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Difference between civil and criminal fraud allegations

Table of Contents
    1. Different Levels of Proof

    The main difference between civil and criminal fraud is the amount of proof that the government must show. In a sentence, “criminal fraud” requires evidence to prove that the taxpayer committed the crime “beyond a reasonable doubt.” By contrast, civil fraud uses a lower standard: the government must prove the taxpayer committed fraud with “clear and convincing evidence” of his or her intent to evade tax.

    The distinction makes a real practical difference, too.   In the first place, a criminal charge is a more serious one, and could potentially lead to jail time. Second, because of the different standards of proof, a taxpayer may be convicted of civil fraud without being convicted of criminal fraud.

    Third, if a taxpayer is convicted of criminal fraud (i.e. a conviction under Section 7201), he may also be convicted of civil fraud. In other words, the road to criminal fraud should not be thought of as a “fork”—one side for civil and one for criminal; rather, it is more of a “one way road” with two stops along the way. However, it should be noted that a criminal conviction does not “automatically” require a civil conviction; it is just often the case that it does.

    Fourth, there are procedural effects that may apply where both a civil and criminal fraud penalty are asserted. If a person is convicted for a criminal penalty under Section 7201, then he is prevented from objecting to a civil fraud penalty because of the doctrine of “collateral estoppel.” In other words, the taxpayer could be a “sitting duck” for a civil fraud penalty once a criminal charge has been given. Now, as a practical matter, this effects the decision whether to settle the case, or move to trial. If you go to court and lose, then—provided the relevant elements for a civil fraud penalty are also satisfied—you could find yourself also stuck with a civil fraud penalty. If you settle the criminal matter with the government, they must still prove the civil fraud elements against you. Accordingly, settling might prove to be a better “divide and conquer” strategy.

    1. How much is the civil fraud penalty?

    The civil fraud penalty is 75% of the underpayment that is due to fraud. IRC §6663(a) provides, If any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.” Underpayment is “due to fraud” when a taxpayer “intends to evade tax.”

    1. How is “fraud” defined—or is it?

    IRC §6663(a) does not define “fraud,” but the courts find fraud when there is the relevant state of mind—namely, as mentioned, an “intent to evade taxation.” This, of course, in turn begs the question what it is to intend to evade taxation. It can be illustrated by contrasting it with its negation: One does not intend to evade taxation when avoiding the tax was due to mere inadvertence, the taxpayer relied on false/incorrect advice from his tax advisor, or there was an honest difference of opinion regarding the law; negligence and carelessness also does not rise to the level of “intent to evade,” so these things will not trigger the criminal fraud penalty.

    1. Indirect or circumstantial evidence is usually used

    In practice, rarely does the government find “direct” proof of a person’s intent. For this reason, proof of a person’s fraudulent intent is usually based on indirect or circumstantial evidence. The government will look to see whether the person (a) attempted or actually deceived the government, (b) misrepresented material facts, (b) altered documents or submitted false documents on a tax return, (c) somehow engaged in other evasion-like behavior, or (d) committed an act of conspiracy against the government.

    To assert a civil fraud penalty, the government must show two things: (1) the person knew there was false content in his or her tax return, and (2) he or she filed it with the intent to evade tax. The government must prove both these items by clear and convincing evidence. See IRC § 7454(a)(explaining that “[i]n any proceeding involving the issue whether the petitioner has been guilty of fraud with intent to evade tax, the burden of proof in respect of such issue shall be upon the Secretary”).

    1. What defenses to a civil fraud penalty exist?

    A “reasonable cause” defense exists for civil fraud. Stated more precisely, if the taxpayer can show that he has reasonable cause for underpaying (or underreporting) his taxes, and he acted in good faith with the government, then the underpayment civil fraud penalty will not apply to that portion. In a post-2010 environment, this reasonable cause exception will apply to a transaction only if it has economic substance. See IRC § 6662(b)(6). The basis for this exception is found in IRC § 6664(c)(1), which provides: “No penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”

    The IRS has outlined circumstances where reasonable cause and good faith may be found:

    1. Honest misunderstanding of fact or law that is reasonable given the experience, knowledge, sophistication and education of taxpayer.
    2. An isolated computational or transcription error.
    3. Reliance on erroneous information reported on Forms W-2, 1099, etc., provided that the taxpayer did not know or have reason to know that the information was incorrect.
    4. Reliance on advice of a tax advisor or appraiser who does not suffer from a conflict of interest or lack of expertise.

    The IRS has also outlined some circumstances where reasonable cause and good faith are not found:

    1. Lack of significant business purpose.
    2. Reliance on advice of a tax advisor or appraiser who the taxpayer knows or should have known lacked sufficient expertise or lacked independence.
    3. Taxpayer agreed with the organizer or promoter of the tax shelter that the taxpayer would protect the confidentiality of the tax aspects of the structure of the tax shelter.
    4. Claimed tax benefits are unreasonable in comparison to the taxpayer’s investment in the tax shelter.
    5. Nondisclosure of a reportable transaction.

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