IRS: Common Badges of Tax Fraud

Section 6663(a) provides that, if any part of an underpayment is due to fraud, there shall be added to the tax an amount equal to 75% of the portion of the underpayment which is attributable to fraud. The IRS bears the burden of proving by clear and convincing evidence that: (1) An underpayment of tax exists; and (2) some portion of the underpayment is attributable to fraud.[i]  Civil tax fraud generally is considered intentional wrongdoing by a taxpayer with the specific purpose of evading a tax. Voluntary disclosure does not mitigate the penalty. The filing of an amended return does not bar assessment of the penalty. Underreporting and inadequate records do not constitute fraud.
In the case of a joint return, intent must be established for each spouse separately and the fraud of one spouse cannot be used to impute fraud to the other spouse. Thus, the civil fraud penalty may be asserted on one spouse only.


FRAUDULENT INTENT. To prove fraudulent intent, the IRS must demonstrate that the taxpayer intended to evade tax he believed to be due, by showing proof of conduct intended to conceal, mislead, or otherwise prevent the collection of such tax.[ii] Fraud can not be imputed or presumed – the government must prove by affirmative evidence that an understatement of tax set forth on the return is attributable to fraud.[iii]  Intent is distinguished from inadvertence, reliance on incorrect technical advice, honest difference of opinion, negligence or carelessness.[iv]
RELIANCE AS A DEFENSE. The existence of fraud is a question of fact to be resolved from the entire record.[v] Because direct proof of a taxpayer’s intent is rarely available, fraud may be proven by circumstantial evidence, and reasonable inferences may be drawn from the relevant facts.[vi] Mere suspicion, however, does not prove fraud.[vii] Reliance on a tax professional is a proper defense to the imposition of penalties, as the Supreme Court has observed:
            “When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place (citations omitted). ‘Ordinary business care and prudence’ do not demand such actions.”[viii]
SENSITIVE ISSUE TAX EXAMINATIONS. In civil tax audits that include potentially sensitive issues, taxpayers often engage a team of representatives, including counsel and a forensic accountant.  Engagement of the accountant by counsel should extend the attorney-client privilege to advice rendered by the accountant pursuant to the engagement.[ix] Although Internal Revenue Code §7525 extended common law protections of confidentiality to tax advice rendered between a taxpayer and a federally-authorized tax practitioner (accountants, etc. to the extent such communications would be considered privileged if they occurred between a taxpayer and counsel), this statutory privilege only applies to non-criminal tax matters before the IRS and non-criminal tax proceedings in federal court.
Unfortunately, this statutory privilege is not available when it is truly needed the most – when a civil tax proceeding moves into the criminal arena.  It also may not be available in certain state-related tax proceedings, or non-tax civil litigation. However, if the accountant is appropriately engaged by counsel, the common law attorney-client privilege should apply to all communications rendered in furtherance of the legal services being provided to the client, both during the investigative stages of the audit and, if necessary, during any subsequent civil or criminal litigation. This privilege does not extend to the actual return preparation.
Counsel’s engagement of the accountant should be in writing, and should indicate that the accountant is acting under the direction of counsel in connection with counsel’s rendering of legal services to the client, communications between the accountant and the client are confidential and are made solely for purposes of enabling counsel to provide legal advice; the accountant’s work-papers are held solely for counsel’s use and convenience and subject to counsel’s right to demand their return; and the accountant is to segregate their work papers, correspondence and other documents gathered during the course of the engagement and designate such documents as property of counsel.
The critical inquiry is often whether counsel should retain the taxpayer’s prior accountant or a new accountant. Many practitioners prefer to engage a new accountant to avoid the necessity of delineating between non-privileged communications (communications prior to counsel’s engagement of the accountant), and privileged communications (communications following counsel’s engagement of the accountant).
In an IRS civil tax fraud examination, the IRS will follow up on all leads identified as fraud indicators (signs or symptoms); securing copies of all relevant data relating to indicators of fraud; and noting from whom and when obtained. Original documents obtained from the taxpayer or third parties should not be marked, indexed, hole punched, or in any way altered by the compliance employee. Also, it is critical that the compliance employee attempt to secure the taxpayer’s explanation(s) for any discrepancies.
Most civil fraud cases involve individual and business taxpayers with poor or nonexistent internal controls and/or where there is little or no separation of duties. When these occur, there is a greater potential for material misstatement of taxable income than in cases involving individuals earning salaries and wages. However, fraud may be present in any type of tax return. In cases where a return has not been filed and fraud is suspected, the IRS representative is instructed not to demand a return from the taxpayer.
Unusual, inconsistent or incongruous items should alert the IRS examiner to the possibility of fraud and the need for further investigation. Taxpayer misconduct is an early warning sign of possible fraudulent conduct. The method of operating a business (i.e., lack of internal controls, dealing in cash, etc.) may be indicative of improperly filed tax returns.
The initial contact by the IRS examiner provides the opportunity to obtain valuable information, which may not be readily available later. Indications of fraud may be disclosed in discussions, financial activities and nonresponsive answers. Questions asked should be recorded verbatim. Similarly, nonresponsive answers are to be noted verbatim and the IRS examiner will exercise their judgment in deciding what information is relevant (affidavits may be used). Examination work papers should be noted as to the tax year, the date of the contact, who was present during the contact, and the author of the examination work papers. IRS examination work papers will include the following information:

