In recent years, the IRS has been asserting more civil fraud penalties during the examination phase. While a civil fraud penalty may be expensive, many clients should be relieved that the case was not referred or accepted for criminal investigation. During 2015, the IRS initiated 3,853 criminal investigations, which led to 3,208 indictments.
In my practice, we refer to our clients’ audits that have criminal or civil fraud exposure as “eggshell audits.” The reason is simple, we are walking on eggshells to try and keep the audit civil without cracking a shell and the audit changing course – civil fraud or a criminal referral.
Tax fraud can be punishable by both civil (i.e. money) and criminal (i.e. jail time and money) penalties, with the civil violations primarily in Title 26 and the criminal violations principally in Title 18, respectively, of the USC. For example, a taxpayer can commit tax fraud and be punished with civil penalties under 26 USC § 6663, without being charged with criminal tax evasion.
There is a statute of limitations for tax crimes, which is the amount of time a prosecutor has to file charges. This statute of limitations represents how long your clients should be looking over their shoulder after – willfully or otherwise – lying on their tax return. The general rule of thumb is the IRS has three years to audit tax returns, and six years if over 25% of income has been omitted from the original filed tax return. You may also need to consider when the six-year period starts. The IRS could prosecute a series of fraudulent tax returns as a single charge and only start counting the six-year period from the last act of tax evasion or fraud. It gets worse. Although the IRS is limited to how far back it can look when filing charges in criminal court, there is no statute of limitations for civil tax fraud. This means the IRS can look back as far as it wants when suing for civil fraud. In practice the IRS rarely goes back more than six years because it has a high enough burden of proof to meet in fraud cases without having to deal with the added difficulties of proving older charges.
Civil tax fraud does not include jail time but it can include severe penalties along with the stigma of being liable for “fraud.” Civil penalties include I.R.C. § 6663 Civil Fraud which carries a penalty of 75% of the tax underpayment due to fraud and I.R.C. §6651(f) Fraudulent Failure to File which carries a possible penalty of 75% of the unreported tax. The term “fraud” means an “intentional wrongdoing on the part of the taxpayer motivated by a specific intent to evade a tax known or believed to be owing.” Stolzfus v. United States, 398 F.2d 1002, 1004 (3rd Cir. 1968), cert. denied, 393 U.S. 1020 (1969). The IRS must establish fraud by clear and convincing evidence. It is presumed that the entire underpayment is attributable to fraud unless the taxpayer can establish otherwise by a preponderance of the evidence. IRC § 6663(b). Also the IRS cannot impose the civil fraud penalty unless a return has been filed. IRC § 6664(b). However, the fraudulent failure to file penalty may be imposed if no return is filed. IRC § 6651(f).
Auditors are trained to look for tax fraud and look for common types of suspicious and fraudulent activity, such as:
· Overstatement of deductions and exemptions.
· Falsification of documents.
· Concealment or transfer of income.
· Keeping two sets of financial ledgers.
· Falsifying personal expenses as business expenses.
· Using a false Social Security number.
· Claiming an exemption for a nonexistent dependent, such as a child.
· Willfully underreporting income.
Although auditors are trained to look for fraud, they do not routinely suspect it. They know the tax law is complex and expect to find a few errors in every tax return. A careless mistake on a tax return might result in a 20% penalty to the tax bill. The line between negligence and fraud is not always clear, however, even to the IRS and the courts.
Lastly, there is also a difference between tax fraud and tax evasion. Tax evasion is a subset of tax fraud and it is typically used in the criminal context, as in someone who is charged with the crime of tax evasion in violation of 26 USC § 7201. Tax evasion usually entails a deliberate act of misrepresentation of taxable income to the IRS. Common examples of acts which could result in a charge of tax evasion are: not declaring all income, deliberately overstating expenses or deductions, or failing to file tax returns when there is taxable income in an attempt to avoid detection.
Adam Fayne is an attorney with the law firm of Arnstein & Lehr LLP. Prior to private practice, he was an attorney with the Internal Revenue Service Office of Chief Counsel. He has represented many taxpayers nationally and internationally with IRS examinations, IRS appeals, Tax Court, criminal defense, and foreign compliance matters. He may be reached at (312-876-7883 or
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