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Taxes

What Is Tax Fraud?

Hundreds of billions of dollars of rightfully owed taxes go unpaid in the U.S. every year, according to the IRS’s tax gap estimates. Sometimes, people accidentally forget to file or pay their taxes. Other times, people or businesses intentionally avoid paying them by falsifying their tax returns, selling goods or services under the table or hiding money in offshore accounts.

This guide will explore the different types of tax fraud, how it's committed, how to report it and more.

What is tax fraud?

Tax fraud occurs when a person or business willfully misrepresents information to the IRS to get out of paying taxes they owe or claim an illegitimate refund. The action must be deliberate and intended to result in unlawful gain to be considered tax fraud.

How does tax fraud work?

Tax fraud works differently depending on how it's carried out, and the methods vary greatly. It can be as simple as not reporting the money you made through your side gig or as complex as hiding money in offshore accounts or stealing another person's identity to claim a fraudulent tax refund.

It's important to note that tax laws are complex, and well-meaning taxpayers occasionally make errors when filing their taxes. An unintentional error is not considered tax fraud, but it could still result in an investigation to rule out deliberate actions meant to defraud the government.

If the IRS investigation concludes that the actions constitute fraud, it may refer the case to the Department of Justice to be prosecuted criminally. For the Department of Justice to convict someone of criminal tax fraud, it must prove beyond a reasonable doubt that the actions were fraudulent in intent. If the government can't prove fraud beyond a reasonable doubt but has clear and convincing evidence, it can pursue tax fraud as a civil case. Civil cases have less severe penalties than criminal cases and do not carry the possibility of jail time.

Common types of tax fraud

Although there are many different actions that can constitute tax fraud, most fall within a few categories. Here are some of the most common examples.

Underreporting taxable income

It might be tough to lie about the income you receive from your employer that's reported directly to the IRS, but that's not the only income you're responsible for reporting. By law, you're required to report all income, even if it's not recorded on a form like a W-2 or 1099. That means you may need to pay taxes on the cash you earn from babysitting and your PayPal earnings from selling your artwork online, for example, depending on how much you earn. You must also pay taxes on the income you receive in goods, property or virtual currencies.

In addition to taxes on income, in many cases, the IRS also requires you to report and pay taxes on dividends and interest earned. Suppose you intentionally leave any income sources out when you file your taxes or report making a lesser amount than you received. In that case, you're committing tax fraud and may be subject to criminal penalties.

False deductions

Both businesses and individuals can claim deductions that lower their total taxable income. Common individual tax deductions include:

Child Tax Credit for caregivers with dependents under 18 years old
Earned Income Tax Credit for low-to-moderate-income taxpayers
American Opportunity Tax Credit (AOTC) for college students

Common business deductions include:

Mileage when using your car for business purposes
Rent for business properties
Employee wages
A portion of meals and lodging related to business purposes

Claiming personal expenses as business deductions is tax fraud, as is reporting credits or deductions you didn't earn or that exceed what you paid. It can be tempting for people to claim false deductions because they usually lead to lowered tax liabilities, but doing so can get you in a lot of trouble with the IRS.

Tax identity theft

Tax identity theft is when someone steals another person's information, like their name and Social Security number, to file a fraudulent tax return or claim a refund. Identity thieves can steal personal information through email phishing scams, mail theft, lost or stolen wallets or sensitive documents found in the garbage. Signs that you may be a victim of tax identity theft include:

Getting a letter from the IRS about a tax return you didn't file

Being unable to file your tax refund electronically because of a duplicate Social Security number

Receiving a tax transcript in the mail that you didn't request

Discovering IRS wage records for an employer you never worked for

To avoid becoming a victim of tax identity theft, always safeguard your personal and financial information. You can do this by:

Shredding sensitive documents before throwing them out
Leaving your Social Security card and passport home whenever possible
Keeping important documents in a locked safe
Creating strong passwords for your online accounts
Researching the latest phishing scams to avoid falling for them

Fraudulent tax returns

Scammers sometimes use stolen information to file fake tax returns. They usually do this to claim a refund that isn't theirs. A criminal may act alone to commit tax return fraud, but large criminal enterprises often run these schemes, according to the U.S. Department of Justice.

Another type of income tax fraud is tax preparer fraud. This happens when a taxpayer uses an unscrupulous professional tax preparer to file their taxes. The preparer might change your return without your knowledge, misrepresenting your income or credits earned to increase your refund. They may then keep some or all of the refund. Tax preparers might change the direct deposit information on the return to steal your refund. Or they could use your information from a previous year to file a fraudulent return in your name.