• Who prepared the information used to complete the tax return,
• Who approved and classified expense items,
• Who deposited business receipts, and
• How business gross receipts, per the tax return, were determined. 

“BADGES OF FRAUD.” Over the years, various courts have developed a list of “badges of fraud” from which fraudulent intent might be inferred. These badges of fraud generally include: (1) understatement of income; (2) inadequate books and records; (3) failure to file tax returns; (4) implausible or inconsistent explanations of behavior; (5) concealing assets; and (6) failure to cooperate with tax authorities.[x] The IRS Fraud Handbook sets forth a non-exclusive list of various indicators of potentially fraudulent conduct, including:[xi]
The IRS examiner will typically search behind the books and to probe beneath the surface to validate and determine the consistency of information provided and statements made to evaluate the credibility of evidence and testimony provided by the taxpayer. If fraud is discovered, it is important for the IRS to determine who is responsible for the fraudulent act(s) – the taxpayer, the tax return preparer or both. If the taxpayer is not responsible, then neither criminal and/or civil fraud penalties apply.

1. Indicators of Fraud—Income

1. Omitting specific items where similar items are included.
2. Omitting entire sources of income.
3. Failing to report or explain substantial amounts of income identified as received.
4. Inability to explain substantial increases in net worth, especially over a period of years.
5. Substantial personal expenditures exceeding reported resources.
6. Inability to explain sources of bank deposits substantially exceeding reported income.
7. Concealing bank accounts, brokerage accounts, and other property.
8. Inadequately explaining dealings in large sums of currency, or the unexplained expenditure of currency.
9. Consistent concealment of unexplained currency, especially in a business not routinely requiring large cash transactions.
10. Failing to deposit receipts in a business account, contrary to established practices.
11. Failing to file a tax return, especially for a period of several years, despite evidence of receipt of substantial amounts of taxable income.
12. Cashing checks, representing income, at check cashing services and at banks where the taxpayer does not maintain an account.
13. Concealing sources of receipts by false description of the source(s) of disclosed income, and/or nontaxable receipts.

1. Indicators of Fraud—Expenses or Deductions

1. Claiming fictitious or substantially overstated deductions.
2. Claiming substantial business expense deductions for personal expenditures.
3. Claiming dependency exemptions for nonexistent, deceased, or self-supporting persons. Providing false or altered documents, such as birth certificates, lease documents, school/medical records, for the purpose of claiming the education credit, additional child tax credit, earned income tax credit (EITC), or other refundable credits.
4. Disguising trust fund loans as expenses or deductions.

1. Indicators of Fraud—Books and Records
   1. Multiple sets of books or no records.

1. Failure to keep adequate records, concealment of records, or refusal to make records available.
2. False entries, or alterations made on the books and records; back-dated or post-dated documents; false invoices, false applications, false statements, or other false documents or applications.
3. Invoices are irregularly numbered, unnumbered or altered.
4. Checks made payable to third parties that are endorsed back to the taxpayer. Checks made payable to vendors and other business payees that are cashed by the taxpayer.
5. Variances between treatment of questionable items as reflected on the tax return, and representations within the books.
6. Intentional under- or over-footing of columns in journal or ledger.
7. Amounts on tax return not in agreement with amounts in books.
8. Amounts posted to ledger accounts not in agreement with source books or records.
9. Journalizing questionable items out of correct account.
10. Recording income items in suspense or asset accounts.
11. False receipts to donors by exempt organizations.

