FRAUD AUDIT GUIDELINES
INDEX
Part II – BADGES OF FRAUD
Section A - UNDERSTATEMENT OF INCOME OR RECEIPTS
Section B - FICTITIOUS OR IMPROPER REPORTING
Section C - ACCOUNTING IRREGULARITIES
Section D - ACTS OR CONDUCT BY THE TAXPAYER
Section E – SUMMARY
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Part II
BADGES OF FRAUD
Some of the most common indications (Abadges@) of fraud are
listed below. However, it should be noted that any one indicator
alone does not constitute fraud. It is necessary to have a
number of indicators taken together in order to prove fraud.
A. UNDERSTATEMENT OF INCOME OR RECEIPTS
1. A substantial underreporting of income or receipts,
particularly over a number of reporting periods, is an
indication of fraud. However, a substantial underreporting
of income or receipts is not by itself sufficient to prove
fraud. The underreporting may be established by indirect
methods such as:
- The omission of specific items where similar items are
included;
- An omission of an entire source of income or receipts.
(Note: the above two items are meant to illustrate
types of underreporting and should not be construed as
limitations of situations of underreporting.)
- Substantial unexplained increases in net worth,
especially over a period of years;
- Substantial excess of personal expenditures over
available resources;
- Bank deposits from unexplained sources substantially
exceeding reported income or receipts.
2. Concealment of bank accounts, brokerage accounts, and other
property:
- Accounts in other cities
- Using fictitious names, wife=s maiden name, or names of
relatives and other persons without disclosing true
ownership;
- Use of a safe deposit box to conceal money.
3. Disguising income by false description of sources of funds.
4. Inadequate explanation of large sums of currency, or the
unexplained expenditure of currency.
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5. Failure to deposit receipts to business bank accounts,
contrary to the taxpayer=s normal practices.
6. Purchases in excess of receipts.
B. FICTITIOUS OR IMPROPER REPORTING
1. Substantial overstatement of deductions, or substantial
amount of personal expenditures charged to deductible
business expenses.
2. Recurrence of improper and fictitious deductions.
3. Claiming exemptions for nonexistent, deceased, selfsupporting, or other non-dependents.
4. Unsupported claims of tax exempt transactions, including
sales to tax-exempt organizations or out-of-state sales.
5. Statements made by a taxpayer which are contrary to the
taxpayer=s earlier statements or to the facts known by the
auditor.
6. Willful failure to file a required return:
- A taxpayer=s refusal or apparent inability to explain the
delinquency;
- Repeated delinquencies in the past, especially when
coupled with an apparent ability to pay.
7. Taxpayer=s lack of cooperation or attempts to interfere
with the auditor in the performance of his/her duties.
C. ACCOUNTING IRREGULARITIES
1. Keeping a double set of books or failing to keep books.
2. False entries or alterations made on the books and records,
back-dated documents, false invoices or other false
documents.
3. Failure to keep adequate records, especially source
documents, destruction of records, concealment of records
or refusal to make certain records available.
4. The payment of personal and business expenses in cash by
the taxpayer when such cash payments are not customary.
Also, the cashing, rather than the depositing, of checks
representing business receipts.
5. Cash transactions which are not traceable.
6. Journalizing of questionable items out of correct
account.
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7. Variance between treatment of questionable item on the
return as compared with their treatment on the books.
8. Unnumbered or irregularly numbered invoices.
9. Underreporting of any kind.
10. Distribution of profits to fictitious partners.
11. In Sales Tax, a reported taxable ratio which is well below
the average taxable ratio reported by businesses in a
certain industry.
12. In Sales Tax, a significant change in the non-taxable ratio
or reported taxable sales immediately after the audit
appointment notice is sent to the taxpayer.
13. Diversion of receipts, income or deductions to related
taxpayers who have lower tax rates may be a significant
factor.
D. ACTS OR CONDUCT BY THE TAXPAYER
1. False statements, especially if made under oath, about a
material fact involved in the investigation:
- A false affidavit;
- A false net worth statement submitted under oath.
2. Inability to verify transactions with other parties.
3. Attempts by the taxpayer to hinder the investigation or the
taxpayer refuses to cooperate:
- The taxpayer refuses to furnish information, or furnishes
incorrect or false information;
- The taxpayer does not appear for scheduled appointments.
4. The reputation of the taxpayer based upon the doubtful
character of past business dealings.
5. The taxpayer has been successfully prosecuted for filing a
false return, grand larceny, or other crimes based in fraud
and deceit.
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6. Inconsistent and illogical explanations for suspected
transactions.
7. The taxpayer=s knowledge of taxes and business practices
that makes implausible any claim that errors on a tax
return were due to ignorance or inexperience.
8. Information from employees concerning irregular business
practices by the taxpayer
E. SUMMARY
In determining whether there is an intent to evade tax, the
auditor should review the information discovered in light of
the Abadges@ from which inferences of fraud may be drawn.
However, the taxpayer must be given the opportunity to
explain every questionable item and the explanation should be
evaluated in light of what a reasonable person would have
done.
In some cases the presence of a substantial omission of income
or receipts or unallowable deductions or exemptions can be
its own evidence of an intent to defraud. In other cases,
the intent is not so obvious but must be determined according
to the circumstances surrounding the case. For instance,
such items as improper allocation of income or expenses
between related businesses or improper original postings must
be considered in relationship to the experience and skill of
bookkeepers and accountants, directions given them by owners
or officers, and the number of such transactions, etc. The
explanation given by owners, officers and employees should be
considered in arriving at a determination.
These badges of fraud are examples only and are not intended
to be a complete listing of all possible tax evasion schemes.
Fraud can vary from simple diversion of cash receipts to
falsification of complex accounting records. The size and
the type of business operation, the manner in which income or
receipts is received, the extent of the records required, or
other factors, are relevant in determining whether there has
been an attempt to evade tax liability.
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FRAUD AUDIT GUIDELINES
INDEX
Part I – FRAUD OVERVIEW
Section A - WHAT IS TAX FRAUD?
Section B - THE CONSEQUENCES OF FINDING A FRAUD
Section C - DISTINGUISHING BETWEEN TAX FRAUD (TAX
EVASION)AND TAX AVOIDANCE
Section D - WHY PROVING FRAUD IS DIFFICULT: THE
INTENT ELEMENT
Section E - HOW FRAUD AUDITS DIFFER FROM
NON-FRAUD AUDITS
Section F - AWARENESS
Section G -PERCEPTION, INVESTIGATION, INDICATION,
AND DETECTION
Section H - OUR PERCEPTIONS AND OUR REASONS TO
BELIEVE FRAUD EXISTS SERVE AS A
STARTING POINT
Section I - INDICATORS OF FRAUD
Section J - FRAUD AUDIT OBSERVATIONS
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Part I
FRAUD OVERVIEW
A. WHAT IS TAX FRAUD?
The Tax Appeals Tribunal has defined tax fraud as Aincluding
willful, knowledgeable and intentional wrongful acts or omissions
constituting false representations, resulting in deliberate
nonpayment or underpayment of taxes due and owing.@ (Matter of
AAA Sign Company, Tax Appeals Tribunal, June 22, 1989, citing
Matter of Ilter Sener, Tax Appeals Tribunal, May 5, 1988 and
Matter of Walter and Gertrude Shutt, State Tax Commission, July
13, 1982.)
In a nutshell, tax fraud (“fraud”) is the intentional
underreporting of tax. It is not underreporting due to accident
or inadvertent error or misunderstanding of law on the part of
the taxpayer or the taxpayer=s return preparer.
There is
usually no direct proof of fraud; it must be proven through
circumstantial evidence, and the burden of proof is higher than
demonstrating underreporting. Yet, it is often difficult to
distinguish underreporting due to inadvertent error from
underreporting due to fraud. As discussed in detail below, the
Department=s approach is to have auditors focus on Abadges of
fraud,@ i.e., objective circumstances that have been derived from
caselaw or the Department=s experience, that are often present in
tax fraud cases. At any time during an audit, if an auditor
notices any badges of fraud as discussed in these guidelines, the
auditor should notify and consult with the team leader so that,
together, they may establish the appropriate steps that need to
be taken and gather any documentation necessary to support the
pursuit of a civil, and possibly criminal, fraud case. In
general, however, the presence of any of these badges of fraud do
not, by themselves, establish tax fraud; their presence, however,
is a signal to the auditor that fraud may be an issue and further
inquiry is necessary.
The following Tax Appeals Tribunal Decision, in Matter of 1126
GENESEE STREET, INC. D/B/A A&N GAS MART(August 22, 2002),
demonstrates that any one of the badges of fraud alone may not
prove tax fraud but taken together, can and do provide evidence
to support the imposition of the fraud penalty.
The Tribunal noted that relevant factors held to be significant
include consistent and substantial understatement of tax, the
amount of the deficiency itself, the existence of a pattern of
repeated deficiencies and the taxpayer's entire course of
conduct. By itself, substantial underreporting is not enough to
establish fraud. However, where it continues throughout the audit
period, it provides strong evidence of fraud. The petitioner's
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actual purchases of taxable items were greater than its reported
taxable sales and were even greater than even its reported gross
sales. Also, the petitioner reported its sales based upon cash on
hand without allowance for cash purchases made. The petitioner
failed to maintain adequate books and records of its purchases
and sales, providing further evidence of fraud. Although the
petitioner's principal was not required to appear and testify at
the hearing, his failure to do so and to offer an explanation for
the absence of adequate records is additional support for the
finding of fraud. Based on the testimony of petitioner's
witness, petitioner did not provide its tax preparer with sales
invoices, cash register tapes or other source documents to
substantiate sales. This is an additional indication of an
intention to evade tax.
You may view the complete text of the decision by accessing
Livelink at:
http://albllink01/livelink/livelink.exe?func=ll&objtype=141&objac
tion=browse, choosing Sales Tax under the Reference Library and
then selecting TSB-D(Decisions), or by using the following
internet link:
http://www.nysdta.org/Decisions/817594.dec.htm
B.
THE CONSEQUENCES OF FINDING A FRAUD
Consistent with its vision statement of providing a fair system
of tax administration, the Department places great importance on
identifying fraud on audit. Rooting out tax fraud is an
important function of this Department, as tax fraud deprives the
State of needed revenue and lessens the equity of our tax system.
A finding of fraud on audit can trigger any or all of the
following:
1. Civil Fraud Penalties: When civil fraud is established, the
taxpayer is subject to a civil fraud penalty. While the burden
of proof is generally on the taxpayer who contests an audit or
assessment, the Department has the burden of proving fraud. To
sustain that burden, the Department must prove by clear and
convincing evidence all elements of fraud, including the state of
mind element that the taxpayer intended to underreport and
underpay. It is the auditor=s responsibility to establish civil
fraud. The civil fraud penalty becomes applicable to the entire
deficiency if any portion of the deficiency can be proven to be
attributable to fraud. The taxpayer has the burden of proof to
establish what portion of the deficiency is not attributable to
fraud.
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2. Criminal Fraud: Tax fraud may be punishable as a misdemeanor
or felony, depending on the amount of tax underreported. A basis
for civil fraud should be established before a referral for
criminal fraud can be considered. As such, although proof of
civil fraud may exist, sufficient evidence constituting criminal
fraud may not be present for referral to the Office of Tax
Enforcement. Also, since the imposition of civil fraud penalties
is the basis for a referral of the audit to the Office of Tax
Enforcement for criminal review, if referred, the documentation
gathered by the civil auditor may be used during the criminal
investigation and subsequent prosecution.
