Most taxpayers believe an IRS audit is a strictly civil matter — an examination of tax returns, documents, and deductions. And for the majority of taxpayers, that’s correct. But some audits quietly escalate into criminal investigations, often without the taxpayer even realizing it happened. Every year, the IRS refers thousands of civil audits to IRS Criminal Investigation (CI).
The frightening truth:
- IRS agents are trained to detect fraud indicators during civil audits.
- When those indicators appear, the audit can “turn criminal.”
- And the IRS will NOT tell you when you’re under criminal investigation.
📘 Reference: IRS Criminal Investigation Overview
Civil vs. Criminal IRS Cases — What’s the Difference?
The fundamental difference between an IRS Civil Audit and a Criminal Investigation (CI) lies in the agency’s objective: a Civil Audit seeks money for unpaid taxes, while a Criminal Investigation seeks evidence of a crime for potential prosecution.
💡 Note: A Civil Audit escalates to a Criminal Investigation only when the IRS believes there was willful intent to break the tax law, meaning the taxpayer knowingly and deliberately violated their tax obligation.
When Can a Civil Audit Become a Criminal Case — “Badges of Fraud”
A civil audit escalates to a criminal investigation when an IRS civil auditor finds “firm indications of fraud” that suggest willful attempt to evade tax rather than honest mistake or negligence. These red flags, or “badges of fraud,” are deliberate actions of deception or concealment.
The primary mechanism for escalation is the Revenue Agent’s discovery of “Badges of Fraud,” as outlined in the IRS Fraud Handbook (IRM 25.1.2). These are specific indicators that signal potential criminal conduct rather than simple mistakes. The presence of multiple badges of fraud significantly increases the risk that the agent will halt the civil audit and refer the case to the Criminal Investigation (CI) division.
These indicators are grouped by the area of the tax return or the taxpayer’s general conduct:
1️⃣ Indicators of Fraud – Income
These indicators signal a deliberate attempt to conceal or misrepresent income, suggesting willful intent to evade tax.
| Category | Specific Indicators of Fraud (Income) |
| Concealment of Income | Omitting entire sources of income. |
| Omitting specific income items where similar items are reported. | |
| Failing to report or explain substantial amounts of identified income. | |
| Asset & Account Hiding | Concealing domestic or foreign bank accounts, brokerage accounts, or digital assets (such as convertible virtual currency and cryptocurrency). |
| Concealing other property or sources of wealth. | |
| Financial Discrepancies | Inability to explain substantial increases in net worth over time. |
| Substantial personal expenditures exceeding reported resources (i.e., living above the reported means). | |
| Inability to explain sources of bank deposits that substantially exceed reported income. | |
| Cash Handling | Inadequately explaining dealings in large sums of currency or unexplained cash expenditures. |
| Consistent concealment of unexplained currency, especially in businesses that don’t typically handle large cash transactions. | |
| Cashing income checks at check-cashing services or at banks where no account is maintained (to avoid a paper trail). | |
| Record/Filing Avoidance | Failing to deposit receipts in a business account, contrary to established practices. |
| Failing to file a tax return, especially for several years, despite having substantial taxable income. | |
| Concealing sources of receipts by falsely describing the source(s) of disclosed income or claiming non-taxable receipts. |
2️⃣ Indicators of Fraud – Expense or Deduction
These indicators point to deliberate misrepresentation or exaggeration of expenses to illegally reduce taxable income.
| Category | Specific Indicators of Fraud (Expenses/Deductions) |
| Fictitious Expenses | Claiming fictitious or substantially overstated deductions. |
| Disguising trust fund loans as expenses or deductions. | |
| Personal vs. Business | Claiming substantial business expense deductions for personal expenditures. |
| False Claims/Credits | Claiming dependency exemptions for nonexistent, deceased, or self-supporting persons. |
| Providing false or altered documents (e.g., birth certificates, lease documents) to claim refundable credits like the Education Credit, Additional Child Tax Credit, or EITC. |
3️⃣ Indicators of Fraud – Books and Records
These indicators point to manipulation, lack of transparency, or destruction of accounting records, suggesting deliberate efforts to obscure financial reality.
