United States I cannot compel you to answer any questions or to submit any information if such answers or information might tend to incriminate you in any way. I also advise you that anything which you say and any information which you submit may be used against you in any criminal proceeding which may be undertaken. I advise you further that you may, if you wish, seek the assistance of an attorney before responding.

 Beckwith v. United States, 425 U.S. 341, 343, 48 L. Ed. 2d 1, 96 S. Ct. 1612 (1976), quoting IRS News Release No. 897 (1967) and IRS News Release IR-949 (1968). All of this regalia is occasioned by the fact that the subject of a CID investigation may end up in jail.

 The Examination Division of the IRS is responsible for conducting civil tax audits. A civil audit is an investigative procedure used to determine whether an individual has paid all of his or her taxes. Cohen v. United States, 405 F.2d 34, 35 n.3 (8th Cir. 1968). When an audit reveals evidence of underpayment, the IRS generally enters a civil settlement with the taxpayer consisting of repayment and possible monetary penalties. For this reason, the Examination Division does not present itself as a criminal law enforcement agency. Civil audits are conducted by revenue agents, who, unlike special agents, do not carry guns and are not required to provide administrative warnings. United States v. Tweel, 550 F.2d 297, 299-300 (5th Cir. 1977) (only special agents are required to provide administrative warnings); United States v. Piper, 681 F. Supp. 833, 839 (M.D.Ga. 1988) ("Revenue agents, unlike special agents, have no duty either to provide Miranda-like warnings or to advise taxpayers that a routine civil audit may lead to criminal proceedings").

 The functional distinction between the CID and the Examination Division blurs, however, when it is considered that a civil audit may produce sufficient evidence of criminal activity to send a person to prison. Piper, 681 F. Supp. at 838 ("[A] routine civil audit may in any situation lead to criminal proceedings"). The Examination Division may refer a case to the CID for a criminal investigation whenever it uncovers firm indications of fraud by the taxpayer. The IRS regulations provide that

 
if, during an examination, an examiner discovers a firm indication of fraud on the part of the taxpayer, the tax return preparer, or both, the examiner shall suspend his/her activities at the earliest opportunity without disclosing to the taxpayer ... the reason for such suspension.

 Internal Revenue Manual § 4565.21(1) (hereinafter IRM); see also Piper, 681 F. Supp. at 838 ("[A] civil examination should be halted upon a finding of 'firm indications of fraud'"). When this occurs, the taxpayer cannot escape criminal sanctions by offering to repay his or her debt.

 Statistically, civil audits lead to criminal prosecutions in only a very small number of cases each year. In 1994, the IRS audited only about 1.25 million of the 114.88 million individual returns filed. U.S. Department of Treasury, Internal Revenue Service, Data Book 1993-1994 89, 96 (1995). In that same year, the CID initiated 5,346 criminal investigations, and these resulted in 3,130 criminal convictions. Id. at 103. In 1989, only about 19 percent of the CID investigations, began with referrals from other divisions of the IRS, although this number was as high as 50 percent in 1978. Michael I. Saltzman, IRS Practice and Procedure 12-9 (1991). These figures suggest that, while the Examination Division does not function primarily as a criminal law enforcement agency, there are some cases where it does. Indeed, this is one such case.

 The Internal Revenue Manual distinguishes a "firm indication" from a "first indication" or "mere suspicion" of fraud. IRM § 4565.21(1); see also Groder v. United States, 816 F.2d 139, 143 (4th Cir. 1987), and Piper, 681 F. Supp. at 838. The purpose of this rule is to permit revenue agents to substantiate or "perfect" preliminary indications of fraud by ruling out, through an audit, possible innocent explanations for faulty returns. See United States v. Caldwell, 820 F.2d 1395, 1402-1403 (5th Cir. 1987) (firm indications rule permits agents "to develop the case in sufficient detail to be sure there is not an innocent explanation for unreported income and to develop the case sufficiently to allow CID to determine whether a criminal investigation is warranted"); United States v. Kaatz, 705 F.2d 1237, 1243 (10th Cir. 1983) (revenue agent need not refer case to CID in the face of unanswered questions); Piper, 681 F. Supp. at 838 (Examination Division must "preclude innocent explanation for unreported income" before referring to CID); see also Saltzman at 12-10 (revenue agents perfect indications of fraud by "examining books and records that may later be unavailable to the IRS").

