Question

How is “underpayment” determined for purposes of the Civil Fraud and I.R.C. 6662 penalty?

Answer 1

25.1.6.2.1 (04-29-2016)

Determination of Underpayment

1. Under IRC 6664 as amended, disallowed refundable credits must be taken into account when determining the tax shown on the return and can reduce the tax shown on a return below zero for purposes of calculating the underpayment subject to penalty under IRC 6662 and IRC 6663. Section 209(d)(1) of the PATH Act provides that the amendment is effective for all returns filed after December 18, 2015, and all returns filed on or before December 18, 2015, for which the period of limitations specified in IRC 6501 had not expired as of that date.
2. The recommendation to impose the 10-year EITC ban is independent of whether the taxpayer’s reporting results in an underpayment per IRC 6664, on which the civil fraud penalty is based. For a discussion of the civil fraud (and accuracy-related) penalties, see IRM 20.1.5.2, Common Features of Accuracy-Related and Civil Fraud Penalties; and IRM 20.1.5.14, IRC 6663, Civil Fraud Penalty.
3. Issues that could impact assertion of the fraud penalty, but should not impact consideration of the 10-year EITC ban include:

Evidence of Fraud

1. Since direct proof of fraudulent intent is rarely available, fraud must be proven by circumstantial evidence and reasonable inferences. Fraud generally involves one or more of the following elements:
   • Deception
   • Misrepresentation of material facts
   • False or altered documents
   • Evasion (i.e., diversion or omission)
2. The courts focus on key badges of fraud in determining whether there was an "intent to evade" tax. A determination of fraud is based on the taxpayer's entire course of conduct, with each badge of fraud given the weight appropriate to a particular case. An evaluation of fraud is based on the weight of the evidence rather than the quantity of the factors. Some of the common "first indicators (or badges) of fraud" include:
   • Understatement of income (e.g., omissions of specific items or entire sources of income, failure to report substantial amounts of income received)
   • Fictitious or improper deductions (e.g., overstatement of deductions, personal items deducted as business expenses)
   • Accounting irregularities (e.g., two sets of books, false entries on documents)
   • Obstructive actions of the taxpayer (e.g., false statements, destruction of records, transfer of assets, failure to cooperate with the examiner, concealment of assets)
   • A consistent pattern over several years of underreporting taxable income
   • Implausible or inconsistent explanations of behavior
   • Engaging in illegal activities (e.g., drug dealing), or attempting to conceal illegal activities
   • Inadequate records
   • Dealing in cash
   • Failure to file returns, and
   • Education and experience
   • The Facts section of the penalty narrative should include a detailed description of all applicable badges of fraud. Additionally the examiner should include other items of deception or instances where the taxpayer may have misled or misrepresented facts to the government.