3. The Inapplicability of the Statute of Limitations: There is
no statute of limitations for tax fraud. Accordingly, a finding
that fraud occurred entitles the Department to assess additional
tax for a period that would otherwise be closed due to the
running of the statute of limitations.
C. DISTINGUISHING BETWEEN TAX FRAUD (TAX EVASION) AND TAX
AVOIDANCE
Tax avoidance is a legitimate means to reduce and minimize tax
liability. Examples of avoidance are: using the most beneficial
legal tax methods to compute tax, investing monies in tax-free
securities, using the accelerated methods of depreciation, etc.
Legitimate avoidance is legal and is not a crime.
Tax evasion is the deliberate concealment or misrepresentation of
facts which result in a fraudulent understatement of tax
liability. This represents tax fraud and is punishable by
penalties, fines and/or imprisonment. Tax fraud involves deceit,
subterfuge, concealment, lies, or an attempt to color or obscure
the facts. Tax fraud can assume various forms; among the more
common are omissions and understatement of taxable receipts.
Fraud is a deception deliberately practiced in order to secure
unfair or unlawful gain.
Fraud implies bad faith, intentional wrongdoing and a sinister
motive.
Fraud is inferred from a taxpayer's conduct calculated to cheat,
mislead and/or conceal.
Fraud usually involves false returns and/or reports, false
records, false documents and/or false statements.
Fraud includes attempted evasion, conspiracy to defraud, aiding
and abetting and/or counseling fraud as well as willful failure
to file tax returns.
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D. WHY PROVING FRAUD IS DIFFICULT: THE INTENT ELEMENT
As mentioned, fraud, at its essence, is the intentional
underreporting of tax. The difficulty in proving a fraud case is
the intent element. That intent element, which has been
variously described as Awillful,@ Adeliberate,@ or Aknowing,@ (see
section A of Part I of these guidelines) requires proof that the
underreporting was not the result of an accident, inadvertent
error, or misunderstanding of the law, but rather resulted from
the taxpayer=s conscious decision.
Thus, what distinguishes tax
fraud from mere tax underreporting is the taxpayer=s intent. The
intent element is usually proven by circumstantial evidence.
As the Tax Appeals Tribunal said in Matter of Cousins Service
Station, Inc. (August 11, 1988), for a taxpayer to be subject to
the fraud penalty, Awillful intent is a critical element; the
individual or the corporation, acting through its officers, must
have acted deliberately . . . with the specific intent to
violate the Tax Law.@ Direct evidence of willfulness can be
obtained only by admission or confession, and confession is
almost never available. Admission includes all statements by
taxpayers as well as their books and records. Questions to
consider when willfulness is suspected: Was the act or omission
committed without justifiable cause and without grounds for
believing it was lawful? Was it done with careless disregard as
to whether or not the taxpayer had the right to so act? If the
answers are no, a taxpayer=s actions may not rise to the level of
fraud.
Importantly, with respect to willfulness, it does not matter if
the taxpayer had a Agood@ purpose in evading tax, such as giving
the unreported income to the poor; the taxpayer is no less
subject to a fraud penalty than the person who spent such income
on a high standard of living.
Key to establishing that the taxpayer=s underreporting was
deliberate is to determine that the taxpayer knew that it was
underreporting. Thus, the auditor should ask:
Questions Relative To Income Based Taxes (i.e. Corporation and
Income Taxes):
In the case of a poorly educated taxpayer, determine the validity
of the lack of knowledge contention. Who handled the financial
affairs? Was the taxpayer shrewd? Business acumen will dispel
the defense of lack of education.
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Determine the actions taken (or omitted) which reasonably lead
you to believe that the reports/returns and/or supporting
documents are intentionally false.
In net worth methods, establish the taxpayer's awareness of the
increase in net assets, the buying of stocks, the purchase of
real estate, the accumulation of savings accounts, the
maintaining of a high standard of living.
For cases involving false deductions, determine what actions the
taxpayer took to falsify such deductions.
Questions Relative To Transaction (Determination) Based Taxes
(i.e. Sales and Miscellaneous Taxes):
If a taxpayer has questionable exemption certificates to support
untaxed sales, determine how the certificates were obtained.
Were they provided by the customer or were they requested by the
vendor? Or, in the worst cases, were the certificates created by
the vendor?
If a taxpayer has a material difference in reporting between
sales tax and corporate/income tax, determine how the two returns
were prepared.
Did the taxpayer know the consequences of the act? Was there a
reasonable awareness that the income, receipts, sales or
purchases reported were understated? In cases involving omitted
business income, were the funds deposited into a personal bank
account? Did the taxpayer engineer the diversion?
Regarding audits based on deposits, determine the following: Do
deposits exceed income or receipts? Who makes the deposits? Was
the taxpayer aware that the deposit receipts were omitted from
the return? Was false information supplied to the bookkeeper to
record certain deposits as "personal"?
Taxpayers will offer many reasons to show that there was no
intention to evade tax. Reliance on the advice of an attorney or
an accountant may be a valid defense to a charge of willfulness.
If it can be shown that the taxpayer did not heed the advice, did
not fully inform the advisor of all the facts or sought advice
from one not qualified to give it, that defense may be overcome.
Taxpayers will often say, "I left everything up to my attorney,
or CPA," while well aware that business income had been
diverted.
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Professional people (doctors, dentists, etc.) may contend that
they were never good at figures and too busy caring for their
practices to keep accurate records of earnings. A person with
marital problems, business problems, poor health, or on the verge
of a nervous breakdown may be too deprived of the sense of reason
to form "bad intent." However, these defenses may be rebutted by
specific acts inferring intentional violations or where the
pattern of understated income covers several years.
A taxpayer may cooperate with the department and make a "full
disclosure to show good intent." If this happens after the Tax
Department has contacted the taxpayer, it has little effect upon
his or her original intent. Intent at the time the act was
committed cannot be changed after the act has been brought to
light or after exposure has been threatened.
A New York State Tax Tribunal Decision - T. Management, Inc. DTA No. 816662 - April 12, 2001 - effectively illustrates proof
of intent. In this decision, although the taxpayer testified that
it was not his intent to commit fraud, the Tribunal found that
the taxpayer=s actions provided clear and convincing proof of
intent. The taxpayer used sales tax collections for other
business purposes and filed false sales tax returns which under
reported and under paid sales taxes due. For the complete text
of this decision, you may find it by going to Livelink, selecting
Reference Library and then choosing the appropriate category.
You may also view the decision by using the following internet
link: http://www.nystatdta.org/Decisions/816662.dec.htm
E.
HOW FRAUD AUDITS DIFFER FROM NON-FRAUD AUDITS:
Once an auditor has reason to believe that the taxpayer=s
underreporting of tax may have been intentional, then the auditor
must approach the audit differently. There is an Aearly warning@
procedure to follow. This procedure is outlined in the OTO memo
98-3.1 (REVISED) which may be found by going to All Audit
Division Documents from the Target Menu and then selecting OTO Memos.
Because the burden of proving fraud is on the Department, and
that burden is heavy, necessitating proof that the taxpayer=s
underreporting was deliberate, the auditor must proceed very
carefully with the audit, taking as many of the following steps
as possible:
1. As mentioned, the Department has the burden to prove fraud and
the standard of proof is quite high. Therefore, the quality of
the audit work in a fraud case is very important. For example, if
an auditor is seeking information from a taxpayer=s supplier as to
the taxpayer=s purchases, the auditor should make the request for
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information in writing and obtain from the supplier a cover
letter that explains the information being furnished and the
records accessed to provide the information. In sum, the auditor
must work under the assumption that all aspects of the audit may
be questioned and, thus, might have to be substantiated.
2. The auditor should keep very detailed notes especially if it
appears that the audit will turn into a fraud case. If
practical, communications with the taxpayer should be in writing.
Also, if practical, the auditor should ask for written responses
from the taxpayer or the taxpayer=s representative with respect to
important issues.
3. The auditor should determine who provided records to the
taxpayer’s preparer.
4. It is critical in a fraud investigation to determine how the
tax returns in questions were prepared. An auditor should
determine:
a. what records were used to prepare the tax returns,
b. who was involved in the preparation of the records, and
c. who was involved in the preparation of the tax returns. In
sum, an auditor needs to trace on audit the entire process by
which the relevant tax returns were prepared. Particular focus
should be on the taxpayer=s involvement in this process.
5. Auditors should ascertain the level of the taxpayer=s
education, business experience and knowledge of the Tax Law. A
high level of education or extensive business experience are
factors that tend to negate the possibility that underreporting
of tax was unintentional, e.g., due to ignorance or inexperience.
See Simms v Comm=r, 42 F2d 340.
6. The auditor should ask the taxpayer or the taxpayer=s
representative for an explanation of an apparent discrepancy in
records or an apparent underreporting of tax. Especially in
cases of determination based taxes, our ability to estimate tax
due is often based on the inadequacy of bookkeeping. Persistence
in demands for an explanation (and written documentation thereof)
can be and has been used as evidence to prove fraud. If a
taxpayer has refused to offer an explanation for an apparent
deficiency in tax even though the auditor has made persistent
demands in writing and orally for an explanation, an inference
can be made that the taxpayer intended to underreport tax that
was due. Also, the auditor should note whether the explanations
offered by the taxpayer change over time because inconsistent
explanations may be proof of fraud.
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7. The auditor should consider expanding the years under audit
if there are strong indicators that fraud existed in periods
prior to the period originally under audit. The longer the period
of underreporting of tax, the stronger the case is for fraud.
8. If there are strong indications that the taxpayer has
committed fraud, the auditor should consider recommending the
taxpayer for audits of any other types of tax returns filed by
the taxpayer. For example, if there is a substantial
underreporting of sales tax due on sales, an income tax audit
should be performed on the taxpayer=s PIT returns, preferably
using an audit method different from the one employed for the
sales tax audit. The advantages of conducting different audits
at the same time are (1) the audit results will buttress each
other if each method discloses a deficiency of tax; (2) an
underreporting of two different taxes by definition means a
larger pattern of underreporting has occurred, which itself is
evidence of fraud; and (3) the second audit, particularly a PIT
audit, might result in the acquisition of information about the
taxpayer=s assets that might be relevant to collection activity.
9. With respect to criminal fraud, the auditor must gather
sufficient evidence upon which to base a referral for criminal
investigation to the Office of Tax Enforcement (OTE), since a
case recommended by OTE for criminal prosecution which is
accepted by a prosecutor must be proved beyond a reasonable
doubt. A criminal fraud referral should be made to the Office of
Tax Enforcement following the procedures established in OTO memo
98-3.1 (Revised), AOTO Referrals to the Office of Tax
Enforcement.@ Once a matter has been referred to OTE, Audit
personnel should have no further contact with the taxpayer to
conduct further audit activity except with the express consent
of, or at the request of, OTE. For cases accepted for
prosecution, OTE will be the sole liaison between the Department
and the prosecutor and OTE and the referring unit will provide
whatever assistance is requested by the prosecutor.
