This section discusses the fact that a fraud case begins with the compliance employee's recognition of affirmative indications and acts of fraud by the taxpayer. Further development of these " indicators" (a sign or symptom, for example, an unexplained increase in net worth) assists the employee in establishing the firm indications (affirmative acts) necessary for a successful fraud case.

When initial indications (signs or symptoms) of fraud are uncovered, the compliance employee should initiate a discussion with his/her group manager and the FRS. Service Center Examination employees should refer to their designated Fraud Coordinator who will act as liaison to the FRS. A plan of action should be developed jointly as early as possible to document firm indications (affirmative acts) of fraud. An integral part of the plan is establishing that sufficient affirmative acts exist to confirm fraud. The plan should be a joint effort of the compliance employee, manager and the FRS.

The compliance employee, with assistance of the FRS, must know when to suspend action on the case and prepare a criminal referral. If the compliance employee stops too soon all the information necessary to document firm indications (affirmative acts) of fraud may not be developed sufficiently for CI.

The minimum plan of development should include following up on all leads indicated as fraud indicators (signs or symptoms), securing copies of all relevant data relating to indicators of fraud (signs or symptoms) and noting from whom and when obtained. Documents obtained from the taxpayer or other third parties should not be annotated with any comments by the compliance employee. It is critical for the employee to secure the taxpayer’s explanations for any discrepancies.

An understatement of the tax liability alone is not fraud. In order to sustain the civil fraud penalty or make a criminal referral, the compliance employee must establish the intent was to defraud.

For area compliance employees, when it is agreed by the examiner, group manager and FRS that potential for fraud exists, the case will be updated to Status Code 17 (Fraud Development Status). This decision is an important event in the examination and should be documented in the case file. Form 11661, Fraud Development Status, may be utilized to document FRS involvement as well as the decision to update the case to Status Code 17. While in Status Code 17 (Fraud Development Status) and Status Code 18 (Accepted by CI), cycle time will be excluded from monthly "aging" reports to management (Month At a Glance Report). AIMS and ERCS data, however, will include all cases. In order to reconcile to the Month At a Glance Report, Status 17 and 18 cases must be excluded from the overage category and the overage percentage manually computed. Cases should be returned to Status Code 12 if it is later determined that fraud potential no longer exists. Service Center Examination employees will coordinate potential fraud case development and preparation of Form 11661 with their manager, designated Fraud Coordinator and the FRS. At this writing, Status 17 is not valid for potential fraud cases at the service centers.

When it is agreed by the revenue officer, group manager and FRS that potential for fraud exists, the case will be updated to ICS sub code 910. Form 11661 may be utilized to document this decision and input of ICS sub code 910. ICS sub code 910 will remain on the case either until the group manager and FRS concur the case no longer has fraud potential or CI declines referral of the case.

The compliance employee or group manager should not obtain advice and/or direction from CI for a specific case under examination. The FRS is available for consultation.

Listed below are examples of fraud indicators. The following lists are not all-inclusive and are only indicative of the types of actions taxpayers may take to deceive or defraud.

Indicators of Fraud—Income

Indicators of Fraud—Expenses or Deductions

Indicators of Fraud—Books and Records

Indicators of Fraud—Allocations of Income

Indicators of Fraud—Conduct of Taxpayer

Indicators of Fraud—Methods of Concealment

Most fraud cases involve individual and business taxpayers with poor or nonexistent internal controls. Those cases where there is no separation of duties have a greater potential for material misstatement of taxable income than individuals with salary and wages. However, fraud can be and is present in all types of returns.

Unusual, inconsistent or incongruous items should alert examiners to the possibility of fraud and the need for further investigation. Taxpayer misconduct should be an early warning sign of possible fraudulent conduct. The method of operating a business (i.e., lack of internal controls, dealing in cash, etc.) may be indicative of improperly filed returns.

