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Badges of Tax Fraud – IRS Goes Undercover in a “Gentleman’s Club”

Posted by Hochman Salkin Toscher Perez P.C. Posted on Monday, February 03, 2014

“If any part of any underpayment of tax required to be shown on a return is due to fraud,” Code section 6663(a) imposes a penalty of 75% of the portion of the underpayment due to fraud. A civil fraud penalty case may be developed based on facts and circumstances of a civil examination or result from a criminal investigation (CI) initiated case. Fraud is intentional wrongdoing designed to evade tax believed to be due and owing.[1] The existence of fraud is a question of fact to be resolved upon consideration of the entire record.[2] Fraud is not to be presumed or based upon mere suspicion.[3] However, because direct proof of a taxpayer’s intent is rarely available, fraudulent intent may be established by circumstantial evidence and reasonable inferences.[4] Fraud will generally involve one or more of deception, misrepresentation of material facts, false or altered documents, or evasion (i.e., diversion or omission).[5]

Fraud includes deception by misrepresentation of material facts, or silence when good faith requires expression, which results in material damage to one who relies on it and has the right to rely on it. Simply stated, it is obtaining something of value from someone else through deceit. 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. Tax fraud requires both a tax due and owing as well as fraudulent intent.

Avoidance of tax is not a criminal offense. “Tax avoidance” generally refers to legally permissible conduct to reduce one’s tax liability while “tax evasion” refers to willfully and knowingly fraudulent actions designed to reduce one’s tax liability.  Taxpayers have the right to reduce, avoid, or minimize their taxes by legitimate means. One who avoids tax does not conceal or misrepresent, but shapes and preplans events to reduce or eliminate tax liability within the parameters of the law. Evasion involves some affirmative act to evade or defeat a tax, or payment of tax. Examples of affirmative acts of evasion might include deceit, subterfuge, camouflage, concealment, attempts to color or obscure events, or make things seem other than they are. A classic description of “tax avoidance” was penned by Judge Learned Hand:

                “Anyone may arrange his affairs that his taxes shall be as low as possible.  He is not bound to choose the pattern which best pays the Treasury, there is not even a patriotic duty to increase one’s taxes.  Over and over again courts have said that there is nothing sinister in so arranging affairs has to keep taxes as low as possible.  Everyone does it, rich and poor alike, and all do right, for nobody owes a public duty to pay more than the law demands.”[6]

The Government satisfies their burden of proof by showing that “the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead or otherwise prevent the collection of taxes.”[7] The taxpayer’s entire course of conduct may be examined to establish the requisite intent, and an intent to mislead may be inferred from a pattern of conduct.[8]

During a civil examination, an IRS Fraud Technical Advisor (FTA) may be involved to assist in developing a potential fraud case. The FTA will be consulted in all cases involving potential criminal fraud, as well as those cases that have potential for a civil fraud penalty.[9] The FTA serves as a resource and liaison to compliance employees in all operating divisions. The FTA is available to assist in fraud investigations and offer advice on matters concerning tax fraud. Upon initial recognition of indicators of fraud, the IRS examiner will discuss the case at the earliest possible opportunity with his/her manager. If the compliance group manager concurs, the FTA will be contacted immediately; and both the compliance group manager and FTA will provide guidance to the compliance employee on how to proceed.

Civil fraud penalties will be asserted by the IRS when there is clear and convincing evidence to prove that some part of the underpayment of tax was due to fraud. Such evidence must show the taxpayer’s intent to evade the assessment of tax which the taxpayer believed to be due. Intent is distinguished from inadvertence, reliance on incorrect technical advice, honest difference of opinion, negligence or carelessness. In the case of a joint return, intent must be established for each spouse separately as required by Code section 6663(c). The fraud of one spouse cannot be used to impute fraud by the other spouse. Thus, the civil fraud penalty may be asserted on one spouse only.[10]

Circumstances that may indicate fraudulent intent, commonly referred to as “badges of fraud,” include but are not limited to: (1) understatement of income (e.g., omissions of specific items or entire sources of income, failure to report relatively substantial amounts of income received) particularly if part of a consistent pattern of underreporting over several years; (2) maintaining inadequate records or accounting irregularities (e.g., two sets of books, false entries on documents); (3) giving implausible or inconsistent explanations of behavior or other acts cts of the taxpayer evidencing an intent to evade tax (e.g., false statements, destruction of records, transfer of assets); (4) concealing income or assets; (5) failing to cooperate with tax authorities; (6) engaging in illegal activities; (7) providing incomplete or misleading information to one’s tax preparer; (8) lack of credibility of the taxpayer’s testimony; (9) filing false documents, including false income tax returns; (10) failing to file tax returns; and (11) dealing in cash.[11] No single factor is dispositive; however, the existence of several factors “is persuasive circumstantial evidence of fraud.”[12]

Some factors have no application in a particular matter while other factors may be regarded as neutral. Typically, in litigation, the court will determine whether, on balance, the “badges of fraud” demonstrate that the taxpayer acted with fraudulent intent for each tax year at issue.

