The federal laws governing bankruptcy and taxation often intersect, although their makeup, effectiveness, and interpretation are significantly impacted by distinct policy concerns, lobbying efforts, and judicial interpretations. These factors influence the interplay between bankruptcy debt dischargeability and tax fraud liability.

Criminal tax fraud

Criminal tax fraud proceedings are punitive in nature. They are prosecuted by the U.S. Attorney’s Office and are brought against alleged criminally culpable taxpayers. The remedy sought by the government can range from criminal fines to imprisonment. Because they are criminal proceedings, the burden of proof is proof beyond a reasonable doubt and rests with the federal government. The government must show that a taxpayer’s violation of a federal criminal tax statute was willful.

Tax evasion

When people think of criminal tax fraud, they generally think of tax evasion, which is defined in Sec. 7201. Under the statute, it is a felony for any person to willfully attempt in any manner to evade or defeat any tax imposed under the Internal Revenue Code or its payment. Sec. 7201 states in full:

Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.

Accordingly, under Sec. 7201, a taxpayer is criminally culpable if the federal government can show beyond a reasonable doubt: (1) the existence of a tax deficiency; (2) willfulness on the part of the taxpayer; and (3) an affirmative act by the taxpayer constituting an evasion or attempted evasion of tax. Sec. 7201, therefore, creates two offenses: (1) the willful attempt to evade or defeat the assessment of a tax, and (2) the willful attempt to evade or defeat the payment of a tax. For example, if a taxpayer transfers assets to prevent the IRS from calculating the taxpayer’s true tax liability, the taxpayer has attempted to evade an assessment. On the other hand, if the taxpayer transfers assets to prevent the IRS from collecting a tax liability, the taxpayer has evaded the payment.

The word “willfully” is not defined in the Internal Revenue Code for purposes of determining whether a taxpayer has acted willfully for purposes of criminal tax evasion. Rather, its definition is derived from case law precedent. The U.S. Supreme Court has described it as the “voluntary, intentional violation of a known legal duty.”Moreover, an “affirmative willful attempt may be inferred from … any conduct, the likely effect of which would be to mislead or to conceal.” Therefore, it is a conscious, knowing decision to take, or fail to take, action.

Affirmative acts that have been deemed criminal tax evasion or attempted criminal tax evasion include filing a false tax return, filing a false amended tax return, and holding property in nominee names. They also include failing to file a tax return in conjunction with an affirmative act such as (1) keeping double sets of books; (2) making false entries or alterations; (3) creating false invoices; (4) destroying records; (5) concealing assets; (6) handling transactions to avoid usual records; and (7) any other conduct likely to conceal or mislead.

Willful failure to collect or pay tax

Under Sec. 7202, it is a felony for a taxpayer to willfully fail to collect or truthfully account for and pay any tax required under the Code. This section was “designed primarily to assure compliance by third parties obligated to collect excise taxes and to deduct from wages paid to employees the employees’ share of Federal Insurance Contributions Act (FICA) taxes and the withholding tax on wages applicable to individual income taxes.” Sec. 7202 states:

Any person required under this title to collect, account for, and pay over any tax imposed by this title who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $10,000, or imprisoned not more than 5 years, or both, together with the costs of prosecution.

To criminally convict a taxpayer of willful failure to collect or pay over tax under Sec. 7202, the federal government must prove beyond a reasonable doubt the following elements: (1) willfulness; (2) a duty to collect, and/or to truthfully account for, and/or pay over tax; and (3) a failure to collect, or truthfully account for, and/or pay over the tax.

The making of a false statement to the IRS that a taxpayer owned no assets and thus did not have the wherewithal to pay a tax was held to be a willful violation of the taxpayer’s duty to pay over tax. In addition, the concealing of assets by using bank accounts of family members and business associates was held to be a willful violation of a taxpayer’s duty to truthfully account for tax.

