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2. 16-2 16 Tax Fraud McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

3. 16-3 What is Tax Fraud? The Tax Court, in Mandt v. Comm’r, TC Memo, 1955-226, stated: Fraud connotes bad faith, a deliberate and calculated intention at the time the returns in question were prepared and filed, to defraud the Government of taxes legally due... [it involves] the personal intent of the taxpayer, and intent being a state of mind, seldom can one isolated act or omission be singled out as evidencing a fraudulent intent. Such intent is to be found by viewing a taxpayer’s entire course of conduct. The Internal Revenue Manual (IRM): “Tax fraud is often defined as an intentional wrongdoing on the part of a taxpayer, with the specific purpose of evading a tax known or believed to be owing” and states that tax fraud requires both an underpayment of tax and fraudulent intent.”

4. 16-4 Indicia of Tax Fraud To determine whether fraud is present, the courts look for objective manifestations of fraudulent intent called badges or indicia, namely one or more acts of intentional wrongdoing by the taxpayer with the specific purpose to evade tax. Affirmative indications represent signs or symptoms of actions that could have been performed for the purpose of deceiving or concealing. Indications, by themselves, do not establish that a particular process was performed with the intent to defraud. Affirmative acts are actions that provide evidence that a process was deliberately done to deceive, undermine, or conceal the true nature of events.

5. 16-5 The IRS The largest of the 12 bureaus of the U.S. Treasury Department. Wage and Investment Division Small Business/Self-Employed Division Large and Mid-Size Business Division (now named the Large Business and International Division) Tax-Exempt and Governmental Entities Division Other divisions within the IRS include Appeals, Communications and Liaison, and Criminal Investigation; the latter handles criminal tax evasion cases. The Criminal Investigation (CI) Division Duties include investigating possible violations of tax laws, money laundering, and violations of the Bank Secrecy Act.

6. 16-6 Types of Taxes and the Internal Revenue Code Individual Income Tax The U.S. individual income tax is a tax based on gross income such as salaries and wages, interest and dividends, business income, gains and losses (e.g., due to sales of real estate), and rental income. The law allows adjustments to gross income for items such as moving expenses, contributions to retirement accounts, and alimony paid. Furthermore, the adjusted gross income (AGI) is reduced either by a standard deduction based on filing status (e.g., single, married filing a joint return) or by deductions the taxpayer itemizes such as mortgage interest, property taxes, charitable deductions, and employee business expenses. The income tax computed on the resulting taxable income is then reduced by credits for items such as child care and foreign tax payments. Finally, the tax after any credits is reduced by amounts already paid in the form of withholding payments and estimated tax payments.

7. 16-7 Types of Taxes and the Internal Revenue Code The government imposes a corporate income tax. The U.S. corporate income tax is a tax on the gross income of corporations. The calculation of corporate taxable income follows closely the calculation of pretax income shown in corporate income statements. Most states also impose an income tax on their citizens or those doing business within their borders. The income tax of most states is a flat rate tax that is based on the AGI from the federal income tax return. Most states levy a corporate income tax. This tax is often called a franchise tax (in some cases, however, only a state intangibles tax is labeled a franchise tax). Most states impose sales and use taxes.

8. 16-8 Types of Taxes and the Internal Revenue Code FICA is assessed only when persons who qualify as employees are paid (this tax, plus federal withholding, is reported quarterly by employers on Form 941). are identical to those that pertain to employees. Federal unemployment taxes (Federal Unemployment Tax Act, or FUTA) are filed on Form 940 and state unemployment (State Unemployment Tax Act, or SUTA) taxes are imposed on employers to pay for unemployment benefits paid (or to be paid) to former employees who are now unemployed. Payroll Tax Avoidance Some employers have tried to avoid paying payroll taxes by inappropriately classifying employees as self-employed individuals.

9. 16-9 The Internal Revenue Code The Internal Revenue Code (IRC) is contained in Title 26 of the U.S. Code, which is divided into subtitles A through I. Each subtitle is further divided into chapters. Chapters are further divided into subchapters, which are further divided into parts. When we refer to specific code sections, normally we do not state the title, subtitle, chapter, subchapter, and part. For example, Title 26, Subtitle A, Chapter 1, Subchapter B, Part VI, § 179 is simply referred to as IRC § 179. However, any subsection, paragraph, subparagraph, and clause are cited. For example, IRC § 179 (b)(3)(B)(i) is read “Internal Revenue Code Section (or simply “Section”) 179, subsection b, paragraph 3, subparagraph B, clause i.”

