How Does the IRS Prove Civil Tax Fraud in Court?

No one wants to be the subject of an IRS civil tax fraud investigation. But a tax audit is only the beginning of the process. When a taxpayer challenges the IRS’s assessment, the government will have to prove civil tax fraud in court. Here’s what that looks like.

Decades-Old Lumber Exporter’s Business Assets Lead to Civil Tax Fraud

The recent U.S. Tax Court case, Harrington v IRS illustrates how the IRS proves civil tax fraud. The IRS had assessed civil fraud penalties against George Harrington for his failure to report offshore investment income in his own name, and on behalf of his wife, Monica Harrington, also called Monica Schrӧder, a dual citizen of the U.S. and Germany from 2005 to 2010.

Decades ago, Harrington was an engineer working as a contractor for Eastern Wood Harvesters (EWH), in Newfoundland and Labrador exporting lumber to Europe. Eventually Harrington took over management of the company and its finances. Changes in the European Union closed the business in 1993 or 1994, but that was only the start of Harrington’s choices.

Between 2002 and 2013, Harrington made a number of financial changes:

• In 2002 he and his wife were identified as beneficial owners of the UBS account.
• In 2003, he traveled to the Cayman Islands to sign documents giving him power of attorney to manage the accounts there.
• In 2007, he closed two accounts, including the Cayman Islands account, transferring them into a UBS conduit account.
• He then shifted that money into a Liechtenstein “stifung” account in his wife’s German name, which operates like a trust to “solve [his] estate planning dilemma.”
• In 2009, UBS closed the stifung account as part of the deferred prosecution agreement. Harrington contributed the assets to two life insurance policies in Liechtenstein with an aggregate value of $3 million.
• In 2013, the life insurance policies were cancelled because the Liechtenstein bank “wasn’t accepting U.S. clients.”

Each year, Harrison filed tax returns disclosing limited income and FBARs listing only his New Zealand accounts.

How Long Can the IRS Wait to Assess Civil Tax Fraud Penalties?

In 2012, Harrison’s accounts were swept up in the IRS’s investigation of UBS accounts. After an extensive investigation, including several interviews with Harrison directly, the IRS issued a notice of deficiency on April 11, 2018, for 2005-2010 totaling $117,897 and fraud penalties for $94,434.

But can the IRS wait more than a decade to issue a tax assessment and collect a tax debt? Generally no. The IRS generally has three years to issue an assessment for tax deficiencies. That period extends to 6 years if the taxpayer omits more than 25% of the gross income stated in the return. However, when fraud claims come into play, there is no period of limitations on those penalties.

How the IRS Proves Civil Tax Fraud

Generally, the older the facts are in the case, the harder it is to prove. To support a fraud penalty, the IRS must show:

• An underpayment of tax for each year
• Fraudulent intent

Underpayment of Tax

The IRS isn’t required to establish the exact amount of the deficiency. Filing amended tax returns disclosing additional income, as Harrington did, can prove an underpayment of tax owed for the IRS.

Badges of Fraud

Generally, the IRS doesn’t have direct evidence of fraud. The IRS can demonstrate fraudulent intent through several “badges of fraud” that tend to show an intent to mislead the IRS, conceal income, and evade taxes:

Understating Income

A pattern of substantially underreporting income over multiple years is strong evidence of fraud, especially when there is no good explanation for the understatements. The income from Harrington’s offshore foreign investments was nearly $800,000 in interest, dividends, and capital gains, but he only reported approximately $170,000 in income.

Keeping Inadequate Records

Failing to maintain and provide records and statements to the IRS is evidence of fraudulent concealment of offshore income. Harrison claimed he never received statements for his investment accounts. However, the Tax Court found this was part of Harrison’s tax-avoidance strategy.

Implausible & Inconsistent Explanations

Tax fraud is often about telling the IRS a false story. As a savvy businessman, the Tax Court did not believe Harrison would have given an attorney $350,000 to backstop a floundering business without some form of loan agreement. It also questioned whether Harrison would still be trying to track down business assets more than 15 years after EWH folded.

Testimony Lacking Credibility

The Tax Court went into detail about how often Harrington changed his story or claimed he did not remember signing important documents. This related both to the implausibility above, and to the general credibility of the taxpayer’s testimony.

Concealing Income & Assets

When a taxpayer willfully conceals income and assets, the IRS can infer a fraudulent intent. Harrington maintained offshore accounts in known tax havens and shelters. When his UBS account closed, rather than bringing the assets home and reporting the income, Harrington used offshore life insurance policies to further conceal his assets, while excluding that income from his FBARs.

Non-cooperation with the IRS

Harrington claimed he cooperated with the IRS by acknowledging his offshore accounts. However, this was years later, and the Tax Court believed this was a strategic gambit.

Illegal Activities

The IRS doesn’t claim that Mr. Harrington committed any illegal acts, which may be, in part, why it imposed civil tax fraud penalties, rather than criminal tax fraud charges.

Misleading the Tax Preparer

Mr. Harrington filed all the tax returns for himself and his wife. He didn’t hire an accountant or tax preparer, who may have been able to warn against his tax fraud behaviors.

Filing False Tax Returns & Documents

The tax returns and FBARs Harrington originally filed were false, and omitted substantial income and assets. The IRS didn’t produce the original tax returns at court, but the amended returns demonstrated how much the income changed.

Failing to File Tax Returns

Mr. Harrington did file a tax return and FBAR filing each year, though he left out substantial income.

Dealing in Cash

People who deal primarily in cash often under-report their income in a form of tax fraud. However, the type of income Mr. Harrington concealed isn’t handled in cash. Still, no one factor defeats a civil tax fraud claim.

Can Fraud in One Year Result in Civil Fraud Penalties for Other Years?

The IRS may cover several years in a single audit, but when it must prove civil tax fraud in court, it must provide evidence for each year. There were problems with the IRS’s case for both 2007 -- where some of the missing income was from domestic accounts -- and 2010, where Harrington properly carried capital losses forward from the year before. The Tax Court pulled back on the civil tax fraud penalties for those years.

When civil tax fraud penalties go to court, the details are everything. By the time these cases go to trial, taxpayers must be working with an experienced tax attorney who can show the gaps in the IRS’s case, and defend against the claims one year at a time.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years of experience. If you have questions about civil tax fraud penalties, contact Joe Viola to schedule a free consultation.