F. AWARENESS
The starting point for all auditors in their effort to detect
fraud is awareness that: some taxpayers understate income or
taxable receipts or taxable purchases; some taxpayers overstate
expenses; some taxpayers alter and falsify documents; some
taxpayers offer false statements; some taxpayers do not file
reports or returns; and some taxpayers file false reports or
returns. Such taxpayers attempt to defraud the State.
Once auditors are aware that some taxpayers willfully act to
defraud the State and thus pay less tax, they can become VIGILANT
IN DETECTING FRAUD. When auditors are aware, they can pursue
reasonable inferences when they believe that fraud may have been
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committed. The elements of awareness include:
- PERCEPTION that a wrong doing may have been committed;
- INVESTIGATION to confirm the possibilities;
- INDICATION that a wrong has been committed;
- DETECTION based on the facts and circumstances;
- DEVELOPMENT of knowledge, intent, pattern and dollars; and
- PROOF of the FRAUD
G. PERCEPTION, INVESTIGATION, INDICATION, AND DETECTION
When was the last time you reviewed a return or a taxpayer=s
records and thought that something was wrong with them? How long
did it take for you to question what you saw?
Questions Relative To Income Based Taxes (i.e. Corporation and
Income Taxes):
Is there something wrong when the taxpayer's net income reported
on his/her return indicates poverty level and the reported
address reflects upper middle class or better neighborhood?
Is something wrong when the taxpayer's gross receipts increase
five fold over the audit years while the net profit turns to net
losses?
Is there something wrong when a taxpayer doesn't know how old
his/her children are and where they were born when asked during
an opening interview?
Is there something wrong when an taxpayer's return shows a
positive cash flow of less than $10,000 when 9 children are
indicated on the tax return with 2 or 3 attending high priced
private schools?
Is there something wrong when an employee of a family corporation
suddenly acquires several parcels of rental property, a new
automobile, beach front property, and a winter home in Florida?
Is there something wrong when a taxpayer's bank loan application
shows his/her net worth at over a half a million dollars while
his/her tax return reflects negative taxable income?
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Is there something wrong when a resort with a motel, several
rental cabins and a restaurant has no employees and the owner,
who reports no income from the business indicates that he/she
works only to have "something to do?"
Is there something wrong when an individual earns about $100,000
in wages but reports a Schedule C loss in excess of $75,000, thus
paying only a small amount of income tax?
Questions Relative To Transaction (Determination) Based Taxes
(i.e. Sales and Miscellaneous Taxes):
Is there something wrong when a business= purchases exceed its
gross sales?
Is there something wrong when a business= suppliers can show that
they sold much more to the business than the business claims to
have purchased? When all transactions are in cash, without
verifiable source documents? When the reported non-taxable ratio
is easily higher than you have seen before for this type of
vendor?
Is it reasonable for gross sales of a business to increase over
time, but the taxable sales remain consistent over the same
period?
Is it reasonable for a business dealing with large transactions
to have cash transactions and no receipts?
Is it reasonable (not to mention legal) for a business selling
appliances or other large ticket items to "include the tax in the
selling price."
Is it reasonable for credits claimed to exceed the liability for
a return?
H. OUR PERCEPTIONS AND OUR REASONS TO BELIEVE FRAUD EXISTS SERVE
AS A STARTING POINT
Sometimes our reasons to believe fraud exists are right; the
taxpayer is preparing fraudulent tax returns and the Department
can prove it.
Sometimes our reasons to believe fraud exists may be allayed when
there is an adequate explanation for what appeared on the surface
to be fraudulent.
Sometimes we have indications of fraud that raise our perception
that there may be a Tax Law violation or violations; however, we
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are not always able to prove fraud.
I. INDICATORS OF FRAUD
An indicator of fraud is a fact or set of facts, usually of an
irregular nature, which in the light of all other known facts and
circumstances may be reasonably interpreted as part of a tax
evasion scheme. There are no stereotyped tax evasion patterns
which may be fitted to all situations to determine if an
indication of fraud exists. Rather, the determination must be
separately made in each case through application of the
professional judgment of the auditor to the known facts and
circumstances. (See Part II of these guidelines for Badges of
Fraud.)
Evidence of fraud is rarely direct because few people confess or
admit that they intended to commit fraud. Evidence of fraud is
therefore usually CIRCUMSTANTIAL. Circumstantial evidence is
indirect proof based on our life experiences to establish that
something has happened. To illustrate the concept of
circumstantial evidence consider the following example:
Footprints in a muddy forest path might allow us to infer
several facts. Has someone (or something) already passed
through? In which direction? Human or animal? If an animal,
large or small? If a human, barefoot or shod? How recently (How
fresh are the tracks)? Although we saw no one (or nothing) pass
through, our experience allows us to infer a great many facts
with certainty.
Any fact, circumstance or event which leads you to
possibility of fraud can be termed an indicator of
possibility that fraud may exist should signal you
observant and to sharpen your investigative skills
techniques. Indicators of fraud include:
surmise the
fraud. The
to become more
and
- A substantial additional tax due for two or more periods.
- False statements and/or documents, misrepresenting facts,
inconsistent statements or incomplete responses.
- Concealment of facts, information or records, destroying
records, altering records or not maintaining adequate
records of transactions.
- Use of a nominee or nominees to disguise or conceal
ownership. A nominee is a person or a group that holds
title to a security or piece of real estate but is not
actually the holder or owner.
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- A prior history of substantial understatement or other
failure to comply with New York State tax laws or the tax
laws of another jurisdiction (such as repeated untimely
payments of tax due with returns and/or reports).
- Income producing illegal activities.
- A standard of living or lifestyle that is excessive in
comparison with reported income.
- Engaging in cash transactions to prevent leaving an audit
trail.
- Unusual business practices (such as cashing rebate checks,
requesting certain sources of income to be paid by
different methods, or other irregularities) which lend
themselves to circumventing normal bookkeeping and
recording of transactions.
- The degree of the taxpayer's control of business
transactions requiring that he/she be knowledgeable about
erroneously categorizing income or expenses as well as any
resulting understatement.
- Large dollar discrepancies of which the taxpayer must have
known. For Sales Tax, a non-taxable ratio which greatly
exceeds what is normal for such a business.
J. FRAUD AUDIT OBSERVATIONS
An auditor, in attempting to determine if fraud is present,
should consider the following:
- Fraud is the intentional misrepresentation of financial
facts.
- Motives for fraud include economic, egocentric, ideological,
and psychotic reasons. The most common motive is financial
economic) gain.
- Fraud usually involves motive, opportunity and benefit.
Auditors should be looking at people and situations that
contain these elements.
- Fraud may be found in a computerized accounting environment
at any state of processing, but the input areas are the most
common.
- Lower level employees= fraud schemes most commonly involve
12
disbursements such as payables, payroll, and benefit and
expense claims.
- Higher level managers= fraud schemes most commonly involve the
manipulation of profit such as deferring expenses, booking
sales too early and overstating inventory.
- Accounting-type frauds often result from the absence of
controls.
- Fraud losses, not fraud incidents, are growing exponentially.
- Accounting frauds are more often discovered by accident than
by intention or design.
- Fraud prevention includes adequate controls and a work
environment in which a high value is placed on personal
honesty and fair dealing.
13
Audit Division Guiding Principles The mission of the Audit Division is to use resources effectively and efficiently to perform quality audits and to determine the correct amount of tax. An essential part of this objective is to verify compliance with the Tax Law and Regulations. Guiding Principles for auditing:  An audit must be performed in accordance with professional standards.  An auditor has a responsibility both to the taxpayer and to the State of New York to make a proper determination of the tax liability.  It must be reasonably concluded that all items necessary for the proper determination of tax have been considered.  There must be a fair and consistent administration of the law.  In the event that a deficiency or overpayment is discovered, the error, along with corrective remedies, should be explained to the taxpayer in a constructive manner. FRAUD AUDIT GUIDELINES
INDEX
Part III – THE AUDIT PROCESS
Section A - PRE-AUDIT ANALYSIS – GENERAL
Section B - ATTITUDE AND CONDUCT OF THE TAXPAYER
Section C - THE AUDIT OF RECORDS
Section D -PERSONAL INCOME TAX
Section E - CORPORATION TAX
Section F - SALES TAX
Section G - MISCELLANEOUS TAXES - FIELD AUDIT
Subsect.1 - FUEL, ALCOHOL, CIGARETTE AND CARRIER TAXES
Subsect.2 - MORTGAGE RECORDING TAX
Subsect.3 - REAL ESTATE TRANSFER TAX (RETT)
Section H - MISCELLANEOUS TAXES (FUEL, ALCOHOL,
CIGARETTE AND CARRIER TAXES)-DESK AUDIT
Subsect.1 - BEVERAGE TAX
Subsect.2 - CIGARETTE TAX
Subsect.3 - FUELS AND HIGHWAY USE TAXES
Subsect.4 - IFTA
Subsect.5 - REGISTRATION & BOND (FUELS, CIGARETTE/
TOBACCO, ALCOHOLIC BEVERAGE)
Subsect.6 - ESTATE TAX
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Part III
THE AUDIT PROCESS
A.
PRE-AUDIT ANALYSIS - GENERAL
Fraud is not ordinarily discovered by a surface examination
of the records or returns. You have to dig deeper to uncover
schemes used to commit fraud. Exercise good judgment in
deciding how deep to probe the fraud issue and, when
necessary, consult your Team Leader and/or Section Head for
additional guidance.
A pre-audit analysis may be the first step in detecting
fraud. The tax return usually identifies the businesses in
which the taxpayer is involved. Fraud is not unique to any
one form of business; it is committed by all types of
businesses (sole-proprietorships, partnerships and
corporations). Certain types of businesses, such as those
dealing primarily in cash or involved in illegal activities
are more likely to be potential fraud cases than others.
Potential fraud is also more likely when only one individual
or a few individuals have control over both the receipts and
the records, or when poor and inadequate records are kept.
Although there may be times at the beginning of an audit that
you have suspicions that fraud has occurred, you ordinarily
do not find firm indicators of fraud until you examine the
books and records of the taxpayer. There are no fixed audit
steps to follow in detecting tax fraud, but be alert and
flexible enough to adapt the audit plan to the facts as they
develop in a particular case.
The benefits of the pre-audit analysis are:
- Prioritizes audit cases within inventory;
- Establishes the tentative plan/scope, or depth of the
audit;
- Raises questions to be answered during the audit;
- Identifies areas where preliminary research on technical
issues may be necessary; and
- Allows the auditor to consider various audit methods.
1
B.
ATTITUDE AND CONDUCT OF THE TAXPAYER
Sometimes the first thing that will alert you to the
possibility of fraud is the uncooperative attitude and
conduct of the taxpayer and/or the representative during the
initial stages of the audit. This conduct during the audit
and the method of doing business may be symptomatic of
improper returns being filed. You should be aware of the
following during the audit process:
- Repeated procrastination on the part of the taxpayer in
making and keeping appointments with the auditor;
- Uncooperative attitude displayed by not complying with
requests for records and not furnishing adequate
explanations for discrepancies or questionable items;
- Failing to keep proper books and records, especially source
documents, in a business or profession, especially if the
taxpayer previously has been audited and advised to improve
its record keeping methods;
- Making false, misleading or inconsistent statements; and
- An offer by the taxpayer to make an early settlement.
