Civil and Criminal Tax Issues: Red Flags and Warning Signs

1. Civil and Criminal Tax Issues: Red Flags and Warning Signs The Financial Planning Association of Greater Rochester, New York Annual Educational Symposium June 6, 2012

2. Civil and Criminal Tax Issues: Red Flags and Warning Signs Scott D. Shimick, Esq. Underberg & Kessler LLP (585) 258-2808 sshimick@underbergkessler.com David H. Fitch, Esq. Underberg & Kessler LLP (585) 258-2840 dfitch@underbergkessler.com

3. Failing to file returns or underreporting income can lead to: • Civil Tax Penalties and Interest • Criminal Prosecution 1

4. Civil Tax Penalties • Failure-to-file penalty • Failure-to-pay penalty • Accuracy-related penalty • Civil tax fraud penalty • Penalty for frivolous return • Information reporting penalties • Penalty for failure to furnish correct payee statements 2

5. Failure-to-File Penalty • A penalty may be imposed for a failure to file your return by the due date (including extensions). • The penalty is 5% of the tax not paid by the due date for each month or part of a month that the return is late, up to 25% of your tax. 3

6. Failure-to-Pay Penalty • A penalty will be imposed for a failure to pay taxes when due. • The penalty is 1/2 of 1% of your unpaid taxes for each month or part of a month after the due date that the tax is not paid, up to a maximum of 25% of your unpaid tax. 4

7. Accuracy-Related Penalty • An accuracy-related penalty of 20% applies to any underpayment due to negligence or disregard of the tax law or due to a substantial understatement of income. • A substantial understatement occurs if the tax due is more than 10% higher than the tax reported or more than $5,000 than the tax reported. 5

8. Civil Tax Fraud Penalty • Civil tax fraud is similar to criminal tax fraud, but with a lower burden of proof by the IRS. • The civil tax fraud penalty is 75% of the tax due. 6

9. Other Penalties • A penalty of $500 may be imposed if you file a return that does not include enough information to figure the correct tax or that shows an incorrect tax amount due to a frivolous tax position or a delay or interference with the administration of federal income tax laws. • Failure to file an information return or a complete and correct information return with the IRS by the due date is subject to a penalty for each failure. A penalty of $15 to $50, depending upon the delay, applies to late-filed information returns. • Failure to provide a taxpayer with a complete and correct copy of an information return (payee statement) by the due date will subject you to a penalty of $50 for each statement. If the failure is due to intentional disregard of the requirement, the penalty is increased to the greater of $100 per statement and 10% of the amount to be shown on the statement. 7

10. Tax Crimes • Failure to file tax returns • False statements on tax returns • Criminal tax fraud/tax evasion • Failure to remit taxes 8

11. Failure to File Tax Returns • 26 U.S.C. § 7203 – Willful failure to file return • Each year a return is not filed can result in prosecution of a misdemeanor, punishable by up to one year incarceration and up to a $25,000 fine. • Traditionally, the IRS would just produce substitute returns and only prosecute the most egregious cases. However, the IRS has begun referring non-filers for criminal prosecution more regularly over the past few years. • It is a crime not to file a return. It is not a crime to fail to pay the tax due. Therefore, file returns even if you can’t pay the tax. 9

12. False Statements on Tax Returns • 26 U.S.C. § 7206 – Fraud and false statements • Violations of this statute occur upon the intentional failure to report income and/or the intentional claiming of a fraudulent deduction. Filing a return that you do not believe to be true and correct as to every material matter is a felony, punishable by up to three years in prison and a fine of up to $100,000. 10

13. Criminal Tax Fraud/Tax Evasion • 26 U.S.C. § 7201 – Attempt to evade or defeat tax • Tax evasion cases usually involve the use of fraudulent tax schemes designed to defer or exclude income or accelerate or inflate deductible expenses. However, failure to file a tax return and the filing of a false statement also may give rise to a tax evasion charge. Criminal tax fraud is a felony, punishable by up to five years in prison and a fine of up to $100,000. 11

14. Failure to Remit • 26 U.S.C. § 7202 - Willful failure to collect or pay over tax • If you are required to collect, account for, and pay over any tax and willfully fail to collect or truthfully account for and pay over such tax you have committed a felony. This is punishable by up to five years in prison and a fine of up to $10,000. 12

