On January 25, 2024, the Department of Justice (DOJ) announced that two owners—a father and his son—of a well-known Philadelphia cheesesteak restaurant were both sentenced to twenty months in prison for “their decade-long conspiracy to defraud the IRS.” According to the DOJ announcement and the indictment, the two individuals concealed substantial gross receipts from their flow-through restaurant business and paid employees “off the books”—i.e., in cash—thereby avoiding federal income and employment taxes.
The indictment suggests that the tax evasion scheme went on from roughly 2006 through 2016. In 2015, the two owners also had a franchise dispute with the company’s remaining owner. Because of this dispute, the father and son grew concerned that the IRS may learn of the unpaid tax liabilities, and they filed amended returns for the company’s 2013 and 2014 tax years. Although the indictment does not specifically state why they became concerned, it may have been that they were fearful of an IRS whistleblower claim or the production of company financials through the discovery process in potential civil litigation.
The above fact pattern and the issues that it raises are thorny ones in the tax world. Taxpayers who have filed a false or fraudulent return cannot eliminate their risk of criminal prosecution simply through filing a correct amended return (note that in the case above, the government contended the amended returns were also not correct, which certainly would not help matters). In addition, the government can use the statements and reported items on an amended return as admissions against a taxpayer in a subsequent criminal investigation, if it chooses to go that route. It is therefore not surprising that taxpayers have concerns in filing amended returns, particularly if the amounts reported on the amended returns vary considerably from the amounts reported on the original returns.
Taxpayers have options in these circumstances. An initial option, known as a “quiet disclosure,” requires the taxpayer to file the corrected amended returns under normal IRS processing procedures. However, because a quiet disclosure provides no criminal protection, taxpayers should carefully consider this option against other potentially better options, including the IRS’ Voluntary Disclosure Practice (VDP).
Under the VDP, a taxpayer generally submits six years of tax returns and other information to the IRS. The taxpayer must cooperate with the IRS and pay all taxes owed for the six-year lookback period, in addition to interest and a 75% civil fraud penalty on the highest tax liability year. In exchange for the VDP disclosure, the taxpayer receives a significantly reduced risk of criminal prosecution.
An example will help illustrate the benefits of the VDP. Assume that the two owners of the Philadelphia cheesesteak restaurant had filed VDPs instead of amended returns. Under the VDP, they would have filed six years of amended company returns (Forms 1120-S) and individual income tax returns (Forms 1040), reporting the correct amounts of gross receipts attributable to the restaurant. Moreover, they would have paid the increased tax liabilities associated with the amended returns, plus interest and a 75% civil fraud penalty on the highest tax liability year. If they had counsel, they would have also been advised to make separate VDP disclosures for the company for the employment tax matters (Forms 940 and 941). This would have resulted in additional employment taxes, failure-to-deposit penalties, interest, and a 75% civil fraud penalty on the highest employment tax quarter in the six-year lookback period (note that the failure-to-deposit penalty applies to employment tax disclosures).
Clearly, the disclosures would have resulted in significant amounts owed to the IRS. But if the two owners met all of the VDP requirements, it is very likely that the IRS would not have recommended criminal referrals to the DOJ, the government’s prosecution arm. Given the choice of paying more taxes and penalties versus jail time, most would almost always choose the former over the latter.
Whether any given taxpayer should file a disclosure under the VDP depends largely on that taxpayer’s circumstances. The decision is often not an easy one. However, taxpayers considering a VDP disclosure must also wrestle with another VDP requirement. Specifically, a disclosure is not timely, and therefore a taxpayer may not enter the VDP, unless it is made prior to the initiation of an IRS civil or criminal examination and before the IRS receives information from a third party (e.g., through an IRS whistleblower claim). Taxpayers on the fence regarding a VDP disclosure must keep this in mind as they wade through their options and next steps.