Badges of Fraud: The IRS Checklist, Explained

Fraud is about intent, and intent is hard to prove directly. People rarely write down "I am hiding this from the IRS." So the IRS, and the courts, look at circumstantial evidence: patterns of conduct that, taken together, suggest a deliberate effort to deceive.

Those patterns are called badges of fraud. The Internal Revenue Manual catalogs them in detail, and examiners are trained to spot them. Knowing the list will not change the facts of your case. It will help you understand why certain questions get asked, why your explanations matter, and when a civil audit is drifting toward something more serious.

This guide is general legal information. It describes what the IRS looks for. It is not, and should not be read as, a guide to avoiding detection.

Indicators are not proof

Start with the most important point, because it is the one the IRS manual makes first. IRM 25.1.1.4 says indicators of fraud are signs or symptoms that "signify that actions may have been taken for the purpose of deceit, concealment or to make things seem other than what they are." Then: "Indications, in and of themselves, do not establish that a particular action was taken."

Fraud requires more. The same section says "fraud cannot be established without affirmative acts of fraud," meaning actions that establish something was done deliberately to deceive or conceal.

The civil fraud chapter adds a second principle. IRM 25.1.6.4 says courts determine fraud based on "the taxpayer's entire course of conduct, with each badge of fraud given the weight appropriate to a particular case," and that an evaluation of fraud "is based on the weight of the evidence rather than the quantity of the factors."

A single badge can have an innocent explanation. Several badges pointing the same direction look different. That is how examiners are taught to think, and it is how a lawyer will evaluate your exposure.

The short list courts focus on

IRM 25.1.6.4 lists common first indicators, or badges, of fraud that courts consider when deciding whether there was an intent to evade tax:

• Understatement of income, such as omitting specific items or entire sources of income
• Fictitious or improper deductions, such as personal items deducted as business expenses
• Accounting irregularities, such as two sets of books or false entries
• Obstructive actions, such as false statements, destruction of records, transfer of assets, failure to cooperate, and concealment of assets
• A consistent pattern over several years of underreporting taxable income
• Implausible or inconsistent explanations of behavior
• Engaging in illegal activities, or attempting to conceal illegal activities
• Inadequate records
• Dealing in cash
• Failure to file returns

The detailed catalog

IRM 25.1.2.3 goes further and organizes indicators into categories. A few highlights from each:

Income. Omitting specific items where similar items are included. Omitting entire sources of income. Inability to explain substantial increases in net worth, especially over several years. Personal spending that exceeds reported resources. Unexplained bank deposits substantially exceeding reported income. Concealing domestic or foreign bank accounts, brokerage accounts, or digital assets such as cryptocurrency. Failing to deposit receipts to a business account contrary to established practice. Failing to file for several years despite evidence of substantial taxable income.

Expenses and deductions. Fictitious or substantially overstated deductions. Business deductions for personal expenditures. Dependency claims for nonexistent people, and false documents used to claim refundable credits.

Books and records. Multiple sets of books or no records. Refusal to make records available. False entries, backdated documents, false invoices. Invoices that are irregularly numbered or altered. Amounts on the return that do not agree with the books.

Allocation of income. Distributing profits to fictitious partners. Shifting income or deductions to a related taxpayer when tax rates differ.

Conduct of the taxpayer. False statements about material facts in the examination. Attempts to hinder or obstruct the exam, including repeated cancelled appointments and refusal to provide records. Failure to follow the advice of an accountant, attorney, or preparer. Failure to make full disclosure to the accountant, attorney, or preparer. Destruction of records, especially just after an exam starts. Transfers of assets for concealment.

Methods of concealment. Asset ownership placed in other names. Transfers made in anticipation of an assessment or while an investigation is pending. Retained use of transferred assets. Secret bank accounts. Deposits in nominee names. Business conducted in false names.

The Supreme Court's version of the list

The badges are not just IRS policy. In Spies v. United States, 317 U.S. 492 (1943), the Supreme Court held that a willful attempt to evade tax requires more than willfully failing to file and pay; it requires some affirmative act. The Court then listed, by way of illustration and not limitation, conduct from which an affirmative willful attempt may be inferred: keeping a double set of books, making false entries or alterations, false invoices or documents, destruction of books or records, concealment of assets or covering up sources of income, handling one's affairs to avoid making the records usual in transactions of the kind, and "any conduct, the likely effect of which would be to mislead or to conceal."

Eighty years later, the IRS manual's list reads like an expanded version of that paragraph. See affirmative acts of evasion.

Three badges people create during the audit

Many badges are about what happened on the return years ago. Some are created in the present, by how a taxpayer responds to an audit:

1. Implausible or inconsistent explanations. An explanation that changes, or that the records contradict, is listed in IRM 25.1.6.4.
2. False statements to the examiner. Listed in IRM 25.1.2.3 under conduct.
3. Destruction of records after the exam begins. Also listed, and potentially a separate crime under IRC 7212(a). See obstruction under section 7212(a).

These are the most avoidable badges in the catalog. A lawyer's first job in an audit with fraud exposure is making sure the response does not add to the evidence.

How badges are used

Badges show up in two very different proceedings.

In a criminal case, they help the government prove willfulness beyond a reasonable doubt. In a civil fraud penalty case, they help the IRS prove fraud by clear and convincing evidence. IRM 25.1.1.3.1 states both standards, and IRC 7454(a) places the burden of proving fraud on the government in Tax Court proceedings. Read civil vs. criminal tax fraud.

Inside the IRS, badges are what move a case into fraud development status, under the procedures in when an audit turns criminal. The IRS fraud manual also notes that a comment regarding consideration of fraud must be documented on field examination cases with adjustments to taxable income that result in an underpayment. Examiners are expected to think about it.

Digital assets are on the list

The manual has kept up. IRM 25.1.2.3 now names "digital assets such as convertible virtual currency and cryptocurrency" among the property whose concealment is an indicator of fraud, alongside domestic and foreign bank and brokerage accounts. The IRS fraud manual also has a separate subsection, IRM 25.1.2.11, devoted to digital asset fraud and its indicators.

What to do if you recognize your situation

If several of these badges describe your history, do not try to explain them to an examiner on the fly. Do not try to fix records after the fact. And do not assume that because nobody has mentioned fraud, nobody is thinking about it.

If you are not under examination, the IRS Criminal Investigation Voluntary Disclosure Practice may be an option, depending on timing. See the Voluntary Disclosure Practice. If you are under examination, read the eggshell audit and talk to a lawyer before the next contact.

Badges also matter after a criminal referral is declined. Under IRM 25.1.3.6, the examination resumes once a declination arrives, and the examiner and Fraud Enforcement Advisor amend the plan of action. If new firm indications of fraud develop, the manual says the case may be referred to Criminal Investigation again.

General information only, not legal advice. Reading this page does not create an attorney-client relationship. Laws and IRS procedures change; the sources cited were reviewed on the date shown above.