Failure to file return or supply information

Under Sec. 7203, it is a misdemeanor for a taxpayer to willfully fail to pay estimated tax or tax, make a return, keep records, or supply information at the time or times required by law or regulations. Sec. 7203 states in part:

Any person required under this title to pay any estimated tax or tax, or required by this title or by regulations made under authority thereof to make a return, keep any records, or supply any information, who willfully fails to pay such estimated tax or tax, make such return, keep such records, or supply such information, at the time or times required by law or regulations, shall, in addition to other penalties provided by law, be guilty of a misdemeanor and, upon conviction thereof, shall be fined not more than $25,000 ($100,000 in the case of a corporation), or imprisoned not more than 1 year, or both, together with the costs of prosecution.

Accordingly, under Sec. 7203 the government must prove: (1) willfulness; (2) a requirement to file a return, pay an estimated tax or tax, maintain records, or supply information; and (3) a failure to file a return, pay an estimated tax or tax, maintain records, or supply information.

Pertaining to a failure to file a return, the government must prove beyond a reasonable doubt that: (1) the person was required to file a return; (2) the person failed to file the return; and (3) the person’s violation was willful. For purposes of failing to pay a tax, the government must prove beyond a reasonable doubt that: (1) the person was required to pay taxes; (2) the person failed to pay the taxes; and (3) the person acted willfully in failing to pay.

Civil tax fraud

Sec. 6663(a) provides for the imposition of additional tax for civil tax fraud. It states: “If any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.” The Internal Revenue Manual Fraud Handbook “provides an overview of fraud, defines the elements of fraud, and provides information for potential fraud examinations and procedures that examiners should understand and apply in the performance of their duties.”

This Fraud Handbook describes affirmative acts of fraud as done deliberately “for the purpose of deceit, subterfuge, camouflage, concealment, some attempt to color or obscure events, or make things seem other than what they are.” Accordingly, like the willfulness requirement needed for a criminal tax fraud conviction, a finding of civil tax fraud requires the fraudulent act to be deliberate. However, rather than being punitive in nature, civil tax fraud allows the government to take remedial measures, such as assessing the correct tax due and imposing civil penalties in addition to the recalculated tax assessment due.

Sec. 6663(b) provides a presumption that the entire underpayment of tax is fraudulent if any portion of it can be shown to be due to fraud. However, it also allows a taxpayer to rebut this presumption if the taxpayer can demonstrate by a preponderance of the evidence that a portion was not attributable to fraud.

The burden of proof regarding the assessment of civil fraud penalties on a taxpayer rests with the federal government under Sec. 7454(a). Although Sec. 6663(b) specifies that a taxpayer may rebut a presumption of fraud by a preponderance of the evidence, Sec. 7454(a) is silent as to which civil standard of proof applies to the government, whether a preponderance of the evidence or clear and convincing evidence. The distinction is important, as “[c]lear and convincing evidence is that measure or degree of proof which will produce in the mind of the trier of facts a firm belief or conviction as to the allegations sought to be established. It is intermediate, being more than a mere preponderance, but not to the extent of such certainty as is required beyond a reasonable doubt as in criminal cases.”

This appropriate burden of proof for civil tax fraud was addressed by the Tax Court in Stone, in which the court held that it is clear and convincing evidence. Accordingly, civil fraud penalties are imposed where there is clear and convincing evidence that some underpayment of tax was due to fraud. For this purpose, a finding of fraud must evidence a taxpayer’s intent to evade a tax assessment believed owed. Intent is distinguished from “inadvertence, reliance on incorrect technical advice, sincerely-held difference of opinion, negligence or carelessness.”

Civil and criminal tax fraud distinguished

To summarize the major differences between civil and criminal tax fraud:

• Statute of limitation: Although the government is not restricted by a statute of limitation to impose civil tax fraud penalties, there is a six-year statute of limitation for the government to commence a criminal tax fraud prosecution.
• Burden of proof: The burden of proof imposed on the government to establish civil tax fraud is clear and convincing evidence, while the burden for a criminal tax fraud proceeding is proof beyond a reasonable doubt.
• Remedy sought: The remedy sought by the government for civil tax fraud is the collection of the recalculated tax owed, interest, and a 75% fraud penalty. A criminal tax fraud conviction under Sec. 7201 leads to criminal fines of up to $100,000 ($500,000 for a corporation) and up to five years of imprisonment.
• Nature of proceeding: Civil fraud is a remedial action, while criminal fraud is punitive in nature.