 The Seventh Circuit described the firm indications rule in United States v. Mapp, where it held that

 
while a revenue agent might know of fraud, he must still, in his discretion, decide when the investigation has progressed to the point at which he has enough information so that the Intelligence Division can make an informed decision on whether or not to undertake a criminal investigation.

 561 F.2d 685, 690 (7th Cir. 1977). In Groder, the Fourth Circuit explained the reasoning behind the rule as follows:

 
If a firm indication is taken to mean the same thing as a mere suspicion, taxpayers would be subject to fraud investigations as a matter of course, and the revenue agent would have to cease almost before he started his investigation.

 816 F.2d at 143 (quotations omitted); accord Caldwell, 820 F.2d at 1402, United States v. Powell, 835 F.2d 1095, 1100 (5th Cir. 1988), and Piper, 681 F. Supp. at 838.

 The question of whether certain evidence constitutes a firm indication of fraud is "a factual determination which can only be [made] on a case by case basis." IRM § 4565.21(1). In making this determination, revenue agents must look to the so-called "badges of fraud" listed in the Internal Revenue Manual. IRS § 940; see also Powell, 835 F.2d at 1097 n.7. The decision that certain "badges of fraud" constitute a firm indication of fraud is almost exclusively within the discretion of the supervisory Examination Division personnel. See Mapp, 561 F.2d at 690 (evaluation of evidence underlying fraud referral is discretionary); Powell, 835 F.2d at 1100-1101 (timing of fraud referral under IRM § 4565.21 is discretionary and requires a revenue agent to "consult with his/her group manager ... to determine if the indicators of fraud are sufficiently developed"), Caldwell, 820 F.2d at 1402 (referral to CID is discretionary and there are "no absolute criterion established for when an investigation should be suspended and the case referred for criminal investigation"), Groder, 816 F.2d at 143 (timing of CID referral is discretionary), and Piper, 681 F. Supp. at 838 ("The decision to refer a matter from the civil division to the CID is a discretionary one").

 In addition to being referred by the Examination Division or some other agency in the IRS, a criminal tax investigation may be prompted by an information item or "tip" from another law enforcement agency or from the public. The IRS receives up to 200,000 information items each year. Saltzman at 12-12. Of these, however, only a very small number develop into fraud investigations; most do not contain sufficient evidence to justify a full-scale criminal investigation. Saltzman at 12-15. Despite the fact that very few information items develop into criminal investigations, the IRS encourages the public to submit such information items directly to the CID. United States v. Robson, 477 F.2d 13, 17 (9th Cir. 1973) ("Every informant's tip received by the IRS comes through the [CID, yet] not every tip results in an investigation").

 Upon receiving an information item, the CID reviews it and determines whether it should be retained for a criminal investigation or referred for a civil tax audit. See generally IRM § 9311; see also Saltzman at 12-12. If the CID decides to retain a case, it may initiate a full investigation or assign the case to a special agent for a limited primary investigation. IRM §§ 9311.2, 9311.3(2); see also Saltzman at 12-20 to 12-21. If, however, the CID determines that a case has a "firm indication of substantial civil tax potential" but has no criminal potential, then it may refer the case to the Examination Division for a civil tax audit. IRM § 9311.83(2); see also Saltzman at 12-21.

 In this case, IRS officials testified that information items trigger immediate criminal investigations only very rarely, as they are usually routed to the Examination Division for civil audits. The CID generally retains information items only when it has a preexisting case file on the taxpayer or some other special interest in the case. Once an information items reaches the Examination Division, it may be disregarded if it does not promise a significant tax recovery.

 Prior to every civil audit, the IRS gives the taxpayer two documents that are of particular relevance here. The first, which is entitled "Your Rights as a Taxpayer," informs taxpayers that they have the right "to know why we are asking you for information, exactly how we will use any information you give, and what might happen if you do not give information." Department of Treasury, Internal Revenue Service, Publication 1, "Your Rights as a Taxpayer," P 9 (June 1989). It explains that taxpayers may be represented by an attorney. Id. at P 13. It further represents that "whenever you owe tax ... we will ...


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