Tread carefully: what CPAs should know about tax fraud.

• Author: Hibschweiler, Arlene M.

EXECUTIVE SUMMARY

* The penalty assessed for civil fraud is 75% of the portion of the taxpayer's underpayment attributable to fraud. The penalty does not apply to any part of an underpayment that is due to reasonable cause if the taxpayer acted in good faith.

* Fraud can be proven through indirect audit methods such as the bank deposits and cash expenditure method and the net worth method.

* Any audit that uncovers a possible case of civil fraud has the potential of turning into a criminal investigation and prosecution of the taxpayer. Because of this potential of criminal prosecution, a CPA should advise a client facing allegations of civil fraud to retain a criminal tax attorney.

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Over the past few years, the IRS has generally demonstrated a pattern of increasing both the number and the aggregate dollar amount of civil tax fraud penalty assessments in individual income tax cases, with a significant increase in fiscal years 2006 and 2007 (see the exhibit). (1) Although the number of corporate income tax cases in which the IRS has assessed the civil fraud penalty and the aggregate dollar amount of the penalty assessed each year during the same period have not followed the same (or apparently any) pattern, (2) the numbers are still significant. For example, in 2007 the Service assessed $222,278,000 in corporate fraud penalties. (3) Sec. 6663 governs the imposition of the federal civil tax fraud penalty. Given the overall increase in the Service's assessment of this penalty, it is important for CPAs to understand when and how the penalty may be assessed and the relevant procedural considerations. Moreover, in any case in which the civil fraud penalty is or may be assessed, there is always the potential for a criminal tax fraud allegation. As a result, it is also important for CPAs to be aware of the interaction between civil and criminal tax fraud and to be able to recognize the warning signs that a civil tax fraud case may become a criminal case.

This article examines Sec. 6663 and the civil tax fraud penalty it imposes. After describing the substantive and procedural aspects of the penalty, it discusses the interaction of the civil tax fraud penalty with criminal fraud penalties and highlights possible indicators that a case may involve a criminal fraud claim or investigation. (4) A significant portion of the article is devoted to the CPA's role in cases involving allegations of tax fraud.

The Civil Tax Fraud Penalty Imposed by Sec. 6663

Amount and Imposition of the Penalty

Sec. 6663(a) provides that "[i]f 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." Thus, the penalty, imposed at the hefty rate of 75 % plus interest, (5) imposed on fraudulent underpayments of amounts required to be shown on a tax return. (6)

The term "fraud" is not defined in Sec. 6663 or the regulations. For civil tax penalty purposes, fraud has been described as "conduct (1) the likely effect of which is to mislead or conceal and (2) in which the taxpayer voluntarily and intentionally engages to evade a tax he knows he has an obligation to pay." (7) Consequently, proof that a taxpayer has intentionally attempted to evade tax involves presenting objective evidence from which the judge or jury may infer the taxpayer's subjective intent of tax evasion.

Indications of tax fraud are commonly referred to as "badges" or "indicators," and the IRS uses proof of one or more of these items to establish that an underpayment is attributable to fraud. The Internal Revenue Manual (IRM) lists six categories of fraud indicators, including income, expenses or deductions, books and records, allocations of income, taxpayer conduct, and methods of concealment.

The IRM lists several examples of potentially fraudulent activity under each category. (8) For example, indicators of fraud in the income category include omitting specific items of income or entire sources of income, failing to explain increases in net worth, making substantial personal expenditures in excess of available resources, making bank deposits from unexplained sources, and concealing bank and other accounts. (9) Each of the indicators is essentially a red flag to an IRS agent that the taxpayer may have engaged in tax fraud.

For purposes of Sec. 6663, Sec. 6664 defines the term "underpayment" as the amount by which the tax imposed exceeds the sum of the amount shown as tax by the taxpayer on his or her return plus amounts not so shown but previously assessed (or collected without assessment). (10) A key part of this definition is that the Sec. 6663 civil fraud penalty is assessable only for returns filed by the taxpayer. The IRS cannot impose the civil fraud penalty on a return it prepares and executes on behalf of a taxpayer who fails to file a return. (11) In that situation, the Service may instead assess the fraudulent failure-to-file penalty under Sec. 665 l(f).

