When the IRS Comes Knocking: Addressing Tax Fraud

Tax fraud typically involves neglecting tax responsibilities, such as by not filing returns or evading tax payments, or engaging in deliberate actions to obstruct the IRS’s assessment or collection of taxes.

The compliance problems that are later found to be tax fraud usually involve actions that pyramid over time. This timing issue arises as repeated behaviors are not immediately detected or corrected by the IRS. This incremental progression of non-compliance is exemplified by taxpayers who neglect to file a return for one year and do not keep records and then continue this pattern year after year, leading to a significant build-up of unfiled tax returns and unreported income.

When the IRS ultimately steps in, often after many years, the accumulated tax liabilities and penalties can be formidable. And then the taxpayer cannot afford to pay the combined tax, penalties, and interest that have accrued.

The recent case of Aldridge v. Commissioner, T.C. Memo. 2024-24, provides an opportunity to consider this type of scenario. It provides an opportunity to consider the factors at play for taxpayers when the IRS is in the process of discovering or about to discover the taxpayer’s tax fraud.

Facts & Procedural History

This case involves a married couple and their business and trust tax returns from 1999 through 2004.

The husband, initially a salesman, ventured into selling trust arrangements aimed at converting personal expenses into tax-deductible business expenses. This arrangement was eventually exposed by an IRS audit, revealing his interconnected trusts and significantly understated taxable income.

While the taxpayers reported minimal income during this period, the IRS investigation uncovered over $4 million in unreported gross receipts.

The couple’s conviction for tax evasion and subsequent prison sentences were followed by the IRS’s pursuit of their outstanding tax liabilities, including civil tax fraud penalties.

Navigating Tax Fraud

Tax fraud has both a civil and a criminal aspect to it. On the civil side, the focus is on the accuracy of tax returns and compliance with tax payments. This includes examining reported income, legitimate tax deductions and tax credits, and adherence to tax filing requirements. From the IRS’s perspective, the civil side of tax fraud generally aims to correct inaccuracies through additional tax assessments, penalties, and interest on unpaid taxes. The civil tax side is a private matter that is not made public, absent the taxpayer challenging the case in court.

Criminal tax evasion, as defined under Section 7201, has a similar compliance aspect to it. The sanction is potentially more severe, so these cases are usually limited to those who know or should have known better or the fraudulent acts are more apparent or blatant. The criminal sentence potentially carries penalties of up to five years in prison, an unlimited fine, and prosecution costs. Suffice it to say that convicted individuals often face significant challenges in rebuilding their financial stability and reputations.

So what exactly is tax fraud? The short answer is that it is conduct to understate or pay income taxes. It is usually identified by various “badges of fraud.”

The Badges of Fraud

The term “badges of fraud” refers to the judicial analysis for evaluating whether the taxpayer’s acts rise to the level of being tax fraud.
These factors or “badges” include:

• Understating Income: Reporting less income than earned to lower taxes owed.
• Inadequate Records: Maintaining poor or no financial records, obscuring actual transactions.
• Asset Concealment: Hiding or shifting assets to evade potential IRS collection efforts.
• Lack of Credibility: Providing false or contradictory statements during an IRS examination.
• Failure to File Returns: Habitually not filing returns, flouting basic filing duties.
• Illegal Activities: Engaging in illegal conduct demonstrating tax obligation disregard.
• Implausible Explanations: Offering unreasonable clarifications when queried about tax return discrepancies.
• Dealing in Cash: Relying extensively on cash deals to limit financial paper trail.
• Complex Transactions: Engineering overly intricate financial maneuvers to blur money flows.
• Lavish Lifestyle: Living extravagantly relative to reported income levels.

While no one factor is determinative, often a combination of several factors is determinative. And in most cases of tax fraud, as it happens, most of the factors are often at play.

An example of this is a tax return that reports a fictitious business that generated a tax loss. The loss is an understatement of income. The taxpayer may have no records of the business and, thus, cannot cooperate when the IRS asks for records. The taxpayer can only offer implausible explanations. This hits across many of the factors noted above even though it is just one act of false reporting.

Mitigating the Damage

If you assume that tax fraud has happened and the IRS is likely to detect it, what do you do? The question is answered by considering some of the primary issues one has to consider in this situation.

Deciding Whether to Cooperate with the IRS

The first decision is whether the taxpayer can or should cooperate with the IRS. The 5th Amendment allows a person not to provide potentially self-incriminating evidence that could expose them to criminal prosecution. This privilege applies in IRS examinations and investigations.

A taxpayer can invoke the 5th to refuse to answer questions, provide documents, or otherwise cooperate if they reasonably believe it could be used against them criminally. However, the 5th Amendment does not allow refusing to file a tax return altogether.
Asserting the 5th cannot be used against the taxpayer in a civil tax case, but it also provides no defense against civil tax assessments. The IRS can still determine and assess tax liability based on available information.

