Dallas Bar Association

The Civil Fraud Penalty

by Kyle Coleman and Amber Haque

The Treasury Inspector General for Tax Administration (TIGTA) issued a press release on April 17, 2013 urging IRS examiners to thoroughly investigate fraud indicators during all field and office audits. The reason for the increased scrutiny is twofold: to encourage voluntary compliance and enhance revenue. The report indicated that only 96 out of 127,100 office audits during fiscal years 2008 through 2011 resulted in civil penalty assessments. Per the press release, identifying and asserting the Civil Fraud Penalty is an enhanced point of interest for the IRS in every audit.  Attorneys and their clients should be aware of the fraud indicators in order to avoid an assessment during an audit.

IRC§ 6663(a) provides that if any underpayment of tax is due to fraud, a penalty is imposed equal to 75 percent of the portion of the underpayment that is due to fraud. For purposes of IRC §6663, a portion of the underpayment will be considered to be due to fraud where it is the result of an intent to evade tax. IRC §6663 does not define “fraud;” however, Courts have long recognized the essence of the fraud penalty is the taxpayer’s state of mind. The requisite state of mind requires an “intent to evade tax” and is distinguished from negligence or carelessness.

In the Fifth Circuit, longstanding precedent identifies certain factors to consider in determining whether fraud exists. The seminal case, Loftin & Woodward, Inc v. U.S,  identifies  ten key factors. The Fifth Circuit also notes that one factor, an understatement of income, will be present in any IRS audit. Thus, a mere understatement of income alone is not sufficient to support a finding of fraud.

The Fifth Circuit’s ten factors are:

1)                  Intentional understatement of income, substantial in amount

2)                  Intentional overstatement of deductions, substantial in amount

3)                  Recurrence of the understatement of income or overstatement of deductions for more than one tax year

4)                  Secret bank deposits for income

5)                  Undisclosed  income from a source other than taxpayer’s regular business

6)                  Undisclosed income derived from illegal business

7)                  Lack of adequate books and records which one would expect of the particular taxpayer, based on his business experience, education, knowledge of books and records, etc.

8)                  False entries and other falsifications in books

9)                  No reasonably acceptable explanation made by the taxpayer (as to why the falsity appears in the return)

10)              Conviction of the taxpayer on criminal tax evasion.

It is important to note that avoidance of tax is not a criminal offense. Taxpayers have the right to reduce, avoid or minimize their taxes by legitimate means. Per the Internal Revenue Manual, the IRS’ internal guidelines for practice, “one who avoids tax does not conceal or misrepresent, but shapes and preplans events to reduce or eliminate tax liability within the perimeters of the law.” See I.R.M. §

Conversely, evasion requires an affirmative act to evade or defeat a tax, or payment of tax. I.R.M § defines affirmative acts as “those actions that establish that a particular action was deliberately done for the purpose of deceit, subterfuge, camouflage, concealment, some attempt to color or obscure events, or make things seem other than what they are.” Examples of common evasion schemes include concealment of assets, improper credits or exemptions, and claiming fictitious or improper deductions.

As is true with most all penalties asserted by the IRS, no fraud penalty will be imposed if it can be shown that there was reasonable cause for the underpayment and that the taxpayer acted in good faith. Reliance on a competent tax professional is an absolute defense. Therefore, even if some of the fraud indicators are present, it is important to analyze the reason for their existence.

In conclusion, tax practitioners and business owners should be aware of the fraud indicators an IRS agent evaluates during an audit. TIGTA has put in place procedures requiring the auditor in every case to consider a civil fraud penalty and whether there are indicators that suggest the taxpayer is engaged in civil or criminal fraud. As such, it is best to take a proactive approach and refute the fraud indicators early in the audit. Remember that not one factor is determinative; thus be sure to consider all factors and any behavior of the taxpayer that may appear to be an affirmative act to conceal or evade tax.


Kyle Coleman is a shareholder and Amber Haque is an associate at The Roberts Law Firm. They can be reached at (972)661-1040 or at info@therobertslawfirm.com.

Back to top