IRS Tax Fraud: Are You at Risk?

Actions ranging from failing to file a required return to deliberately hiding income in an offshore arrangement may lead to civil penalties or, when the elements of a crime are established, criminal liability. An honest mistake or an inability to pay is not automatically tax fraud. The legal duty, intent, evidence, and applicable statute matter. Civil fraud penalties can be substantial even when no criminal prosecution occurs.

This article explains how the IRS defines tax fraud and identifies the circumstances that might subject a taxpayer to claims of civil and/or criminal tax fraud including a discussion of the associated penalties, fines, and punishment.

Tax Fraud Defined

Internal Revenue Manual (IRM) Section 25.1.1.3 describes tax fraud as intentional wrongdoing aimed at evading tax the taxpayer knows or believes is owed. Fraudulent intent must be established; an inaccurate return or additional tax assessment alone does not prove it. Civil fraud and individual criminal offenses have different legal elements and burdens of proof.

Deliberately understating income, overstating deductions, or supplying false information may support a fraud finding when the required intent is shown. Failure to file can also carry civil penalties or criminal consequences, but nonfiling alone does not automatically prove fraud or felony tax evasion. A good-faith error must be distinguished from an intentional violation.

The IRS identifies circumstances that may warrant further inquiry. These indicators do not prove fraud on their own and must be assessed in context:

• Substantial unexplained increases in net worth;
• Substantial spending above available income and assets;
• Bank deposits from unexplained sources that substantially exceed reported income;
• Documents that appear to be altered or false;
• Closing and starting new businesses repeatedly;
• Missing records to support the items claimed on the tax return;
• Suddenly spending more money on luxury items;
• Using cash extensively.

The IRM distinguishes warning signs from affirmative acts showing deliberate deception or concealment. Felony tax evasion under Section 7201 requires an affirmative attempt to evade tax or payment, together with willfulness and tax due. By contrast, specified willful failures under Section 7203 may be criminal without that additional affirmative act. Depending on intent and the surrounding facts, examples of conduct relevant to a fraud or evasion inquiry include:

• Concealment of bank accounts or other assets;
• Willful failure to deposit receipts to business accounts;
• Covering up sources of receipts;
• Intentional omission of specific items where similar items were included on the tax return;
• Knowingly claiming dependents you are not legally entitled to claim;
• Keeping two sets of books or making false entries in books;
• Knowingly claiming false or overstated deductions on your tax return;
• Deliberately disguising personal expenses as deductible business expenses;
• Hiding or transferring assets or income to evade tax or its collection.

The same conduct can have civil and criminal tax consequences. A civil fraud penalty and a criminal charge are separate matters, with different purposes, procedures, and proof requirements.

• Civil tax fraud involves the correction of tax due and the imposition of civil penalties whereas criminal tax fraud involves punitive action with penalties consisting of fines and/or imprisonment.
• For a false or fraudulent return filed with intent to evade tax, Section 6501(c)(1) permits assessment at any time. Criminal limitation periods depend on the offense: Section 6531 generally provides three years, with six years for specified offenses including tax evasion and certain willful failures. Exceptions and suspension rules can affect the calculation;
• The burden of proof in a civil tax fraud case requires a lesser showing of proof of tax fraud by clear and convincing evidence while in criminal cases the government must prove the existence of a tax fraud crime beyond a reasonable doubt.

Civil Tax Fraud Penalties

Civil consequences depend on the conduct and the applicable penalty. Fraudulent failure to file may be addressed under Section 6651(f), separately from the Section 6663 penalty for an underpayment due to fraud. Ordinary mistakes and nonfraudulent filing failures are not automatically subject to a fraud penalty.

Internal Revenue Code Section 6663 imposes a civil penalty equal to 75% of the underpayment attributable to fraud. If the IRS establishes that part of an underpayment is due to fraud, the entire underpayment is treated as fraudulent unless the taxpayer establishes, by a preponderance of the evidence, that a portion is not attributable to fraud. This penalty does not automatically apply to every additional assessment.

On a joint return, the civil fraud penalty applies to a spouse only if some part of the underpayment is due to that spouse’s fraud; one spouse’s conduct is not automatically imputed to the other. Filing an amended return does not erase fraud in the original return or automatically remove the penalty. Potential liability affecting a deceased taxpayer’s estate requires separate legal analysis rather than an assumption that death resolves the tax matter.

Criminal Tax Fraud and Tax Evasion

Willfulness is a common element of federal tax crimes. IRM Section 25.1.1.5 defines it as the voluntary, intentional violation of a known legal duty. A genuine good-faith misunderstanding of the law or belief that the conduct complies with it may negate willfulness; the facts and applicable offense still require careful examination.

Federal tax offenses have distinct statutory elements. Some are felonies and others are misdemeanors; a list of suspicious conduct is not a finding of guilt. Depending on the required intent and other elements, conduct that may lead to criminal investigation or charges includes:

• Willfully failing to pay tax when legally required, or affirmatively attempting to evade tax or payment;
• Willfully failing to file a federal income tax return;
• Deliberately omitting income when required to report it;
• Knowingly making materially false statements in a tax return or a fraudulent claim for refund;
• Willfully failing to collect, account for, or pay over required payroll taxes, or deliberately concealing payroll. Paying employees in cash is not itself fraud if reporting and payroll tax obligations are met;
• Refund fraud (filing a false tax return to obtain a refund);
• Deliberately concealing offshore income or assets. FBAR and FATCA-related reporting have separate requirements and penalties; a missed filing does not by itself establish Section 7201 tax evasion.

Section 7201 addresses willful attempted tax evasion, Section 7203 addresses specified willful failures, and Section 7206 addresses specified false statements and related conduct. “Tax fraud” is not a single offense with one universal penalty. For Section 7201, the government must establish willfulness, an affirmative attempt to evade, and tax due. Evasion may concern assessment, such as deliberately filing a false return to evade tax, or payment, such as concealing assets to defeat collection.

Do You Need a Tax Attorney?

A tax attorney can evaluate possible civil and criminal exposure before recommending delinquent returns, amendments, or a disclosure procedure. If assessed tax and penalties cannot be paid in full, counsel can assess collection alternatives based on eligibility and financial facts. A timely, truthful and complete voluntary disclosure may be considered in deciding whether to recommend prosecution, but it does not guarantee immunity or eliminate tax, interest, or penalties. Different compliance routes apply to willful and nonwillful conduct; obtain advice before making submissions.

If you are being investigated for tax crimes such as tax fraud or tax evasion, you will want to consult with a tax attorney that specializes in criminal tax matters.

Segal, Cohen & Landis (SCL) can discuss civil tax compliance and penalty issues and whether the matter requires specialized criminal tax counsel. Depending on the engagement and facts, assistance may include:

• Obtain IRS account transcripts and wage and income transcripts to assist clients with filing compliance;
• Make recommendations regarding the filing of amended returns to correct information included in an original filing;
• Represent a taxpayer in an audit and challenge unsupported adjustments or penalties using the applicable evidence and legal standards;
• Evaluate eligibility for disclosure or compliance procedures and explain their limits, including the absence of guaranteed immunity from prosecution;
• Discuss referral to criminal tax counsel when an investigation or potential criminal exposure calls for that expertise.

To discuss a consultation regarding your tax matter, contact SCL at (310) 285-3999. Confirm the scope, fees, and proposed representative before retaining counsel. No outcome or penalty reduction is guaranteed.