15. Avoid an Audit • Most audits are generated by red flags marked by a computer program (the Discriminant Inventory Function System, “DIF”). • When civil penalties are assessed and criminal investigations have been made, the assessments and investigations usually stem from a civil tax audit. • Revenue Agent finds deficiencies that lead to civil penalties. • Revenue Agent finds badges of fraud that lead to criminal investigation and prosecution. 13

16. 10 Ways to Avoid an Audit • Consistently low income • Moderate charitable deductions • No home office deductions • Report all income • Avoid Passive Rental Losses • Report Foreign Bank Accounts • Do not engage in currency transactions • Limit deduction of business use of vehicle • Avoid small business losses • Ensure accurate investment income reporting 14

17. Consistently Low Income • Generally, 1% of returns are audited. • For taxpayers with income over $200k, that rises to 4%. • For taxpayers with income over $1MM, that rises to 12%. • Another red flag is having a large fluctuation in annual income. 15

18. Moderate Charitable Deductions • The IRS has a formula for average deductions for taxpayers at each income level. Greatly exceeding this formula may trigger an audit. • For example, the average deduction for taxpayers making $100k is $3,900 per year. 16

19. No Home Office Deductions • Home offices must be exclusively used for your work and must be your principal place of business. • Taxpayers with a W-2 wage will rarely meet this stringent guideline and risk an audit. 17

20. Report All Income • The IRS gets copies of all 1099s and W-2s. If the amount of income reported is less than the amount of income their records show, this will likely trigger an audit. • This type of underpayment is a large source of civil and criminal tax fraud. 18

21. Avoid Passive Rental Losses • Passive loss rules prevent taking these deductions. However, some taxpayers may be allowed this deduction: • Taxpayers with less than $25k of loss and AGI less than $150k; and • Taxpayers that are in the business of rental real property. • To be in the business of rental real property, more than half your work hours must be devoted to the management of your properties and you must log at least 750 hours for the year. Because of the potential for abuse, the IRS flags the purported real estate professionals. • If you plan to take this deduction, be sure to carefully log all your working hours. 19

22. Report Foreign Bank Accounts • Foreign bank accounts are often maintained for the purposes of evading U.S. taxes. Therefore, Congress has made it is a crime to have an unreported foreign bank account that has had a balance of over $10k. • The IRS will find out about these accounts. Even Swiss banks are beginning to divulge this information. The IRS is pursuing criminal prosecutions of taxpayers that fail to report these accounts. 20

23. Do Not Engage in Currency Transactions • Most illicit activities are transacted in cash. Therefore, the IRS requires CTRs for all cash transactions of $10k or more and for any other suspicious cash transactions. • CTRs may trigger an audit to determine the source of the extensive cash flow. 21

24. Limit Deduction of Business Use of Your Vehicle • No one uses vehicles for solely business purposes. So, the IRS targets those claiming 100% vehicle deductions for audit. • Keep a careful log of all business trips, including purpose of the trip, date, time, and beginning and ending mileage. Keep the log in your glove box and make it a habit to enter mileage. 22

25. Avoid Small Business Losses Many small business owners run their personal expenses through their business. So, when the IRS sees little income or losses from a small business, the IRS gets curious about the deductions. 23

26. Ensure Accurate Investment Income Reporting Your bank, broker, and mutual funds send the IRS statements listing every penny they paid you. However, like everyone else, financial institutions make mistakes. • For example, if you make your an IRA contribution between January 1st and April 15th, your broker might inadvertently report the tax year as the current tax year, as opposed to the prior tax year. When you make an IRA contribution, be sure to get a receipt from the brokerage stating the tax year and make sure it reflects your intended contribution date. 24

27. Warning Signs of a Criminal Investigation The first warning sign is a long, unexplained silence by the Revenue Agent after much investigative activity. During this period the Revenue Agent may be consulting with a fraud specialist regarding a potential criminal fraud referral. Another warning sign is the refusal of the Revenue Agent to discuss the status or timing of closing the audit. Other warning signs may involve the subpoena or other discovery of information from third parties (e.g. banks, investment brokers, suppliers, or customers). 25

28. Badges of Fraud If a Revenue Agent spots badges of fraud during an audit, the agent may refer the case to the Criminal Investigation Division of the IRS. The badges of fraud include: • Income indicators; • Deduction indicators; • Records indicators; • Allocations of income indicators; • Conduct of taxpayer; and • Methods of concealment. 26

