The 75 Percent Penalty: Fraudulent Failure to File Under IRC 6651(f)

For most people with unfiled returns, the late-filing penalty tops out at 25 percent of the tax. That is painful, but it is predictable. There is a second version of the same penalty that runs three times as fast and goes three times as high. It applies when the IRS concludes that the failure to file was fraudulent.

If you have anything in your history that looks like hiding, you need to understand this penalty before you talk to the IRS.

What the statute says

IRC 6651(f) is titled Increase in penalty for fraudulent failure to file. It says that if any failure to file a return is fraudulent, the regular failure-to-file rule in IRC 6651(a)(1) is applied:

1. by substituting 15 percent for 5 percent, and
2. by substituting 75 percent for 25 percent.

The examination manual confirms the effect: the fraudulent failure to file penalty "increases the FTF penalty under IRC 6651(a)(1) from 5% a month to 15% a month, and the maximum penalty from 25% to 75%" (IRM 4.12.1.11.1.2). At 15 percent per month, the penalty hits its 75 percent cap in five months.

IRM 25.1.7.1.2 notes that this penalty may apply to all returns due after December 31, 1989, without regard to extensions.

Fraud is about intent

The regular penalty is about a missed deadline. The fraud penalty is about why the deadline was missed. Fraud means intent to evade tax. That is a big step up from carelessness, procrastination, depression, or disorganization. None of those is fraud.

The IRS knows this. That is why the manual treats fraud as something that has to be developed with evidence, not assumed from the fact of non-filing.

How the IRS screens for it

IRM 25.1.7.2 tells IRS compliance employees to screen every non-filer case for potential fraud. It lists indicators, including:

• A history of non-filing or late filing combined with an apparent ability to pay
• Knowledge of the filing requirements, such as advanced education, business or tax experience, or a record of previous filing
• Experience in tax matters, such as being a CPA or tax attorney
• Failure to reveal or attempts to conceal income or assets
• Failing to cooperate with IRS employees
• Providing incomplete or misleading information to a return preparer
• Failing to keep adequate records
• Filing false documents with the IRS or third parties
• Implausible or inconsistent explanations
• Substantial tax liability after withholding and estimated payments
• Large numbers of cash transactions, or paying expenses in cash when that is unusual
• Significant income shown on information returns
• Refusal or inability to explain the failure to file
• A prior history of criminal tax prosecutions

The manual adds an important note about the first indicator. A history of non-filing with an apparent ability to pay "alone is insufficient support for assertion of the FFTF penalty and should be cited in combination with other fraud indicators." In other words, simply not filing while having money is not enough. The IRS needs more.

If indicators exist, the employee discusses the case with a group manager, and if the manager agrees, a fraud enforcement advisor gets involved. We cover that process in fraud indicators in non-filer cases.

The IRS has to prove it

This is where the law protects taxpayers. Under IRC 7454(a), in any proceeding involving whether the taxpayer has been guilty of fraud with intent to evade tax, "the burden of proof in respect of such issue shall be upon the Secretary." Tax Court Rule 142(b) adds the standard: the burden is on the IRS, and it must be carried "by clear and convincing evidence."

Clear and convincing evidence is a higher bar than the usual civil standard. The IRS cannot win a fraud penalty on suspicion or on the size of the balance alone.

Internal checks before the penalty is proposed

The manual also builds in internal review. IRM 4.12.1.11.1.2 states that "to ensure case facts support fraud and because the assessment of a FFTF penalty attributable to the amount originally shown on a return is not reviewable by the Tax Court, all 30-day letters proposing a FFTF penalty on a deficiency must be reviewed and approved by Area Counsel prior to issuance."

That sentence contains a warning, too. Part of this penalty, the part attributable to tax shown on a return you eventually file, may not be reviewable by the Tax Court. That is one more reason to get the strategy right before the return goes in.

Stacking with the civil fraud penalty

There is a separate civil fraud penalty under IRC 6663 that applies to underpayments on returns. A non-filer who eventually files a return containing fraudulent understatements could face both penalties for the same year.

IRM 25.1.7.6 addresses this. It says that if the failure to file and the delinquent return are both fraudulent, assertion of both the fraudulent failure-to-file penalty and the civil fraud penalty should be considered. But it also cautions that "the court is not likely to sustain the determination of both penalties unless compelling facts support the IRS's position," and that Area Counsel should be consulted before determining both on the same return.

The practical lesson is simple. A late return must be an accurate return. Filing a false late return can turn one fraud problem into two.

How this connects to criminal exposure

The civil fraud penalty and criminal prosecution are separate tracks, but they draw on the same facts. IRM 25.1.7.1.2 explains that willful failure to file is a misdemeanor under IRC 7203, and that where an overt act of evasion occurred, it may be elevated to a felony under IRC 7201. When fraud indicators show up and criminal criteria are met, the case can be referred to Criminal Investigation instead of being resolved civilly (IRM 25.1.7.5).

If the IRS is asking fraud-type questions, you are in territory where what you say and what you file can be used in more than one way. See is not filing taxes a crime?.

What does not count as fraud

It is worth saying plainly what does not, by itself, make a failure to file fraudulent. Being overwhelmed. Losing records. A business collapse. Illness. Grief. Addiction. A spouse who handled the finances and stopped. Fear of a balance you could not pay. These are the reasons most people stop filing, and none of them is intent to evade tax.

The IRS manual reflects this in how it develops fraud. IRM 25.1.7.4 tells employees to interview the taxpayer to determine the reason for the noncompliance and to identify any personal reasons that could affect the taxpayer's ability to comply. Those personal reasons are part of the record. If they are real, documented, and consistent, they cut against a fraud finding.

The trouble starts when the story and the evidence do not match: claiming no income while depositing large sums, saying records were lost while spending heavily in cash, or giving the IRS one explanation and a lender another.

What to do if fraud is on the table

• Do not give oral explanations to IRS employees without counsel. The manual tells employees to document questions and answers verbatim where possible (IRM 25.1.7.4).
• Do not file anything until a lawyer has reviewed the whole history.
• Gather records that show the real reasons for non-filing, such as medical, family, or business events, with dates.
• Make sure any return eventually filed is complete and accurate.
• Understand that the IRS must prove fraud by clear and convincing evidence, and do not hand it that evidence.