The penalties for tax fraud–the willful attempt to evade or defeat the payment of tax–are steep. For instance, under Internal Revenue Code section 6663(a) (dealing with civil fraud penalties), if any part of the underpayment of tax required to be shown on your return is due to fraud, the penalty is 75% of the portion of the underpayment attributable to fraud. Criminal fraud penalties can be as high as $500,000, and involve jail time as well.
To impose fraud penalties, the IRS has to prove, by clear and convincing evidence, that you underpaid your tax and that the underpayment was due to fraud. The IRS can prove fraud by circumstantial evidence, and your conduct may establish the requisite fraudulent intent.
“Badges of fraud” are circumstances that show intent to defraud. The term dates back to at least the year 1601 CE, to a case involving a fraudulent deed (Twyne). In tax cases, badges of fraud include failure to report substantial amounts of income from business activities, failure to file returns, failure to keep records, and implausible explanations of behavior.