Guide on False Tax Deductions: Penalties, Risks, and Avoiding Fraud
The IRS is both an imposing, terrifying monolith, and a surprisingly forgiving institution. People are only human, and as long as the tax system of the United States is centered around tax preparation services, anyone who handles taxes on their own (or has an unscrupulous or ignorant tax preparer) can make mistakes.
In general, the IRS will review your tax filings and look for errors or mistakes, which they can identify because they have information from other sources independently reported to them, and can verify that the numbers you report match.
Mistakes can happen, and when they’re detected, the IRS may pursue an audit or inquire about your return for clarification. If the mistake is just that – a mistake – it can be rectified and no one needs to be penalized for it. On the other hand, if it’s deliberate fraud, the penalties can be severe.
There’s a lot of misinformation out there over what is considered to be a valid deduction or a fraudulent deduction. Today, we’re going to shed some light on this subject to help you better understand the line between valid deductions and tax fraud.
Let’s dig in!
A Common Tax Fraud: False Deductions
Business owners and individuals are allowed to deduct various business expenses as part of their operation, reducing their overall tax burden and leading to either less paid in taxes, or more returned as a refund, depending on the situation.
This is a strong incentive for individuals and businesses to look for any deduction they can find to claim. To minimize how much work individuals need to do to find every deduction they can claim, the IRS allows for a Standard Deduction.
The Standard Deduction is a flat value that suffices as a good average deduction for most people. For the 2020 tax year, for example, the single filer standard deduction is $12,400.
What this means is that anyone filing as a single entity can take the standard deduction of $12,400, or they can choose to itemize their deductions. Itemized deductions allow you to list out and prove every deduction you want to take for every applicable expense, and, if it totals up to more than the standard deduction, claim the larger number as their deduction on their taxes.
Thus, we reach a decision point. Do you:
- Ignore deductions entirely, take the standard deduction, and call it good enough?
- Seek out every itemized deduction you can, to maximize your deductions and pay as little as possible in income taxes?
- Artificially inflate your itemized deductions, to maximize your deductions and get as large a return as possible?
The first item, #1, is standard tax filing. The second item, #2, is what is known as Tax Avoidance; the art and science of avoiding as much tax as possible, within the legal bounds of what is and isn’t allowed within the tax code. The third item, #3, is known as Tax Evasion and includes being dishonest with the government, lying about deductions, claiming false deductions, and getting more money back (or paying less) than you deserve.
As you can imagine, #1 and #2 are legal, and #3 is not legal. The government doesn’t care if you exploit the rules for your benefit, so long as you stay within them; it’s only when you break them that you encounter penalties.
False deductions are a common form of tax fraud. So common, in fact, that the IRS has added additional rules and penalties to help disincentivize it.
Tax deductions come in many forms, including:
- Claiming a dependent.
- Donating money to a registered charitable organization.
- Deducting large medical bills of over 7.5% of your AGI.
- Contributing to certain kinds of retirement accounts, including 401(k)s and trad IRAs.
- Paying for educational expenses as a teacher.
- Itemizing qualifying business expenses.
There are dozens of different deductions for both individuals and businesses. The IRS maintains a comprehensive website with lists of these deductions. This page covers individual deductions, while the business deductions are covered here.
What Constitutes a False Deduction?
False deductions occur when you claim a number as a deduction, and that number is not accurate. This can happen for both individuals and businesses and is surprisingly common as a mistake.
Here’s a common scenario. You’re an individual running a business. You’re allowed to deduct the expenses of a vehicle that you use for your business. The IRS allows two forms of deduction: a standard mileage value deduction, and an itemized deduction for individual list items such as depreciation, lease payments, gas costs, tire costs, tune-ups, and insurance fees.
Because the vehicle is used both as your personal vehicle and as your business vehicle, you can’t claim the full value of the vehicle on either set of taxes. You have to divide it between each, at a pro-rated rate dependent on how much usage it gets in each context.
A common tax mistake is claiming the full value on both personal and business taxes. This can be considered fraud if it is done intentionally and not rectified.
Another common form of tax evasion is charitable deductions that aren’t real. When you donate money to a registered charity, you can deduct the value of that donation from your taxes. Some people, then, choose to make “donations” to charities that don’t exist, or to charities that do exist but which have no record of the donation on their end. These fraudulent deductions constitute tax evasion and can be penalized.
There are many different classes of fraudulent deductions that constitute tax evasion. In the past, penalties for minor cases of tax evasion were relatively minimal, but given the rise over the last decade of tax evasion schemes, penalties have been increased.
False Deduction Penalties
Whether an individual or business chooses to pad their charitable contributions, overstate or pad business expenses, or claim tax credits they don’t actually qualify for, the IRS can discover the issue and pursue a penalty.
Penalties for false deductions are rising. Typically, an error in filing taxes is considered worth a penalty if it results in more than 10% underpayment in taxes; that is, you should owe $X, and you pay $X-10%. Additionally, even if the number is less than 10%, if it’s more than $5,000, it is considered substantial and worth a penalty.