29. Indicators of Fraud—Income A. Omissions of specific items where similar items are included. B. Omissions of entire sources of income. C. Unexplained failure to report substantial amounts of income identified as received. D. Substantial unexplained increases in net worth, especially over a period of years. E. Substantial excess of personal expenditures over reported available resources. • Bank deposits from unexplained sources substantially exceeding reported income. • Concealment of bank accounts, brokerage accounts, and other property. 27

30. Indicators of Fraud—Income (con’t) H. Inadequate explanation for dealing in large sums of currency, or the unexplained expenditure of currency. I. Consistent concealment of unexplained currency, especially in a business not routinely calling for large amounts of cash. J. Failure to deposit receipts to business account, contrary to normal practices. • Failure to file a tax return, especially for a period of several years although substantial amounts of taxable income were received. • Cashing checks, representing income, at check cashing services and at banks where the taxpayer does not maintain an account. • Concealing sources of receipts by false description of the source(s) of disclosed income, and/or nontaxable receipts. 28

31. Indicators of Fraud—Expenses or Deductions A. Substantial overstatement of deductions. B. Substantial amounts of personal expenditures deducted as business expenses. C. Claiming fictitious deductions. D. Dependency exemption claimed for nonexistent, deceased, or self-supporting persons. E. Trust fund loans disguised as expenses or deductions. 29

32. Indicators of Fraud—Books and Records • Keeping two sets of books or no records. • False entries or alterations made on the books and records, back-dated or post-dated documents, false invoices, false applications, statements, other false documents, or applications. • Invoices are irregularly numbered, unnumbered or altered. • Checks made payable to third parties are endorsed back to the taxpayer. Checks made payable to vendors and other business payees are cashed by the taxpayer. • Failure to keep adequate records, concealment of records, or refusal to make certain records available. 30

33. Indicators of Fraud—Books and Records (con’t) • Variances between treatment of questionable items reflected on the tax return, as compared with books. • Intentional under or over footing of columns in journal or ledger. • Amounts on return not in agreement with amounts in books. • Amounts posted to ledger accounts not in agreement with source books or records. • Journalizing of questionable items out of correct account. • Recording income items in suspense or asset accounts. • False receipts to donors by exempt organizations. 31

34. Indicators of Fraud—Allocations of Income • Distribution of profits to fictitious partners. • Inclusion of income or deductions in the tax return of a related taxpayer, when difference in tax rates is a factor. 32

35. Indicators of Fraud—Conduct of Taxpayer • False statement about a material fact involved in the examination. • Attempts to hinder the examination. For example, failure to answer pertinent questions, repeated cancellations of appointments, refusal to provide records, threatening potential witnesses, including the examiner or assaulting the examiner. • Failure to follow the advice of accountant or attorney. • Failure to make full disclosure of relevant facts to the accountant. • The taxpayer’s knowledge of taxes and business practices where numerous questionable items appear on the returns. 33

36. Indicators of Fraud—Conduct of Taxpayer (con’t) • Testimony of employees concerning irregular business practices by the taxpayer. • Destruction of books and records, especially if just after examination was started. • Transfer of assets for purposes of concealment, or diversion of funds and/or assets by officials or trustees. • Patterns of consistent failure over several years to report income fully. • Proof that the tax return was incorrect to such an extent and in respect to items of such magnitude and character as to compel the conclusion that the falsity was known and deliberate. 34

37. Indicators of Fraud—Conduct of Taxpayer (con’t) • Payment of improper expenses by or for officials or trustees. • Willful and intentional failure to execute pension plan amendments • Backdating of applications and related documents. • Making false statements on Tax Exempt/Government Entity (TEGE) determination letter applications. • Use of false social security numbers. • Submission of false Form W–4. • Submitting a false affidavit. • Attempts to bribe the examiner. 35

38. Indicators of Fraud—Methods of Concealment • Inadequacy of consideration. • Insolvency of transferor. • Assets placed in other names. • Transfer of all or nearly all of debtor's property. • Close relationship between parties to the transfer. • Transfer made in anticipation of a tax assessment or while the investigation of a deficiency is pending. • Reservation of any interest in the property transferred. 36

39. Indicators of Fraud—Methods of Concealment (con’t) • Transaction not in the usual course of business. • Retention of possession. • Transactions surrounded by secrecy. • False entries in books of transferor or transferee. • Unusual disposition of the consideration received for the property. • Use of secret bank accounts for income. • Deposits into bank accounts under nominee names. • Conduct of business transactions in false names. 37

40. Questions ? 38