When pursuing investigations for suspected incidents of tax fraud, the IRS looks for what it commonly refers to as "badges of fraud." This phrase refers to certain behaviors, patterns, or circumstances that can indicate intentional misconduct in complying with tax laws.

These "badges" serve as red flags for the Internal Revenue Service (IRS) and other federal investigators, guiding them toward cases that may involve fraudulent activity. However, while these indicators raise suspicions, they do not, by themselves, constitute proof of fraud.

The badges of fraud refer to certain behaviors that might indicate misconduct in complying with tax laws.

Fraud, particularly tax fraud, is a serious civil and criminal violation that the IRS and the US Government vigorously investigate. It's important to note that there is no statute of limitations for a civil violation.

This means the IRS could pursue someone for years if they believe they committed tax fraud. The burden of proof for tax fraud is higher than for most other violations, and the penalties are also significantly higher (26 U.S.C. 6663).

What's more, the IRS and the US government can pursue criminal and civil tax fraud claims simultaneously. Defendants will typically seek a stay of proceedings in conjunction with pleading the Fifth Amendment.

One key identifier in determining whether someone may have committed tax fraud, especially fraudulent transfers of assets, money, and investments, is the badges of fraud.

Badges or fraud are indicators of whether a person's actions or omissions were done to commit tax fraud or other types of fraud related to the IRS, such as preparing or submitting false documentation. The IRS will refer to the different badges of fraud to assess these indicators of fraud.

Let's discuss some of these common "badges of fraud" that might attract unwanted attention from federal investigators-and what to do if you find yourself under scrutiny.

Understanding Badges of Fraud

Fraud occurs when someone deliberately deceives or misrepresents facts to gain an illegal advantage or avoid obligations, such as paying taxes. Proving intent is critical in fraud cases, which sets them apart from mere mistakes or negligence.

The investigators' challenge is establishing this intent. This is where the concept of badges of fraud comes into play.

Badges of fraud are behaviors, patterns, or actions that may suggest a taxpayer intentionally evaded their legal obligations. When present, they act as markers that give investigators reason to look deeper into a taxpayer's returns and overall compliance.

Think of these badges as a collection of clues rather than direct evidence. If enough badges are present, they can help build a case against an individual, but their presence alone does not equal guilt.

There are, in fact, many potential indicators that the IRS might consider a "red flag." Still, some behaviors are more likely than others to draw unnecessary attention to yourself or your business-especially if they occur in tandem with one another.

Here are some common examples (not a comprehensive list) that investigators often consider as potential indicators of fraudulent activity.

Underreporting Income

One of the most frequent badges of fraud is knowingly failing to report all sources of income. This includes hiding cash income, failing to report side jobs, or creating fictitious entities to conceal money.

For example, if a taxpayer's reported income is inconsistent with their lifestyles, such as owning luxury cars or properties while showing minimal earnings, this discrepancy can raise significant concerns. Some other indicators of fraud related to income include the following:

• Failing to report or explain substantial amounts of income.
• Inability to explain substantial increases in net worth.
• Omitting specific items where similar items are included.
• Omitting entire sources of income.
• Substantial personal expenditure exceeding reported resources.
• Inability to explain sources of bank deposits exceeding reported income.
• Concealing domestic or foreign bank accounts, brokerage accounts, and digital assets such as virtual currency or other property.
• Inadequately explaining dealings in large sums of currency.
• Consistent concealment of unexplained currency, especially in a business not typically requiring large cash transactions.
• Failing to deposit receipts in a business account.
• Failing to file a tax return, especially for several years when there is evidence of receipt of substantial amounts of taxable income.
• Cashing checks, representing income, at check cashing services and at banks where the taxpayer does not have an account.
• Concealing sources of receipts by false descriptions of disclosed income.

Keeping False or Insufficient Records

Accurate record-keeping is essential for tax compliance. A lack of proper documentation or deliberate falsification of records can be a major red flag.