C.
THE AUDIT OF RECORDS
One of the first things an auditor should do on audit is
determine how the tax returns in question were prepared. The
auditor should find out who was involved in the tax
preparation process, with particular focus on the taxpayer=s
own involvement. The auditor should also find out which
records were used to prepare the return and who prepared
these records.
The primary objective of the audit is to determine if the
taxpayer has fully complied with the New York State Tax Law,
and if the filed returns are accurate. Although not always
the case, the books and records may be in agreement with the
tax returns or reports. You should reconcile the books to
the tax returns or reports and verify entries with source
documents. At the same time you will become familiar with
the accounts and may note any unusual items which will
require further analysis. At this time, you should note any
inadequacies in the books and records, especially source
documents. This initial step is of particular importance if
the return is later determined to be fraudulent, because to
2
allege that the taxpayer has not reported certain income,
receipts, sales or purchases, it is first necessary to
establish what has been reported.
During the early stages of the audit, you should review any
financial statements, accountant's work papers and any prior
audit reports. You should note any inconsistencies between
the return and the data contained in these other documents.
You should attempt to verify entries with verifiable source
documents, and attempt to follow the Apaper trail@ from source
documents to return. The accountant's work papers or reports
may indicate to what extent independent verification has
already been made of the entries in the taxpayer's books.
The auditor can take this into consideration when judging the
reliability of the books and records. Any audit report from
another government agency should be reviewed to determine the
New York State tax effect.
For those taxes where returns or reports are available(e.g.,
corporation and personal income taxes) comparison of returns
for several periods is an excellent method of obtaining
valuable information. Changes in the taxpayer's financial
position can be noted from the asset acquisitions over the
years and the increase in liabilities and capital accounts.
Changes in the sources of income and deductions and their
amounts may give leads to tax evasion practices. Any
discrepancies in inventory or other balance sheet accounts
carried forward in current returns can be discovered. For
sales or miscellaneous taxes, third party verification may
prove valuable in determining fraudulent conduct, even if the
returns match the records.
Until information alerts you to the possibility of fraud, the
audit will ordinarily not be of the same scope or intensity
as one where fraud is suspected. The extent of the audit
will depend on your judgment and experience based on the
facts in each case. Every audit should be thorough enough to
explain any questionable items reported, and to adequately
cover any information items associated with the return or
report that may have caused the audit. However, as the audit
progresses, the scope or intensity of the audit may increase
according to the auditor's findings.
For taxes based on or measured by income, items of income
should be analyzed as to the source, nature and amount. All
peculiar or unusual items, irrespective of the amount, should
be analyzed and clarified. You must look behind the book
3
entries and determine the reason for the entry; insist on
verifiable source documents. You must seek explanations for
inconsistencies. You should follow transactions to fully
understand the item. When a taxpayer=s records are nonexistent,
unavailable or inadequate, you should consult your team leader or
section head for the appropriate next step in the audit process.
Keep in mind that the Department has various methods (or tools)
available to reconstruct the income or receipts of an individual
who falls into this category. A good example of a method is one
of the indirect methods utilized to reconstruct the income or
receipts of an individual without adequate records.
During the examination of the books and records, you may note
inconsistencies or irregularities that indicate potential
fraud even though you had noticed nothing unusual in the preaudit analysis, or your conversations with the taxpayer or
the representative. However, if during the course of an
audit, material discrepancies are discovered which may exist
in prior and/or subsequent years, you may wish to expand the
audit to include other periods.
It should be noted that auditors are unable to audit expired
periods unless a minimum level of civil fraud exists (see
Part I, Section B of these guidelines). When such proof
exists, the taxpayer or representative must be advised of the
auditor=s intention to audit expired periods and a written
request for access to the records for such periods must be
made. For Corporation and Income Taxes, auditors are unable
to assess tax beyond the normal three year statute of
limitations period unless the taxpayer omits from his New
York taxable income an amount properly includible therein
which is in excess of twenty five percent of the amount of
New York income, in which case there is a six year statute of
limitations, or any portion of the underreporting of income
is attributable to fraud as mentioned above, in which case
there is an unlimited statute of limitations to assess tax
(See sections 683 (c) and (d) and 1083 (c) and (d)of the Tax
Law). A pattern of understated income, receipts, sales,
purchases or overstated expenses is one significant factor to
consider in determining if there are firm indicators of
fraud.
Auditing techniques employed by New York's auditors, if they
are effective, should be designed to disclose not only errors
in accounting and application of law, but also irregularities
that indicate the possibility of fraud. You should not set
out to deliberately make a fraud case of every return or
4
report assigned to you. However, you should recognize
indications of possible fraud when they exist, and discuss
them with your supervisor.
When inconsistencies or irregularities do surface during the
audit, your task as an auditor is to develop the case and
obtain information and documentation that will provide you
with a basis for determining how you will proceed on audit.
The development of a case as a potential fraud referral will
require detailed explanations wherever possible, and
definitive reasons why the case is a good audit referral. A
well-prepared and documented case will increase the chances
for success in making a good referral to OTE and obtaining a
successful prosecution. A well-prepared and documented case
will also preserve the amount of civil tax due, plus
penalties and interest when the case is ready to be settled
civilly.
D.
PERSONAL INCOME TAX
1. OVERVIEW
Certain types of income items lend themselves to being
not reported or underreported. These include, among
others, manufacturer's rebates, nonrecurring income
items, income received from the sale of by-products (such
as scrap), sale of business assets, or wholly diverted
income from selected sources. Similarly, there is always
the potential that personal expenses have been falsely
charged to business expenses. The range of potential
personal expenditures which may be misclassified and
deducted as business expenses is limited only by the
imagination and opportunity of the individual.
2. PRE-AUDIT ANALYSIS
For a personal income tax audit, review the returns you have
for audit. Many times you may be able to identify areas for
questioning simply by comparing available income to an
individual's apparent living style.
Your pre-audit analysis must be based upon your personal
experiences and tailored to the individual return you are
assigned to audit. You will consider at least briefly almost
all of the entries on the return. Consider the filing status,
size of the family, geographical location of the business and
the residence if identified, and the sources of income that
5
the taxpayer is reporting.
The sources of income be they from a sole proprietorship,
partnership or corporate entity, could give you an indication
of the taxpayer's business connections. Your review should
also be based primarily on the tax specialty to which you are
assigned, but should include a cursory review of the
individual's reporting history for the other taxes. This can
be accomplished with a quick review of the system files
available to you as a New York State auditor.
Income and expense schedules may help you identify areas of
potential fraud. One significant factor is control over
income and expenses recording and/or reporting. Where your
taxpayer is personally responsible to account for income or
has the ability to classify or approve business expenses, the
potential for misapplication of funds arises. You can check
reported profits against the industry standards.
Reported interest income can assist you in projecting the
amount of accumulated savings. Are you surprised that your
taxpayer has saved that amount of money? If there were
substantial increases in reported interest income over a
prior year, what is the source of the funds being used to
make up these deposits?
Significant, unusual, and questionable items may also be
found on the balance sheet. When a balance sheet is
available, it is an integral part of the scope of your audit.
The following areas should be looked at during the review of
a return:
- Adequacy of the reserve for bad debts;
- Taxpayer's method and practice of accounting for inventory;
- Large or unusual changes in asset or liability accounts;
- Loans from shareholders;
- Loans to shareholders;
- Contingent or estimated liabilities not deductible for tax
purposes;
6
- Detailed analysis of retained earnings (Partnership Capital
Account/Owner's Equity Account) and reconciliation and
verification of all significant differences between the
book (financial) and taxable income;
- Propriety of deferred revenue accounts; and
- Any other account for which the book and proper tax
accounting may not be the same, such as goodwill
amortization, capitalized interest or taxes on
construction, or prepaid expenses which are currently
deductible for tax purposes.
The relationship of certain items on a tax return can raise
pertinent questions during an audit. It is these
relationships that often become the focus of the pre-audit
analysis. For example:
- The individual's address may indicate a style of living
that cannot be supported by the income reported.
- If other reported income is low, large interest or dividend
income might raise the question of the source of funds to
acquire the underlying assets. If the loans are the
source, how are these loans repaid?
- Recently acquired assets on the depreciation schedule with
no increase in interest expense, should raise the question
of the source of funds used to acquire the asset.
- High real estate taxes and little mortgage interest expense
might also raise the question as to the source of funds to
acquire the real estate.
- Fluctuations of income reported from year to year may
indicate omission of income or overstated deductions in low
income years.
- What items are reported on the return versus what isn't.
- Are the items identified on the return this year consistent
with items reported in past years or subsequent periods?
3. DURING THE AUDIT
Follow the various audit guidelines prepared for Income Tax
Programs. As the audit progresses, be aware of what you see
7
and hear. Use third party verification if needed. Stop and
speak with your team leader or section head if badges of
fraud appear.
Look over the tax return itself. You may wish to test
reported gross receipts, or verify business expenses or
itemized deductions/exemptions. Many times areas for
questioning may be identified simply by comparing available
income to a taxpayer=s style of living. For example, a
taxpayer with a spouse and two dependents owns a home and a
car and appears from your analysis of itemized deductions to
be in a substantial income tax bracket. This should raise
questions in your mind as the taxpayer reports an amount as
taxable income that is insufficient to support the expected
living expenses of that family unit. The return(s) may show
an amount of taxable income that even the taxpayer agrees is
inadequate to pay living expenses.
Reported interest income can assist in projecting the amount
of accumulated savings. If there is a substantial increase
in reported interest income over a prior year, question the
source of the funds being used to make these deposits. If
the taxpayer is reporting dividends from a number of
corporations, is the taxpayer reporting any capital
transactions? Reviewing itemized deductions can give insight
into a taxpayer=s life style, especially the potential for
unreported receipts or overstated expenses. Increased
interest expense can alert you to non-taxable sources of
funds. What was the source of the funds used to make
payments on existing and new loans?
Check with the Department of Motor Vehicles to determine if
the taxpayer purchased any vehicles. An increase in reported
real estate taxes may indicate the acquisition of property or
remodeling expense. If additional real estate has been
purchased, does it produce income? Miscellaneous deductions
should also be analyzed. A significant amount expended for
safety deposit box rental, for example, should cause you to
question what is being protected.
- INTERVIEWING THE TAXPAYER
One of the most important activities an auditor does during
the audit is to interview the taxpayer. The initial
interview of a taxpayer establishes the foundation for your
entire examination. You have an opportunity to establish an
effective business relationship in order to gain cooperation
8
from the taxpayer.
During the interview you will be trying to arrive at an
accurate understanding of the taxpayer=s entire tax
situation. This would include business operations, income
and expenses, and itemized deductions - all of which may
potentially be factors in a fraud scheme. Make sure you
understand the taxpayer=s record keeping procedures,
including recording of all gross receipts as well as
expenses. Determine who was responsible for setting up the
bookkeeping procedures and who gives directions to employees
concerning questionable items.