The initial contact provides the opportunity to obtain valuable information which may not be readily available later. Indications of fraud may be disclosed in discussions, financial activities and nonresponsive answers. Questions asked should be recorded verbatim. Nonresponsive answers should be noted and judgment used in deciding what information is relevant (affidavits may be used). Workpapers should be noted as to the tax year, the date of the contact, who was present during the contact and the maker of the workpapers. Workpapers should include such information as:

The compliance employee should prepare a memorandum of interview summarizing information obtained and statements made. This will become part of the workpapers to aid in the fraud development.

Throughout the investigation, it is important to keep a current and accurate historical record of all contacts and conversations with the taxpayer. This is necessary to track statements, when records were received and from whom and steps taken to determine the correctness of the information volunteered. Annotations should not be made on records and other evidence received. It is important that the chain of custody of evidence obtained be clearly established through the historical record. Although necessary in any investigation, this area can be critical in sustaining fraud.

Fraud will not ordinarily be discovered when compliance employees readily accept the completeness and accuracy of the records presented and the explanation offered by the taxpayer. It is necessary to go behind the books and to probe beneath the surface. The judgment of the employee will determine the techniques used. The investigation should be extended to the point where the employee is satisfied and the results are substantially correct.

It is important to determine who is responsible for the fraudulent act(s). If the taxpayer isn’t responsible then neither criminal and/or civil fraud are applicable. If the preparer is culpable then preparer penalties should be considered. See IRM 20.1.6.

If a questionable preparer is discovered, contact the Return Preparer Coordinator in your Area PSP. Also see chapter 3.3 in this IRM for additional guidance.

There are also civil and criminal penalties for anyone who aids and abets an understatement of tax liability under IRC Sections 6701 and 7206(2). The individual must be directly involved in the preparation or presentation of the false or fraudulent document. This may include independent contractors such as lawyers, accountants and appraisers who counsel on a course of action. It is possible for criminal referrals and/or civil penalties to apply to both the taxpayer and the person assisting the taxpayer.

CI field offices are now authorized to utilize bankruptcy fraud statutes 18 USC 152 and 157 in the prosecution of bankruptcy related tax fraud investigations. Investigations involving allegations of bankruptcy fraud are appropriate when the IRS is a major creditor and tax crimes are suspected. Statute jurisdiction has been extended to bankruptcy fraud violations to increase tax compliance and facilitate bankruptcy related fraud referrals.

The purpose of this section is to alert compliance employees to the tax consequences that may result in a "bust out" or scam. The individual perpetrating bankruptcy fraud may be converting merchandise inventory, cash or other assets to personal use and for personal gain. For an in-depth discussion of bankruptcy fraud, compliance employees should refer to Document 9762, revision 9–96, "Desk Guide for Bankruptcy Tax Crime Referrals."

Compliance employees should become familiar with the methods used in perpetrating bankruptcy fraud and to recognize these illegal acts.

One type of bankruptcy fraud involves the concealment of the transfer of ownership of a business which is acquired either legally or illegally. The creditors, not knowing of the change in ownership, permit the new owners to operate on the former proprietor’s credit rating. After acquiring a business, frequently a number of large bank deposits are made to establish a more favorable credit rating. Then large amounts of merchandise are purchased from a number of suppliers. First, purchases are made for cash, then on fifteen day credit, then on thirty day credit and finally on whatever the creditors will bear. Favoring merchandise that is troublesome to trace, easy to transport and simple to market, such as appliances, furniture and office equipment, payment for all goods is made regularly and on time. The orders are steadily increased but payments eventually decline as to the percentage of what is due. Then, usually just before a busy season or on some specific event, huge orders are placed. When the goods arrive, the " bust out" occurs. The merchandise is sold for cash, sometimes at less than wholesale prices, to organized crime figures or to other business people who are willing to buy at cut-rate prices with little or no questions asked. The creditors are left with substantial claims and a bankrupt business with no assets.

Another scheme is to give the " selected" company a name almost identical to that of a well known and highly creditworthy corporation. The address given may even be on the same street as the reputable concern. Capitalizing on the favorable credit rating of the well known firm, the "selected company" proceeds to order goods from misled suppliers. In this case, the "bust out" can proceed faster because there is a pre-established credit rating and financial statements are often unnecessary.