1. Indicators of Fraud—Allocations of Income

1. Distribution of profits to fictitious partners.
2. Inclusion of income or deductions in the tax return of a related taxpayer, when tax rate differences are a factor.

1. Indicators of Fraud—Conduct of Taxpayer
   1. False statement about a material fact pertaining to the examination.
   2. Attempt to hinder or obstruct the examination. For example, failure to answer questions; repeated cancelled or rescheduled appointments; refusal to provide records; threatening potential witnesses, including the examiner; or assaulting the examiner.
   3. Failure to follow the advice of accountant, attorney or return preparer.
   4. Failure to make full disclosure of relevant facts to the accountant, attorney or return preparer.

1. The taxpayer’s knowledge of taxes and business practices where numerous questionable items appear on the tax returns.
2. Testimony of employees concerning irregular business practices by the taxpayer.
3. Destruction of books and records, especially if just after examination was started.
4. Transfer of assets for purposes of concealment, or diversion of funds and/or assets by officials or trustees.
5. Pattern of consistent failure over several years to report income fully.
6. Proof that the tax return was incorrect to such an extent and in respect to items of such magnitude and character as to compel the conclusion that the falsity was known and deliberate.
7. Payment of improper expenses by or for officials or trustees.
8. Willful and intentional failure to execute pension plan amendments
9. Backdated applications and related documents.
10. False statements on Tax Exempt/Government Entity (TE/GE) determination letter applications.
11. Use of false social security numbers.
12. Submission of false Form W–4.
13. Submission of a false affidavit.
14. Attempt to bribe the examiner.
15. Submission of tax returns with false claims of withholding (Form 1099-OID, Form W-2) or refundable credits (Form 4136, Form 2439) resulting in a substantial refund.
16. Intentional submission of a bad check resulting in erroneous refunds and releases of liens.
17. Submission of false Form W-7 information to secure Individual Taxpayer Identification Number (ITIN) for self and dependants.

1. Indicators of Fraud—Methods of Concealment
   1. Inadequacy of consideration.

1. Insolvency of transferor.
2. Asset ownership placed in other names.
3. Transfer of all or nearly all of debtor’s property.
4. Close relationship between parties to the transfer.
5. Transfer made in anticipation of a tax assessment or while the investigation of a deficiency is pending.
6. Reservation of any interest in the property transferred.
7. Transaction not in the usual course of business.
8. Retention of possession or continued use of asset.
9. Transactions surrounded by secrecy.
10. False entries in books of transferor or transferee.
11. Unusual disposition of the consideration received for the property.
12. Use of secret bank accounts for income.
13. Deposits into bank accounts under nominee names.
14. Conduct of business transactions in false names.
15. 
    

[i] IRC § 7454(a); Rule 142(b); DiLeo v. Commissioner, 96 T.C. 858, 873 (1991), aff’d. 959 F.2d 16 (2d Cir. 1992).
[ii] See Recklitis v. Commissioner, 91 T.C. 874, 909 (1988).
[iii] See Beaver v. Commissioner, 55 T.C. 85, 92 (1970); Senyszyn v Commissioner, T.C. Memo. 2013-274.
[iv] Internal Revenue Manual 25.1.6.1 (10-30-2009)
[v] See Gajewski v. Commissioner, 67 T.C. 181, 199 (1976).
[vi] See Spies v. United States, 317 U.S. 492, 499 (1943); Stephenson v. Commissioner, 79 T.C. 995, 1006 (1982).
[vii] See Cirillo v. Commissioner, 314 F.2d 478, 482 (3d Cir. 1963); Katz v. Commissioner, 90 T.C. 1130, 1144 (1988); Shaw v. Commissioner, 27 T.C. 561, 569-570 (1956).
[viii] United States v. Boyle, 469 U.S. 241, 251 (1985); Henry v. Comm., 170 F. 3d 1217, 1220 (9th Cir. 1999).
[ix] United States v. Kovel, 292 F.2d 18 (2d Cir. 1961).
[x] Bradford v. Comm’r, 796 F.2d 303, 307 (9th Cir. 1986).
[xi] Internal Revenue Manual (IRM) 25.1.2.3 Indicators of Fraud

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