The Eggshell Audit: A Civil Exam With Criminal Exposure Underneath

"Eggshell audit" is not an IRS term. You will not find it in the Internal Revenue Manual. It is what tax lawyers call a civil examination of a taxpayer who has potential criminal exposure that the examiner does not know about yet.

The examiner is looking at a return. The taxpayer knows something about that return, or about other years, that could turn a civil adjustment into a fraud referral. Everyone is walking on eggshells, except the examiner, who does not know the eggshells are there.

This guide explains why that situation is so delicate, what the IRS manual tells examiners to watch for, and why the person who should be making decisions in an eggshell audit is a lawyer. It is general information. It is not a guide to keeping anything from the IRS, and nothing here suggests you should.

Why an ordinary audit can become dangerous

A civil audit exists to determine the correct tax. A criminal investigation exists to determine whether a crime was committed. The same facts can serve both purposes, and the IRS has a formal process for moving a case from one track to the other.

The fraud procedures in IRM 25.1.2 apply to compliance employees across the IRS, examiners and revenue officers alike. When an employee finds indicators of fraud, IRM 25.1.2.2 requires the employee to document them and discuss them with the group manager. If the manager agrees, the employee contacts a Fraud Enforcement Advisor. If they all agree the potential for fraud exists, the case goes into fraud development status with a written plan to develop what the manual calls affirmative acts of fraud.

If those affirmative acts are established and the criminal criteria are met, the next step is a referral to Criminal Investigation. That process is covered in when an audit turns criminal.

What the examiner is trained to notice

The IRS manual is unusually specific here. IRM 25.1.2.3 lists indicators of fraud in categories: income, expenses and deductions, books and records, allocations of income, conduct of the taxpayer, and methods of concealment. The conduct category is the one that matters most in an eggshell audit, because it is about what happens during the audit itself. It includes:

• A false statement about a material fact pertaining to the examination.
• An attempt to hinder or obstruct the examination, with examples such as failure to answer questions, repeated cancelled or rescheduled appointments, and refusal to provide records.
• Failure to make full disclosure of relevant facts to the accountant, attorney, or return preparer.
• Destruction of books and records, especially if just after the examination was started.
• Transfer of assets for purposes of concealment.

Read that list again with an eggshell audit in mind. Some of the most damaging evidence in a fraud case is created after the audit letter arrives. See badges of fraud for the full picture.

The first meeting is where cases are made

The IRS manual tells examiners how to approach the initial contact. IRM 25.1.2.4 says the initial contact "provides the opportunity to obtain valuable information, which may not be readily available later," that questions asked should be recorded verbatim, and that nonresponsive answers should be noted verbatim. The examiner must prepare a memorandum of interview summarizing the information obtained and statements made.

The same section tells examiners that fraud "is not ordinarily discovered when compliance employees readily accept the completeness and accuracy of records presented," and that it is necessary "to go behind the books and to probe beneath the surface."

In other words, the examiner is trained to treat your explanations as evidence to be tested. In an ordinary audit, that is fine. In an eggshell audit, a casual explanation that turns out to be false becomes the most important fact in the file.

What you will and will not be told

Here is the part that surprises people. If the examiner finds firm indications of fraud and the case meets criminal criteria, IRM 25.1.3.3 says the compliance employee "will suspend the examination/collection activity without disclosing to the taxpayer or representative the reason for the suspension."

The manual also sets a limit. Based on guidance from the courts, compliance employees may decline to answer questions about criminal potential, but they may not deceive taxpayers when asked specifically about the character or nature of an investigation. They are not required to volunteer that fraud indicators are developing.

So the examiner does not have to tell you the audit has changed character, and often will not. Silence from the examiner after a period of active questions is something a lawyer will take seriously.

Privilege is the first structural decision

In a normal audit, many people are represented by a CPA or enrolled agent, and that is often the right choice. In an eggshell audit, the question of who represents you, and who you confide in, is a legal question.

IRC 7525 extends attorney-client style confidentiality to communications with a federally authorized tax practitioner, but the statute says that privilege may be asserted only in noncriminal tax matters before the IRS and noncriminal tax proceedings in federal court. If the matter becomes criminal, that statutory protection is not available.

Communications with a lawyer for the purpose of legal advice are protected by the attorney-client privilege. A lawyer can also engage an accountant to help the lawyer give legal advice, an arrangement courts have recognized since United States v. Kovel, 296 F.2d 918 (2d Cir. 1961). The details are in Kovel arrangements and accountant privilege.

Two mistakes that make everything worse

Lying to the examiner. A false statement about a material fact is a listed indicator of fraud. Submitting a document you know is false to an IRS employee is itself a misdemeanor under IRC 7207, according to the IRS's own summary of criminal statutes in Exhibit 25.1.1-1. And knowingly and willfully making a materially false statement to a federal agency can be charged under 18 U.S.C. 1001.

Cleaning up. Destroying, altering, or backdating records after an audit starts is a listed indicator of fraud and can support an obstruction charge under IRC 7212(a). The Supreme Court in Marinello v. United States, 584 U.S. 1 (2018), held that the omnibus clause of section 7212(a) requires a connection to a pending or reasonably foreseeable tax proceeding, such as a particular investigation or audit. An open audit is exactly that. See obstruction under section 7212(a).

Can you still make a voluntary disclosure?

Usually not. Under IRM 9.5.11.9, a voluntary disclosure is timely only if it is received before the IRS has commenced a civil examination or criminal investigation of the taxpayer, or notified the taxpayer that it intends to start one. An examination of you generally closes that door.

That is why the timing guide matters so much for people who are not yet under audit. Read voluntary disclosure timeliness.

What a lawyer does in an eggshell audit

Every case is different, and this is not advice for yours. In general terms, counsel will:

1. Learn the full history in a privileged setting before anyone speaks to the IRS.
2. Decide who will deal with the examiner, and how.
3. Make sure everything provided to the IRS is accurate. Silence on a point may be appropriate. False statements never are.
4. Preserve records.
5. Watch for signs that the examination has changed character, such as a sudden suspension.

The goal is not to hide anything. The goal is to make sure decisions with criminal consequences are made by someone who understands those consequences.

The bottom line

If you are being audited and you know something about your returns that keeps you up at night, you are in an eggshell audit. Do not try to manage it with charm, a shoebox of receipts, and a good story. Talk to a tax lawyer before the next meeting with the examiner.

One more caution. When an examiner finds firm indications of fraud, IRM 25.1.3.3 says the taxpayer's explanation of those indications goes into the Form 2797 referral to Criminal Investigation.

General information only, not legal advice. Reading this page does not create an attorney-client relationship. Laws and IRS procedures change; the sources cited were reviewed on the date shown above.