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Don’t fixate on the numbers

Overreliance on income tax data



April 2013

income-tax-fraud.jpgThe home of former U.S. vice presidential candidate Sarah Palin now has another claim to fame. In spring 2012, the U.S. Internal Revenue Service (IRS) charged a Wasilla, Alaska, tax preparer with six counts of preparing false tax returns. Two factors make this scheme particularly interesting: 1) the tax preparer laundered illegal drug profits by setting up a fake company to mask the true source of income and profits and 2) even though the preparer had little professional and technical training and limited experience, the deception was innovative and complex.

Normally, authorities charge tax evaders when the criminals either underreport illegal activities or don’t report them at all. Interestingly, in this case, the tax preparer went one step further: The false business she created for her client allowed him to obtain credit through local financial institutions.

This fraud scheme will be relevant especially to small- and medium-size banks and credit unions, auto finance companies and even mortgage companies because they often don’t have expert in-house fraud groups that can detect questionable clients or customers. These financial institutions, when vetting self-employed individuals and small businesses for creditworthiness, normally rely heavily — if not exclusively — on federal income tax returns. (A coauthor of this article serves on the board of a local credit union with assets of $125 million. Its loan policy explicitly requires the most recent two years of federal tax returns for small business and self-employed borrowers.) Firms that examine potential borrowers seldom investigate tax return information beyond obtaining and comparing IRS copies. This is poor procedure as we show in this case.

THE DRUG DEALERS' ACCOUNTANT 

Beginning in the spring of 2007, Jamie Powell (not her real name) began preparing false tax returns for a local drug dealer we’ll call BJ, and his wife. The returns reported a portion of BJ’s illegal income as legitimate construction company profits. Powell, who also apparently bought drugs from BJ, worked hard to make his income look legitimate even though she lacked accounting education or extensive professional experience. (Powell billed BJ and his wife tax preparation fees that were 20 times greater than those she charged her legitimate clients.)

The elaborate scheme included fake sales receipts, purchase invoices and bills of sale and other supporting source documents just in case the IRS audited BJ. The reported income omitted enough of BJ and his wife’s true income so they could also qualify, and receive, the earned income credit. Eventually, Powell prepared and filed prior year false income tax returns back to 2003 for BJ and his wife. They used these false returns to apply for and obtain loans to purchase vehicles and obtain credit cards. 
 


According to court records, Powell had another drug dealer client referred to as “DH,” who preceded BJ. Powell performed nearly identical services for DH — preparing false income tax returns and supporting documentation — but DH’s income was substantially greater, and she helped conceal the illegal drug proceeds by creating two fictitious businesses. DH also used the income substantiated by these false income tax forms to dupe financial institutions into giving him credit cards and loans.

DETECTION METHOD(S)

How did the IRS discover this scheme? The court records only show that an IRS agent — posing as a potential client — requested Powell to prepare his federal income tax returns with false information to make his illegal drug profits appear as legitimate business income. She even offered her “bonus” service of preparing fake supporting source documents for him in case the IRS would audit him. After she performed her services and received payment she was arrested.

While the IRS isn’t saying exactly how it initially identified Powell, we suspect this case isn’t unique. Presently, the U.S. federal government doesn’t restrict who can prepare federal tax returns. (Only the state of Oregon requires training, testing and licensure of tax preparers. Other states regulate tax preparers; of those only California requires any form of education.) Therefore, other preparers such as Powell prepare false returns in exchange for oversized fees. These frauds potentially represent significant threats to financial institutions and others who rely on federal tax returns as primary sources of information on current and potential customers.

In 2014, the IRS will require most tax preparers in the U.S. who aren’t CPAs, attorneys or enrolled agents to become Registered Tax Return Preparers by passing a proficiency test and then completing 15 hours of continuing education annually. Though these regulations were successfully challenged in Washington, D.C., the IRS has appealed the court decision. (See "U.S. court strikes down IRS tax preparer regulations.")

Lenders that rely only on federal income tax data need some safeguards, given the relative ease with which anyone can open a tax preparation service and not be subjected to any quality control other than an occasional, unlikely IRS audit.

SAFEGUARDING TAX INFORMATION 

Lenders and others who rely on U.S. federal tax information can assess their reliability using these simple procedures:
 

  1. Check out the customer’s tax preparer. Most banks restrict property appraisals to a preapproved group of licensed appraisers who meet prescribed performance criteria. You can easily adopt a similar policy for tax preparers. If a preparer isn’t on the list of respectable local tax preparers or isn’t a licensed CPA then perform additional verification procedures. Also, a CPA won’t sign a return unless there is ample supporting documentation for reported amounts and fixed assets schedules going back to the business asset’s purchase date. 
  2. Ask for several past tax returns. Unusual returns or significant changes in activities should lead to additional questions. Examine the filing dates. They should follow in chronological sequence approximately one year apart. Be concerned if they were filed out of sequence or several years returns were filed during the same time period. Find out why they were filed late; if there’s no legitimate answer investigate further. A retired banker once told us that during his entire career he never loaned money to someone with an IRS lien. He figured that if they wouldn’t pay the IRS what chance did the bank have of getting repaid? 
  3. Verify the business’ existence and date of establishment. Check business license data, trade organization membership and the number of years that tax returns that have been filed for the business. Does the data match the borrower’s representation over this time period? 
  4. Review the prospective customer’s transaction history if you’ve allowed previous loans. High volume or large amounts of cash transactions — deposits and withdrawals — are strong warnings that the business has suspicious activities. Banking regulations only apply to larger cash transactions, so fraudsters easily can keep them below the radar. However, a predominance of cash transactions are always suspect in today’s credit card age. 
  5. Do the reported amounts make sense? We suspect that fraudulent tax preparers such as the one in this case likely won’t be aware of financial statement analysis, and so data analysis will reveal unusual or implausible relationships in revenues and expenses, especially in relation to trade data. Compute common profitability and trend analyses, and then compare these to industry figures and amounts. If they seem out of line then investigate further. Perform horizontal and vertical analyses, and look for unusual changes in activity. 
  6. Scrutinize the numbers. Individuals fabricating numbers usually assume that the digits 1 through 9 have an equal chance of appearing in the first position, but reality is quite different. Many audit software programs can run a Benford’s Law analysis on the amounts to see if the frequency of digits matches up with expectations.  

 


We propose a dynamic process in which the lending institution’s staff review customers' tax information beyond just the reported amounts for income and expenses to discover clues about their validity and sources. Obviously, expand your initial screening when you detect red flags.

LESSONS LEARNED 

Smaller financial institutions, when assessing customers’ creditworthiness, often rely exclusively on financial data in federal income tax returns. However, if you rely on just income tax data you might incorrectly assess potential borrowers. 
 


Develop a review process that flags customers whose tax information appears questionable or unreliable so that you can make the correct loan commitments. This process will take additional time and resources. However, you’ll protect your institution from costly and embarrassing frauds.

EPILOGUE

Powell pled guilty to filing false tax returns for multiple people whose primary income came from selling illegal drugs. She received a 10-month sentence and one year of supervised release. She is prohibited from preparing tax returns during her year of supervision.

Kevin Berry, Ph.D., CFE, is an accounting professor at the School of Management, University of Alaska Fairbanks. 

H. Charles Sparks, Ph.D., CPA, is an accounting professor at the School of Management, University of Alaska Fairbanks. 

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