Civil and criminal tax fraud cases arise under Title 26, with the majority of the Title 26 cases being either pursuant to Internal Revenue Code (IRC) § 7201 or IRC § 7206. Both of these IRC sections are felony statutes. Section 7201 relates to tax evasion, while § 7206 relates to fraud. Both of these sections require “intent” on the defendant party, and intent is found by proving up the “badges of fraud.” There are many badges of fraud, but the most common ones are understating income, and concealing income or assets.

Most of these cases begin at the audit stage, where they are handled most often by a revenue agent. Once “firm indicators of fraud” appear to the revenue agent or other agent handling the case, and then the agent will make a “referral” to the IRS Criminal Investigation Division (CID). Once these “firm indicators” appear, the civil action (audit) must cease, or the IRS risks losing evidence by violating a taxpayer's Fourth Amendment right.

Once the case is handed over to CID, CID is in charge of building the case against the taxpayer. CID special agents handle the case, and these special agents are law enforcement, meaning they carry badges and guns. They handle the investigation through interviews and search warrants, much like a police detective.

However, CID agents do not decide to pursue criminal charges. The CID agents refer the case to the Department of Justice. Many of these cases are referred to the Washington D.C. headquarters, where they are evaluated, then referred back to the jurisdiction that the taxpayer resides in. The Department of Justice is responsible for handling criminal proceedings. Around 90 percent of all cases referred by CID are accepted by the Department of Justice (DOJ) and U.S. Attorney's Office. Approximately 95 percent of criminal tax cases result in conviction of sentencing. Of the 95 percent, 90 percent are the result of a plea agreement. While a plea agreement might sound more lenient, the deals offered by the government are not great, and still result in jail time.

Searching for the Badges of Fraud

There are some dead giveaways to fraud, and some that indicate that fraud might be going on. For instance, when specifically talking about income, if a taxpayer can't explain sources of bank deposits that substantially exceed reported income, then that would be an indicator of fraud. Some others include:

• Concealing bank accounts
• Cashing checks at check cashing services and banks where taxpayer doesn't maintain an account
• Substantial spending exceeding reported resources.

When dealing with expenses and deductions, fictitious and substantially overstated deductions raise a red flag, as does claiming dependency exemptions for people who are deceased.

When it comes to books and records, multiple sets of books, or no books at all, are top indicators, or badges, of fraud. False entries, failure to keep adequate records, concealment of records, out of order invoices, and amounts on tax returns not agreeing with amounts in books are all also indicators of fraud.

Obviously, direct testimony of employees on business practices would be a red flag, but some schemes by taxpayers can run deep, and are harder to uncover. For instance, issues such as the insolvency of a transferor, or assets being placed in the ownership of someone else, are harder to spot. These usually require some other red flag in order to surface.

Often times, a revenue agent will stumble across one of the badges of fraud during an audit, such as a side bank account, or something that shows the taxpayer has a lavish lifestyle not supported by the numbers on the tax return.

Once the badges of fraud appear, criminal investigation special agents are brought in to work on the investigation. The CID special agents are the workhorses in a criminal tax investigation. They look into possible fraud by corporate executives, small business owners, return preparers, and wage earners. Some of the most typical fraud schemes seen by CID agents are:

• Deliberately underreporting or omitting income;
• Creating false entries in books and records;
• Hidden or transferred assets for the purposes of avoiding paying taxes.

In conducting an investigation, a special agent must do the following:

• Gather, organize and evaluate evidence;
• Employ various investigative tools to identify evidence of fraud;
• Interview and communicate.

No case is the same, but once CID is involved, the agents' investigation could start with checking IRS databases, tax returns, Law Enforcement Information Networks, and other records. Of course, any information collected by a revenue agent would also be included. From there, the agents could go undercover, either to “shop” a return preparer who is allegedly inflating charitable contributions on returns, or talk to a bar owner who is thought to be skimming cash. The agents might also interview a postal clerk to track down a multi-filer, or a drug dealer. Or, the agents could set up surveillance of a heavy casino gambler who is spending above his means.

While a criminal tax investigation might not be as intricate as weeding out a fraud perpetrator who is receiving kickbacks from a vendor, they still are time consuming. The CID agents also must be careful with their investigations. The agents must coordinate their investigation in a manner that does not give too much away to the person being investigated. If the potential fraud perpetrator knows what the agents are looking for, then that gives the perpetrator a chance to try to cover up his or her tracks.

Special agents must be proficient in handling physical evidence, but they must be especially adept at searching and preserving electronic evidence. Most everyone runs QuickBooks or other accounting software on their computer. With the affordability of scanners, many people keep electronic copies of their records. Mishandling or incorrectly seizing a hard drive could make the data on it inadmissible in court, which would obviously undermine the whole purpose of the investigation.

Criminal investigations can start through information from a whistleblower, another branch of government, or even someone complaining about their tax preparer. The most common cause of the start of a criminal investigation is a referral from a tax examiner or revenue agent. Once the badges of fraud are present, the IRS will take action, and it is necessary to seek legal counsel.

Note –
The information above is not to be construed as legal advice. If you need legal advice, please contact an attorney. The information above is general information, and may not be specific to your situation.