To avoid becoming a victim of tax preparer fraud, only use a preparer with an established business who will sign the return as the preparer. Never agree to sign a blank return. And avoid preparers who base their fees on the size of your return.

Payroll tax fraud

The IRS requires employers to withhold income taxes, unemployment tax and Social Security and Medicare taxes from employee paychecks and pass this money along to the IRS. Payroll tax fraud often occurs when a business pays its employees under the table, usually in cash, to avoid paying these taxes. Other times, employers misclassify employees as independent contractors to avoid taxes. Sometimes, employers withhold taxes but keep them for themselves instead of giving them to the IRS as required.

Sales tax fraud

Sales tax fraud is when a business doesn't report all its sales to avoid paying the full sales tax owed. The business might make off-the-books transactions, avoid reporting out-of-state sales or understate its total sales. Anytime a business makes transactions without collecting sales tax and passing it along to the IRS, it is tax fraud.

Tax fraud vs. tax evasion: What's the difference?

The difference between tax evasion and tax fraud is sometimes confused because there is some overlap between the two. Tax fraud involves falsifying or misrepresenting records to avoid paying legally owed taxes. Tax evasion, on the other hand, is the refusal to pay the taxes you owe. You may ignore the bill or choose not to pay it. Both are serious crimes against the IRS that carry potentially harsh consequences, including fines and jail time. If the IRS is investigating you for tax fraud or tax evasion, consider consulting a tax fraud lawyer to learn your best course of action.

Indicators of tax fraud

Some common indicators of tax fraud can draw unwanted attention from the IRS. Here are some signs that may be red flags.

Unusual fluctuations in income

Unusual fluctuations in your income can serve as a warning to the IRS that you may be involved in tax fraud. Red flags include:

Spending much more than you claim in income
Bank deposits that greatly exceed your reported income
A significant unexplained increase in net worth

Inconsistent tax deductions

Like fluctuations in your income, significant changes in your claimed deductions over time can get the IRS's attention. It could be a red flag if you've claimed one dependent for years and suddenly claim five. Or if you continue to claim a dependent who has died or become self-supporting.

Similarly, if you own a business and your claimed deductions for rent and wages are unusually inconsistent over time, the IRS might contact you for an explanation. If you didn’t commit fraud, you should have legitimate paperwork backing up the fluctuations to avoid an investigation.

Frequent changes in filing status

While it's normal for your filing status to change once or even a few times in your life, frequent changes can indicate to the IRS that tax fraud is possible. Your filing status determines the following:

Whether you're required to file a federal tax return
Your standard deduction
Which tax credits you can claim
How much you owe in taxes

Like all aspects of your tax returns, inconsistency in your filing status over time is a red flag.

Hidden offshore investments

Having money in offshore investments isn't illegal, but hiding it from the IRS is a crime. If the IRS discovers you have money in offshore accounts that you've failed to report, there's a good chance it will investigate for tax fraud. The IRS will also consider it fraud if they discover you're hiding any bank or brokerage accounts or digital currency.

How to report tax fraud to the IRS

The IRS doesn't take fraud reports by phone. If you suspect a person or company is breaking tax laws, you can report tax fraud anonymously using the online Form 3949-A on the IRS website. If you don't want to remain anonymous, you can apply for a reward for reporting tax fraud through the IRS Whistleblower Office. Rewards generally range from 15% to 30% of the amount the IRS collects based on the reported information.

If you suspect a tax professional or IRS employee of committing fraud, you can report it at 800-366-4484. If you have questions about tax identity theft, you can get assistance by calling 800-908-4490. Check your state government's website to learn how to report state-level tax fraud. Some states have hotlines available for reporting tax fraud.

Is tax fraud a felony?

Tax fraud can be a felony in the U.S. In addition to hefty penalty fees, the punishment for tax fraud is up to $100,000 in fines and five years in prison. Corporations can face fines of up to $500,000. The penalty for tax fraud that involves participating in a conspiracy to defraud the government is even steeper, including up to 10 years in prison.

Is there a statute of limitations for tax fraud?

The statute of limitations for criminal tax fraud is up to six years, depending on the exact method of fraud and the amount of evaded taxes. After that time, the Justice Department can no longer prosecute or punish a tax fraud case criminally. However, there is no statute of limitations for civil fraud cases, which have a lower burden of proof and less severe consequences.

Summary of Money's What Is Tax Fraud?

Tax fraud is a felony punishable by fines and time in prison. It occurs when an individual or business intentionally falsifies records to avoid paying taxes or to claim an illegitimate tax refund. Common types of tax fraud include:

Underreporting taxable income
False deductions
Tax identity theft
Fraudulent tax returns
Payroll tax fraud
Sales tax fraud