Practices and Procedures · Sanctionable acts

Fraudulent transactions (e.g., badges of fraud)

Fraud is not aggressive tax planning that went badly. The IRS defines it as deception by misrepresentation of material facts, or silence where good faith requires speech, and tax fraud as an intentional wrongdoing with the specific purpose of evading a tax known or believed to be owing (IRM 25.1.1.3). Two elements, both required: a tax due and owing, and fraudulent intent. A practitioner who understands only that sentence already knows more than most of what the exam tests.

The rule

Avoidance is lawful; evasion is not. Taxpayers may reduce, avoid or minimise tax by legitimate means. One who avoids tax “does not conceal or misrepresent, but shapes and preplans events to reduce or eliminate tax liability within the parameters of the law”. Evasion requires some affirmative act to evade or defeat tax or its payment — deceit, subterfuge, camouflage, concealment, or an attempt to colour or obscure events (IRM 25.1.1.3.3).

Indicators are not proof. Indicators of fraud are signs or symptoms; they signify that action may have been taken for the purpose of deceit, but “in and of themselves, do not establish that a particular action was taken”. Affirmative acts — firm indications — are actions that establish a thing was deliberately done to deceive. Fraud cannot be established without affirmative acts of fraud (IRM 25.1.1.4). That sentence is the whole of the distinction, and it is what a practitioner argues from.

The burden is always the government’s. In civil fraud cases the government must prove fraud by clear and convincing evidence, the burden resting on the government^TY2026. In criminal cases the standard is beyond a reasonable doubt, the burden resting on the government^TY2026 (IRM 25.1.1.3.1). Neither burden ever shifts to the taxpayer on the fraud question itself.

Civil consequences. The fraud penalty is 75% of the underpayment attributable to fraud^TY2026 (IRC § 6663(a)). Once the Secretary establishes that any portion of an underpayment is attributable to fraud, the entire underpayment is treated as fraudulent except so much as the taxpayer establishes, by a preponderance, is not (IRC § 6663(b)) — a burden that does shift, on apportionment only. On a joint return the penalty does not reach a spouse unless some part of the underpayment is due to that spouse’s fraud (IRC § 6663(c)).

A fraudulent failure to file is separate: § 6651(f) substitutes 15% of the tax per month or part month, maximum 75%^TY2026 for the ordinary failure-to-file rate.

The statute never closes. On a false or fraudulent return filed with intent to evade, there is no limitation period — tax may be assessed at any time on a false or fraudulent return filed with intent to evade^TY2026 (IRC § 6501(c)(1)).

Criminal consequences. Willfully attempting in any manner to evade or defeat any tax, or its payment, is a felony: a fine of up to $100,000 ($500,000 for a corporation), imprisonment of up to 5 years, or both, plus costs of prosecution^TY2026 (IRC § 7201). Section 7206(1) reaches willfully making and subscribing any document verified under penalties of perjury that the signer does not believe true and correct as to every material matter; § 7206(2) reaches willfully aiding, assisting, procuring, counselling or advising the preparation of a false or fraudulent document — whether or not the taxpayer knew or consented. Willfulness means a voluntary, intentional violation of a known legal duty, and a good faith misunderstanding of the law negates it (IRM 25.1.1.5).

The six categories of indicators. IRM 25.1.2.3 groups them, each list expressly not all-inclusive: income (omitting specific items where similar items are included, unexplained increases in net worth, bank deposits exceeding reported income, concealed accounts including digital assets, cashing income cheques at services where no account is held); expenses and deductions (fictitious or substantially overstated deductions, personal expenditure claimed as business expense, dependants who are nonexistent or deceased, false or altered documents supporting refundable credits); books and records (two sets of books or none, false or altered entries, back-dated documents, cheques payable to third parties endorsed back to the taxpayer, return amounts disagreeing with the books); allocations of income (profits distributed to fictitious partners, income or deductions placed on a related taxpayer’s return where rate differences matter); conduct of the taxpayer (false statements about material facts in the examination, obstruction, destruction of records especially just after an examination begins, failure to disclose relevant facts to the accountant or preparer, transfer of assets to conceal, attempting to bribe the examiner); and methods of concealment (inadequacy of consideration, insolvency of the transferor, assets placed in other names, transfers made in anticipation of assessment or during an investigation, transactions surrounded by secrecy, secret or nominee bank accounts, business conducted in false names).

