Small Business Taxes & Management^TM--Copyright 2015, A/N Group, Inc.

Breaching the Fraud Threshold

Most tax fraud cases involve relatively substantial amounts of unreported income. But not always. The concern is that the fraud penalty can be 75% of the additional tax involved. Moreover, the IRS is not adverse to seeking jail time. Here are two cases where the taxpayers were liable for the fraud penalty, one where unsubstantiated deductions were involved, the second where a unreported income was the issue.

In the first case the taxpayer (we'll call her taxpayer Linda Flood) claimed $8,611 for medical expenses, $7,214 for charitable contributions, $4,659 for casualty losses, and $12,656 for employee and miscellaneous expenses. During the audit of her return, the taxpayer provided two documents to substantiate her medical expenses and charitable contributions. The first was a receipt on the letterhead of a doctor. The receipt designated the taxpayer's son as the patient with $8,611 as both the amount of charges and as the amount paid. A handwritten notation read "paid by L. Flood cashier chk."

The second item for substantiation purposes was a document on the letterhead of Trinity Baptist Church entitled "1994 Contribution Statement" stating that Linda Flood contributed $7,214 during the year.

The IRS requested a copy of the check used to pay the doctor. The taxpayer wrote the IRS there was no copy. The IRS again requested a copy or, if it was unavailable, verification of the method used to purchase the cashier's check. The taxpayer responded that she paid the medical expenses in cash so there was no check. The IRS inquired of the church regarding the contributions. The church responded that they did not receive any contributions. The taxpayer wrote the IRS advising them that the contributions were anonymous.

When the case came to trial the taxpayer left before the presentation of any evidence. The IRS called the doctor and the financial secretary of the church as witnesses. The doctor did not recall treating the taxpayer or her son and the handwriting on the receipt did not belong to either the doctor or his office manager, the only two individuals who prepare receipts in his practice. In addition, the receipt did not bear the stamp customarily placed on such documents by the doctor.

The financial secretary of the church searched the contribution records and found no record of any gifts from the taxpayer. Indeed, the taxpayer was not listed in the past or present membership records of the church.

The court obviously disallowed the deductions because the taxpayer presented no credible evidence for any of the deductions. The court recited the rules with respect to civil fraud. Fraud is generally defined as intentional wrongdoing on the part of the taxpayer, with the specific purpose of evading tax believed to be owed. The IRS must prove that the taxpayer intended to evade tax believed to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of such tax. Nonetheless, the IRS need not establish that tax evasion was a primary motive of the taxpayer, but may satisfy its burden of proof by showing that a tax-evasion motive played any part in the conduct. The presence of fraud is a question of fact to be resolved on consideration of the entire record. Although fraud is never imputed or presumed, intent to defraud may be proven by circumstantial evidence.

The court found that an underpayment of tax was established. In addition, through presentation of circumstantial evidence, the IRS carried the burden of showing that some portion of the underpayment was due to fraud. Moreover, because the taxpayer failed to offer any evidence that some part of the deficiency was not due to fraud, the fraud penalty applied to the entire underpayment.

The court said the case revealed a specific fraudulent intent on the part of the taxpayer to evade tax. The taxpayer neglected to maintain adequate records to substantiate more than $25,000 in deductions. In addition, evidence of intent to defraud was particularly apparent in the implausibility and inconsistencies surrounding the two documents allegedly offered to validate the deductions. Because testimony indicated that neither document was legitimate, the taxpayer presented false evidence for purposes of misleading tax authorities.

In the second case (we'll call the taxpayer Madison Equipment) the taxpayer was a very successful manufacturer of recreational vehicles. The president and sole shareholder purchased property on Lake Tahoe with the intention of building a home there. The president had the construction company bill Madison for materials used on the home. In order to pay the wages of the construction workers, he put them on Madison's payroll. On its books, the taxpayer listed the construction expenses as corporate expenses. The outside accountant did not question the expenses which were carried on the books as cost of goods sold.

In an earlier case, the IRS interviewed the president regarding allegations that he underreported his income and that the company improperly deducted the construction expenses. The president said, that with the exception of one instance of a $75,000 bill, he did not deduct construction expenses on the company's return. However, he was convicted of fraud and sentenced to one year in jail and a $500,000 fine, in addition to paying the taxes owed with respect to his individual tax returns.

In this case the IRS contended that the construction expenses paid by the company constitute nondeductible constructive dividends and that the company underpaid its taxes when it deducted those constructive dividends. The company argued that while the expenses were improperly classified as cost of goods sold, they were actually reasonable compensation for services rendered by the president and were therefore deductible.

The court sided with the IRS. It noted that a taxpayer can deduct payments for personal services only if the payments are intended as compensation. It is a question of fact whether payments are made with an intent to compensate for services performed. The relevant time for determining the required intent is when the purported compensation payment is made, not, for example, years later when an amended return is filed after the start of an IRS audit.

The court noted that in this case the board of directors established the president's salary and bonuses during its yearly meetings. The board did not designate the construction expenses as compensation for the president's services. Madison deducted the construction expenses as cost of goods sold instead of compensation. Indeed, a clerk questioned the invoices and was told by the president to pay them in the course of business. When the outside accountants questioned the payment, the president did not claim the amounts were additional compensation, but rather amounts that he would repay. That shows that Madison did not intend the construction expenses to be compensation. The court held that the company, through the president, committed fraud. The outside accountants deducted some of the expenses because the company had inadequate records (the records showed the construction expenses as cost of goods sold). The president's dealings with Madison's employees and with the outside accountants demonstrated an intent to mislead, one of the indications of fraud. Finally, the president lied to the IRS agents and attempted to mislead them.

The courts have developed a list of factors that demonstrate fraudulent intent. These "badges of fraud" include:

• understatement of income,
  
• inadequate records,
  
• failure to file returns,
  
• implausible or inconsistent explanations of behavior,
  
• concealment of income or assets,
  
• failure to cooperate with tax authorities,
  
• presence of illegal activities,
  
• an intent to mislead which may be inferred from a pattern of conduct,
  
• lack of credibility of the taxpayer's testimony,
  
• filing false documents, and
  
• dealing in cash.

The last one needs some explanation. This item wouldn't indicate fraud if cash transactions are normal in the business. It does become a factor if the cash transactions are designed to hide income. For example, equipment purchases in cash where one would normally expect them to be paid by check or on account.

These aren't the only "badges of fraud", but they are the most common. The more factors that apply to you, the more likely the IRS will assert fraud and the greater the chance the courts will agree.

It's not unusual for taxpayers to take a questionable deduction or two or deduct some clearly personal expenses. More often than not the result is additional taxes and, if the understatement is large enough, a negligence penalty. However, as you can see from these two cases, such action can escalate to a fraud case. In the first case, the taxpayer might have avoided a fraud penalty if she hadn't provided the false documentation. Then the consequences are much more severe. The penalties are higher and can even include jail time. The dividing line is not always easy to see, but once you start falsifying documents and lying to the IRS, you're on your way to big problems. And the IRS is not adverse in seeking both criminal fraud charges, which can bring jail time, and civil fraud charges which can result in substantial penalties. Even the allegation will be costly because you'll definitely want legal representation.  

--Last Update 03/26/15