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The United States’ official tax system dates back to 1913 with the 16th amendment. In the U.S., taxpayers receive income upon which taxes must be reported and paid to the Treasury. Checks and balances exist for methodology and procedure, but the Internal Revenue Service imposes penalties for failure to comply.
How Can Penalties Make this “Voluntary” Reporting Requirement Successful?
As Justice Black’s words express, the taxpayer must “confess” to taxes owed in a timely manner or face penalties. Chapter 68 of the Internal Revenue Code provides for a variety of penalties that taxpayers may face, ranging from failure-to-file to accuracy-related penalties on underpayments and understatements to gross valuation misstatements to civil fraud penalties. Most of these penalties impose fees of 20% to 40%. Those assessed with civil fraud will suffer much harsher penalties of 75% of the amount of the underpayment. With interest, this punitive penalty can almost double the amount of the reported tax payment.
What Gives the IRS the Right to Impose Fraud Penalties?
IRC Section 6663(a) imposes a 75% percent penalty of any part of any fraudulent underpayment of tax required to be shown on a return.
Because this penalty is imposed on “underpayment” of tax, its implementation requires that the parties have filed their tax return. By contrast, the failure to file penalty under IRC section 6651(f), imposes penalties for fraudulently failing to file. For purposes of this article, only IRC section 6663 is addressed.
The code further explains that the “underpayment attributable to the fraud” includes the entire underpayment unless the taxpayer establishes that any portion is not attributable to fraud by a preponderance of the evidence. To meet this standard, the taxpayer must persuade the fact finder that a greater than 50% chance exists that the disputed claim is true. The ability to produce substantiating documentation supporting the claim is often critical to meeting this burden.
As draconian as the 75% civil fraud penalty is, it cannot be asserted by the IRS in the absence of “clear and convincing evidence.” Thus, unlike the traditional burden of proof in a federal tax dispute that falls on a taxpayer, the burden of proof in the case of a civil fraud penalty is on the IRS. For these purposes, “clear and convincing evidence” is satisfied when the IRS convinces the fact finder that its assertion is highly probable. Matthews v. Commissioner, T.C. Memo. 2018-212. Under this standard, the IRS must establish that the underpayment of the tax occurred and some portion of that underpayment resulted from fraud. Analysis of an alleged underpayment remains straightforward, but proving fraud requires much more scrutiny.
How Does the IRS Find and “Prove” Fraud?
As established, fraud must be proven by clear and convincing evidence. But how is that done? First, unlike a tax dispute that does not involve fraud, the passage of time is not a factor because there is no statute of limitations in a fraud case. Thus, the IRS has unlimited time to analyze the facts and develop its case. It does so by utilizing a so-called badges/indicators of fraud analysis. Because fraud must be substantiated by establishing affirmative acts, the IRS will look at actions taken by the taxpayer, return preparer and/or promoter to deceive or defraud. But most importantly, fraud requires proof of specific intent to evade tax known or believed to be owing through conduct intended to conceal, mislead or prevent collection. Beaver v. Commissioner, 55 T.C. 85, 92 (1970).
A wide variety of indicia may trigger a finding of fraud, but the IRS Fraud Handbook lists the following categories, each with comprehensive lists of what may constitute fraud: income, expenses/deductions, books and records, allocations of income, conduct of taxpayer and methods of concealment. Nonexhaustive examples of primary badges examined by the courts listed in the IRS Fraud Handbook include:
- Understatement of income
- Inadequate records
- Failure to file tax returns
- Implausible or inconsistent explanations of behavior
- Concealment of assets
- Failure to cooperate with tax authorities
- Filing false Forms W–4 or other forms
- Failure to make estimated tax payments
- Dealing in cash
- Engaging in illegal activity
- Attempting to conceal illegal activity
Bradford v. Commissioner, 796 F.2d 303 (9th Cir. 1986); Niedringhaus v. Commissioner, 99 T.C. 202 (1992); Buckelew Farm, LLC v. Commissioner, T.C. Memo. 2024-52 (2024).
These badges all point to an intent to evade taxes. The IRS may be able to prove intent to conceal or mislead by establishing a pattern of conduct. Spies v. United States, 317 U.S. 492 (1943). Does any pattern of conduct suffice? No, the pattern must persist beyond negligence or mere suspicion. In evaluating these badges of fraud, the courts and the IRS will consider a taxpayer's intelligence, education and tax expertise in determining whether they acted with the requisite fraudulent intent. Buckelew Farm, LLC v. Commissioner, T.C. Memo. 2024-52 (2024).
Once an IRS agent concludes that there are “firm indications of fraud,” the agent is required to refer the case to a special criminal investigation agent to determine if criminal fraud should be invoked. If the criminal investigation leads to evidence of a criminal violation, the case is sent to the Department of Justice for prosecution. If evidence of a criminal violation is not found, the case moves forward with the civil audit. When an audit goes silent for a time after a period of significant activity, the civil examination may have escalated into a criminal referral or prosecution.
Assuming that does not occur and the matter remains a civil one, IRC section 6751(b)(1) mandates the penalty must be personally approved (in writing) by the immediate supervisor of the individual making the fraud determination.
The IRS Asserts Fraud: What Now?
Fraud allegations can do more than hurt the pocketbook; they may also destroy a reputation if they become public. If a taxpayer facing a fraud penalty cannot convince the IRS to back off, whether at the exam or appeals level, the taxpayer’s only recourse to dispute the claim may be to petition the Tax Court, at which point the matter generally becomes public.
Given both the monetary and reputational stakes of a finding of fraud, taxpayers should take every advantage possible of the elevated burden of proof placed on the IRS in a fraud case, some of which may be easy to attack. Here are eight potential arguments to combat these IRS attacks:
Challenge the IRS underpayment assessment – no underpayment, no fraud.
If an underpayment exists, focus on demonstrating good faith reliance upon tax advisers.
Courts require proof of intentional wrongdoing motivated by specific purpose to evade tax; reckless or negligent conduct does not suffice. Beck v. C.I.R., T.C. Memo. 2001-270 (2001). Intent at the time of the act remains difficult to prove. Establishing patterns of conduct that oppose badges of fraud may be helpful. For example, failing to pay an extension payment on April 15 may be considered an indicator of fraud, but demonstrating a pattern of paying the extension for the last ten years and then accidentally checking the wrong box for the extension can help combat a fraudulent claim.
Make sure to disclose any and all tax matters if in question and keep a record of doing so. Disclosure precludes optics of concealment. Matter of Howard, 167 B.R. 684 (1994).
Ask for all activity records, interviews and evidence the IRS uses to support its fraud allegation, then pick it apart and determine whether isolated occurrences can possibly demonstrate fraud.
For joint returns, the fraud penalty does not apply automatically to both spouses. The fraud penalty only applies here to the extent the underpayment is due to that person’s fraud as demonstrated by the intent.
Challenge constitutionality of the civil fraud penalty, especially if fees are excessive.
Finally, question the IRC section 6751 supervisory approval. Failure to obtain approval prevents penalty assessment, and the IRS bears the burden to show compliance.
On the front end, to avoid a finding of fraud, it is imperative that taxpayers keep adequate books and records and err on the side of disclosure. If faced with a fraud penalty, cooperating with the IRS even while disagreeing with its position and potentially reaching a private settlement that avoids a showdown in a public litigation forum often results in a better outcome. And remember, a fraudulent return cannot be fixed by submitting an amended return after the filer commits fraud, which means the best defense to fraud is to avoid it all costs.
Reprinted with permission from the November 6, 2025 edition of Daily Report © 2025 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.