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How Does the IRS Develop an Employment Tax Fraud Case from the First Indication of Fraud to a Criminal Indictment?

Table of Contents

    According to information provided by IRS employment tax auditors and examiners, the most common forms of employment tax fraud are:

    • Willful failure to account for, collect, or pay over taxes (IRC 7202)
    • Willful failure to file a return (IRC 7203)
    • Willful failure to pay taxes owed (IRC 7203)
    • Willful submission of a false statement under (IRC 7206(1))
    • Failure to collect and deposit in a special trust fund account (IRC 7215 and IRC 7512(b))
    • Attempts to obstruct or impede tax administration (IRC 7212(a))

    However, prior to the filing of criminal tax charges significant workup and investigations occur. This generally involves a process that first screens for initial indicators of fraud which are sometimes referred to as badges of fraud. The mere presence of first indicators of fraud is not sufficient to bring a case against a taxpayer and these indicators must be developed into what the IRS terms “firm indications of fraud.” Once firm indicators of fraud have been developed, the auditor or examiner will determine whether the matter should be referred to IRS Criminal Investigations for further development.

    What Are First Indicators of Tax Fraud?

    First indications of tax fraud can be described as a mere suspicion by the auditor or examiner that the taxpayer has committed fraud. IRS policy and resource manuals direct agents that they are not only legally able to ask taxpayers questions about discrepancies but they are expected to do so. In fact, an array of investigative techniques is set forth in Internal Revenue Manual § 25.1 – Investigative Techniques. Agents are advised that even at this initial stage, investigative techniques should seek to develop all aspects of fraud including errors of law, errors of fact, errors in accounting, and irregularities like backdated documents.

    Badges of fraud set forth in IRM § may aid this investigation and include indicators of fraud for income, expenses and deductions, books and records, allocation of income, the conduct of the taxpayer, and methods of concealment. For instance, common badges of fraud regarding allocations of earnings or income frequently include disbursements to fictitious payees or the inclusion of income or deductions on the tax return of a related taxpayer, when tax rate differences are a factor. Similarly, there are thirteen badges of fraud relating to income including:

    • Failure to include certain sources of income
    • Inability to account for a substantial increase in net worth
    • Concealment of bank or other financial accounts
      Use of a check cashing service to convert client checks or other income into cash or other practices that deviate from accepted business norms
    • Inadequate explanations for use of large amounts of cash especially in industries where the use of currency is not common or customary.

    When first indicators of fraud are detected, the agent will discuss the facts and circumstances with a manager. If the agent and managers agree that fraud is likely, plan of action should be developed to establish and document the affirmative acts or firm indications of fraud.

    Developing Firm indicators of Fraud

    Once initial indicators of fraud are detected and the matter is escalated, the agents will work to develop firm indicators of fraud. As opposed to initial indicators, firm indicators of fraud can only be developed through a case-specific assessment of the facts and circumstances present. Essentially, the agent will work to further establish and develop the type of fraud detected at the initial stage. They may assess taxpayer filings or even seek additional information to further develop the initial indicators of fraud into firm indicators.

    For taxpayers, a suspension of the investigation may seem to indicate that the matter has been resolved. However, in reality, it may be a sign that the agent has gathered sufficient evidence to develop the initial indicators into firm indicators of fraud. In fact, the Internal Revenue Manual directs agents that upon discovery or development of firm indicators of fraud, the examination should be immediately suspended. Furthermore, the agent is instructed to provide no reason for the suspension of the examination.

    How Does the Refer Employment Tax Fraud Matters to Criminal Investigations?

    • If the facts of the case warrant a criminal referral, the examiner will prepare a referral on Form 2797, Referral Report of Potential Criminal Fraud Cases. See IRM The referral should include a detailed analysis of all evidence used to establish that firm indicators of fraud exist. According to IRS documents the report should include:
      All affirmative acts conducted by the taxpayer or his or her agent
    • How the taxpayer has justified or explained his or her actions or accounting practices
      Additional supporting documents like the last filed tax return, financial statements, or checks from entities of public record are provided to CI at the 10-day conference.

    The referral will then be forwarded to the referring examiner’s manager for additional approval. Thereafter, the referral is directed to IRS Criminal Investigation (CI) for approval by the Criminal Investigation Special Agent in Charge and the Supervisory Special Agent (SSA). Once this approval is granted, the matter will be assigned to a Special Agent.

    Facing an Audit or Examination?

    One can probably already see the danger that is inherent in even a seemingly routine audit. That is, the agent assigned to your matter may interpret innocent actions as indicators of fraud and proceed with a more stringent investigation into your finances. If you may have engaged in “odd” transactions, like visiting a check cashing service or paying employees in cash, they agent may interpret these actions as signs of fraud. In light of actions like these, the agent may even interpret mistakes on tax filings as a sign that the taxpayer is engaged in more than meets the eye or is being disclosed. All the while, you may make statements or admissions to the agent thinking that they would help.

    Then, when the examination is abruptly halted, they may even believe that they have successfully navigated the audit. In reality, IRS-CI is likely assessing and may be building a criminal case against the taxpayer. At the same time, the taxpayer is sitting idly while time that could be used to prepare to meet the criminal tax charges is passing.
    What Should I do if I’m Contacted for an Employment Tax or Other Audit?

    If you have been contacted for a tax audit and are concerned about certain underlying issues, it is prudent to contact a tax attorney immediately. If criminal tax charges are a concern it is essential that you speak to a lawyer because only the attorney-client privilege or work product doctrine are sufficient to protect any disclosures, you may make. Returning to your original accountant or to tax preparer can result in the preparer attempting to protect his or her license by blaming the taxpayer. If he or she is subpoenaed to testify against you, the privilege will not protect disclosure and you should fully expect the testimony to be unfavorable.

    Therefore, at the outset of any audit or examination, it is often wise to seek out a tax attorney. At this stage, an attorney can help guide the audit process and reduce the likelihood of common mistakes that could raise the first indication of fraud suspicions. However, if an examiner seems particularly interested in certain transactions and seems to be probing for any inkling of impropriety, it is probably time to contact a tax controversy and litigation attorney. To schedule a confidential, reduced-rate consultation with a tax lawyer from the Tax Law Office of David W. Klasing, please call 800-681-1295 today.

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