| Category | Specific Indicators of Fraud (Books and Records) |
| Record Keeping/Access | Multiple sets of books or no records maintained at all. |
| Failure to keep adequate records, or concealment of records (such as refusing to make them available to the IRS). | |
| False/Altered Documents | False entries or alterations made on the books and records. |
| Use of back-dated or post-dated documents. | |
| Use of false invoices, applications, or statements. | |
| Invoices that are irregularly numbered, unnumbered, or altered. | |
| Accounting Manipulation | Intentional under- or over-footing of columns in journals or ledgers. |
| Amounts on the tax return not in agreement with amounts in the books. | |
| Amounts posted to ledger accounts not in agreement with source books or records. | |
| Journalizing questionable items out of the correct account (misclassification). | |
| Recording income items in suspense or asset accounts. | |
| Suspicious Checks | Checks made payable to third parties that are endorsed back to the taxpayer. |
| Checks made payable to vendors/business payees that are cashed by the taxpayer. | |
| Exempt Organizations | False receipts to donors by exempt organizations. |
4️⃣ Indicators of Fraud – Allocations of Income
These indicators involve manipulating who reports the income or deduction to take advantage of lower tax rates or avoid reporting altogether.
| Category | Specific Indicators of Fraud (Allocations of Income) |
| Fictitious Partners | Distribution of profits to fictitious partners . |
| Tax Rate Manipulation | Inclusion of income or deductions in the tax return of a related taxpayer when tax rate differences are a factor. |
5️⃣ Indicators of Fraud – Taxpayer’s Conduct
These indicators focus on the taxpayer’s behavior—specifically, their attempts to obstruct the examination, conceal information, or knowingly file false documents.
| Category | Specific Indicators of Fraud (Taxpayer Conduct) |
| Obstruction of Examination | False statements about a material fact pertaining to the examination. |
| Attempt to hinder or obstruct the examination, such as: | |
| Failure to answer questions or refusal to provide records. | |
| Repeatedly cancelled or rescheduled appointments. | |
| Threatening potential witnesses, including the examiner, or assaulting the examiner. | |
| Attempt to bribe the examiner. | |
| Concealment & Destruction | Destruction of books and records, especially if done just after the examination began. |
| Transfer of assets for purposes of concealment, or diversion of funds/assets by officials or trustees. | |
| Professional Misconduct | Failure to follow the advice of an accountant, attorney, or preparer. |
| Failure to make full disclosure of relevant facts to the accountant, attorney, or preparer. | |
| Backdated applications and related documents. | |
| Knowledge & Intent | The taxpayer’s knowledge of taxes and business practices where numerous questionable items appear on the returns. |
| Testimony of employees concerning irregular business practices by the taxpayer. | |
| Pattern of consistent failure over several years to report income fully. | |
| Proof that the tax return was incorrect to such an extent and in respect to items of such magnitude and character as to compel the conclusion that the falsity was known and deliberate. | |
| False Documents/Claims | Use of false social security numbers or submission of false Form W-7 information to secure an ITIN. |
| Submission of false Form W-4 or a false affidavit. | |
| Submission of tax returns with false claims of withholding (Form 1099-OID, Form W-2) or refundable credits resulting in a substantial refund. | |
| Intentional submission of a bad check resulting in erroneous refunds and releases of liens. | |
| False statements on TE/GE determination letter applications. |
6️⃣ Indicators of Fraud – Methods of Concealment
These indicators show the steps a taxpayer takes to hide assets, income, or the true nature of transactions, making it harder for the IRS to locate taxable wealth.
