Tax Lawyer's Blog

Despite the many urban myths that are circulating about the IRS’s vicious and unforgiving nature, it takes a lot before a Revenue Officer or Agent will refer a case to the Criminal Investigation Division (CID).

And it takes even more for a federal prosecutor to pursue an indictment.

But there are certain instances where you can count on a Criminal Investigation and an ensuing indictment.

Here are 3 common ones we’ve encountered:

Intentionally fail to report your business cash receipts

The Problem

Businesses like restaurants and grocery stores receive a significant portion of their revenues from cash payments. 

It is, therefore, tempting for business owners to “pocket” this cash and not include it as income on their tax return.

The IRS knows this.

How You’ll Get Caught

The IRS has industry specific audit programs where it targets and selects for audit the tax returns of certain businesses that are known to have a significant number of cash transactions.

Once the return is selected for audit, the IRS may employ one or more of the following sophisticated techniques to identify the under reporting of income:

1. The Net Worth Method;
2. The Cash Expenditures Method;
3. The Bank Deposits Method; and
4. The Normal Markup Method.  

But note that since the passage of The Internal Revenue Service Restructuring and Reform Act of 199 (RRA 98) (PDF), the IRS must have a good reason to use one of these indirect methods.

Sec. 7602(e),”Limitation on Financial Status Audit Techniques,” was added to the tax code via RRA 1998 and it provides that,

 “The [IRS] shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income.”

Before RRA 98 the IRS could use what are called “financial status” or “economic reality” audit techniques to determine the existence of unreported income any time it liked.

As a practical matter, however, the limitation on the use of these indirect audit methods has no teeth because the IRS can almost always show that there is a “reasonable indication” of underrreported income.

Flaunt an affluence that greatly exceeds the amount of income reported on your tax return

The Problem

In the movie Goodfellas wiseguy Jimmy Conway, played by Robert DeNiro, chastizes one of his underlings for going on a spending spree after Conway’s crew had just pulled off one of the biggest heists in mob history:

What did I tell you?  What did I tell you?

You don’t buy anything. You don’t buy anything.

Why was Conway so adamant about this?

The answer should be obvious, but to many tax cheats it’s not.

A dramatic upward change in your standard of living is a red flag and will cause the feds (not to mention your neighbors) wonder about the source of this new found wealth.

Listen to these cases we’ve had:

• A pub owner showed an Adjusted Gross Income (AGI) on his tax return of $80,000. He owned a Jaguar X-K6, a 30 foot Catamaran, Orlando Magic season tickets and a $750,000 Windermere home. He had 3 children and his wife did not work.
• The owner of six gas stations reported an AGI of $120,000.00 on his federal income tax return. He drove a brand new Cadillac Escalade, a Harley Davidson motorcycle, a $500,000 home and a beach condo valued at $300,000. In addition, he wore a $5,000.00 Rolex and had just bought his fiance a $40,000, 4.5 carat, diamond ring.
• A restaurant owner reported an AGI of $135,000. He claimed on the same return a charitable contribution deduction of $65,000.00 and was paying for 3 daughters to attend private colleges.

How You’ll Get Caught

In egregious cases like these where there is a blatant and obvious discrepancy between the income reported on the taxpayer’s return and his or her standard of living, the IRS will sometimes find out about the taxpayer through an informant or whistleblower.

After a preliminary investigation it will inevitably select the taxpayer’s returns for audit and employ one of the indirect methods mentioned above to determine and prove the extent of the underreporting.

Unless the taxpayer can show some source of non-taxable income such as an inheritance, a gift, a loan taken out by him or the repayment of a loan previously made by him, he’s is in deep trouble and the case is likely to be referred to the CID for criminal investigation.

Help others file fraudulent tax returns and accept a fee for It

The Problem

This one applies to tax preparers rather than taxpayers, but it has consequences for taxpayers as well.

The IRS has published what it calls its Dirty Dozen tax scams.

Number 9 on the list is preparer tax fraud:

Dishonest tax return preparers can cause many problems for taxpayers who fall victim to their schemes. These scam artists make their money by skimming a portion of their clients’ refunds and charging inflated fees for return preparation services.

They attract new clients by promising large refunds.

Some preparers promote the filing of fraudulent claims for refunds on items such as fuel tax credits to recover taxes paid in prior years.

Taxpayers should choose carefully when hiring a tax preparer, especially one who promises something that seems too good to be true.

We have represented hundreds of clients who were audited simply because the name of a known, fraudulent tax preparer appeared on their return.

By far the most common preparer fraud schemes we see are the overstatement or complete fabrication of Schedule C, Sole Proprietorship business expenses and the intentional overstatement of Schedule A, Employee Business Expenses.

In a good 80% of these cases the preparers are criminally investigated for tax fraud and in many of those cases an indictment is obtained.

How You’ll Get Caught

Fraudulent tax preparers fall into two categories:

1. Those who are difficult to catch; and
2. Those who are easy to catch.

The tax preparers who are difficult to catch are diaboloical.

They use alaises and false preparer ID numbers or fail to sign their clients’ tax returns altogether.

These are the shysters who set up tax shops in various communities, promise their clients big refunds, include bogus tax credits (slavery reparation credit is one of my favorites) and tax payments on the tax returns, and then skip town before the fit hits the shan.

Next tax season they do it all over again in a new city.

The easy ones to catch usually have legitimate offices and a long list of recurring clients.

They won’t fabricate the amounts the taxpayer paid in to the IRS during the year because they know this will be discovered.

Instead, they tell their clients that most of the personal expenditures they made during the year are, in fact, deductible business expenses.

There are two common versions of this scheme:

1. The Schedule C Scheme - the fraudmeister convinces the taxpayer that he or she can deduct personal expenses as business expenses even though the taxpayer did not actually run a business during the year.
2. The Employee Business Expense Scheme- the preparer convinces the taxpayer that he or she is entitled to deduct personal expenses such as cell phone, computer, internet service, cable TV, automobile expense as expenses related to the conduct of their regular job.

In short, these scammers are playing what is called the “audit lottery.”

They know that typically it is a long shot that any particular tax return prepared by them will be selected for audit.

This is a miscalculation, however, because the returns prepared by these folks almost always contain major red flags like huge Schedule C losses with very little Schedule C income and large amounts of Employee Business Expenses even though the taxpayer works for a company that has a generous reimbursement policy.

The other way the IRS catches these preparers is by monitoring all tax returns prepared by them.

Fraudulent tax preparers have their favorite fraud techniques and it is relatively easy for the IRS to discover a pattern.

And when that happens, “no more soup for you!”