What is a Badge of Fraud?

A “badge of fraud” is an indicator used by the Internal Revenue Service (IRS) to flag a potentially fraudulent return, transaction, or activity. A better understanding of what triggers IRS interest can help you steer clear of an IRS audit, or worse, an IRS criminal tax investigation.

When evaluating for tax fraud, the IRS uses badges of fraud as key markers of criminal activity. When a badge of fraud is identified, the finding initiates a circuitous compliance process to evaluate the event as a candidate for further investigation. The purpose of the investigative process is to establish evidence or “affirmative acts.” To the IRS, “Affirmative acts of fraud are actions taken by the taxpayer, return preparer, and/or promoter to deceive or defraud.”

Basically, a badge of fraud is a tip-off to the IRS of fraudulent behavior, like a false income tax return, or fraudulent business activities. These indicators of fraud may arise during a routine review of a flagged tax return or during an IRS civil audit.

Among others, indicators of potential fraud can take many forms, including:

• Accounting practices: Keeping a second set of books, lack of good record keeping around deposits made (or not made) to a business account, opacity around income sources and specifically excluding some items on a return, but not others
• Reporting: Inadequate records, underreported income over several years, cash transactions, and failure to file tax returns
• Hidden transactions: There is a realm of behavior that points directly to fraud including companies and bank accounts held by persons not affiliated with the business, transfers of money and assets in anticipation of an audit, transfer of assets between partners wherein the asset is not actually transferred, and unusual transactions
• Suspicious practices: Inability to explain documents, unreported bank accounts, false or fake documents, fictitious deductions or personnel, evidence of concealment, destruction of documents, and disguising loans as deductions are fast-track flags of fraud

Findings of potential fraud on a return can trigger an audit where you may be asked to explain the anomaly or provide additional documentation for examination. If you receive a letter from the IRS notifying you of an audit, preparation for the audit beforehand is critical. The auditor working with you may ask you to explain discrepancies, provide additional documents, and listen to your explanations. These meetings can easily lead to a referral for criminal tax investigation without your knowledge.

In all interactions with the IRS, be polite, courteous, and responsive. It goes without saying you should not try to bribe an examiner—but this does happen. If you know you have potentially fraudulent activity on your tax returns or books, speak with an experienced criminal tax defense attorney before you respond to the IRS. There is virtually no likelihood you can hoodwink the IRS. Your tax attorney can provide you with strategic and straightforward options to reduce the impact of the audit and potentially defer criminal tax charges.