Current figures

How it works in practice

The indicator-versus-affirmative-act line is where representation actually happens. An examiner may open a file on indicators — the net worth does not explain itself, the deposits exceed the reported income — but the IRM tells the examiner that indicators alone establish nothing. The representative’s work is to supply the innocent explanation before the indicator hardens into an affirmative act, and to resist the elision of “unexplained” into “concealed”.

Conduct indicators are the ones clients create during the examination, and they are the ones a representative can prevent. Cancelled appointments, records that never arrive, a story that changes, documents destroyed after the notice — every one is on the IRM’s list, and none of them relates to the original return. A client who was merely careless on the return can manufacture a fraud case during the audit, and the practitioner’s most valuable early advice is usually procedural rather than substantive.

Note the asymmetry in § 6663(b). The government proves fraud as to a part; the whole underpayment then carries the seventy-five percent unless the taxpayer disaggregates it by a preponderance. So the fight over which items are fraudulent is a fight the taxpayer must win item by item, having already lost the threshold question.

For the practitioner, three lines matter. Section 7206(2) does not require the client’s knowledge or consent — a preparer can be criminally liable on a return the client believed honest. Circular 230 § 10.51(a)(7) makes willfully assisting or counselling a client in violating a federal tax law disreputable conduct. And § 10.21 requires a practitioner who knows a client has not complied, or has made an error or omission, to advise the client promptly of the fact and of the consequences — the obligation is to inform, not to correct the return without instruction and not to disclose to the IRS.

How this has changed

Section 6663 in its present form dates from the Improved Penalty Administration and Compliance Tax Act of 1989 (Pub. L. 101-239 § 7721), applying to returns due after 31 December 1989, which split the fraud penalty out of the old § 6653 and set it at seventy-five percent of the fraudulent portion. The IRM’s treatment is more recent and still moving: IRM 25.1.1 was revised 22 April 2021, which renamed the Fraud Technical Advisor as the Fraud Enforcement Advisor and placed the programme under the Office of Fraud Enforcement, and IRM 25.1.2 was revised 20 May 2024 to add a full treatment of digital asset fraud, including indicators specific to convertible virtual currency. The income indicator list now names digital assets alongside domestic and foreign bank and brokerage accounts.

Exam focus

The definition of tax fraud and its two required elements. The avoidance/evasion distinction, expressed as concealment and misrepresentation versus preplanning within the law. The difference between an indicator and an affirmative act, and that fraud cannot be established without the latter. Both standards of proof and that the burden is the government’s. Section 6663’s seventy-five percent, the § 6663(b) whole-underpayment rule and the § 6663(c) joint return rule. That § 6501(c)(1) leaves no assessment period. Expect a fact pattern asking you to sort listed items into indicators and affirmative acts.

Check yourself

1. An examiner finds unexplained increases in a taxpayer’s net worth over four years. Standing alone, this is: (A) An affirmative act of fraud (B) An indicator of fraud, which does not by itself establish that any action was taken (C) Conclusive of intent to evade (D) Irrelevant to a fraud determination Answer: B. IRM 25.1.1.4.

2. In a civil fraud case the government must prove fraud: (A) By a preponderance of the evidence (B) By clear and convincing evidence (C) Beyond a reasonable doubt (D) By substantial evidence Answer: B. Beyond a reasonable doubt is the criminal standard.

3. The Secretary establishes that one item of a $200,000 underpayment is fraudulent. Under IRC 6663(b): (A) Only that item carries the penalty (B) The entire underpayment is treated as fraudulent unless the taxpayer establishes otherwise by a preponderance (C) The penalty is prorated automatically (D) The penalty applies only if the fraudulent item exceeds half the underpayment Answer: B.

4. A taxpayer restructures a transaction in advance, disclosing everything, to fall within a favourable provision. This is: (A) Evasion, because the purpose was to reduce tax (B) Avoidance, which is lawful, there being no concealment or misrepresentation (C) A frivolous position (D) An affirmative act of fraud Answer: B. IRM 25.1.1.3.3.

5. A preparer discovers that a client’s prior-year return omitted income. Circular 230 requires the practitioner to: (A) File an amended return immediately (B) Advise the client promptly of the noncompliance and its consequences (C) Notify the IRS (D) Withdraw from the engagement without explanation Answer: B. Section 10.21 is an obligation to inform the client, not the IRS.