What is tax fraud?
Tax fraud is a general term for when a person or firm intentionally defrauds the government in order to avoid paying taxes. Major examples of fraud include failure to file a tax return, intentional failure to pay taxes, intentional under-reporting of income, preparation of false files, filing a false tax return, and using a fake Social Security number. Tax fraud is a serious offense with brutal consequences. Along with jail time, individuals convicted of tax fraud can be fined up to $250,000 and businesses can be fined up to $500,000.
The key component to fraud is that the taxpayer’s actions are intentional. Taxpayers are legally bound to accurately report income and expenses on their tax return. Withholding or falsifying information on a return is illegal and can result in either civil or criminal charges. If the auditor reviewing your return finds evidence or sufficient suspicion of tax fraud, your return may end up in the hands of the IRS Criminal Investigation Unit.
It is important to note that, while the IRS usually has 3 years to conduct an audit, there is no statute of limitations if they find evidence of fraud in your tax return. The IRS can investigate a fraudulent return for however long they require and can open up returns from previous years, so don’t try to wait them out.
If you intentionally commit tax fraud, the IRS will find out. The IRS combines both trained auditors and computer systems to detect discrepancies within your return. The auditors are trained to find fraud within a return, however most of the errors they find are honest mistakes. So what distinguishes fraud and mistake to the IRS?
Fraud or Negligence?
The IRS can tell the difference between honest mistakes and fraudulent actions. If you did not intentionally falsify your tax return, you don’t have anything to worry about. Honest mistakes do happen, though. The IRS knows that the tax code is complicated and most people are unaware of how it works. When errors are found in a return, the IRS generally gives the taxpayer the benefit of the doubt and assumes the mistake was out of negligence. Intent is the key difference between fraud and negligence. Common intentional actions that serve as red flags to the IRS include:
- Overstatement of deductions and exemptions
- Falsification of documents
- Concealing income
- Keeping two sets of books
- Falsifying personal expenses as business expenses
- Using a false Social Security number
- Claiming an exemption for a nonexistent dependent, such as a child
A 20% penalty can be placed on you for negligent actions such as failing to keep adequate records. This means that if you owe $10,000 in taxes and are given a 20% penalty, the penalty will amount to $2,000 for a total of $12,000 plus interest. This is an honest mistake and is much better for you than the 75% penalty placed on you for civil fraud. Negligence isn’t illegal, but you can still pay for it. Be careful to keep records and to file your return accurately. The IRS is trained to tell the difference between fraud and negligence, but you don’t want to give them any reason to take a closer look at your finances.
The chances of you being charged criminally for fraud are extremely low. The IRS Criminal Investigation Unit only investigates about 2% of taxpayers, only 20% of that actually face charges. When an auditor spots an error in a return, they usually just place civil penalties to avoid extra paperwork. The IRS unofficially only conducts criminal investigations on cases with at least $70,000 in unpaid taxes. Considering most people don’t even make that in a year, the average American shouldn’t worry about being accused of tax fraud.
How the IRS Proves Fraud
The IRS relies on four indirect methods for determining fraud. They examine specific items, bank deposits, expenditures, and net worth to determine if you have committed tax fraud.
Specific items, such as checks given in payment to a company that are pocketed by the company owner, are useful in an investigation but there must be enough specific items to prove fraud. Unless a single check is pocketed for a significant amount of money, anywhere between 15 to 20 specific items are needed to prove fraud.
Bank deposits are the easiest way for the IRS to prove fraud because the auditor only has to find the sum of all of your deposits and compare it to your reported income. If your deposits exceed your reported income, you will be accused of fraud.
As with bank deposits, the IRS will calculate the sum of all your expenditures such as written checks, living expenses, and estimated cash expenses. The auditor can even use statistics on the cost of living in your area. If the sum of all of your expenditures exceeds your reported income, the IRS will be suspicious of tax fraud. The auditor will want you to fill out IRS Form 4822 which lists your living expenses. Do not do this. There is no punishment for refusing to fill it out and it only makes it easier for them to incriminate you.
Net worth is calculated by the IRS by finding the sum of all your liabilities and subtracts it from the sum of all of your assets from the start and end of the year under audit. If there is an increase of net worth without an increase of income from the previous year, the IRS will suspect you of tax fraud.
The IRS has additionally compiled a list of “badges of fraud” which are specific indicators that fraud is present. The badges are various but generally fall under the categories of understated income, insufficient books and records, failure to file tax returns, inconsistent or unlikely financial behavior, concealing assets, and failure to cooperate with the IRS.
No one of these badges are enough to prove fraud on their own. Multiple indicators are necessary for the IRS to conduct a criminal investigation.
A Clear Example of Tax Fraud
It is fairly easy for a self-employed person to fall into fraudulent habits. Since they keep track of their own books and records, it is easy for them to write off personal or fictitious expenses as business related. This would give them tax benefits they are not actually entitled to.
Say you own a restaurant and you decide to write off personal expenses such as vacations, personal travel expenses, or your phone and internet bill as business you can amount large illegal deductions that hide the actual amount of money you owe the IRS. This is an example of intentionally fraudulent behavior that can result in criminal consequences.
It is the IRS’s responsibility to prove that you intentionally committed fraudulent actions. Regardless, it is vital that you cease contact with the IRS and get legal representation such as the Law Offices of Jef Henninger as soon as you discover you are being investigated for fraud.