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The civil fraud penalty is the IRS’s most drastic civil remedy for forcing taxpayers to comply with our tax laws, yet very little is written about this penalty.

The civil fraud penalty is imposed on taxpayers when the IRS believes that the taxpayer filed a false or fraudulent document with the IRS. The civil fraud penalty is equal to 75% of the tax underpayment that is attributable to fraud. A tax underpayment is basically the amount of tax that the taxpayer would have paid absent their attempt to defraud the US Treasury. This usually consists of a taxpayer failing to report certain items of income or claiming a tax deduction and/or credit that they were not entitled to.

The IRS generally only has to prove that the taxpayer unerreported one particular item, and if proven, fraud is presumed for all other items. For example, if a Schedule C small business owner reports $100,000 of taxable business income when the business owner actually had $200,000 of taxable business income, then the IRS only has to prove that $1 of income was not reported. If proven, the fraud penalty will be based on the $100,000 that was not reported - not merely the $1.

Once the fraud penalty is imposed, the penalty and interest on the penalty will be begin to accrue from the date of the underpayment. There is no statute of limitation or time period for the IRS to assert the fraud penalty if the IRS is able to prove that fraud actually occurred.

The IRS is usually able to prove that fraud occurred by relying on circumstantial evidence or “badges of fraud.” “Badges of fraud” include a taxpayer’s history of failing to file or underreporting income, claiming false deductions or improperly deducting personal expenses, using false documents to support tax positions, failing to keep records or dealing in cash, and failing to cooperate during an IRS audit or examination.

Taxpayers have a number of options for dealing with the civil fraud penalty. The best way to resolve IRS fraud penalty issues is to show that the underlying tax liability or tax understatement was not owed. For example, the fraud penalty can be eliminated or minimized if a taxpayer can show that his or her tax liability was zero or less than that asserted by the IRS, even though the taxpayer had falsely claimed a $100,000 tax deduction. In this example, if the $100,000 tax deduction would have saved the taxpayer $20,000 in taxes, the taxpayer will need to come up with $20,000 of additional legitimate tax savings to offset the $20,000 understatement.

Taxpayers may also be able to defend against civil fraud penalty claims by asserting that they relied in good faith on the advice of tax counsel or they made an honest mistake or error. These defenses will generally negate mental state that is required for the penalty.

In the event that the taxpayer is successful in avoiding the civil fraud penalty, the IRS will likely seek to impose an accuracy related penalty. The accuracy penalty is substantially smaller than the 75% civil fraud penalty.

Taxpayers who think that they may be subject to the civil fraud penalty should immediately hire an experienced tax attorney to discuss their tax matter.

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