Some red flags that signal that a bust out scheme might be in process include:

A third form of planned bankruptcy is similar to the first one listed above. In this case, however, orders are placed for merchandise unrelated to the regular line of business, such as a furniture store ordering jewelry as door prizes, usually during the supplier’s busy season. Sometimes rush orders are made during the supplier’s slack season, in the hope that creditors will omit a credit check in their haste to cash in on rush or off season business.

Still another scheme exists whereby an individual acquires a profitable business by surreptitiously acquiring control of the outstanding stock of a corporation. Once in control of the stock, he/she quickly moves in and takes control of the business. All assets of the corporation are then quickly sold for whatever price they will bring leaving the remaining shareholders with a bankrupt corporation.

The compliance employee should also be alert to the purchases of merchandise inventory and other assets for cash near or below the supplier’s cost because of the potential for a "skimming " case. A "skimming" case is one in which the individual or corporation skims off the top by understating sales or revenues. They then correspondingly understate purchases and cost of sales to keep the markup percentage in line with the understated sales or revenues.

Bankruptcy fraud is very subtle. It may be evidenced when examining the accounts receivable and bad debt accounts of a suspected "scam" victim. These telltale signs may take the form of one or more of the following.

In the examination of bankrupt companies which have been a part of a scam conspiracy, the officers or principals are generally vague about their plight and are unable or unwilling to furnish details of what transpired. Books and records are generally inadequate or have disappeared. The bankrupt taxpayer’s payroll and expense accounts may be unusually generous. Finally, the remaining assets are usually nominal and include the oldest and least salable kind.

The package audit policy described in Policy Statement P–4–4, IRM 1.2.1.4.2 (IRM 1.2.1, Policies of the Internal Revenue Service) particularly relates to the examination of employment tax liabilities. Frequently taxpayers fail to treat as employees persons they generally designate as "self-employed or casual labor." There may also be willful attempts to camouflage salary payments or to list as wages, payments where no services have been performed. The most common employment tax fraud, however, is simply not remitting trust fund taxes to the Government. Multiple schemes have been concocted to evade employment tax. The following paragraphs describe the major identified schemes. Also, please see IRM 9.5.3.3.1.1 for a discussion of various employment tax schemes.

Pyramiding liabilities occur where the subject withholds the tax but does not pay it over. After several quarters, the subject moves the assets to a new corporation and abandons the old business activity. The subject continues the withholding but does not pay the tax over, and again abandons the second company when financial problems occur, and forms a new company. When this is accompanied by bankruptcy of the predecessor companies, further complications arise.

Employee leasing companies are a growing area of fraud. This is an industry where an employee leasing company contracts with a client company to handle the client company's administrative duties and hire some or all of the client company's employees, leasing back these employees to the client company. When the leasing company does not pay the employment taxes due on the employees it leases, huge tax deficiencies can occur in a short span of time because the leasing company can be responsible for several client companies. Generally, the employee leasing company will not have any significant assets to collect against, as it is only a service company. When there is indicia of fraud indicating that an employee leasing company was established to fraudulently evade federal employment taxes, consideration should be given to referring the case for CI consideration.

A scheme commonly referred to as the 861 refund scheme, uses Forms 941C, or some other claim for refund, to request a refund of all employment taxes paid. The promoters of these schemes also advise employers to opt out of the income tax system and stop withholding taxes and filing employment tax returns.

In addition to other indications of fraud, the following incidents should be considered in excise cases:

In collected taxes cases warranting assertion of the Trust Fund Recovery Penalty, there will be instances when any appreciable delay in asserting and collecting the tax or penalty would jeopardize the revenue. In all such cases, the area director is authorized to decide whether collection of the penalty might be jeopardized. If in the area director’s opinion the revenue might be jeopardized by following such procedure, the director may disregard it and promptly assess and collect the penalty involved, making necessary quick assessments or jeopardy assessments, as circumstances warrant. Except for potential jeopardy cases, the Service does not authorize assessment of additional penalties during the time a recommendation for criminal prosecution is under consideration or during the period such cases may be awaiting trial or pending an appeal.