Fraudsters Beware: The Taxman Cometh

When all else fails, non-payment of income tax can stick some fraudsters in jail. But victims can go beyond the satisfaction that the culprits are behind bars; they can recover some of the stolen funds through income tax savings.

One of the most notorious criminals of the 20th century was Al Capone. He built a Chicago crime syndicate in the late 1920s and managed to elude justice while amassing vast power and wealth. Widespread bootlegging, extortion, bribery, and even murder were attributed to Capone and his mob. Capone's ruthlessness was typified by the St. Valentine's Day massacre, in which seven members of a rival gang were machine-gunned by Capone gang members posing as police. However, it was an investigation led by the Internal Revenue Service that ultimately led to Capone's conviction for tax evasion and his subsequent trip to the penitentiary. Capone was done in by the long arm of the tax law.

These days, less-violent fraudsters still forget that income tax violations can land them in jail. And fraud examiners should know how income tax provisions can impact investigations and subsequent attempts for asset recovery.

INCOME TAX PRIMER 

The U.S. Internal Revenue Code defines gross income very broadly as "all income from whatever source derived."¹ A 1961 revenue ruling provides "the proceeds of embezzlement constitutes gross income to the embezzler in the year of the embezzlement."² Failure to declare embezzled income can be considered tax fraud, a felony punishable with a fine up to $100,000 and/or five years imprisonment plus costs to prosecute.³ (Repayment of stolen money doesn't affect the IRS requirement to report the income from embezzlement on a tax return. However, believe it or not, the fraudster is able to claim a deduction for the amount of restitution in the year it is paid. The repayment is ironically treated as a "theft loss" and reported as an itemized deduction.⁴ 

Because the proceeds from embezzlement are considered part of the fraudster's gross income, the amount is subject to federal, state, and local income taxes. Federal income tax rates vary, as shown in the table below.

Marginal Federal Income Tax Rates for 2006 based on the next dollar of taxable income

If the embezzled monies are associated with self-employment activity, the fraudster might also be liable for federal self-employment taxes (12.4 percent Social Security and 2.9 percent Medicare taxes). Also, state and local income taxes vary considerably; a thief in New York could have a 10.5 percent higher tax burden than a counterpart in Tennessee. [The highest marginal income tax rate for New York City is about 3.65 percent and New York State is 6.85 percent (2006 rates). There are no state or local income taxes in Tennessee, except for a tax on income from stocks and bonds.]

RECOVERING STOLEN FUNDS THROUGH TAX SAVINGS 

Embezzlement victims are able to receive some relief from income taxes. A theft loss is deductible in the year it's discovered by the taxpayer regardless of when the theft actually occurred.⁵ Theft is defined by the IRS as "the unlawful taking and removing of money or property with the intent to deprive the owner of it, and includes ... larceny, robbery and embezzlement."⁶ This definition has been expanded to include crimes such as extortion, kidnapping for ransom, threats, or blackmail.⁷  

The embezzlement victim must establish that a crime occurred to claim a deduction. An unsubstantiated allegation doesn't constitute adequate support for the deduction. A common test is if the taxpayer filed a police report. This test evolved from a tax court case.⁸ The amount of theft loss must be reduced if a claim for reimbursement exists and there's a reasonable chance of recovery. Such recoveries might come from insurance claims (employee dishonesty policy) or civil judgments.

U.S. corporate income tax rates vary from 15 percent to 39 percent for taxable income up to $335,000; taxable income between $335,000 and $10 million is taxed at 34 percent. Accordingly, a profitable company might recover more than one-third of an embezzlement loss through tax savings.

TAX REPORTING ISSUES 

The embezzlement victim might wish to report the theft to the IRS as a means to document the loss and support the tax deduction. Reporting embezzlement also alerts the IRS to the fraudster's possible unreported income. This becomes a powerful tool because the fraudster seldom, of course, reports the embezzlement income on his or her tax return. But proceed with caution; reporting a fraudster to the IRS may create problems for the victim if the embezzlement hasn't been legally substantiated.

Adequate substantiation isn't clearly defined in the U.S. Internal Revenue Code and supporting regulations. The Tax Court has held that a theft loss is supportable "if the reasonable inferences from the evidence point to a theft rather than mysterious disappearance."⁹ For example, the disappearance of jewelry from a locked box to which a taxpayer's maid has access is deemed supportable if the loss coincided with the maid's termination.

