IRS examinations can take different forms; from a computer algorithm, a letter audit asking for information, or a full-blown in-person audit. During the process the IRS will be keenly aware that fraud may exist. When indicators (badges) of fraud are uncovered, the matter is serious enough to immediately involve management and technical advisors as the case for fraud is developed. The taxpayer now has the full attention of the most powerful collection agency in the United States.
Allegations of fraud by the IRS could not be more serious. The penalty for civil fraud is 75% of the tax that was not paid (plus interest), and in cases of criminal fraud, the penalty is 100% of unpaid taxes, interest, and possibly jail time. Criminal fraud is often referred to as tax evasion, especially when the fraud involves the willful and intentional concealment of income.
Most cases of fraud are smaller civil cases because proving willful and intentional criminal fraud is difficult. A typical example of civil fraud might be something like a construction contractor who fails to report 1099 income; we had a case like this once. His payer issued a form 1099-MISC reporting about $110,000 of gross income. The IRS got their carbon-copy of the 1099, but because the contractor had moved, and failed to forward his mail, he didn’t get his copy. Since he did not get a 1099 he must not be responsible to report that income, right? The answer is that, 1099 or not, you are responsible for reporting all of your worldwide income.
In this case the IRS re-computed the tax and added the 75% civil fraud penalty with interest. Because he was basically caught red-handed, the only thing we could do was amend the original tax return to at least include business expenses, and protect his rights. The tax owed was about $22,000, add the 75% penalty at $16,500, other smaller penalties, and interest that started at April 15, and the liability was about $44,000.
Assuming that your business and family survive this blow, it can take as long as 10 years to recover from a pitfall like this. If something like this happens to you, or the IRS is proposing a charge of fraud, this is the time to seek out professional help and it needs to come from a licensed tax professional.