A thorough taxpayer interview is a necessary ingredient in
quality examinations. You must have a firm indication of
fraud from the circumstances of the case and the taxpayer=s
admissions, if any. But keep in mind that even in an
examination which is intended to be wholly civil, a taxpayer
may use the Fifth Amendment privilege and decline to respond
to your questions. Assertion of Fifth Amendment rights is
not a ground for fraud referral. A taxpayer may required to
produce records even if he is asserting the Fifth Amendment.
Under the required records doctrine, a person has no
expectation of privacy in regard to records he is required by
law to maintain(Matter of Roebling Liquors, Inc., TAT,
11/24/99). Thus, a taxpayer=s refusal to furnish his records on
Fourth or Fifth Amendment grounds may be evidence of fraud
even if a refusal to answer questions is not. Work smart,
plan ahead and obtain information (and documentation) as it
becomes available.
During the interview with the taxpayer, try to answer all of
the questions you have raised in your pre-examination
planning. Follow up on leads to new areas as they emerge.
Determine from the taxpayer all non-taxable sources of income
including: loans, gifts, inheritances, unemployment benefits,
retirement benefits, insurance, and proceeds from the sale of
personally owned assets.
The following are examples of inappropriateness that may be
discovered during the audit:
- INCOME TAX
a. You are auditing an attorney who claims excess (6)
9
dependents. You discover during the course of your audit
that he is a bachelor who has never been married. His
parents are alive and report their own returns. Their
federal returns show two deductions.
b. A CPA/Attorney files New York State IT-201's for the last
ten years using an upstate New York address. During the
audit you discover the CPA/Attorney resides in Manhattan
and the address being used is that of a summer house.
When the taxpayer is questioned about it, no explanation
is provided for the address discrepancy. (The advantage
gained by using this upstate New York address is to avoid
New York City residency tax).
c. When reviewing documentation of mortgage interest and
taxes, the property address shown is not the address where
the taxpayer resides. Review of Coles or telephone
directories indicate that other persons live at this
address. Although no rental income is being reported,
there is a strong possibility that this is in fact rental
property.
-
WITHHOLDING TAX
During a three year withholding tax audit, you discover the
taxpayer failed to report and remit 50% of the withholding
tax collected from his employees. The taxpayer cannot
provide any explanation for why this happened. During the
audit, you can determine whether the withholding tax was used
to pay for a new boat, house, or other personal expense of
the taxpayer.
E
CORPORATION TAX
1. OVERVIEW
Certain types of income items lend themselves to being not
reported or underreported. These include, among others,
manufacturer's rebates, nonrecurring income items, income
received from the sale of by-products (such as scrap), sale
of business assets, or wholly diverted income from selected
sources. Similarly, there is always the potential that an
officer=s or employee=s personal expenses have been falsely
10
charged to business expenses. The range of potential
personal expenditures which may be misclassified and deducted
as business expenses is limited only by the imagination and
opportunity of the corporation=s officer(s) or employee(s).
2. PRE-AUDIT ANALYSIS - INCOME STATEMENT
Income and expense schedules may help you identify areas of
potential fraud. One significant factor is control over
income and expenses recording and/or reporting. Where an
officer of the corporation or other person responsible to
account for income has the ability to classify or approve
business expenses, the potential for misapplication of funds
arises. You can check reported profits against industry
standards. Other indicators to look for include:
-
If other reported income is low, large interest or
dividend income might raise the question of the source of
funds to acquire the underlying assets. If loans are the
source, how are these loans repaid?
- Fluctuations of income reported from year to year may
indicate omission of income or overstated deductions in
low income years.
- Discrepancies between the wages reported on the employee’s
wage and tax statements (W-2’s) to the employer’s and
employees’ tax returns.
3. PRE-AUDIT ANALYSIS - BALANCE SHEET
With business entities, be sure to look for changes in
balance sheet accounts, loans to or from officers, and bad
debts, as well as interrelationship with businesses
controlled by related individuals. You should determine the
sources of increases to loans from officers= accounts or
increases in stock ownership.
Other significant, unusual, and questionable items may also
be found on the balance sheet. The balance sheet is an
integral part of the scope of your audit. The following
areas can be looked at during the review of a franchise tax
report:
-
Adequacy of the reserve for bad debts;
11
-
Taxpayer's method and practice of accounting for
inventory;
-
Large or unusual changes in asset or liability accounts;
-
Loans from shareholders;
-
Loans to shareholders;
-
Contingent or estimated liabilities not deductible for tax
purposes;
-
Detailed analysis of retained earnings and reconciliation
and verification of all significant differences between
the book (financial) and taxable income;
-
Propriety of deferred revenue accounts; and
-
Any other account for which the book and proper tax
accounting may not be the same, such as goodwill
amortization, capitalized interest or taxes on
construction, or prepaid expenses which are currently
deductible for tax purposes.
Relationship of certain items on a franchise tax report can
raise pertinent questions during an audit. It is these
relationships that often become the focus of the pre-audit
analysis. For example:
-
An officer=s or employee=s address may indicate a style of
living that cannot be supported by the wages paid to such
officer or employee.
-
Recently acquired assets on the depreciation schedule with
no increase in interest expense should raise the question
of the source of funds used to acquire the asset.
-
What items are reported on the franchise tax report versus
what isn't.
-
Are the items identified on the franchise tax report this
year consistent with items reported in past years or
subsequent periods?
4. DURING THE AUDIT
With the experience obtained in performing audits, not only
12
does an auditor develop, among other things, his or her
skills and self-confidence but also frequently a certain
intuitive sense and an ability to make observations, all of
which may prove to be invaluable in uncovering some
significant tax issue or scheme.
From the first time an auditor approaches or arrives at the
taxpayer=s business location, he or she begins to make
observations and perhaps mental notations on or about the
physical surroundings and what is present there. As
meaningless or insignificant as these often are, the
possibility exists that some relevant observation(s) could be
made in regards to what is known at that time or as the audit
progresses about the taxpayer, its business, or its tax
reports.
The auditor should therefore be keenly aware of
what he or she sees.
The auditor should continue to make observations once he or
she is inside the taxpayer=s offices. Do they appear to be
well-organized and staffed or not? Are they elaborate or are
valuable items or collections present? Are there secure
areas? Are security personnel employed? Does there appear to
be anything unusual or is there any other information to be
learned before meeting with the individuals with whom the
auditor will be working?
Once the auditor meets those with whom he or she will be
working and has explained the taxpayer=s rights and the audit
process, the auditor should conduct an interview that will
maximize information and brings out facts. To do this
effectively, questions should be posed in a cordial manner
and structured so as to elicit information and responses upon
which facts may be determined. Posing questions that give
the impression of suspicion or accusation will harm this
process and may also affect further cooperation. Of course
any lack of cooperation or a poor attitude on the part of the
taxpayer=s representatives or employees at any time during
the audit may be an indication that something is being hidden
from the auditor. As important as asking questions
effectively is, so too is the auditor=s ability to listen
carefully to the answers. These answers may very well
provide a clue or a lead to uncovering something wrong. It
is important that the auditor write down the answers as
accurately and as soon as possible which may not be until
after the interview has been completed. If during the
interview, the auditor senses that the questions asked have
been miscommunicated or the answers given are unclear, not
13
understood, or are unresponsive, he or she should politely
explain so to the taxpayer and then follow-up by:
a. repeating or rephrasing the questions;
b. asking for further clarification or explanation of the
answers; or
c. reiterating the answer to the representative and then
asking the representative whether the auditor=s
understanding is correct.
In addition to those questions resulting from the pre-audit
analysis and any observations previously made, the initial
interview provides the auditor with the opportunity to ask,
determine, and/or request information about:
a. the taxpayer=s ownership, business, structure, management,
products, and services;
b. related businesses and related-party transactions;
c. other audits;
d. books, records, and their maintenance;
e. tax return preparation;
f. internal controls; and
g. fraudulent activity itself within the business.
For internal controls and fraudulent activity within the
corporation, the auditor may start by making general
inquiries as to whether the corporation has experienced any
significant problems with fraud or theft within the
corporation and, if so, how were these problems discovered?
Also, what controls are or have been put in place to prevent
fraud and theft and to safeguard the assets? Does the
company employ an accounting staff and/or an auditing staff?
How Alarge@ are these staffs? Are both internal and external
staffs employed? Are there audited financial statements?
Depending on the information that has been gathered up to
this point, the auditor may now be in a better position to
know whether wrongdoing is a possibility. Generally
speaking, in order to have effective control over their
business purpose(s) and prosperity and in order to protect
their assets and income from the personal gain of their
employees, i.e., theft or other unintended personal benefit,
large corporations will of necessity have:
a. internal controls in place, including the traditional
separation of duties and the handling of transactions;
b. written corporate policies and manuals to be followed;
14
c. internal and external accountants and auditors; and
d. security staff, etc.
Where these protective measures are lacking or nonexistent,
the opportunity to commit fraud is considerably greater.
This is especially true in what we regard as the relatively
small or medium-sized corporations including those which are
closely-held or family-operated; those whose corporate owners
or officers can influence, direct, or themselves make
accounting entries, alterations, disbursements or other
transactions; and those whose business receipts or purchases
are to a large degree in the form of cash. There is a
greater degree of probability of fraudulent activity in such
circumstances, and indeed, fraudulent activity is frequently
uncovered while auditing these type of corporations.
Usually upon completion of the initial interview, the auditor
will be provided with certain corporate books, records, and
reports. The taxpayer should be asked by the auditor to
briefly review what is being provided. While this is being
done, the auditor should check any document requests
previously made, e.g., in an appointment confirmation letter,
to note what has not been provided. Any missing records
considered important should be noted and again requested.
The auditor is now generally free to begin auditing the
records; however, before doing so and if it hasn=t been done
already, any information learned up to this time which has
not been recorded, such as that learned during the initial
interview, should be written down while it is still Afresh@ in
the auditor=s mind. The recording and documenting of all
information should be done as soon as possible throughout the
audit. It is also important to write down and keep lists of:
a. further questions to ask resulting from the audit of the
records;
b. further documents or information to request;
c. any discrepancies noted in the audit of the returns or
records;
d. audit adjustments to be made; and
e. any thoughts which the auditor may think of that could
possibly be relevant to the audit.
Normally the records and supporting documents the auditor
will be auditing depends on such variables as the type of the
audit being conducted and the assessment of the records
provided, the record keeping, and internal controls. If the
audit is of a large publicly-traded multistate or
15
multinational corporation with internal controls in place,
the audit may not deal with or be focused on the
understatement of gross receipts or the source documents
behind business deductions - leaving the audit of these
instead to the Internal Revenue Service. An exception to
this may be for some large unusual account or expense noted
by the auditor. Another exception may be for any corporation
where an expense or credit directly affects only New York
income or the computation of New York tax, such as a tax
credit or an item of income or expense related to other than
business capital. In these cases, it may be necessary to
request and examine source documents for verification.
Another audit area common to the audit of all corporations
and one of particular concern is the examination of relatedparty transactions, whether they be between the taxpayer and
its affiliated corporations, partnerships, or owners. The
auditor should analyze these thoroughly for the possibility
of uncovering some tax scheme or misconduct involving the
shifting or understatement of income or the shifting or
overstatement of expenses. If anything is uncovered, it
should be documented and attempts made to trace it back to
its origin.
