This section discusses recognition of the signs of fraud, known as indicators of fraud, and the development process used to prove fraud. Fraud is substantiated by establishing affirmative acts (firm indications) of fraud. Affirmative acts of fraud are actions taken by the taxpayer, return preparer and/or promoter to deceive or defraud.

Procedures that relate to a specific operating division or function are covered in other sections of the Fraud Handbook (IRM 25.1).

When indicators (signs) of fraud are uncovered, the compliance employee will initiate a discussion with their group manager. If the group manager concurs that there are indicators of fraud warranting fraud development, the compliance employee will contact the fraud technical advisor (FTA) assigned to that area. In the Campus environment, the Campus Fraud Coordinator(CFC) is responsible for developing fraud in the SB/SE Campuses, while the Exam Fraud Coordinator (EFC) is responsible for developing fraud in the W&I Campuses. The CFC and EFC will evaluate referrals submitted on Forms 13549, Campus Fraud Lead Sheet, and discuss the cases with the FTA. Timely and appropriate actions are very important when potential fraud is an issue.

If the compliance employee, group manager and FTA agree the potential for fraud exists, the compliance employee will prepare Form 11661, Fraud Development Recommendation – Examination, or Form 11661-A, Fraud Development Recommendation - Collection, and forward the completed form to the group manager for approval.

The group manager will review the Form 11661/11661-A and indicate approval by entering his/her name and date, and will electronically forward the completed form to the FTA for consideration.

If the FTA concurs with fraud development, the FTA will complete Form 11661/11661-A and return it to the compliance employee and group manager. A copy of the form should placed in the Examination work papers or in the Collection file and a copy retained by the FTA.

If a case is being placed in fraud development status, a plan of action (plan) should be formulated as early as possible to develop and document the affirmative acts of fraud.

The compliance employee will place the case in fraud development status. The examiner will update the Audit Information Management System (AIMS) to Status Code 17, or the revenue officer will input Integrated Collection System (ICS) Sub-code 910 and request copies of the original tax returns, if the original returns have not been secured. The compliance employee will then proceed with the plan until affirmative acts of fraud are established or a determination is made that the potential for fraud no longer exists. Cycle time is excluded from the monthly aging reports to management (Month At a Glance Report) as long as the case is in fraud development status.

Warning: The compliance employee or the group manager should never obtain advice from CI for a specific case under examination/collection activity.

A case will stay in fraud development status while there is active involvement in an ongoing audit or collection activity, or the FTA recommends one of the following actions:

Listed below are examples of fraud indicators. The following lists are not all-inclusive and only indicate 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

The minimum plan of action should include following up on all leads identified as fraud indicators (signs or symptoms), securing copies of all relevant data relating to indicators of fraud and noting from whom and when obtained.

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 may be present in any type of tax return.

Unusual, inconsistent or incongruous items should alert compliance employees 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 tax 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). Work papers should be noted as to the tax year, the date of the contact, who was present during the contact and the maker of the work papers.

The compliance employee should prepare a Memorandum of Interview summarizing information obtained and statements made. This will become part of the Examination work papers or Collection case file, and 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 accuracy of the information volunteered. Annotations should not be made on records and other evidence received. It is important that the chain of custody for the 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 to validate information provided and statements made in order to evaluate the creditability of evidence and testimony provided by the taxpayer. 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 is not 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 AreaPlanning & Special programs (PSP). Also, see IRM 25.1.3.3 for additional guidance.

Civil and criminal penalties also apply to anyone who aids and abets an understatement of tax liability, under IRC § 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, a frequent 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 time frame 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 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 where 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 or collection determination 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(6), Policies of the Internal Revenue Service, and IRM Exhibit 1.2.1-1, Policy Statements by Process, particularly relates to the examination of employment tax liabilities. Frequently taxpayers fail to treat as employees, those persons generally designated 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 were performed. The most common employment tax fraud, however, is simply not remitting trust fund taxes to the Government. Multiple schemes have been designed to evade employment tax. The following paragraphs describe the major identified schemes. Also, see IRM 9.5.3.2.1.2, Employment Tax, for a discussion of various employment tax schemes and employment tax investigations.

Pyramiding liabilities occur where the subject fails to pay over taxes withheld or collected from employees and/or fails to pay over the matching FICA. 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, and/or matching FICA 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 the employee leasing company contracts with a client company to handle the client company's administrative duties and hires some or all of the client company's employees, leasing back these same employees to the client company. When the leasing company does not pay the employment taxes due on the employees it leases, significant tax deficiencies can occur in a short span of time because the leasing company can be contracted by for several client companies. Generally, the employee leasing company, as a service company, will not have significant assets to collect against. When indicia that an employee leasing company was established to fraudulently evade federal employment taxes, a referral to Criminal Investigation (CI) should be considered.

A scheme commonly referred to as the "861 refund scheme " , uses Forms 941-X, Adjusted Employer's QUARTERLY Federal Tax Return or Claim for Refund, Forms 943-X, Adjusted Employer's Annual Federal Tax Return for Agricultural Employees or Claim for Refund, Forms 944-X, Adjusted Employer's Annual Federal Tax Return or Claim for Refund, Forms 945-X, Adjusted Annual Return of Withheld Federal Income Tax or Claim for Refund, Forms CT-1X, Adjusted Employer's Annual Railroad Retirement Tax Return or Claim for Refund, or some other claim for refund, to request a refund of all employment taxes paid. Prior to January 1, 2009, Forms 941-C,Supporting Statement To Correct Information, or some other claim for refund was used for this purpose. Promoters also advise employers to opt out of the employment tax system by no longer withholding taxes, thereby avoiding the filing of employment tax returns.

In addition to other indications of fraud, the following incidents should be considered in excise 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. However, there will be instances when assertion of the Trust Fund Recovery Penalty is warranted and any appreciable delay in asserting it would jeopardize collection of the tax or penalty. In such cases, the area director is authorized to make that determination and, if so, may disregard normal procedures and promptly assess and collect the penalty involved, through quick or jeopardy assessments.