What Are Tax Schemes and How to Report Them

An illegal plan or arrangement intended to help individuals or businesses evade their tax obligations is known as a tax scheme. These arrangements are designed to improperly reduce or eliminate a tax liability that is rightfully owed. Promoters of these schemes often mislead taxpayers with promises of significant tax savings or refunds. This article explains what constitutes an illegal tax scheme, how to identify one, and the channels for reporting suspected tax fraud to the Internal Revenue Service (IRS).

Defining and Identifying Tax Schemes

A foundational concept in tax law is the distinction between tax avoidance and tax evasion. Tax avoidance involves the legal use of the tax code to reduce one’s tax liability, such as contributing to a retirement account or claiming eligible tax credits. Tax evasion, conversely, is the illegal act of intentionally not paying taxes that are legally due, often involving deceit or concealment. Tax schemes are the vehicles through which tax evasion is committed, and the IRS actively pursues both their promoters and participants.

The IRS annually releases a “Dirty Dozen” list, which highlights common tax scams. Prevalent schemes include:

• Abusive trusts where taxpayers transfer assets into complex trusts to obscure ownership and make it appear as though the income does not belong to them.
• Offshore tax evasion, which involves using foreign bank accounts or trusts in tax-haven countries to hide income. A taxpayer might use an offshore debit card to access funds, and the use of cryptocurrency has been identified as another method for moving money offshore.
• Frivolous tax arguments, which are baseless claims used to argue that a taxpayer is not subject to federal income tax, such as contending that wages are not income.
• Schemes involving inflated deductions or credits, like creating fake charities or claiming tax credits one is not entitled to, such as the fuel tax credit.
• Hiding income, often by dealing primarily in cash, by keeping two sets of books or using software designed to hide a portion of sales.

Recognizing the warning signs of a tax scheme promoter is important for taxpayers. Be wary of individuals who promise refunds that are unusually large or seem too good to be true. Another red flag is a preparer who bases their fee on a percentage of the refund amount. You should also be cautious of any preparer who refuses to sign the tax return they prepare or will not provide their Preparer Tax Identification Number (PTIN).

Civil and Criminal Penalties

Participation in an illegal tax scheme can lead to severe consequences from the IRS, divided into civil and criminal penalties. Civil penalties are monetary and are assessed by the IRS, while criminal penalties involve prosecution and can lead to imprisonment.

The most common civil penalty is the accuracy-related penalty, which is 20% of the underpayment if you underpay tax due to negligence or a substantial understatement of income. A more severe civil fraud penalty can be asserted if the IRS proves intent to evade tax. This penalty is 75% of the underpayment portion attributable to fraud. These penalties are in addition to paying back the full tax originally due, plus accrued interest.

Other civil penalties can also apply. Failing to file a tax return can result in a penalty of 5% of the unpaid taxes for each month a return is late, up to a maximum of 25%. If the failure to file is fraudulent, the penalty increases to 15% per month, with a maximum of 75%.

Criminal penalties are reserved for the most serious cases of tax fraud. A taxpayer can be prosecuted for tax evasion under Internal Revenue Code Section 7201, a felony which can result in a prison sentence of up to five years and a fine of up to $250,000 for individuals or $500,000 for corporations. Another charge is filing a false return under Internal Revenue Code Section 7206. This felony carries a potential prison sentence of up to three years and similar fines, even if the false return did not result in a tax deficiency.

Information for Reporting Suspected Tax Fraud

When you suspect tax fraud, gathering specific information is the first step before making a report. Having well-organized documentation increases the likelihood that the IRS can take action. You should collect as much identifying information as possible about the individual or business you are reporting.

This includes:

• The person’s full name, Social Security Number, and current or last known address.
• For a business, the full business name, Employer Identification Number (EIN), and the business address.
• A detailed description of the alleged fraudulent activity, including how the tax scheme works, the years involved, and an estimate of the dollar amount.
• Supporting documentation, which can include copies of promotional materials, emails, contracts, or financial statements related to the scheme.

The primary document for reporting this information to the IRS is Form 3949-A, Information Referral. This form is designed to capture the necessary details for the IRS to evaluate a claim of tax fraud. You can download the most current version directly from the IRS website.

Process for Reporting Tax Schemes

Once you have completed Form 3949-A, you should mail it along with all your supporting documentation to the designated IRS office listed in the form’s instructions. After you have submitted the report, it is important to understand what to expect. Due to strict taxpayer privacy laws under Internal Revenue Code Section 6103, the IRS is prohibited from providing you with any updates on the status or outcome of the investigation.

You will not be contacted by the IRS regarding the case unless they require additional information from you. This confidentiality protects the integrity of the investigation and the privacy of all parties involved.

A separate process exists for individuals who wish to report tax fraud and potentially receive a monetary award. This is handled by the IRS Whistleblower Office using Form 211, Application for Award for Original Information. This program is generally for cases where the tax and penalties in dispute exceed $2 million. If the IRS uses the information you provide and collects unpaid taxes, you may be eligible for an award ranging from 15 to 30 percent of the amount collected. This program provides a significant incentive for individuals with substantial information about large-scale tax fraud to come forward.