| Category | Specific Indicators of Fraud (Methods of Concealment) |
| Asset Transfers | Transfer of all or nearly all of the debtor’s property. |
| Asset ownership placed in other names. | |
| Inadequacy of consideration (selling an asset for far less than its value). | |
| Transfer made in anticipation of a tax assessment or while an investigation is pending. | |
| Close relationship between parties to the transfer (e.g., family members, etc.). | |
| Retention of possession or continued use of the asset after it was supposedly transferred. | |
| Secret Transactions | Concealed interest in the property transferred. |
| Transactions surrounded by secrecy. | |
| Transaction not in the usual course of business. | |
| Financial Secrecy | Use of secret bank accounts for income. |
| Deposits into bank accounts under nominee names. | |
| Conduct of business transactions in false names. | |
| Record Falsification | False entries in books of the transferor or the transferee. |
| Unusual disposition of the consideration received for the property. |
📘 Reference: Indicators of Fraud (25.1.2.3 (11-03-2023))
What IRS Criminal Investigation (CI) Actually Does?
The IRS Criminal Investigation (CI) division is the law enforcement arm of the IRS. Its core mission is to investigate potential criminal violations of the U.S. Internal Revenue Code and related financial crimes. CI special agents use financial expertise to investigate tax and non-tax crimes, with their findings referred to the Department of Justice for prosecution to maintain public confidence in the tax system.
Unlike Civil Audits, which seek to determine and collect unpaid tax, CI investigations seek evidence of willful criminal intent for purposes of prosecution. Since IRS CI Special Agents are sworn federal law enforcement officers with unique expertise in finance and forensic accounting, their primary function is to “follow the money” in complex financial crimes.
| Role Function | Description |
| Financial Investigation | Use forensic accounting skills to analyze intricate financial records, decrypt files, execute search warrants, and conduct interviews. |
| Law Enforcement Action | Carry firearms, execute search and arrest warrants, and engage in undercover operations, often in cooperation with other federal agencies. |
| Prosecution Referral | Conduct the investigation and then refer cases with sufficient evidence (proof beyond a reasonable doubt) to the Department of Justice (DOJ) for prosecution. |
| Deterrence | Focus on investigating and prosecuting high-profile, egregious cases that generate maximum deterrent effect, thereby encouraging voluntary tax compliance among the public. |
Criminal Tax Penalties — What You’re Actually Facing?
Criminal tax cases are real federal felonies and misdemeanors prosecuted by the Department of Justice (DOJ), not the IRS itself. A conviction carries the risk of prison time, substantial fines, and the continued liability for taxes owed.
| Offense (IRC Code Section) | Classification | Maximum Prison Sentence | Maximum Fine (Individuals) | Other Consequences |
| Tax Evasion (IRC §7201) | Felony | Up to 5 years | Up to $250,000 for individuals ($500,000 for corporations) | Must still pay back taxes, interest, and other civil penalties. |
| Filing a False Return (IRC §7206(1)) | Felony | Up to 3 years | Up to $100,000 for individuals ($500,000 for corporations) | Loss of professional licenses, severe impact on reputation. |
| Willful Failure to File (IRC §7203) | Misdemeanor | Up to 1 year | Up to $25,000 for individuals ($100,000 for corporations) | Must still file and pay outstanding tax liability. |
Warning Signs Your IRS Audit is Turning Criminal
The shift from a Civil Audit (seeking money) to a Criminal Investigation (seeking evidence of a crime) is marked by a distinct change in procedure. These signals indicate the IRS is moving from a fact-finding mission to a case-building effort, requiring immediate legal counsel.