In a recent case involving a “gentlemen’s club,” IRS special agents (from IRS CI) engaged in an undercover investigation by posing as buyers interested in acquiring the business.[13] According to the opinion of the U.S. Tax Court, the owner assured the IRS agents that the club was much more profitable than it appeared. He explained that he deposited in the corporate account only enough of the business revenues to cover its expenses and that he wired the balance of its revenues to his personal bank account in Florida. Subsequently the club owner was criminally charged with eight counts under Code section 7206(1) and (2) for making and subscribing false tax returns, and for assisting in the preparation of false tax returns, for himself and the corporate owner of the club.

Ultimately, the taxpayer pleaded guilty to one count of making and subscribing a false Form 1120 on behalf of the corporate owner for a single tax year. Pursuant to his plea, the taxpayer was sentenced to 18 months’ prison time and supervised release for one year.

He was also ordered to pay restitution of $ 400,000. In the factual basis for his guilty plea, the taxpayer admitted under penalties of perjury that he willfully submitted false tax

returns for the corporation for the 2002-05 tax years; that he did not believe those returns to be true and correct as to every material matter; and that he had falsely subscribed those returns with the specific intent to violate the law. During his criminal sentencing the taxpayer stated: “I admitted I falsified my returns and so forth, and it [has] caused me a lot of problems.”

During the criminal investigation, IRS agents seized upwards of $ 200,000 in cash and obtained a second set of sales ledgers that apparently accurately tracked its daily receipts. These ledgers confirmed that annual receipts for 2002-05 were vastly in excess of the amounts that had been reported to the IRS. The difference between its actual gross receipts and the gross receipts reported on the company’s Forms 1120 for those years exceeded $ 2 million.

After the search by the IRS, when he knew he was under criminal investigation, the taxpayer provided his accountant additional bank account information for the 2003-05 tax years. His accountant used this information to file amended Federal income tax returns for those years, both for the corporation and for the taxpayer individually. The IRS assessed additional income tax and penalties (for late filing as well as civil fraud) on the basis of the amounts shown on the amended returns for 2003-05.

Extensive dealings in cash are a badge of fraud because they are indicative of a taxpayer’s attempt to conceal income and avoid scrutiny of his finances.[14] Fraudulent intent may be inferred when a taxpayer handles his affairs in a manner designed “to avoid making the records usual in transactions of the kind.”[15]

As a “gentlemen’s club,” petitioner’s business was a cash-based operation. Its sales receipts were derived principally from food and drink charges run through the cash register, door cover charges, juke box moneys, pool table receipts, and moneys paid to him by the dancers for the privilege of “dancing.” The taxpayer admitted that he weekly wired large amounts of this cash to his personal bank account in Florida. These wire transfers were invariably made in amounts less than $ 10,000 in order to avoid detection. During the search, IRS agents seized more than $ 200,000 in cash from the premises. Although conducting a cash business does not necessarily prove fraud, “[w]hen coupled with attempts to conceal transactions or avoid the requirement of reporting cash transactions, it becomes more probative.”[16]

The taxpayer contended that he lacked fraudulent intent because he is uneducated and unsophisticated and had to hire tax professionals to file his personal and corporate tax returns. However, the Tax Court determined that his lack of education and sophistication is irrelevant. In this context, the Tax Court stated that the tax laws he violated are not esoteric or complex.[17] Civil examinations involving sensitive issues must be handled cautiously. Amending returns during an examination might be the last link necessary for a civil examination to be referred to CI for a criminal investigation.

Tax practitioners must understand the process by which a civil tax case winds its way through the system. Identifying the decision-makers and the factors they consider important may have an impact on the ultimate resolution of the examination. There is no substitute for mastering the facts and anticipating which, if any, “badges of fraud” may arise so as to be able to prepare a cogent response during the civil examination. Filing current year returns during the examination requires extreme judgment since they will have an impact, although not always a taxpayer-favorable impact, on the process. Of equal importance, counseling a client not to perpetuate possible badges of fraud during the investigation, including falsifying, destroying or altering records, continuing questionable practices into the present and future years, or transferring or concealing assets under investigation may be the difference between a civil resolution and a criminal referral.