If the case remains civil, staying silent and asserting the 5th forces the IRS to prove the underlying tax fraud. However, it prevents the taxpayer from providing potentially exculpatory evidence.

And it should be noted that the failure to cooperate is one of the badges of fraud. While some cooperation is required, as the IRS has tools for force cooperation, determining the level of cooperation with the IRS has to be considered. The lack of cooperation also has a negative perception of the taxpayer with government employees and can cause the case to become more than it should be.

Understanding the Tax Assessment Period and Statutes of Limitation

Another key factor is understanding the tax assessment period and various statutes of limitation. There are statutes of limitations on assessing taxes and penalties and statutes of limitations for criminal charges.

For assessing taxes and penalties, the IRS typically has a three-year window from the filing date of a return to assess additional taxes and penalties. This period does not commence if no return is filed or a return is deemed fraudulent. As a result, the IRS can retrospectively assess taxes for many years, potentially leading to significant liabilities.

For the crime of tax evasion, the statute of limitations for the criminal offense of tax evasion under 26 U.S.C. § 7201 is six years. Prosecutions for willful attempts to evade or defeat any tax must be initiated within 6 years after the tax evasion offense is committed. The clock starts running on the date the individual commits the last affirmative act of tax evasion, not the date the return is due or filed.
If there is a pattern of acts in furtherance of tax evasion (like multiple years of underreporting income), the statute resets with each instance though only the last 6 years are prosecutable.

There is also an extension if the taxpayer is outside of the U.S. The statute of limitations is suspended if the individual is living continuously outside the U.S. for 18 months. Time resumes running once they re-enter the country.
Comprehending these timelines is essential in developing a response strategy, which may involve negotiating with the IRS to exclude older years based on record availability and the feasibility of resolution.

Making Filings and Paying Tax During Criminal Proceedings

Choosing whether to file overdue returns or pay taxes during an ongoing criminal investigation is another complex decision one has to consider.

While making tax return filings and payments might allow some years to pass under the statute of limitations or avoid further accrual of penalties or interest, thereby minimizing exposure, such actions could be perceived as admissions of guilt, complicating the criminal defense strategy.

There are some potential avenues available for this. The proffer can be one of them. In these cases, a proffer agreement might allow for sharing information about civil tax compliance efforts without it being used as evidence of guilt in the criminal case.
Incorporating Tax Payments into Sentencing

If criminal sanctions are being pursued and the trial is pending or ongoing, there might be an opportunity to address the civil tax balance as part of the criminal case.

This can include negotiating court-ordered criminal restitution to be applied towards the tax liability, potentially avoiding future IRS assessments. With this option, the taxpayer may make payments under a court order. This is different from remitting payments to the IRS outside of the court order.

This approach can have drawbacks, however. For example, it can limit the possibility of later submitting an offer in compromise with the IRS to settle the tax balances. It can also impact other administrative remedies that may have otherwise been available.

Strategy for Mitigating the Fallout

This brings us back to the Aldridge case, as the case provides some context for understanding how these concepts can play out.

In the Aldridge case, the taxpayers chose not to cooperate with the IRS investigation. The husband provided misleading answers to IRS agents and falsely claimed that his trust had been dormant for years. The taxpayer’s failure to cooperate seems to have contributed to their criminal convictions. The criminal convictions not only served as conclusive evidence of fraud in the civil tax case, they also resulted in the assessment period for the civil tax case being suspended indefinitely. This is the effect of fraud, i.e., the IRS has an unlimited statute of limitations for assessing tax.

Given the criminal charges, it appears that the taxpayers did not file late or amended tax returns or pay additional taxes during the investigation. The court noted that the taxpayers went to a tax preparer who was also under indictment for tax crimes. The taxpayers probably did not file or amend tax returns during the criminal proceeding due to such actions being deemed admissions for the criminal proceedings.

Even after the convictions when the taxpayers were serving time in prison, it appears that they still did not take the opportunity to file returns and/or submit an offer in compromise to settle their taxes. This could have started the assessment and/or collection period running. It could have also resulted in their tax balances being addressed before the time they were released from prison.

Similarly, it appears that there were no criminal restitution payments covering tax liabilities as part of their conviction or sentencing, suggesting they did not enter a plea agreement or ask the court to order payment of the taxes. This left them open to later IRS assessment actions. This also maintained flexibility for settlement options based on doubt as to collectibility, such as settling their balances with the IRS using an offer in compromise. This might not be possible if there was a binding criminal restitution order as a criminal restitution order cannot be compromised by the IRS administratively.

The Takeaway

The Aldridge case shows the gradual buildup and ultimate consequences of prolonged tax fraud schemes. To mitigate the damage, taxpayers should often proactively and transparently address compliance issues. Concealing income or delaying IRS actions typically results in more severe long-term repercussions. Strategic decision-making and careful consideration of various factors are critical when dealing with potential or imminent IRS action in tax fraud cases.