⚠️ Procedural & Personnel Changes
| Warning Sign | What It Means |
| Silent Examiner / Lack of Communication | The IRS agent stops communicating or scheduling meetings. This is the most crucial warning sign. The civil process has likely been suspended while the agent prepares a criminal referral package. |
| Two “Special Agents” Show Up | Two individuals identify themselves as IRS Criminal Investigation (CI) Special Agents. CI agents always travel in pairs and signal the official start of a criminal inquiry. |
| Refusal to Explain the Audit Scope | The agent becomes evasive or refuses to clarify what tax years or specific issues they are examining, often to avoid tipping off a potential target. |
| You Receive a “Silence Letter” | A rare, formal notification that the civil audit has been frozen or suspended, directly indicating a potential criminal referral is underway. |
⚠️ Investigative Focus Changes
| Warning Sign | What It Means |
| Requests to Interview Employees/Insiders | The IRS requests to interview your bookkeeper, employees, or former employees. CI frequently gathers testimony from insiders to prove willful intent and irregular business practices. |
| Summonses Issued Directly to Banks | The IRS issues formal legal summonses (subpoenas) directly to banks or third parties early in the process. While civil audits use summonses, early use against financial institutions is a major indicator of criminal intent. |
| Focus on Cash Transactions | The auditor becomes intensely interested in large, undocumented, or structured cash transactions.Cash is often used to conceal income and the lack of documentation is a “Badge of Fraud.” |
| Questions Pertaining to “Intent” | The agent begins asking “why” you did something rather than just “what” the expense was. Questions about knowledge, belief, or purpose indicate they are building a case to prove willful intent (the key element of a tax crime). |
How a Tax Attorney Protects You From a Criminal Referral?
The primary objective of a tax attorney during a suspicious civil audit is to interrupt the pathway to criminal prosecution by containing the investigation, controlling the flow of information, and preemptively addressing “Badges of Fraud.”
| Area of Protection | Attorney’s Action | Strategic Goal |
| Communication | Intercepts all IRS communication and acts as the sole point of contact. | Prevents the taxpayer from making incriminating statements or providing legally damaging testimony (e.g., questions about willful intent). |
| Evidence & Records | Controls document production and determines which records are provided to the auditor, and in what format. | Identifies “Badges of Fraud” early and ensures documents are presented in the least incriminating manner. |
| Legal Privilege | Asserts attorney-client privilege over communications, providing a shield against disclosure. | Protects discussions about the facts of the case and the legal strategy being developed. |
| Negotiation & Resolution | Negotiates a civil resolution (e.g., payment plan, penalty abatement) with the civil division. | The ultimate goal is to resolve the matter civilly to avoid a referral to Criminal Investigation (CI). |
| Defense Preparation | Prepares defenses for the case before CI becomes involved. | Builds a foundation for a defense should the case ultimately be referred to the Department of Justice (DOJ). |
| Coordination | Coordinates with criminal counsel if a referral to CI is imminent or has already occurred. | Ensures a seamless transition to a criminal defense strategy under the protection of privilege. |
The core function of the tax attorney in this situation is to assert themselves as the necessary barrier between the IRS auditor and the taxpayer, ensuring that the civil inquiry does not generate the proof of willful intent required for a criminal indictment.
📘 Reference: Form 2848 – Power of Attorney
Immediate Legal Protection is Required When an Audit Signals Fraud
If you are experiencing any warning signs, such as “Badges of Fraud”, during an IRS audit, you are facing potential criminal tax exposure and must secure representation immediately.
At Pelham PLLC, our priority is to contain the investigation and prevent the civil audit from escalating into a criminal prosecution.
- Audit Containment: We immediately intervene to stop audits from escalating into a formal Criminal Investigation (CI).
- Statement Protection: We intercede as your sole point of contact to protect your statements and your rights, preventing you from inadvertently providing the proof of “willful intent” needed for indictment.
- Crisis Management: We manage crisis situations with urgency and handle all communication with both IRS Revenue Agents and CI Special Agents.
- Defense & Negotiation: We prepare defenses immediately and proactively negotiate civil outcomes to resolve the tax liability while successfully avoiding federal prosecution.
- Expert Representation: We specialize in defending clients who are already facing or anticipate criminal tax charges.
Federal investigators may already be building their case—let us build yours. Contact us today for confidential criminal tax defense.
FAQs
Will the IRS tell me if my audit becomes criminal?
No.
What is the #1 sign a criminal referral is happening?
A sudden stop in communication from the auditor.
Can I talk my way out of a criminal tax issue?
No. Anything you say can be used against you.
Should I speak to special agents if they arrive?
No — politely decline and request counsel.
