by Jim Marasco, CPA, CFE, CIA Fraud Matters, Spring 2010

The income tax system of the United States is essentially based on the notion of voluntary compliance. You are expected to report and remit the income you’ve earned and the corresponding taxes that are due to the government. Herein lies the potential for fraud and abuse. As white-collar crime has flourished in the recent recession, tax fraud has also captured recent headlines. The government has been aggressively trying to close loopholes and remedy weaknesses to secure more revenue for the Treasury. Cracking down on tax evasion has proven to be quite lucrative.

Tax fraud crime categories

The IRS classifies tax fraud into two basic categories: legal source tax crimes and illegal source financial crimes. Legal source crimes involve individuals who legally earn income but evade tax laws by either underreporting income or exaggerating their deductions, thereby reducing their tax liability. Illegal source financial crimes include money gained through illegal sources of income (the “underground economy”) that never gets reported to the government. Therefore, the tax on this income is never remitted.

Tax preparers put on notice

Prior to the current tax filing season, the IRS sent letters to 10,000 paid tax preparers nationwide. These preparers are among those with large volumes of specific tax returns in which the IRS typically experiences frequent errors. In addition, thousands of these preparers will be visited by IRS revenue agents to discuss their obligations and responsibilities to prepare accurate tax returns. The IRS has said its revenue agents will also visit tax preparers posing as potential clients.

Starting next year, the IRS is planning additional new initiatives to help eliminate fraud and abuse in tax return filing, including:

• Requiring all paid tax return preparers to register with the IRS and obtain a preparer tax identification number. These preparers will be subject to a limited tax compliance check to ensure they have filed federal personal, employment and business tax returns and that the tax due on those returns has been paid.
• Requiring competency tests for all paid tax return preparers except attorneys, CPAs and enrolled agents (EAs) who are active and in good standing with their respective licensing agencies.
• Requiring ongoing continuing professional education for all paid tax return preparers except attorneys, CPAs and EAs.
• Extending the ethical rules set forth by the Treasury Department to include all paid preparers, not just attorneys, CPAs and EAs.

Tax fraud headlines

One case that received a great deal of notoriety in 2008 involved actor Wesley Snipes.

Snipes stopped filing tax returns from 1999 through 2004. In addition, he requested more than $11 million in refunds from prior years in which he had remitted taxes.

Although he was acquitted of tax fraud, Snipes was convicted of failing to file income tax returns and received a 36-month sentence. His two advisers were convicted of tax fraud charges for rendering fraudulent advice and falsely filing refund requests on his behalf. They received prison sentences of 4½ and 10 years.

Offshore tax evasion has made big headlines this past year and has a few public accounting firms and their clients running scared.

A 2008 Senate report estimated that offshore holdings and secret dealings cost the United States $100 billion in lost annual tax revenue. In early 2009, UBS, the largest Swiss bank, agreed to a $780 million settlement of criminal charges that involved assisting U.S. clients to evade taxes. Last August, UBS agreed to provide data for nearly 4,500 U.S. clients whose accounts once held an estimated $18 billion.

This past year, accountants who worked for national accounting firms Ernst & Young and KPMG were found guilty of selling illegal tax shelters to wealthy clients.

The tax shelters generated billions of dollars in noneconomic or paper tax losses that were used to offset actual income or gains recognized by their clients. KPMG paid $456 million in fines, restitution and penalties.

Reporting fraud to the IRS

If you come across tax fraud, you can benefit financially by reporting it to the IRS. You could be entitled to awards between 15 and 30 percent of the amount of back taxes, penalties and interest ultimately collected by the IRS. However, to be considered, the potential amount owed to the IRS must be greater than $2 million.

In cases of individuals who defraud the government, the taxpayer’s gross annual income must exceed $200,000.

Penalties for noncompliance

If you run afoul of the IRS, there are a myriad of civil penalties. The penalties fall under two categories: failure-to-file and failure-to-pay.

There are also accuracy-related penalties as well. These penalties could be quite substantial, potentially amounting to 100 percent of the unpaid tax, in addition to the unpaid liability.

Criminal penalties could also apply and may result in substantial fines and extended prison sentences for those convicted.

Today, more than ever, the U.S. government is motivated to curb tax fraud and recover funds. The expanding reach of sophisticated technology and forced cooperation with foreign banks and countries is facilitating the IRS effort to remedy weaknesses and close loopholes in our income tax system. James I. Marasco, CPA/CFF, CFE, CIA Jim is a partner at EFPR Group. He brings more than 18 years of public accounting and auditing experience. He is a full-time management consultant and travels extensively throughout the country while leading StoneBridge Business Partners (an EFPR Group affiliate company). Article republished with the permission of CPA America.