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Kevin O'Flaherty

 This article will discuss the difference between tax fraud, tax evasion, and negligence and how consumers can avoid costly tax mistakes. We will cover the following topics:


  • How do people cheat on their taxes?
  • Common signs of tax fraud.
  • Tax fraud versus tax evasion.
  • Tax fraud versus negligence
  • When does the IRS give a negligence penalty?


With tax season right around the corner, Americans collect their W-2s, 1099s, deductible receipts and start warming up their calculators. It’s estimated that between forty and fifty percent of taxpayers that file electronically complete their taxes on their own with little or no outside help. With more than 100 million people filing individual or joint income tax returns, it’s a wonder how the IRS can track them all. It begs the question, “How does the IRS know if someone commits tax fraud, tax evasion, or is just being negligent?” The quick answer is computer software. The long answer is below.


How Do People Cheat On Their Taxes?


The most common way people cheat on their taxes is by underreporting their income. Many of those caught are small business owners and self-employed taxpayers. Self-employed individuals don’t have taxes automatically withheld from their income, so they must be responsible for paying and reporting their taxes. Whether through ignorance or willing participation, a percentage of self-employed taxpayers seem to think that the IRS only knows how much money you collect if it’s reporting. This is a fallacy that has landed millions in hot water with the IRS.


A distance second to under-reporting income is over-deducting or creating false deductions. Taxpayers frequently try to deduct items such as car payments, office space, vacations, client dinners, etc., that have strict limitations or are not eligible for deduction. Often, over-deductions lead to audits where IRS agents find underreporting of income and other examples of tax fraud.


Common Signs of Tax Fraud


An individual doesn’t have to be under a full-fledged audit for an IRS agent to start looking for tax fraud. If the system flags a person for unusual financial behavior, an IRS agent will begin digging through what information is available before taking legal action to sequester documentation. Auditors are trained to recognize real tax fraud versus simple mistakes and negligence. Some examples of deliberate attempts to evade tax laws include:


  • Deliberately underreporting income
  • Listing personal expenses as business expenses
  • Using a fake social security number
  • Supplying false documents
  • Listing too many deductions or exemptions
  • Concealing or transferring income


Typically, those charged with tax fraud are suspected or guilty of multiple violations, with a clear plan to game the tax system and save money.


Tax Fraud Versus Tax Evasion


Think of tax evasion as one of many branches of a tax fraud oak tree. Tax fraud encompasses all the different ways a taxpayer might try to avoid paying taxes intentionally. Proving tax fraud requires that the IRS show that the taxpayer failed to pay and acted with the intention not to pay. 


To return to our tree metaphor; tax evasion is one of the larger tax fraud tree branches. Tax evasion refers to the deliberate and intentional misrepresentation of taxable income to avoid paying higher income. Tax evasion comes in many forms, such as failure to report income, overstating deductions and expenses, claiming nonexistent dependents, poor record-keeping, false receipts, and failure to report income.


Although being charged with tax fraud would suggest the individual committed multiple violations and thus should receive a harsher sentence, tax evasion carries the more significant penalty between the two. Those convicted of tax evasion can be hit with six-figure fines, a prison sentence, the cost of the IRS’s legal fees, loss of business, loss of license, etc. 


Tax Fraud Versus Tax Negligence


Although the IRS may come off as unsympathetic, it understands that completing taxes takes time, and people make mistakes. Those with a larger estate or many moving parts in their business will naturally have more complex tax returns. Unfortunately, complexity is no excuse, and even an innocent error can lead to a negligence penalty. 


The IRS doesn’t just assume someone committed fraud if they find a discrepancy, especially if it is a one-off, but that mistake still comes at a cost. When differentiating between fraud and negligence, the main factor that the IRS looks for is intent. If it’s clear that there was no intent to mislead the IRS in an attempt to save money, the worst you’ll get hit with is a negligence penalty. But if the IRS finds multiple discrepancies across different aspects of a tax filing, they’ll start building a case for fraud.


When Does The IRS Give A Negligence Penalty?


The IRS can charge a negligence penalty for many different reasons, including:


  • Changing your return to state you owe more than you calculated (this is known as an accuracy penalty, is really just the difference between what you thought you owed and what you really owed.);
  • Overstatement of deductions;
  • Underreporting income;
  • Failing to keep accurate records (this might come up if audited);
  • Failing to include income from all statements; or
  • Failing to make a good faith effort to confirm your eligibility for listed exclusions, credits, or deductions 


Negligence penalties can vary, but they often come in around twenty percent of the amount you underpaid, which can be a significant financial blow for some taxpayers. If you’re facing a negligence penalty or getting audited, it’s best to seek guidance from a qualified tax attorney. Furthermore, the best way to avoid a tax penalty and getting flagged for an audit is by working with an accountant and tax attorney. The peace of mind is well worth the cost, and you may end up with a greater return than you anticipated.


Disclaimer: The information provided on this blog is intended for general informational purposes only and should not be construed as legal advice on any subject matter. This information is not intended to create, and receipt or viewing does not constitute an attorney-client relationship. Each individual's legal needs are unique, and these materials may not be applicable to your legal situation. Always seek the advice of a competent attorney with any questions you may have regarding a legal issue. Do not disregard professional legal advice or delay in seeking it because of something you have read on this blog.


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