What's the difference between tax fraud and negligence?

The IRS recognizes that taxes are complex, and mistakes will happen. Nevertheless, mistakes can be costly, or even worse, lead to charges of tax fraud. What happens when the IRS finds an inaccuracy on your return?

In the vast majority of cases, mistakes won't lead to accusations of tax fraud or criminal charges.

Ordinary mistakes

For an ordinary mistake, such as a simple miscalculation of taxes owed, the IRS charges a .5% fee per month or partial month, up to 25% of the total underpayment. For example, if your additional tax was outstanding for 2.5 months, the penalty will be assessed at 1.5% of the amount due. The IRS doesn't charge a penalty if you overpaid, and the IRS owes you a refund.

Negligence

The IRS will assess an additional penalty of 20% of the amount underpaid if there is a “substantial understatement" on your return, or if the IRS feels that the circumstances around your underpayment demonstrate “negligence or disregard of the rules and regulations."

The IRS deems an understatement to be substantial (for individuals) if it is greater than the larger of 10% of the tax due or $5,000.

According to the IRS, negligence includes but is not limited to, any failure to maintain adequate books and records, exercise ordinary and reasonable care in preparing a return, or make a reasonable effort to comply with regulations. In other words, the IRS will assess an additional negligence penalty if it deems that you recklessly or wantonly took a position on your return with little or no effort to determine if it was correct. On the other hand, if you acted in good faith and had a reasonable basis for your position, you will not have to pay a negligence penalty.

Civil fraud

The IRS will assess a penalty of 75% of the underpayment amount in the case of tax fraud. In addition, the IRS may refer the case to the IRS Criminal Investigation Division for possible criminal prosecution. If a taxpayer is found guilty of criminal tax evasion, the taxpayer may be responsible for paying fines up to $250,000 and serving up to five years of jail time. Both civil sanctions and criminal prosecution may be imposed in the case of fraud.

Interest

The IRS will assess interest (in addition to penalties) from the date the tax became due until the date the tax is paid. Interest is determined quarterly and compounds daily. Aside from corporations, interest is charged at 3 percentage points above the federal short-term rate.

Negligence or fraud?

While the 20% penalty for negligence may seem steep, it is a lot less steep than the 75% penalty for tax fraud. Negligence involves a careless or even reckless mistake, while fraud involves intentional deceit. However, the line between negligence and fraud is not always so clear-cut since often it is intent, along with the ability to substantiate reported items, that is the decisive factor.

For example, if your bank deposits total more than your reported income, you may have understated your income, or there may be a perfectly legitimate explanation. The excess deposit amounts may be transfers between multiple bank accounts or non-taxable items, such as loans or gifts. On the other hand, claiming a deceased dependent, using a false social security number, or maintaining two sets of books are obvious examples of fraud that cannot be simply explained away.

Auditors are trained to look for “badges of fraud" which are common red flags that may indicate fraud. If you can reasonably substantiate any concerns that are raised in an audit, it is unlikely that civil fraud penalties will be assessed. As always, accurate record-keeping will help you out here.

Any mistake may turn out to be costly, but mistakes do happen. If you are audited by the IRS, and you can demonstrate that you acted reasonably and in good faith, you will avoid any negligence or fraud-related penalties. When it comes to taxes, not only is honesty the best policy, as the old saying goes—it is likely the cheaper one as well.