Before you start to panic, understand that committing tax fraud involves more than making common mistakes on your income tax return.
But there are numerous types of tax fraud and evasion that could result in civil or criminal penalties.
The Internal Revenue Service (IRS) treats fraud and tax evasion seriously.
If they conduct an investigation and discover substantive evidence against you, a civil tax matter can become a criminal tax prosecution resulting in criminal charges and your arrest.
Keep reading to learn more about how tax fraud is defined, common types of fraud, civil vs. criminal fraud, and penalties involved for committing it. We'll also touch on what to do if you’re charged with tax fraud.
What is Tax Fraud?
The government distinguishes between negligence and fraud. If you commit tax fraud, you’re deliberately making false statements and attempting to avoid your obligations to make tax payments.
Tax fraud requires an intentional dishonest act. It includes examples such as submitting a dishonest tax return or failing to file a return.
According to the IRS, fraud involves someone willfully submitting false documents or statements in connection with a return.
IRS investigators watch for the following types of signs that fraud may have occurred:
- Intentional failure to pay taxes
- Falsified documents
- Underreporting income
- Overreporting exemptions or deductions
- Use of a false Social Security number
When unable to identify signs of fraud, the IRS will likely assume you’ve made an unintentional error.
While a mistake on your tax return will not result in criminal charges, it can result in a penalty of 20% of the amount of your underpayment.
Before you submit your tax information to the IRS, always be sure it’s accurate to avoid penalties and other problems.
Civil vs. criminal fraud
When the IRS pursues a civil fraud action against you, it will need to prove the elements by clear and convincing evidence, which is a slightly lower burden of proof than what a criminal fraud case requires.
Should the IRS prevail in a civil fraud case, you'll pay civil tax penalties in addition to the underpayment amount.
If the IRS files a criminal tax fraud case against you, they’ll be required to prove the elements of the charged offense beyond a reasonable doubt. This is the highest burden of proof required by a court.
Should you be found guilty, you may face substantial fines and the possibility of a long prison sentence.
Common types of tax fraud
While it can be committed in numerous forms, there are several common ways people engage in tax fraud.
Understanding these types of consciously deceitful activities can help you avoid doing something that could lead to charges against you, with hefty fines, lawyer fees, or worse.
1. Frivolous tax claims
While Americans are free to express their opinions about the tax code, they cannot refuse to pay taxes.
If you file a return that includes unreasonable claims, such as overly inflated deductions, to try to avoid paying the taxes you owe, you can face severe penalties.
Arguing that taxes are immoral or that you’re not subject to the federal government's tax laws will not get you anywhere. Other than potentially in trouble.
Related reading: The Truth About Frivolous Tax Arguments
2. Payroll and employment tax fraud
Many companies engage in payroll and employment tax fraud. These types of fraud can include collecting payroll taxes from employees but failing to submit them to the IRS and paying employees under the table in cash.
Some businesses willfully misclassify employees as independent contractors to avoid employment and payroll taxes and underreport their number of employees.
There are plenty of examples of employment investigations on the IRS website.
Business owners who engage in these practices are gambling with their future and their company's success.
3. Tax refund fraud
Some taxpayers engage in refund fraud to secure tax refunds they haven’t earned or to pay less in tax.
They might do this through identity theft, claiming false deductions, claiming invalid exemptions or tax credits, or fraudulently reporting personal expenses as business expenses.
Failing to claim all of your income (tips, cash, or freelance income) may also be seen as tax evasion or a willful failure to supply information.
4. Abusive tax practices
Taxpayers in the U.S. are required to report all of their worldwide income – even if they’re no longer living in the U.S.
If you have accounts overseas, you must file the report of foreign bank and financial accounts or FBAR each year and comply with the regulatory requirements of the Foreign Account Tax Compliance Act.
If you try to hide money overseas, you could face serious criminal penalties.
While many wealthy people might want the greater degree of privacy afforded by using offshore tax-havens, they must be careful to avoid unwittingly crossing the line into engaging in an abusive tax scheme.
What are the penalties?
The penalties you might face for tax fraud will depend on whether you face civil or criminal prosecution.
Some of the common types of civil tax fraud violations and their penalties include:
- Deceptively failing to file an income tax return – 15% of the net tax owed per month for up to five months with a maximum 75% penalty of the amount of the unpaid tax
- Filing a dishonest return – Tax penalty of 75% of the underpayment
If you’re convicted of criminal charges, you may be sentenced to prison and be assessed substantial fines. The penalties you might face will depend on your crime of conviction.
Examples of tax fraud crimes and their penalties for being found guilty of fraudulent activity include:
- Willfully failing to pay, file returns, or to keep sufficient records – Prison for up to one year and a fine of up to $25,000 for individuals or up to $100,000 for businesses
- Tax evasion – Up to five years in prison and a fine of up to $100,000 for individuals or up to $500,000 for businesses
What to do if you're facing an IRS investigation or charges
Should you find yourself faced with charges of tax fraud, talk to an experienced tax attorney as soon as possible.
When you receive a notice or otherwise become aware of the IRS's interest in you, responding immediately is important. Retaining an experienced tax lawyer as soon as possible might help you avoid litigation.
Make sure to locate and retain all of the records that might be needed by the IRS. Do not try to change any records or destroy them.
Avoid calling witnesses to discuss what to say. If you try to alter or destroy evidence or tamper with witnesses, you could be charged with additional crimes.
Throughout the process, make sure to cooperate and to be honest.
Work closely with your lawyer to ensure your responses are consistent. Even if you end up facing a substantial tax liability through negotiations, it's better than trying to litigate the matter.
Depending on the seriousness of the allegations against you, your attorney might be able to secure an agreement for you to repay what you owe instead of facing criminal charges.
The statistical chances you’ll be charged with criminally avoiding the tax code are very low.
However, you do not want to be among the small percentage of people who face an IRS criminal investigation.
If you’re concerned you might be facing tax fraud allegations, consult with an experienced tax attorney as soon as possible to learn about any options you might have.
- How to Make Estimated Tax Payments and Avoid IRS Penalties
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Vicki and Amy are authors of Estate Planning 101 – a Crash Course in Planning for the Unexpected -coming soon from Adams Media.