Red Flags That Turn a Non-Filer Case Into a Fraud Case

Every IRS employee who picks up a non-filer case is supposed to ask one question before anything else: does this look like fraud? The answer decides whether the case is handled as a routine request to file or as something much more serious.

The IRS wrote down what it looks for. If you have unfiled returns, you should read the list before the IRS does.

The screening requirement

IRM 25.1.7.2, Pre-screening Non-filers, says: "On the initial screening of a non-filer case, the compliance employee must determine if the facts indicate potential fraud."

The examination manual for nonfiled returns says the same thing from the examiner's side. When examiners discover non-filing, they are to determine the periods involved, ascertain the reasons for non-filing, and "determine whether any indications of fraud exist" before soliciting any returns (IRM 4.12.1.4). That order matters. The fraud question comes before the request to file.

The indicators

IRM 25.1.7.2 lists potential indicators of fraud for non-filers, in addition to the general indicators of fraud in IRM 25.1.2.3. Here they are, grouped by what each one suggests.

Knowledge

• History of non-filing or late filing, and an apparent ability to pay
• Repeated contacts by the IRS
• Knowledge of the filing requirements, such as advanced education, business experience, especially tax experience, or a record of previous filing
• Experience in tax matters, such as a law professor, CPA, or tax attorney

Concealment

• Failure to reveal or attempts to conceal income or assets
• Understating income
• Large number of cash transactions, including cash purchases and large cash deposits, payment of personal and business expenses in cash when that is unusual, and cashing rather than depositing business receipts
• Indications of significant income on information returns, such as substantial interest and dividends, IRA investments, stock and bond transactions, or high mortgage interest paid

Conduct

• Failing to cooperate with IRS employees
• Providing incomplete or misleading information to a return preparer
• Failing to maintain adequate records
• Filing false documents, including false returns with the IRS or third parties
• Offering implausible or inconsistent explanations
• Refusal or inability to explain the failure to file
• Prior history of criminal tax prosecutions

Context

• Age, health, and occupation of the taxpayer
• Substantial tax liability after withholding and estimated payments

What the IRS says about the indicators

Two notes in the manual are worth emphasizing.

First, the history-plus-ability-to-pay indicator is not enough on its own. The manual says it "is insufficient support for assertion of the FFTF penalty and should be cited in combination with other fraud indicators." Not filing while having money is the profile of a great many ordinary non-filers. It takes more.

Second, the manual cautions examiners about cash-intensive businesses. It tells them to consider whether the business is cash-intensive and must use cash for expenses, giving the marijuana industry as an example where banks have been reluctant to provide accounts. Cash alone is not fraud. Cash plus concealment is a different story.

What happens when the flags go up

If indicators exist, the process changes.

1. Manager review. The employee discusses the case with the group manager (IRM 25.1.7.2).
2. Fraud enforcement advisor. If the manager agrees fraud is possible, a fraud enforcement advisor, or FEA, gets involved. The examination manual says the FEA helps identify affirmative acts of fraud, develop an investigative plan, and determine whether a criminal referral should be made (IRM 4.12.1.7).
3. Quiet changes. The examination manual tells examiners that where fraud indicators are present they should not solicit tax returns, volunteer advice, or discuss referral possibilities with the taxpayer (IRM 4.12.1.7.1). If there is a firm indication of fraud, preparation of a substitute for return is postponed (IRM 4.12.1.7.2).
4. Fraud development. Employees interview the taxpayer about the reasons for non-filing, document questions and answers verbatim where possible, try to establish cash on hand, and verify income from many sources, including FinCEN data, third-party records, and public records of assets (IRM 25.1.7.4).
5. Referral or civil closure. If the group manager and FEA agree that firm indications of fraud exist and criminal criteria are met, a referral to Criminal Investigation is prepared (IRM 25.1.7.5). If criminal criteria are not met, the case continues civilly, and the fraudulent failure-to-file penalty may be considered (IRM 25.1.7.7).

The warning signs you can see

You cannot see the IRS's internal case file. You can see behavior. Watch for:

• An examiner or Revenue Officer who was asking for returns and suddenly stops
• Questions focused on your lifestyle, cash, assets, and why you did not file, rather than on preparing returns
• Requests for statements about cash on hand in prior years
• Meetings canceled or postponed without explanation
• Contact from someone new, especially anyone from IRS Criminal Investigation

Any of those is a reason to stop and call a lawyer before you say another word.

Indicators are not conclusions

It is worth repeating that the IRM calls these "potential indicators." An indicator starts a conversation inside the IRS. It does not end one. Many honest non-filers have one or two items from the list: a professional job, some cash income, or a history of filing before they stopped. The examination manual describes fraud development as "a matter of progressing from the indicators of fraud, to affirmative acts of fraud, where the taxpayer deliberately took action to evade a tax" (IRM 4.12.1.7). The distance between an indicator and an affirmative act is where most cases stay civil.

And if the case reaches the civil fraud penalty stage, the IRS still has to prove fraud. Under IRC 7454(a) and Tax Court Rule 142(b), the burden is on the IRS, by clear and convincing evidence.

Why the IRS looks at your lifestyle

Some of the questions in a non-filer interview can feel invasive: what you drive, where you live, how you pay your bills. The fraud handbook tells employees to secure current financial information, including checking public records for assets and physically observing the taxpayer's residence and place of business, and notes that information about when assets were acquired can show whether the taxpayer had the ability to pay the taxes when due (IRM 25.1.7.4). The goal is to compare the lifestyle to the reported or reconstructed income. Large unexplained gaps are what turn indicators into questions about intent.

How to keep an ordinary case ordinary

Most non-filer cases are exactly what they look like: someone fell behind and stayed behind. The way to keep the case in that category is to avoid creating new indicators.

• Respond to IRS contacts, through a representative if you prefer, rather than ignoring them. Repeated ignored contacts are an indicator.
• Give your preparer complete information. Misleading a preparer is an indicator.
• Do not move or retitle assets while unfiled years are open.
• Keep your explanation consistent, documented, and true.
• File accurate returns. Understating income on a late return turns a filing problem into a fraud problem.

When the facts are already there

Sometimes the indicators exist before anyone calls. There is cash income that never hit a bank, an account in someone else's name, or a professional background that makes "I didn't know" hard to say. In that situation the order of operations is critical. The decision about whether, when, and how to file is a legal strategy decision, and it should be made with a tax attorney before you contact the IRS or send in returns.