In today’s blog post, I want to examine the indicators of fraud (sometimes called “badges of fraud,” though the terms are interchangeable) that can potentially trigger a criminal referral. These indicators/badges of fraud are extremely important, among other places, during FBAR investigations. I have written about the FBAR at length in previous posts--you can read these posts here and here --and the presence of fraud in an FBAR investigation can alter the dynamic considerably. When a finding of fraud is made, IRS criminal investigations may become involved; civil penalties increase to 75% of the additional tax due and there is an unlimited statute of limitations to audit a return.
The IRS fraud handbook offers a comprehensive if hardly exhaustive list of these indicators/badges, and taxpayers with an inadequate or confused understanding of their financial situation--usually sole proprietors or small businesses with a small chain of command--often run afoul of them either through an attempt to inflate expenses and understate income or simply through sheer recklessness. Offenses are sometimes tied to Chapter 9 of Title 18 of the U.S. Code, as consumers in bankruptcy proceedings may trigger fraud investigations because they are transferring assets for no consideration, leading an extravagant lifestyle, and failing to file the required income tax returns.
Although there are many potential indicators/badges of fraud, a handful of them are particularly common and will attract the attention of IRS examiners. Shell companies that hire employees and lease them back to the parent corporation, companies that withhold taxes from employees but fail to pay them to the government, the payment of cash wages, excise tax fraud, and the use of fictitious subcontractors as a way of paying employees off the books are all extremely common indicators of fraudulent activity. Revenue agents and revenue examiners are familiar with such behaviors and can very quickly assess and stereotype organizations that are engaging in them.
Once these fraud indicators/badges are discovered, IRS revenue agents will consult with their group manager and a Fraud Technical Advisor (FTA) to determine if a Fraud Development Recommendation should be filed. From there, agents will request returns--excepting, of course, those returns that have not been filed that have raised the suspicion of fraud. The IRS strives to avoid the perception that it is using a civil examination process to develop a criminal case against the taxpayer. That said, once the appropriate referral paperwork is complete, the revenue agent will forward the case to the FTA, who will recommend a criminal investigation, if necessary. At this point, evidence gathered in the case, including tax returns and a consideration of the taxpayer’s demographic profile, will determine what further subsequent steps are taken, such as additional investigation and prosecution.
The best way to avoid this situation is to keep detailed business records and avoid the business practices listed here or outlined in the IRS fraud handbook. However, once an IRS investigation begins, taxpayers wishing to avoid or reduce civil and criminal penalties are advised to consult with an experienced tax attorney to explore the options available to them.
For a free phone consultation regarding this subject or other tax matters, please contact The Law Office of Aaron P Richter, a Bethesda-based law firm with expertise in Tax Controversy, Business Formation, Estate Planning, and Tax Preparation.