How does the IRS determine who gets flagged for potential tax fraud activity? The agency judges taxpayer actions against a list of over 60 “badges” or indications of fraud ranging from misrepresenting expenses and deductions to lying, bribery and concealment.
Of course, badges are usually given out for a job well done. Receiving an IRS badge of fraud, on the other hand, is not an accomplishment to brag about.
The badges are guideposts used by the IRS Office of Fraud Enforcement (OFE) to help detect tax fraud. These “first indicators” of possible fraudulent action aren’t proven or “affirmative” acts; they’re simply signs that fraud may be at hand and, therefore, could be investigated further.
Below are summarized examples of the badges identified in OFE’s Internal Revenue Manual (IRM) Fraud Handbook, updated on April 23, 2021. It’s not a complete list, but it will give you an idea of behaviors the IRS will flag for analysis. Collect enough badges—or significant ones—and you can expect that the IRS will deem you “worthy” of a closer look. The group may even hand you off to the Criminal Investigations (CI) unit.
Indicators of Fraud Involving Income
This category involves omitting or failing to report specific items or sources of income, an inability to explain substantial increases in net worth, and substantial expenditures or unexplained sources of bank deposits exceeding reported income. Failing to file a tax return at all, especially for several years, can also be a trigger.
Also included may be the concealment of domestic or foreign bank accounts, brokerage accounts, digital assets such as virtual currency, or other property. It’s a catch-all, too, for failing to deposit receipts in a business account or exhibiting other badge-worthy behaviors like cashing checks at check cashing service locations and banks where the taxpayer does not maintain an account.
Indicators of Fraud Involving Expenses or Deductions
This category centers around fictitious or substantially overstated deductions. The IRS is also looking for substantial business expense deductions for personal expenditures; dependency exemptions for nonexistent, deceased, or self-supporting persons; and falsified or altered documents used to claim tax credits. Trust fund loans disguised as expenses or deductions are also on the table.
Indicators of Fraud Involving Books and Records
Multiple sets of books or no records at all for your business can certainly get you flagged. The IRS will also be concerned about a failure to keep adequate records, concealment of records, or refusal to make records available. A laundry list of sins falls under this category involving falsified entries, documents, applications, donor receipts, or statements; suspicious invoices, checks, or ledger entries; and tax returns that don’t match the books.
Indicators of Fraud Involving Allocations of Income
The primary sources of scrutiny here are the distribution of profits to fictitious partners and the inclusion of income or deductions in the tax return of a related taxpayer when tax rate differences are factors.
Indicators of Fraud Involving Conduct of Taxpayer
The suspicion of false statements about a material fact pertaining to an IRS examination, aka lying, is central here. Attempts to hinder or obstruct an IRS examination are also triggers. “For example, failure to answer questions; repeated canceled or rescheduled appointments; refusal to provide records; threatening potential witnesses, including the examiner; or assaulting the examiner,” the manual points out.
Dozens of other behaviors can earn you badges in this category, ranging from merely showing a pattern of consistent failure over several years to report income fully to attempting to bribe an IRS examiner. Failing to follow the advice of your accountant, attorney or return preparer, as well as failing to fully disclose relevant facts to your accountant, attorney or return preparer, can be triggers, too.
Indicators of Fraud Involving Methods of Concealment
This final category is for those suspected of ramping up their concealment. Placing assets in others’ names to avoid taxes or debt collection is commonly flagged in this area. Even “transactions surrounded by secrecy” are enough to earn you a badge.
As for what to do when you’re “awarded” a badge? That’s between you and your tax attorney. We can tell you with absolute certainty that this circumstance is yet another reason to respond quickly and with due diligence to IRS letters and notices. Your case will not be escalated to a fraud investigator without plenty of notifications and requests for meetings with an auditor or a compliance officer. A CPA can represent clients to the IRS during these types of interactions and can help determine when a tax attorney should be brought in. Feel free to contact us with questions.