For purposes of determining the existence and amount of an underpayment, the amount of tax shown on the taxpayer's return includes an amount listed as additional tax on certain amended returns. (12) This means that an amended return can have the effect of reducing the amount of the taxpayer's underpayment. However, this rule does not apply in cases involving a fraudulent position on the taxpayer's original return. (13) As a result, amending a fraudulent return does not negate the possibility of a civil fraud penalty assessment.

Reasonable Cause Exception to the Civil Fraud Penalty

Under Sec. 6664(c)(1), the civil fraud penalty imposed by Sec. 6663 does not apply to any part of an underpayment that is due to reasonable cause, provided that the taxpayer acted in good faith. The regulation regarding the reasonable cause exception for purposes of the accuracy-related penalty imposed by Sec. 6662 (14) and the discussion of reasonable cause in the Consolidated Penalty Handbook portion of the Internal Revenue Manual (15) are the primary sources of the Service's approach to applying the reasonable cause exception.

In general, whether the IRS treats the taxpayer as having reasonable cause for an underpayment of tax is determined based on all the facts and circumstances. Reasonable cause relief from a penalty "is generally granted when the taxpayer exercises ordinary business care and prudence in determining their tax obligations but nevertheless is unable to comply with those obligations." (16)

The IRS summarily rules out several possible explanations for an underpayment as not consistent with ordinary business care and prudence and therefore as not a basis for a reasonable cause exception. These explanations include claims that the taxpayer is ignorant of the obligation to file and/or pay taxes, claims that the taxpayer made a mistake, and claims of forgetfulness or oversight by the taxpayer. (17) Reasonable cause can include death, serious illness, unavoidable absence, and the inability to obtain records; (18) however, these would not appear relevant to a claim of fraud that involves an intent to evade tax.

Much more relevant to the question of whether the taxpayer had reasonable cause for an underpayment in the context of the civil fraud penalty is the taxpayer's reliance on advice provided by the IRS or a tax professional. The Code requires the IRS to abate the portion of any penalty attributable to written advice furnished by an officer or employee of the Service acting in an official capacity. (19) However, a new or revised regulation or ruling resulting from a change in the law is treated as notice to the taxpayer that the prior written advice is no longer correct. (20) Penalty relief may also be granted based on oral advice from the IRS, with the Service considering whether the taxpayer exercised ordinary business care and prudence in relying on the oral advice, the relationship between the taxpayer's situation and the advice provided, the taxpayer's tax history, and supporting documentation. (21)

Reliance on a tax professional's advice may also be the basis of penalty relief. In this regard, the IRM specifically notes the potential for relief where the tax adviser "provides advice on a substantive tax issue" and limits such relief to advice relating "to issues generally considered technical or complicated" and not to those related to the taxpayer's responsibility to file, pay, or deposit taxes. (22)

The regulation regarding the reasonable cause exception for purposes of the accuracy-related penalty provides further guidance regarding reliance on an opinion or advice that should also be relevant in the context of the civil fraud penalty. This includes consideration of the taxpayer's education, sophistication, and business experience and a requirement that the advice must be based on all pertinent facts and circumstances and not on unreasonable factual or legal assumptions. (23) As noted below, the tax adviser should retain proof of the facts and circumstances relied on in rendering advice to the client both to support a taxpayer's reasonable cause defense and to protect the adviser from a malpractice or tax fraud allegation.

Procedural Considerations

Burden of Proof and Methods of Proof

In a civil tax fraud case, the IRS has the burden of proving by clear and convincing evidence that an underpayment is attributable to fraud. (24) Under Sec. 6663(b), once the IRS establishes that any part of an underpayment is due to fraud, the entire underpayment is treated as fraudulent and is therefore subject to the 75% penalty. However, the taxpayer can rebut this presumption for any portion of the underpayment by establishing by a preponderance of the evidence that it was not due to fraud. (25)

The IRS has an arsenal of indirect audit methods it uses to prove tax fraud. The indirect audit methods described in the Internal Revenue...