An audit of the small or medium-sized corporation where
internal controls and record keeping are inadequate or where
the business has extensive cash transactions will require the
auditor to probe more deeply into the verification of income
and expenses. Source documents, inventory records, bank
records, check payments, cash disbursements, investment
accounts, loan details, personal tax returns of corporate
owners or possibly even those of family members may be
required for analysis. One or more of the methods used to
reconstruct receipts (source & application of funds, bank
deposit, net worth) may have to be done to either verify the
reported income or uncover its understatement. If there is
evidence or the likelihood of understatement, skimming, or
other wrongdoing, the auditor will also have to take into
account the personal income, expenses, assets, liabilities,
and lifestyle of the corporation=s owners, officers, and
possibly even family members.
Finally, one of the easiest ways fraud is uncovered is by
someone who has knowledge of it telling someone else. Some
corporations even employ the use of hotlines for this
purpose. Just as corporations therefore occasionally learn
from their employees of fraudulent activity occurring within
the corporation itself, so also does the department
16
occasionally learn from informers about taxpayer fraud,
including that of corporations. When this happens, the
auditor usually is informed about the alleged fraudulent
activity and will proceed with the audit either to prove and
document or disprove the allegation.
F
SALES TAX
1. OVERVIEW
Sales tax is a transaction tax, with various elements
combining to determine what should be correctly reported on a
sales tax return. The vendor collects the tax as an agent of
the State, and has a fiduciary responsibility to report and
remit the tax on its sales tax returns. A sales tax fraud
occurs when a vendor intentionally evades the collection or
payment of tax to the State. Another tax fraud occurs when a
taxpayer intentionally avoids paying a use tax that he or she
knew was due. Fraud also occurs when someone knowingly
requests and obtains a refund even though use tax was never
paid originally.
When fraud occurs at the time of a transaction, usually the
cooperation of the customer is involved. For example, a
company sells and delivers an item in New York, but claims
that delivery occurred outside the state, thus not imposing
tax on the sale.
Most fraud occurs during the recording and the reporting
process. The simplest of evading schemes is to misstate on
the books and records the receipts or sales tax collected.
These schemes involve the misstatement of the business
transactions and activities on the books and records and/or
failure to record business transactions and activities on the
books and records. The challenge for the auditor is to
detect and document the fraud, and the extent to which it
takes place (i.e., audit area and amount).
2. PRE-AUDIT ANALYSIS
Signs of fraud may be found as early as the pre-audit
analysis. For example, are the gross sales per the sales tax
returns consistent with the corp tax filings? Do the
expenses of the business, per the corp tax returns, exceed
the gross receipts? Is the taxable ratio within the expected
range for the industry? Is there a trend in reporting, or do
sales fluctuate without a pattern? Has the business been
17
subject to public investigations for questionable business
practices or other tax problems? All of these, and more, are
indicators of possible fraud activity.
Review the transcript summarizing all recent sales tax return
activity. Look to see if credits have been used to reduce
the sales tax due, or if any refund claims have been filed
and paid in the audit period. If so, during the audit, the
auditor must make certain these refunds/credits were actually
due.
Understanding the business, and its general industry, can
allow the auditor to see discrepancies that may point to
fraud activity. For example, would we expect a plumber who
advertises AEmergency 24/7 service@ to have mostly exempt
sales? Or a used car dealer, specializing in vehicles under
$5,000, to have trade-ins on most sales? Or a liquor store
to have a sizable percentage of exempt sales? The failure to
understand the nature of the business may result in
accepting, as fact, information that should be an indicator
of fraud.
3. DURING THE AUDIT
Early in the audit, the auditor should identify those people
who have control over the business operations and the sales
tax reporting. One or more of these individuals must be
involved to create a business fraud. While these individuals
are most likely those who will be identified as responsible
officers, it=s possible that individuals outside the business
may commit the fraud.
Certain circumstances are more likely to lead to fraud
activity. It is easier to commit fraud in a small business,
with little or no delegation of duties. Also, it is easier
to manipulate cash sales than credit card, check, or accounts
receivable sales. Remember that adequate records require
more than the ability to trace a transaction to the return.
The lack of internal controls can be the basis for labeling
books and records inadequate. Where otherwise adequate books
and records are not supported by a good internal control
system, the auditor should use an alternate methodology to
determine the adequacy of the records.
Understand how a transaction is initially recorded, how it is
entered into the books, who has the ability to make
adjustments to accounts, and how the sales tax return is
18
prepared. At a larger level, understand the terminology and
common business practices that exist within an industry. For
example, the corner bar and the national bar/restaurant offer
similar services, and have similar issues. But the
differences can be striking. For example, a corner bar is
operated by the owner, who works most hours the business is
open. The owner waits on the customers, runs the register,
makes deposits, keeps the books, pays the bills, and gives
the information to his accountant for filing the sales tax
returns. In comparison, the national chain is publicly-owned
and subject to SEC filing requirements. Each location is
operated by a commonly-trained management staff, and has the
same strict guidelines for the recording of transactions,
handling of receipts, and other business matters. All
transactional data is recorded with sufficient detail, and is
sent to a central location for processing.
Once the audit is underway, it is critical to reconcile the
transactions to the books and records, and the books and
records to the filed returns. Review the deposits of the
company, along with any credit card sales or accounts
receivable. One of the simplest methods of tax fraud is to
keep a stream of income off the books. For example, a
business with multiple cash registers may choose not to
record the receipts from one cash register. When bank
deposits exceed gross receipts, the disparity should be
investigated. Also, if the company maintains a sales tax
payable account, make certain that all tax collected is
recorded, and that all reductions from the account are for
proper refunds to customers, adjusting entries, and payments
to the State.
In the most difficult of fraud cases, a taxpayer may have
gone to the difficulty of recreating the source
documentation, so that the books and records allow a smooth
reconciliation from transaction to reporting. This will
typically occur in a small business, where few individuals
have access and control of the business records. This is a
good example of why we use certain audit techniques to
determine the adequacy of the business records. Some of
these audit techniques are requests for third party
information and observation tests. Third party requests can
be made to customers, vendors, and government agencies.
Observation tests involve a methodical observation of
business activity to determine how present activity matches
up with the activity in the books and records.
19
G.
MISCELLANEOUS TAXES - FIELD AUDIT
1. FUEL, ALCOHOL, CIGARETTE AND CARRIER TAXES
a. OVERVIEW
Most miscellaneous taxes are transaction taxes, with
various elements combining to determine what should be
correctly reported on the appropriate tax returns. The
vendor collects the tax as an agent of the State, and has
a fiduciary responsibility to report and remit the tax on
its miscellaneous tax returns. A miscellaneous tax fraud
occurs when a vendor intentionally diverts tax from the
State. A use tax fraud occurs when a taxpayer
intentionally avoids paying a tax that he or she knew was
due. Fraud also occurs when someone obtains a refund even
though use tax was never originally paid.
Fraud typically occurs at one or more of three distinct
points: the transaction, the entry into the books and
records, or the reporting. Occasionally, fraud occurs at
the time of the transaction. This usually requires the
cooperation of the customer. For example, a company sells
and delivers fuel, cigarettes or alcoholic beverage in NEW
YORK, but claims that delivery occurred outside the state,
thus not imposing tax on the sale.
Most fraud occurs at the recording and the reporting. The
simplest of schemes is to misstate what is in the books
and records on the return. However, most fraud also
involves the misstatement of the business activity in the
books and records. The difficulty for the auditor is to
detect and document the fraud.
b. PRE-AUDIT ANALYSIS
Signs of fraud may be found as early as the pre-audit
analysis. For example, is a motor fuel distributor who is
located in the middle of the state making large amounts of
transfers out of state? Is a fuel business not located
near any Indian reservations making large quantities of
sales to Indian reservations? Is there a disproportionate
amount of exempt sales to exempt organizations or
government agencies? Do the expenses of the business, per
the corp tax returns, exceed the gross receipts? Is there
a trend in reporting, or do sales fluctuate without a
pattern? Has the business been subject to public
20
investigations for questionable business practices or
other tax problems? All of these, and more, are
indicators of possible fraud activity.
Review the third party information submitted from other
states and suppliers; for example, Schedule 10's,
transporter reports, suppliers= returns, etc., for
quantities of fuel, cigarettes and alcoholic beverages,
depending on the type of audit. Look to see if credits
have been used to reduce the miscellaneous tax due, or if
any refund claims have been filed and paid in the audit
period. If so, during the audit, the auditor must make
certain these refunds/credits were actually due.
Understanding the business, and its general industry, can
allow the auditor to see discrepancies that may point to
fraud activity. For example, is a diesel distributor
reporting large amounts of kerosene sales in the summer
months? Is a construction business filing highway use tax
returns that do not increase miles during the summer
months which would be their busiest season? Is an IFTA
carrier located in Northern New York reporting a higher
percentage of New Jersey miles as opposed to New York
miles? These could all be possible signs of fraud, so it
is important to understand the nature of the business so
that the auditor does not accept, as fact, information
that should be an indicator of fraud.
c. DURING THE AUDIT
Early in the audit, the auditor should identify those
people who have control over the business operations and
the miscellaneous tax reporting. One or more of these
individuals must be involved to create a business fraud.
While these individuals are most likely those who will be
identified as responsible officers, it=s possible that
individuals outside the business may commit the fraud.
Certain circumstances are more likely to lead to fraud
activity. It is easier to commit fraud in a small
business, with little or no delegation of duties. Also,
it is easier to manipulate cash sales than credit card,
check, or accounts receivable sales. Remember that
adequate records require more than the ability to trace a
transaction to the return. The lack of internal controls
can be the basis for labeling books and records
21
inadequate. Where otherwise adequate books and records
are not supported by a good internal control system, the
auditor should use an alternate methodology to determine
the adequacy of the records.
Understand how a transaction is initially recorded, how it
is entered into the books, who has the ability to make
adjustments to accounts, and how the miscellaneous tax
return is prepared. At a larger level, understand the
terminology and common business practices that exist
within an industry.
A small motor fuel distributor and a major oil company
offer similar services and may have similar audit issues;
however, the differences can be striking. For example, a
small distributor may have the product purchased, loaded
and delivered by the owner, who also pays the bills, makes
the deposits, keeps the books and also gives the
documentation to the accountant to prepare the returns.
Whereas, the major oil company is publicly-owned, and
subject to SEC filing requirements. Each location is
operated by a commonly-trained management staff, and has
the same strict guidelines for the recording of
transactions, handling of receipts, and other business
matters. All transactional data is recorded with
sufficient detail, and is sent to a central location for
processing.
Once the audit is underway, it is critical to reconcile
the transactions to the books and records, and the books
and records to the filed returns. Review the deposits of
the company, along with any credit card sales or accounts
receivable. One of the simplest methods of tax fraud is
to keep a stream of income off the books. For example, a
trucking company with multiple terminals may choose not to
report the mileage from one or more of the terminals.
When disparities on Thruway statements indicate additional
vehicles exist, this would need to be investigated
further. Also, if the company maintains payroll records,
it may be possible to verify the existence of additional
drivers.
In the most difficult of fraud cases, a taxpayer may have
gone to the difficulty of recreating the source
documentation, so that the books and records allow a
smooth reconciliation from transaction to reporting. This
will typically occur in a small business, where few
22
individuals have access and control of the business
records. This is a good example of why we use an
investigative technique to determine the adequacy of the
business records. Common investigative techniques are
requests for third party information and observation
tests. Third party requests can be made to customers,
vendors, and government agencies. Observation tests
involve a methodical observation of business activity to
determine how present activity matches up with the
activity in the books and records.