Of course, the strongest support for a theft loss deduction is a criminal conviction or a civil judgment against the perpetrator. However, these proceedings might take a significant amount of time. A signed confession by the fraudster might be adequate substantiation of a loss, if there's ample supporting evidence.

Amounts lost through embezzlement during the course of conducting a trade or business can be reported to the IRS on Form 1099-MISC as Non-employee Compensation. A separate Form 1099-MISC is prepared for each tax year of the fraudster's embezzlement and filed in the year the theft is substantiated. The 1099-MISC forms are information returns deemed to be filed "late." If an embezzlement is established but the exact amount is uncertain, the fraudster has the responsibility to prove the amounts reported by the victim are incorrect.

MORE RECOVERY CONSIDERATIONS 

Reporting a fraudster to the tax authorities can substantiate a victim's loss from embezzlement and create economic hardship for the culprit, which is clearly desirable to those who suffer from a fraudster's schemes. But the difficulty lies in determining the timing. As previously mentioned, the deduction for a theft loss from embezzlement must be reported net of any expected recoveries.

The amount of a recovery (or the loss) is usually difficult to determine until an investigation or prosecution is nearly complete. Also, if a victim underestimates a recovery for purposes of calculating the embezzlement loss, any future recovery in excess of the estimate will be taxed to the victim as ordinary income in the year of receipt.

It's also important to assess the possibility for recovery of embezzled funds from the fraudster. There will be a slim chance of recovery if the embezzler has spent the embezzled money. Fortunately, however, many fraudsters use their funds for conspicuous consumer goods such as jewelry, luxury cars, and expensive homes. Early notice of embezzlement gives tax authorities the ability to assess tax liens on the fraudster's assets. The tax liens typically include significant assessments for penalties and interest.

The civil penalty for fraudulent underpayment of tax is equal to 75 percent of the portion of the underpayment attributable to fraud. Any underpayment of tax not attributable to fraud is subject to a 20 percent accuracy-related penalty (if the understatement of tax exceeds the greater of 10 percent of tax required or $5,000).¹⁰ Liens generally have a legal priority and might take a big bite out of the fraudster's assets available to repay the victim.

Generally, there's a three-year statute of limitations on federal income tax assessments. The assessment period is extended to six years for federal income tax returns that omit more than 25 percent of gross income and is indefinite if a fraudster files a false return with the intent to evade taxes.¹¹ The applicable statute of limitations for state and local income taxes varies depending on the jurisdiction.

THE DEVIL IS IN THE DETAILS 

Ask these questions to determine if it's advantageous to take a tax deduction for a theft loss from embezzlement: Can the loss be substantiated? What form of substantiation presently exists? Can additional substantiation be obtained? Is the amount and the duration of the loss reasonably determinable? What is the relevant statute of limitations for federal, state, and local income tax reporting?

Given the complexity of income tax considerations, it's prudent to consult with tax professionals and legal counsel about income tax matters during a fraud examination. If you do, you might not only put the fraudster in jail but you could recover some of the stolen funds through the income tax savings. 

Chris G. Peterson, CFE, CPA, is a principal at UHY Advisors MI Inc., at which he leads the Fraud & Forensic service line for the FLVS group in the Michigan offices.  

Jeffrey G. Collins, Esq., is shareholder at Phifer & White PC, at which he heads the White Collar Defense and Corporate Compliance Practice.  

References  

¹I.R.C. § 61
²Rev. Rul. 61-185,1961-2
³I.R.C. § 7201
⁴Rev. Rul. 65-254, 1965-2 and I.R.C. ß 165 (a)
⁵I.R.C. § 165(e)
⁶Reg § 1.165-8 (d)
⁷Rev. Rul. 72-112, 1972-1
⁸Birnbaum & Manaker PC. (1993), Tax Court memorandum decision 1993-485
⁹Jacobson v. CIR, 73 TC 610, 613 (1979)
¹⁰I.R.C. § 6662 (a) and 6662 (b)
¹¹I.R.C. § 6501 (a), 6501 (e) and 6501 (c) (1)

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