What Are the IRS Penalties for Tax Fraud?

The Internal Revenue Service (IRS) views tax fraud as a serious offense with substantial financial and legal repercussions. A key distinction exists between an honest mistake on a tax return and a deliberate act of deception. The latter, which the IRS defines as fraud, involves a willful attempt to underpay or avoid taxes. This can lead to significant monetary penalties and criminal prosecution, depending on whether the IRS pursues a civil or criminal case.

Defining Civil Tax Fraud

Civil tax fraud is determined by a taxpayer’s intent. Because direct proof of a person’s state of mind is rarely available, the IRS and courts rely on circumstantial evidence to infer fraudulent intent. This evidence is compiled by identifying “badges of fraud,” which are specific actions that suggest a taxpayer was not merely negligent but was actively trying to cheat on their taxes.

One of the most common badges of fraud is the understatement of income. This can involve omitting entire sources of income, like freelance work, or failing to report specific transactions. A consistent pattern of underreporting income over several years is particularly persuasive evidence for the IRS, as it suggests a deliberate scheme rather than a one-time oversight.

Another badge of fraud involves record-keeping. Maintaining a double set of books—one reflecting actual income and another falsified set for the IRS—is a clear sign of deception. Similarly, creating false invoices, backdating documents, or destroying records can be used to build a case for fraud. Claiming fictitious or substantially overstated deductions is also a major red flag.

Concealing assets is another action that points toward fraudulent intent. This could involve placing property in the names of others, using offshore bank accounts to hide income, or conducting business in cash to avoid a paper trail. When questioned by the IRS, providing implausible or false explanations for financial transactions can further strengthen the government’s case.

The Civil Fraud Penalty

The primary penalty for civil tax fraud is outlined in Internal Revenue Code (IRC) Section 6663. This imposes a penalty equal to 75% of the tax underpayment that is directly attributable to fraud. The penalty applies only to the specific amount of unpaid tax resulting from fraudulent activity, not the entire tax liability for the year.

A key aspect of this penalty is the burden of proof. If the IRS establishes that any part of an underpayment is due to fraud, the law presumes the entire underpayment is fraudulent. The burden then shifts to the taxpayer to prove that specific portions of the underpayment were not the result of fraud.

For example, imagine a taxpayer files a return with a $10,000 tax liability. An audit determines the correct liability was $30,000, creating a $20,000 underpayment. The IRS proves that $15,000 of this underpayment was from intentionally hidden income, while the remaining $5,000 was from a non-fraudulent error. The civil fraud penalty is 75% of the $15,000 fraudulent portion, resulting in an $11,250 penalty. The taxpayer would owe the $20,000 underpayment, the $11,250 penalty, and accrued interest. If the taxpayer could not prove the $5,000 portion was a non-fraudulent error, the 75% penalty could be applied to the entire $20,000 underpayment.

This penalty does not apply to a spouse on a joint return unless the IRS can prove that the spouse was also involved in the fraud.

Additional Civil Penalties

The IRS can assert other civil penalties that increase the total financial liability. If a taxpayer commits fraud and fails to file a return, the IRS can impose a penalty for fraudulent failure to file under IRC Section 6651. This penalty is 15% of the net tax due for each month the return is late, capped at a maximum of 75%. This is significantly steeper than the standard 5% per month failure-to-file penalty, reflecting the fraudulent intent.

A separate failure-to-pay penalty also exists, which is 0.5% of the unpaid taxes for each month they remain unpaid, capped at 25% of the unpaid tax. This penalty can be applied alongside the fraud penalty. When both the failure-to-file and failure-to-pay penalties apply in the same month, the failure-to-file penalty is reduced by the amount of the failure-to-pay penalty.

It is important to note that the civil fraud penalty replaces other accuracy-related penalties. The IRS cannot apply both the 75% fraud penalty and the 20% accuracy-related penalty for negligence to the same portion of an underpayment. The agency must choose to assert either the fraud penalty or a lesser accuracy-related penalty.

Criminal Fraud Penalties

Beyond civil penalties, the IRS can refer serious tax fraud cases for criminal prosecution. This elevates the matter from a financial dispute to a legal proceeding that can result in imprisonment and large fines. Criminal fraud requires the government to prove guilt “beyond a reasonable doubt,” a much higher legal standard than the “clear and convincing evidence” needed for civil cases.

Criminal prosecutions are reserved for cases involving egregious behavior over multiple years or large sums of unpaid tax. Under Title 26 U.S.C. § 7201, tax evasion is a felony. A conviction can carry a prison sentence of up to five years and a fine of up to $250,000 for an individual or $500,000 for a corporation. These fines are in addition to paying the original tax, interest, and any civil penalties.

Other statutes target different aspects of tax fraud. Filing a false return, covered by 26 U.S.C. § 7206, is a felony that can result in up to three years in prison and similar fines. Even the willful failure to file a return or pay tax can be a criminal offense under 26 U.S.C. § 7203, often treated as a misdemeanor punishable by up to one year in prison and a fine of up to $100,000.

The decision to pursue a criminal case is made by the IRS’s Criminal Investigation (CI) division and the Department of Justice. A criminal conviction does not prevent the IRS from also imposing civil fraud penalties. This means a taxpayer could face both jail time and the 75% civil penalty on the underpayment.