Examples include failing to keep receipts, altering financial statements, or keeping two sets of books, one for actual business transactions and another that is manipulated to reduce taxable income. Some other indicators of fraud include the following:

• Failure to keep adequate records, concealment of records, or refusal to make records available.
• False entries or alterations made on the books and records.
• False entries backdated or post-dated documents.
• False invoices, false applications, false statements, or other false documents or applications.
• Invoices are irregularly numbered, unnumbered, or altered.
• Checks made payable to third parties that are endorsed back to the taxpayer.
• Checks are made payable to vendors and other business payees that the taxpayer cashes.
• Variances between the treatment of questionable items as reflected on the tax return and books.
• Intentional under or over-footing of columns in a journal or ledger.
• Amounts on tax returns are not in agreement with amounts in books.
• Amounts posted to ledger accounts are not in agreement with sourcebooks.
• Journalizing questionable items out of the correct account.
• False receipts to donors by exempt organizations.
• Recording income items in suspense or asset accounts.

Claiming False Deductions or Exemptions

Falsely inflating deductions, expenses, or exemptions is another common badge of fraud. This might involve reporting personal expenses as business deductions, exaggerating charitable contributions, or claiming dependents who do not actually qualify.

These actions can significantly reduce a person's tax liability and are often areas investigators scrutinize. Some other examples include the following:

• Disguising trust fund loans as expenses or deductions.
• Claiming fictitious or substantially overstated deductions.
• Claiming substantial business expense deductions for personal expenditures.
• Providing false or altered documents, such as birth certificates, lease documents, and school and medical records, for the purpose of claiming the education credit, additional child tax credit, earned income tax credit (EITC), or other refundable credits.

Concealing Assets

Taxpayers who attempt to hide their assets-whether by transferring them into another person's name, maintaining undisclosed offshore accounts, or using shell companies, are likely to attract the attention of investigators.

Keeping certain assets off the books suggests an intent to evade taxation on those holdings. Some other common examples of methods of concealment include:

• Inadequacy of consideration or insolvency of the transferor.
• Asset ownership is placed in other names.
• Transfer of all or nearly all the debtor's property.
• Close relationship between parties to the transfer.
• Transfer made in anticipation of a tax assessment.
• A concealed interest in the property transferred.
• Transaction not in the usual course of business.

Making False Statements

Submitting false information is another badge of fraud. This might involve providing misleading details on tax returns, such as falsified income, expenses, or employment details. Verifying the truthfulness of these statements is a priority during investigations. Some other examples of conduct by the taxpayer include:

• Attempt to hinder or obstruct the examination.
• Failure to answer questions.
• Repeated canceled or rescheduled appointments.
• Refusal to provide records.
• False statement about a material fact related to the examination.
• Threatening potential witnesses, including the examiner.
• Failure to follow the advice of an accountant or attorney.
• Failure to make full disclosure of relevant facts to the accountant.
• Numerous questionable items appear on the tax returns.
• Testimony of employees concerning irregular business practices.
• Destruction of books and records after examination was started.
• Transfer of assets for purposes of concealment.
• Diversion of funds and assets by officials or trustees.

Badges of Fraud Are Not Definitive Proof

Further, unusual financial behaviors, like sudden shifts in account balances, excessive cash transactions, or creating entities primarily for tax avoidance purposes, often signal to investigators that deeper analysis is warranted. Though not inherently illegal, these actions often accompany fraudulent schemes.

It's important to understand that badges of fraud alone do not confirm fraud. Just because a taxpayer exhibits one or even several of these behaviors does not necessarily mean they committed a criminal act.

For instance, underreporting income could result from a misunderstanding of tax laws, not intentional deception. Similarly, misplacing receipts or making errors in deductions could be harmless mistakes rather than deliberate schemes.

The IRS recognizes that taxpayers make errors, which is why intent-often described legally as "willfulness" is such a critical factor in fraud cases. Investigators must gather additional evidence to demonstrate that a taxpayer's actions were intentional, systematic, and not simply accidental.

Seek Legal Guidance if You're Under Investigation

If you suspect that you are being investigated for potential tax fraud, it is critical to act quickly. An experienced federal criminal defense attorney can help protect your rights and explain your side of the story. Attempting to handle such situations without proper legal representation can lead to serious consequences, including criminal charges and financial penalties.

A skilled attorney will review the facts of your case, challenge the government's interpretation of the evidence, and respond effectively to any allegations. By addressing the situation proactively, you can ensure the strongest possible defense against fraud accusations. Contact Eisner Gorin LLP, based in Los Angeles, for additional information.

Related Content:

• 26 U.S. Code 6663
• Tax Avoidance vs. Evasion
• Statutes Used by the IRS