As the IRS has shed jobs, some taxpayers and tax professionals expected to see a slowdown in audits and investigations. Bryan Skarlatos, a partner at the tax litigation firm Kostelanetz LLP, has experienced just the opposite. There have been “no slowdowns,” he said. While old tax law cases have been wrapping up, there’s been no shortage of new cases—they’ve seen more activity, Skarlatos says, in the past six months than in the past two years.
That’s why the firm jumped at the chance to sign on Karen Kelly, the immediate past head of the Department of Justice’s Tax Division. Kelly is joining the firm’s Washington, D.C., office as a partner, where she will focus on state and federal civil tax controversies, criminal tax and white collar investigations, internal investigations, representing legal and tax professionals and their firms in license and regulatory matters, and complex civil and criminal litigation.
About Karen Kelly
Kelly began her legal career as a state prosecutor in Virginia. There, Kelly got her first taste of tax cases. “Revenuers,” she said, describing former IRS agents, would bring tax cases to the Commonwealth. Eventually, they convinced her to make the move to the tax division at the Department of Justice.
She found the work to be immediately interesting. “Tax,” she says, “is different.”
“Tax touches on all citizens’ lives—unlike drugs and gambling.” (The latter are some of the kinds of cases she worked on outside of tax.)
As a result, she says, it was important to ensure that tax enforcement is uniformly fair. Taxpayers should believe that they will be treated the same “in Portland, Maine, as they are in Portland, Oregon.”
Kelly should know. In her nearly thirty-year tenure at the Department of Justice (DOJ), she has served all over the country. She began her federal career as a Trial Attorney in the Northern Criminal Enforcement Section, where she conducted sophisticated grand jury investigations and prosecuted criminal tax trials in federal district courts. She then moved to the Southern Criminal Enforcement Section, where she served as Chief. As Chief, Karen supervised all aspects of criminal tax investigation and litigation in 16 states and territories, including authorizing investigations and prosecution referrals from IRS Criminal Investigation.
While at the DOJ, Kelly was the recipient of the Attorney General’s Award for Outstanding Service for her contributions to the Jack Abramoff task force, a high-profile case that she cites as a career highlight. The former lobbyist was a central figure in a corruption scandal that not only resulted in his conviction, but also guilty pleas or verdicts for nearly two dozen others.
Most recently, Kelly served as the Acting Assistant Attorney General and delegated component head of the Tax Division, where she supervised more than 300 attorneys conducting civil and criminal investigations and prosecutions.
While she has relished her leadership role, it was very “big picture management,” she says. Kelly is looking forward to representing clients in her new position at Kostelanetz.
The timing, she notes, is perfect. Courts are busy, she says, and that means there is a need for more attorneys.
Tax Trends: Employment Tax Cases, Crypto, and Refund Suits
What kinds of cases are keeping tax attorneys busy? Skarlatos has noticed a few trends in his work: increases in employment tax cases (specifically payroll tax-related), crypto-related actions, and refund suits, including Employee Retention Credit (ERC) litigation.
The current DOJ is not walking away from crypto, he notes. However, the government does appear to be changing its tack by taking a more traditional tax approach to crypto cases, rather than trying novel theories. That means back to the basics, focusing on crypto investors who failed to report gains or accurately track their basis.
(Those John Doe summonses aren’t going away, but may present an opportunity for some crypto investors and other taxpayers who did not report to come clean.)
ERC litigation is also gaining steam. The ERC was designed to help eligible employers keep the lights on and pay employees during the pandemic. The credit was worth 50% of up to $10,000 in wages, meaning that it can be as high as $5,000 per employee in 2020 and as high as $21,000 per employee in 202. Typically, to qualify, you must have been able to demonstrate that your business was shut down by a government order or that you experienced a specific decline in gross receipts during the eligibility periods.
As the IRS saw an uptick in what the agency characterized as improper refund claims in late 2023, it put the brakes on, announcing a moratorium on processing new ERC claims. That was followed by a flurry of denials and slow payments as new claims were reviewed. Most recently, the One Big Beautiful Bill Act disallows pending ERC claims submitted after January 31, 2024, for the third and fourth quarter of 2021. That feels like a death knell for businesses who haven’t yet received their money—or have had their funds clawed back. But businesses that have claimed the ERC and believe they are entitled to a refund may consider taking legal action to force the government to take action.
Tax Trends: Employment Tax, Voluntary Disclosures, Exempt Organizations, SALT
Kostelanetz partner Caroline Ciraolo agrees that there has been no slowdown in tax enforcement, noting that attorneys are staying busy. Ciraolo also echoes Skarlatos’ observations that there has been an uptick in activity in the employment tax space—with a twist.
Employers have a legal responsibility to collect and pay over to the IRS taxes withheld from their employees’ wages—those are payroll taxes and include withheld federal income tax, as well as the employees’ share of social security and Medicare taxes. When employers willfully fail to collect, account for, and deposit those taxes, it’s a crime. It can also be a substantial amount of money: amounts withheld from employee wages represent nearly 70% of all revenue collected by the IRS.
(Ciraolo notes that not all unpaid taxes result in criminal charges—some may remain on the civil side, offering clients an opportunity to move into compliance, including through voluntary disclosures.)
However, now in addition to pursuing unpaid employment taxes, the DOJ is bundling those cases with Title 8 (immigration) and pandemic fraud cases. Every case, she says, is likely to be looked at from a few angles.
Another space where Ciraolo has seen a substantial boost in compliance initiatives is tax-exempt organizations. That coincides with the current administration’s stance, including signals from President Donald Trump that his administration could crack down on tax-exempt organizations.
Ciraolo also says that she has seen a bump in state and local tax (SALT) activity. That’s being primarily driven by two factors: revenue and talent. With respect to revenue, state and local governments are feeling stretched in the current economic climate, and rather than ride the coattails of federal audits, they are increasingly digging in on their own investigations to raise revenues. That may be made easier by an infusion of talent—as the federal government workforce and some private sector jobs shrink, state and local governments are seizing the opportunity to pick up those employees.
Finally, Ciraolo has observed that recent audits aren’t necessarily restricted to one area of tax. For example, an income tax audit may now lead to a gift tax audit.
New Preparedness
Kostelanetz has responded to the increase in investigations and audits by being more proactive with clients, including wellness checks to ensure compliance.
Adding new talent is another step to boost client service. “We are thrilled,” Ciraolo says, about bringing on Kelly, noting that it signals how the firm feels about the future of tax enforcement.
The firm is also partnering with the federal government to provide pro bono representation. Through an arrangement with the Office of the Federal Public Defender, which provides legal representation to individuals who cannot afford an attorney in federal criminal cases, young Kostelanetz attorneys are gaining criminal tax and trial experience. Attorneys at the firm also volunteer with the IRS Office of Chief Counsel during Virtual Settlement Weeks, a program that pairs attorneys are paired with taxpayers to meet virtually with the IRS attorney assigned to the case in Tax Court.
Taxpayers who believe that enforcement and compliance aren’t as important to tax authorities as before may be caught by surprise, especially as the government increasingly relies on data analytics to ferret out trends and flag outliers. That’s because it can be a numbers game. “Everyone speeds down I-95,” Ciraolo quips, “but someone is going to get caught.” The key is to be prepared when it happens.