10. 16-10 Principal Tax Evasion Crimes Principal crimes include willfully evading tax or willfully failing to pay a tax (income tax as well as other taxes such as estate, gift, and excise taxes), making false statements on any return that is to be filed with the federal government, or aiding in the preparation of fraudulent tax returns. Once a criminal tax investigation has begun, full payment of taxes, penalties, and interest will not prevent prosecution. While the filing of an amended return is not considered an admission of guilt with respect to a crime it can be used to determine the amount of the underpayment.

11. 16-11 Penalties in General Conviction of a felony tax offense usually results in the assessment of a sentence and penalties. For example, the following sentence and penalties are usually assessed for each count of evasion (IRC § 7201): Imprisonment up to five years, fine of up to $250K, a civil fraud penalty of 75 percent on the portion of the underpayment due to fraud, costs of prosecution, and interest on the underpayment The taxpayer is precluded from challenging the imposition of the civil fraud penalty because the IRS met the higher standard of proof required for criminal conviction. Criminal prosecution normally takes place before civil proceedings

12. 16-12 Willful Attempt to Evade or Defeat the Imposition of Tax IRC § 7201 punishes willful attempts to evade or defeat any tax imposed by the Internal Revenue Code or the payment of the tax. An innocent spouse rule may help some spouses in joint returns. Three elements of IRC § 7201 must be proven to sustain a charge under this section: Substantial Tax Liability, Attempt to Evade the Tax by an Affirmative Act, and Willful Intent Willfully Attempting to Evade A good faith misunderstanding of the law will prevent a finding of willfulness.

13. 16-13 IRC § 7202: Willfully Failing to Collect or Remit Tax IRC § 7202: any person who has a duty to collect, account for, and remit any tax imposed by the Internal Revenue Code and who willfully fails to do so is guilty of a felony. Violations can be classified in the following two categories: Willful failure to collect the taxes. Willful failure to account for these taxes and to remit them. Instead of being charged under IRC § 7202—which requires proof of willfulness—taxpayers are more likely to be charged under IRC § 7215 for either failing to collect, account for truthfully, or remit taxes held in trust or for failure to make deposits, payments, or file returns relating to taxes held in trust.

14. 16-14 IRC § 7203: Willfully Failing to Pay Tax, File Return, or Supply Information IRC § 7203: any person required by the Internal Revenue Code to pay estimated tax or tax and who willfully fails to pay this estimated tax or tax, file a return, keep records, or supply requested information will, in addition to other penalties provided by law, be guilty of misdemeanor. IRC § 7203 specifies four punishable offenses: Willful failure to make (i.e., file) a return. Willful failure to supply information. Willful failure to pay tax and estimated tax. Willful failure to maintain records. To be convicted, the taxpayer must have had a legal duty to file a return for the taxable year for which she was charged and willfully failed to file a timely return.

15. 16-15 IRC § 7207: Delivering Fraudulent Returns, Statements, or Other Documents IRC § 7207: An offense to willfully deliver or disclose any list, return, account, statement, or other document, that they know to be fraudulent or false as to any material matter. This statute is rarely used; its use has been limited to prosecuting persons who alter cancelled checks and invoices to support inflated deductions in circumstances in which felony prosecutions are not warranted.

16. 16-16 IRC § 7204, § 7204 : Employee Withholding Statements IRC § 7204: Typically provides punishments to employers who don’t provide employees with, or provide employees with false, W-2 or W-3 forms. IRC § 7205(a) states that any individual required to furnish an employer information about income tax withholding violates that law if the employee willfully supplies false or fraudulent information or willfully fails to supply the required information and the failure results in the withholding of less tax than had the true information been supplied (typically applies to W-4 forms). IRC § 7205(b): Provides for penalties for failure to a furnish taxpayer identification numbers to banks and other payers of interest and dividends.

17. 16-17 IRC § 7206: Committing Fraud and Making False Statements IRC § 7206(1): An offense to willfully make (i.e., prepare and file) and subscribe (e.g., sign) any return, statement, or other document that contains or is verified by a written declaration that it is made under penalties of perjury and that the person does not believe to be true and correct as to every material matter. For example, IRC § 7206(1) applies if the taxpayer characterized illicit sales of drugs as sales of nutritional supplements on an income tax return. No tax deficiency is required for IRC § 7206(1). Taxpayer can be charged with both IRC § 7201 and IRC § 7206(1) offenses. IRC § 7206(2): Makes aiding and abetting preparation of a false return illegal. The document doesn’t have to be made under oath (as is the case under IRC § 7206(1)).