2. MORTGAGE RECORDING TAX
a. OVERVIEW
The Mortgage Recording Tax is an excise tax imposed on the
privilege of recording a mortgage. It is extremely
unlikely that fraud would occur in a mortgage transaction
due to the lenders security interest in the property. If
fraud did occur, however, it would usually require the
cooperation of both the Mortgagor (borrower) and Mortgagee
(lender). In most cases, there would also be some
collusion on behalf of their representatives (e.g.,
attorney, title company).
b. PRE-AUDIT ANALYSIS
For the most part, mortgages are recorded and are never
audited by the Department. However, as part of our
administrative responsibilities, we are required to review
all claims for refunds. Accordingly, any signs of fraud
may be found during the initial review of the claim and
will probably be based on your personal experiences of
doing prior audits of refund claims.
c. DURING THE AUDIT
Although during the pre-audit analysis of the claim for
refund you may become suspicious of fraud, you ordinarily
will not find firm indicators of fraud until you ask for
and examine the documentation for the transaction. This
documentation includes: a copy of the recorded mortgage, a
County Clerk receipt of taxes paid, affidavits or any
other information which may be available such as a title
insurance policy.
23
A complete and thorough examination of these documents and
comparison to the information reported on the return
should give you a clearer idea if the parties intended to
commit fraud.
3. REAL ESTATE TRANSFER TAX (RETT)
a. OVERVIEW
RETT is a transaction tax, with various elements combining
to determine what should be correctly reported on the RETT
return. This tax includes a “mansion tax” which assesses
a 1% tax on sales of residential real property over
$1,000,000. A RETT fraud occurs when a taxpayer
intentionally conceals or misrepresents facts which
results in an understatement of tax liability. Fraud also
occurs when someone seeks to obtain a refund even though
the taxpayer knows the tax was never paid originally.
Fraud would typically occur at one of two distinct points:
the transaction or the reporting. If fraud occurs at the
time of the transaction, this would usually require the
cooperation of both the Grantor (seller) and Grantee
(buyer). In most cases, there would also be some
collusion on behalf of their representatives (e.g.
attorney, title company). If fraud occurs at the time of
reporting, the likelihood is that the RETT return has been
intentionally altered after the return has been signed by
either the Grantor or Grantee.
b. PRE-AUDIT ANALYSIS
Signs of fraud may be found during the initial review of
the returns you have for audit. This will probably be
based on your personal experiences and tailored toward the
type of transaction you are assigned to audit.
The primary areas in which fraud will occur are as
follows:
- the intentional understating of consideration;
- the intentional claiming of a deduction, credit or
exemption to which the parties are not entitled; and
- the intentional misrepresentation of the type of
24
property conveyed to avoid the Amansion@ tax.
c. DURING THE AUDIT
Although during the pre-audit analysis of the return you
may become suspicious of fraud, you ordinarily will not
find firm indicators of fraud until you ask for and
examine the documentation for the transaction. This
documentation includes: the contract of sale, any
mortgages on the property, an independent appraisal of the
property or any other information which may be available,
such as a title insurance policy.
A complete and thorough examination of these documents and
comparison to the information reported on the return
should give you a clearer idea if the parties intended to
commit fraud.
H.
MISCELLANEOUS TAXES (FUEL, ALCOHOL, CIGARETTE AND CARRIER
TAXES)-DESK AUDIT
1. BEVERAGE TAX
a. OVERVIEW
In determining whether there is any intent to evade tax,
the technician should review any of the discovered badges
of fraud or acts of conduct with his team leader, and
determine whether any inferences of fraud may be drawn.
However, the taxpayer must be given an opportunity to
explain every questionable item. In addition, a referral
to Field Audit may be discussed.
b. PRE-AUDIT ANALYSIS
Before the audit is started, the technician should
consider looking for the following fraud indicators:
- Reputation of the taxpayer based on previous business
dealings;
- Statements by, or squeal letters from, former employees
or significant other partners; and
- Prior prosecution for filing a false instrument.
25
c. DURING THE AUDIT
Some of the common indications of fraud to look for during
the audit, and which may point to a tax evasion for
Beverage Tax (Understatement & Fictitious or Improper
Reporting), are:
- Improper movements of tax-free product to and from
surrounding states;
- Substantial reported loss and waste without
substantiation;
- Substantial reported product theft without police
reports or insurance reports;
- Large, unreported, tax-free products imported from out
of state sources;
- Large, unreported, tax-free products from foreign
countries;
- Daisy chain operation when a distributor moves product
from one distributor to another;
- Continual underreporting of the alcoholic content of
imported product, so that a reduced tax rate will be
paid;
- Importing and selling product while not being
registered;
- Inability to verify transactions with other parties;
- Attempts by taxpayer to hinder the investigation; and
- Filing a false affidavit regarding the taxpayer=s
operations.
2. CIGARETTE TAX
a. OVERVIEW
All cigarettes possessed in New York State by any person
for sale are subject to the cigarette tax. The evidence
of payment of this tax is the cigarette stamp which is
affixed to each pack of cigarettes. The tax on cigarettes
26
held for sale is imposed at a rate of 75 cents for each 10
cigarettes ($1.50 for a standard pack of 20 cigarettes).
The rate of tax on the cigarette packs in excess of 20 is
372 cents for each five cigarettes or fraction thereof.
It shall be presumed that all cigarettes within the state
are subject to tax until the contrary is established and
the burden of proof that any cigarettes are not taxable
shall be upon the person in possession of such cigarettes.
Although the cigarette tax is legally imposed on the
consumer, such tax is advanced and paid by licensed
cigarette agents. An agent is thus liable for the
collection and payment of the tax on cigarettes it
possesses within the state for sale. The agent pays the
tax to the Department of Taxation and Finance by
purchasing stamps from the fiscal agent or agent bank duly
authorized to sell stamps on the Department=s behalf.
Agents located both inside and outside the state shall
purchase such stamps and affix such stamps, in the manner
prescribed, to packages of cigarettes to be sold within
New York State.
Every licensed cigarette agent must file a monthly
cigarette tax information report with the Department. The
agent must account for all stamps purchased as well as its
stamped and unstamped inventory. Refunds for the
cigarette tax may be requested by the agents within two
years from the date the stamps are purchased or affixed.
Fraud may occur at the time of the affixing of the stamps
by the agents and at the time they request a refund.
b. PRE-AUDIT ANALYSIS
Signs of fraud may be found during the initial review of
an agent=s reports. If the report shows that the amount
of stamps used for the period does not equal the amount of
stamps required to be used, understamping or overstamping
may have occurred. Any difference in these amounts must
be explained by the agent on the back of the report. Each
month stands on its own merits.
If the agent=s reports show a consistent pattern of
understamping or overstamping or a large discrepancy, the
unit supervisor should notify the program manager and
recommend that the case be referred for a field audit to
27
be conducted. At that point, the auditor can take a closer
look at the books, records, stamp purchases, and actual
inventory of the agent.
Fraud may also occur when the agent requests a refund.
The required documentation necessary for requesting a
refund is an affidavit from the manufacturer stating that
it has received a specific number of stamped product back
from the agent, either damaged or stale.
c. DURING THE AUDIT
The primary areas to search for fraud during the audit
are:
- The agent=s reports indicate that there were fewer
stamps affixed than should have been affixed, resulting
in understamping. The agent may be affixing only half a
stamp to each pack of cigarettes.
- The agent could submit duplicate or fraudulent
manufacturer affidavits with the refund claim. This is
done when requesting a refund of the stamped product
that is returned to the manufacturer.
3. FUELS AND HIGHWAY USE TAXES
a. OVERVIEW
Detection of fraud in the course of a desk audit tends to
be difficult, due to the limited information that we
generally have to work with, but it is not impossible.
The guidance provided in the field audit section also
applies in desk audit, but the identification of fraud
will usually come from a direct comparison of information
from two or more independent sources.
b. PRE-AUDIT ANALYSIS
The following are examples of the types of situations you
should be looking for before you begin the audit:
- A bus company files a refund claim based on operation of
vehicles under contract with a school district.
However, when contacted for a copy of the contract, the
claimant can=t produce one, and the school district says
it has no contract with the bus company.
28
- Reports are received from other states (commonly called
ASchedule 10s@) which indicate recurring exports to a
distributor in New York, yet the distributor=s returns
do not include any imports.
- Documents or copies submitted to support a refund claim
appear to be altered with changes to the purchaser,
date, quantity or tax-paid status. Verification may be
requested from the supplier and if the supplier=s
information does not agree, this could be an indicator
of fraud.
- A Retailer of Heating Oil Only (“ROHO”) located within a
locality that does not exempt home energy from sales tax
who nonetheless files zero or very low dollar sales tax
returns.
c. DURING THE AUDIT
When you find situations where you=re making substantial
adjustments (as either a percentage of reported/claimed or
total tax dollars involved), stop for a moment and think
about what innocent mistakes or oversights might have led
to the errors you=re correcting. If you can=t imagine a
set of circumstances in which an honest misunderstanding
or even careless oversight led to the errors, then discuss
with your supervisor the possibility that fraud was
involved.
Some of the most common indications of fraud which may
point to some form of tax evasion schemes are as follows:
Highway Use Tax - (Understatement or Failure to File)
- Taxpayer reports New York miles on IFTA and reports $0
tax due on his Highway Use Tax Reports.
- Taxpayer files -0- tax returns for periods after an
audit, even though taxpayer has valid permits for the
current series, and is found to be operating in the
state.
- Taxpayer permits his vehicles well below his registered
maximum gross weights, and reports his liability on the
Maximum Gross Weight method.
29
- Taxpayer continually re-permits his vehicle under
different corporations to avoid incurring any road tax
liability.
- Taxpayer gets permits in his own name and reports that
another taxpayer is responsible for the tax. However,
this person is not permitted and cannot be located.
Acts by a taxpayer which may indicate that fraud may
have occurred:
- False statements about a material fact involved in the
audit;
- Inability to produce records involving transactions with
other parties;
- Attempts by the taxpayer to hinder the technician or a
refusal to cooperate;
- The reputation of the taxpayer or the taxpayer=s
representative in previous audits;
- Inconsistent and illogical explanations of questionable
operations;
- The taxpayer or the taxpayer=s representatives= previous
knowledge of road taxes and business practices which are
inconsistent with numerous questionable operations in
the state;
- Statements by, and squeal letters of, former employees
or significant other partners; and
- Prior criminal wrong doing by the taxpayer or the
taxpayer=s representative;
In determining whether there is an intent to evade tax,
the technician should review the information with his or
her supervisor and determine whether there is a
possibility of fraud. However, the taxpayer must be given
the opportunity to explain every questionable item and the
explanation should be evaluated in the light of what a
reasonable person would have done. In addition, referral
to Field Audit for further investigation should be
considered.
30
4. IFTA
a. OVERVIEW
Motor carriers report fuel used in all jurisdictions that
participate in IFTA. They may purchase fuel and travel
through a number of different states and provinces in the
course of their business. Fuel purchased in one
jurisdiction may be used in another. Fuel and applicable
taxes are usually paid at the pump when purchased, but
fuel tax rates vary from jurisdiction to jurisdiction.