The penalty can be severe. There are several possible penalties, which can be levied individually or jointly.
First of all, there is a 20% penalty on the money owed. If the IRS audits your return and determines that you filed deductions that are not allowed, you will be asked to pay what you would have owed without those deductions, plus an additional 20% of that value.
If your tax return is so incorrect that it is wildly outside of what the IRS expects you to be paying, it may be deemed a frivolous return. The penalty for filing a frivolous return is $5,000. You will still need to file a real return as well, and pay the real value of taxes owed.
If the amount you’ve paid is underpaid by a substantial amount, or if the cause of the underpayment is determined to be tax fraud (tax evasion) rather than a simple mistake or attempt at good-faith filing, you may be required to pay an additional 75% of the tax burden owed as well.
On top of all of this, in particularly egregious cases, the IRS can also pursue criminal charges. Criminal prosecution can include charges of tax evasion, willful failure to file a return, fraud, filing a fraudulent return, or identity theft. All of these will require court trials and have varying penalties depending on the outcome of those trials. Penalties can include further fines and even jail time.
Avoiding Fraud, Avoiding Penalties
Dealing with the IRS is scary for many people, and tax preparation services can be expensive, but it’s also very easy to lose track of paperwork, miswrite or mistype numbers, or simply make mistakes. Human error is very common.
The IRS is not an immovable monolith. If you are audited and it is determined that there is an error on your taxes, you will be given an opportunity to refute, appeal, or adjust your tax filing. You may or may not need to pay a penalty, depending on the actions you take.
If you claim a deduction, and that deduction is eventually determined to be false, you may be able to appeal and file an amended return without having to pay a penalty by providing an argument as to why you claimed it in the first place.
You may also be able to argue intent. The IRS will attempt to determine whether or not your false deduction is willful. Willfulness affects both the severity of penalties and the chances of further investigation, prosecution, or penalties.
Contrary to some popular beliefs, ignorance of the law is not an excuse to break it. The tax code is huge and labyrinthine, but the resources exist to learn it, and you can prepare your taxes through qualified means that will help you avoid claiming deductions you aren’t owed.
If you can successfully argue that your deductions were made in good faith, and demonstrate a desire to make things right through an amended return, you may not have to pay further penalties. Intent matters.
In terms of tangibly avoiding making false deductions, here are some tips.
Consider simply taking the standard deduction. The standard deduction is often larger than many people, filing as individuals or jointly, or businesses filing their taxes will end up benefitting from itemized deductions. Some businesses take advantage of year-end charitable contributions to reduce their tax burden, but this must be done properly to avoid accusations of fraud. In general, it’s often faster, easier, and more valuable to simply claim the standard deduction, especially when it has been increased as it has in recent years.
We recommend keeping records (see below) and calculating what you might report if you itemized your deductions. If it’s less than the standard deduction, there’s no reason to make use of the records; simply claim the larger standard deduction and continue with life.
Keep accurate records. The biggest tool you can have on your side when proving your deductions is a detailed set of records. Keeping detailed records about the expenses you deduct allows you to back up those claims. Make sure that you’re keeping accurate, honest information; keeping multiple sets of books and recording inaccurate information is strong evidence of intent to commit tax fraud and can earn you even more significant penalties or prosecution.
Familiarize yourself with the rules. Above, we linked to the IRS pages on deductions. Read through them and familiarize yourself with what is and isn’t a qualified deduction. Some deductions may not apply to your business or personal filing and can be ignored; for example, your business cannot claim dependents. While knowing what is and isn’t a deduction removes your ability to claim ignorance, ignorance is rarely a good defense and it very rarely works on the IRS.
Hire a tax professional to handle taxes for you. A professional tax accountant can ask for everything they need to properly record, itemize, and optimize your tax situation, without exaggerating, claiming false information, or otherwise committing fraud. You have to trust your accountant, of course, but the vast majority of accountants are trustworthy. Hiring a professional and providing them with accurate information is the best way to ensure that you’re not committing tax fraud.
Don’t stress over an audit letter. The IRS will frequently perform small audits to clarify individual points. Often, if a discrepancy is found, the only penalty is paying what you owe but didn’t pay. Penalties on top of your base tax burden are relatively rare, and excess penalties that come with accusations of fraud are even less common. Criminal charges are often reserved solely for the biggest, easiest cases.
You will also likely want to make an appeal. Unless the discrepancy is a legitimate mistake that can be fixed, an appeal can argue your case and get penalties removed, or even get the deduction accepted. And, if it comes to that, you can simply go to tax court to argue your perspective. Receive an audit letter is not the end of the world or the end of your business.
If you are eventually assessed a tax burden and may have trouble paying for it, there are resources available to help you with that as well.
Have you had any issues writing off deductions? Are you considering whether or not to log a deduction and if it’s safe? Are you trying to reduce your tax debt with a tax return amendment? Let us know in the comments below, or reach out to us to speak with a tax specialist!