18. 16-18 IRC § 7212(a): Interference with Tax Laws IRC § 7212(a): illegal to attempt to interfere with the administration of internal revenue laws Does not require the person to be successful in interfering Force—or even the explicit threat of force—is not required for successful prosecution under this section. IRC § 7212(a) has become a versatile weapon against tax fraud. It does not require proof of a tax deficiency (as required by IRC § 7201), the existence of a return or document as required by IRC § 7206(1), or proof of a false or fraudulent return or document as required by IRC § 7206(2) IRC § 7212(a) even applies to improper rescuing of property seized by the IRS

19. 16-19 Termination and Jeopardy Assessments of Income Tax If the IRS becomes aware that a taxpayer is likely either to depart quickly from the United States, to remove his property from the United States, in any way conceal himself or his property from the authorities or becomes aware that the taxpayer’s financial status is in peril, it can act to make a jeopardy assessment according to IRC §§ 6861, 6862, and 6867. A termination assessment can be made by the IRS when it believes the taxpayer might act to stop or interfere with the collection of taxes for the current or immediately preceding year. The tax becomes immediately due and the assessment includes the tax as well any applicable interest.

20. 16-20 Civil Tax Fraud There are typically more civil fraud convictions than criminal fraud convictions because criminal cases require a higher burden of proof (beyond a reasonable doubt).. Innocent errors can excuse liability. Civil Fraud Indicia and Evidence Failure to file a return is only prima facie evidence of negligence, but a long history of not filing could indicate fraud. In civil tax cases, the taxpayer does not have the burden to disprove fraud. However, the taxpayer may present evidence indicating that the civil fraud penalty should not be applied.

21. 16-21 Civil Fraud Penalties and Other Penalties The civil fraud penalty of IRC § 6663 provides that if any part of an underpayment of tax is due to fraud, a penalty of 75 percent of the part of the underpayment attributable to fraud will be assessed. If the taxpayer fails to file a return, the penalty is normally 5 percent of the underpayment per month and is limited to a maximum of 25 percent according to IRC § 6651(a)(1). If, however, the failure to file is fraudulent, the penalty is 15 percent for each month the failure exists up to a maximum of 75 percent of the tax due (IRC § 6651(f)). The failure-to-pay penalty is applied to the balance of the taxes that remain unpaid after the due date of the return.

22. 16-22 Computation of Civil Fraud Penalties The computation of the civil fraud penalty is determined by multiplying the 75 percent penalty rate by the amount of the tax underpayment that the taxpayer cannot prove was due to innocent errors. According to the regulations the formula specified for calculating an income tax underpayment is: U = W – (X + Y – Z), where U = the amount of underpayment W = the amount of tax imposed (i.e., the “correct” tax) X = the amount of tax shown by the taxpayer on the return Y = the amount not shown on the return but that was previously assessed or collected without assessment Z = the amount of any rebates made; IRC § 6664(a) defines rebate as an abatement, credit, refund, or other repayment

23. 16-23 STATUTE OF LIMITATIONS Criminal Tax Prosecutions IRC § 6531: Generally, a person cannot be tried or punished unless indicted within three years of the offense. However, the period of limitation is six years for certain offenses that include tax evasion. For purposes of IRC § 7201, the statute of limitations begins to run when the defendant engages in an affirmative act and has a tax deficiency. IRC § 6513(a) states that a return filed before the due date shall be considered filed on the due date for that return. If an amended return is filed to correct the filing of a false return, the statue begins with the filing of the amended return, not the original return. If the defendant is “outside the United States or is a fugitive from justice” during any part of the statutory period of limitations, the time he is outside the United States or a fugitive does not count as a part of the statute (IRC § 6531).

24. 16-24 Statute of Limitations Assessment and Collection of Tax According to IRC § 6501, the statute of limitations on the assessment and collection of tax is generally three years. If, however, the taxpayer filed a false or fraudulent return with the intent to evade tax, willfully attempted to defeat or evade tax, or failed to file a return, the government can assess the tax or begin a proceeding in court for collection of the tax at any time.

25. 16-25 Methods of Proof Direct Methods Point-of-Payment Analysis Point-of-Receipt Analysis Indirect Methods There are three primary indirect methods: net worth, expenditures, and bank deposits. These methods can be used to show that the taxpayer’s estimated income is higher than his reported income. These methods, however, cannot show the source of the understatement. The “proof” provided by these three methods is much like circumstantial evidence. In fraud cases, it must be combined with other evidence to support the assertion that the understatement of taxable income was due to fraud.