The motor carrier is required to pay the fuel tax rate for
the jurisdiction where the fuel is used. Fuel purchased
in a jurisdiction with a lower tax rate, but used in a
jurisdiction with a higher tax rate, would result in
additional fuel tax due to the highest jurisdiction. Fuel
purchased in a jurisdiction with a higher tax rate and
used in a jurisdiction with a lower tax rate would result
in a credit for fuel tax paid. The motor carrier must
maintain records of fuel purchased, fuel tax paid, and
miles traveled.
The IFTA member jurisdiction reports all fuel taxes owed
to any other IFTA member jurisdiction to the licensee=s
base jurisdiction. Additional fuel tax due and fuel tax
credits are netted on the return. The base jurisdiction
collects any tax due from the carrier. Credits are
accrued with the base jurisdiction and a refund may be
requested by the carrier. Refunds are processed by the
carrier=s base jurisdiction which nets all returns,
distributes monies to, and collects monies due from the
individual jurisdictions.
The IFTA licenses and decals are issued by the motor
carrier=s base jurisdiction and must be renewed annually.
The applicant is not required to identify the motor
vehicles used and the decals are not assigned to specific
motor vehicles.
Audits are conducted by the IFTA carrier=s base
jurisdiction.
b. PRE-AUDIT ANALYSIS
The auditor should check TID to see if the company is
associated with any other taxes, especially Highway Use
Tax. It=s possible for the carrier to only be associated
31
with IFTA, but this would be rare. The IFTA Only Filers
report will be in production soon. This will be a
quarterly report listing carriers that are filing for IFTA
only or IFTA and Highway Use Tax.
The IFTA registration should be checked to see how many
vehicles are registered. Looking at the IFTA schedule for
miles traveled, you can determine if the miles claimed is
reasonable, considering how many vehicles are registered.
The IF-1945, Excessive Miles Reported Per Vehicle Report,
lists these filers with excessive miles traveled based on
the number of vehicles registered.
A check to see if only post office addresses are given,
might indicate a problem. Has the carrier given a phone
number for its company?
c. DURING THE AUDIT
The schedule should be checked to see if there is a
pattern of all fuel being purchased in the high rate
jurisdictions and used in the jurisdictions with the lower
rates. If a taxpayer claims it is tax exempt, a check
might be done to determine if the vehicle is used for
purposes other than the exempt purpose the carrier claims.
If either of these conditions exist, the auditor should
alert the Program Manager to advise if this information
should be given to Field Audit for further review.
The following examples are types of situations that the
auditor should be looking for during the audit:
- Carrier reports tax paid gallons for fuel purchased
resulting in a refund by a company that doesn=t exist.
- Carrier overstates miles traveled and tax paid gallons
resulting in a larger refund.
- Carrier erroneously often reports purchase of fuel in
higher rate jurisdictions and used in jurisdictions with
low rates.
- Carrier claims vehicle exempt when the vehicle is used
for other purposes.
With the exception of the first example, these issues
would have to be addressed by the field auditor, who would
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be examining the carrier=s books and records.
5. REGISTRATION & BOND (FUELS, CIGARETTE/TOBACCO,
ALCOHOLIC BEVERAGE)
a.
OVERVIEW
We attempt to identify fraud through the use of our
mainframe applications, Department of Motor Vehicles
records, internet resources, requesting specific
information and/or documentation from the applicant, Field
Audit Management interviews with the applicant, and
through a thorough review of the information supplied on
the application itself. Every attempt is made to ensure
the license is legitimately obtained in an effort to
maintain fairness in our process, to protect the interests
of the Tax Department and New York State, and to enforce
compliance with the Tax Law.
The primary type of fraud encountered in the registration
process, especially with fuel registrations, is an
applicant attempting to procure a license for someone who
is unlicenseable.
b. PRE-AUDIT ANALYSIS
Some, but certainly not all, indicators of possible fraud
are:
- Applicant listing the same phone number, business
address, and/or assets (i.e., vehicles, customers list,
FAX machine, etc.) of a recently canceled licensee;
- Applicant with no experience in the fuel business
(usually a relative or friend of a recently canceled
licensee);
- Applicant listing a business name similar to one which
was recently canceled (e.g., Flying High Oil
Company/High Flying Oil Corp.);
- Applicant unable to answer even the most basic questions
about the business;
- Applicant with no visible income starting a business
listing assets far beyond his or her means;
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- Applicant unable to provide documentation that would
statement is provided showing $50,000 in cash but the
normally be readily available (e.g., if a financial
applicant is unable to provide bank statements
substantiating that claim);
- Applicant claims sole responsibility for all duties
relative to the business, including driving the fuel
delivery vehicle, yet does not possess the requisite
commercial driver=s license;
- Applicant fails to disclose other businesses in which he
or she has an ownership interest or is considered a
Aresponsible person@;
- Applicant provides one or more phone numbers at which he
or she is never available and must always return our
calls;
- Vague, inconsistent, contradictory and illogical
explanations when asked for information; and
- Applicant lists the same home address and/or phone
numbers of a recently canceled licensee.
c. DURING THE AUDIT
Any one of the examples in the preceding section does not
necessarily indicate a fraudulent application, but the
more examples encountered, the stronger the possibility
exists. Some of the noted schemes may be utilized for
procurement of cigarette/tobacco or alcoholic beverage
licenses, but these ploys are much more prevalent relative
to fuel licenses.
One area of concern is cigarette chain store licenses.
It=s possible that an applicant may attempt to procure a
cigarette chain store business license by fraudulently
listing businesses which are fictitious or are not owned
by the applicant. Possession of the license allows the
person to purchase cigarettes at a reduced price under the
Cigarette Marketing Standards Act price structure.
Indicators to look for during the audit to detect fraud
are:
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- Legal name or d.b.a. inconsistent with a cigarette
business, e.g., AJosie=s Ice Cream Parlor and Smokes@;
- Address on phone disc does not show any type of business
activity; and
- Applicant that owns several established businesses and
suddenly registers several new businesses as cigarette
retailers close to the time of filing the application.
By registering these new businesses, the applicant now
has at least the requisite 15 locations to qualify for
the license.
6. ESTATE TAX
a. OVERVIEW
The estate tax is an excise tax levied upon the transfer
of a person=s property at the time of that person=s death.
The basis of the tax is the value of those assets. The
estate=s representative must identify all of the decedent=s
assets, file an estate tax return when required, and pay
the tax due, if any. Estate tax has a unique feature in
that the individual who may have known the most about the
estate (the decedent) is not available to assist with the
return=s preparation; therefore, it is more difficult to
determine whether the actions taken by the estate=s
representative were deliberate, or whether they were just
an honest misunderstanding or accidental error. In estate
tax, there are also many issues which lend themselves to
an abundance of avoidance strategies providing an
alternative to outright evasion. Fraud detection is every
technician=s business. We have the obligation to identify
situations where individuals try to beat the estate tax by
failing to file returns or by filing false returns. Your
fraud awareness will go a long way to assist our Revenue
Crimes Bureau (RCB) to identify and develop a potential
fraud issue when it exists. We can be a useful tool in the
Department=s effort to successfully prosecute tax fraud.
b. PRE-AUDIT ANALYSIS
Fraud is seldom apparent on the face of a return and is
rarely discovered from a cursory review of the taxpayer=s
return. Regardless of what audit technique the technician
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uses, every audit should begin with a pre-audit analysis,
which is an analytical review of the return information
along with the information contained in the various
documents submitted with the tax return. Third party
sources, such as the internet or other Department data,
should also be used. At this time, you should identify
the issues to be addressed in the audit covering all
aspects of the return. As you perform your analysis of
the information in the return and the information
available in the case folder, write down your questions
and thoughts. Make sure you get answers to your questions
during the audit. Many answers may lead you to ask
follow-up questions. Make sure you follow through on a
line of inquiry until you are satisfied with the answers
provided (supported by documentation and facts).
Your pre-audit analysis will be based upon your personal
experiences and tailored to the individual return you are
assigned to audit. You will consider at least briefly
almost all of the entries on the return. Consider the
filing status (resident or non-resident), the size of the
estate, the assets reported and any other facts you have
available.
Prior years’ income tax returns can assist you in
estimating the value of certain assets and assist in
identifying other assets which may not be included in the
estate tax return. Look for such items as: interest
income, dividend income, rental income, Schedule C profit
and loss (small business), trust income and other income.
This income tax information may help you identify areas of
potential fraud on the estate tax return.
The relationship of certain items on a tax return can
raise pertinent questions for pre-audit analysis.
For example:
- The value of the decedent=s residence and the address of
such residence may suggest a standard of living that is
inconsistent with the rest of the assets reported on the
return or the lack of other assets reported.
- A deduction for a mortgage on real estate while no
corresponding real property is reported as an asset must
be reconciled.
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- The predeceased spouse died two years prior to the
decedent. Is the current estate consistent with what was
reported and how the assets of the first estate were
distributed?
c. DURING THE AUDIT
Early in the audit, the technician should identify those
individuals who have control over the estate and the
estate tax reporting. One or more of these individuals
must be involved to create estate tax fraud.
As a technician, you are responsible for enforcing the Tax
Law. If you come across situations where there are
indications of fraud, you will need to develop them as you
perform your audit. Tax fraud can rarely be identified on
the face of a return. You must dig beneath the surface if
warranted, to discover the true nature of what has
occurred. In a fraud case, the burden of proof falls
fully on the Department to show the fraud was the intended
course of action by the individual. Once the audit is
underway, it is critical to reconcile discrepancies by
first giving the estate the opportunity to explain the
discrepancies. There could be a very good reason or
explanation for what would otherwise appear to be an
indication of fraud. If the estate cannot provide you
with a satisfactory explanation, then you will need to
examine further documentation, obtain third party
information, complete a thorough review of the
documents/information and compare all of this with the
information reported on the return.
You should perform the audit using established policies
and procedures. You must confer with your supervisor on
the details of the audit and never inform the estate of
the audit finding or issue an assessment without the
approval of your supervisor and section head.
The importance of work papers in a potential fraud case
cannot be over emphasized. All relevant statements from
the estate representative, the representative=s attorney,
and third parties should be documented immediately and
supported by evidence wherever available. Work papers
should always be legible (typed if possible), initialed,
dated, and in complete agreement with any reports on the
audit.
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Some examples of situations to look for during an audit
are:
- An executor (the decedent's son) claims a marital
deduction on the decedent's estate tax return when the
son is well aware that the decedent's spouse died before
the decedent.
- You discover an unreported estate asset relating to
reported income generated from an intangible asset. The
joint tenant (the executor) on the account withdraws all
the funds from the joint account after the date of death
but before the bank knows about the death of the
depositor. The executor, knowing about the account,
does not report the asset on the estate tax return.
- A large amount of insurance proceeds are reported on the
estate tax return along with stock, cash and real
property. The real property was sold two months after
death for $500,000 to a third party at arms length. The
executor obtains a real estate appraisal for the
property valued at $150,000 and reports the lower value
on the estate tax return.
In all of the above cases, the executor is well aware of
the filing requirements and what has to be reported for
estate tax purposes.
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