From the Tax Law Offices of David W. Klasing - Can Employment Tax Crimes Lead to Prison Time?

IRVINE, Calif., Feb. 5, 2025 /PRNewswire/ -- When people envision criminal tax cases that result in incarceration, they often think of high-profile celebrity cases. Yet any business owner, company executive, accounting personal, internal or external bookkeeper, or even a lender with control over financial decisions can face life-altering consequences if they mishandle employment taxes. Under federal law, all employers must withhold income, Social Security, and Medicare taxes (often called "trust fund taxes") from employees' wages and promptly remit them to the IRS. Additionally, employers must comply with state payroll tax requirements by remitting taxes to state authorities such as California's Employment Development Department (EDD) for example. If the IRS or applicable state government is unable to recover the missing amounts from the business, it will pursue you personally—sometimes even your spouse—if you exercised or shared control over the funds.

Yes, employment tax crimes can lead to prison time. With the IRS criminal investigation division's clandestine investigation procedures, a situation that seems like a routine federal civil tax audit can suddenly become an exponentially more intense criminal tax investigation when initial indicators of fraud are identified, carrying severe negative public attention and potential life-altering incarceration.

Ordinary Oversight or a Felony? The IRS's Take on Payroll Taxes
Withheld employment taxes serve as a special trust for the government. Any perceived shortfall—particularly if repeated or deliberate—can trigger a wave of civil and criminal tax penalties. According to IRS examiners, frequent violations include:

1. Willful Failure to Account For, Collect, or Pay Over Taxes (IRC § 7202)
2. Willful Failure to File a Return (IRC § 7203)
3. Willful Failure to Pay Taxes Owed (IRC § 7203)
4. Willful Submission of a False Statement (IRC § 7206(1))
5. Failure to Collect and Deposit in a Special Trust Account (IRC §§ 7215, 7512(b))
6. Attempts to Obstruct or Impede Tax Administration (IRC § 7212(a))

Any single violation can have severe civil and criminal tax repercussions. Once an agent sees indications of intentional wrongdoing—like using a check-cashing service to convert payroll funds into untraceable cash—an ordinary civil tax audit can evolve into a criminal employment tax matter, leading to potential prosecution, incarceration & restitution. A restitution order cannot be discharged in bankruptcy, potentially leading to lifelong financial problems.

How Fraud Indicators Transform a Civil Audit into a Criminal Tax Investigation
IRS policy and Internal Revenue Manual (IRM) guidance clarify that the leap from a "routine" payroll tax audit to criminal employment tax charges involves several steps:

1. Initial or First Indicators of Fraud: Often referred to as "badges of fraud," these can be mere suspicions—like unexplained bank accounts, using check-cashing services to pay employees in cash followed by a failure to issue W2's or 1099's, intentionally underreporting employees' wages, Consistently failing to remit required payroll tax and withholding or suspiciously incomplete books. The agent is obligated to ask probing questions and examine any discrepancies.
2. Developing Firm Indicators of Fraud: When the agent believes the suspicion rises above a mere hunch, they work to solidify "firm indications of fraud." This might entail evaluating the scope of unaccounted income, identifying misclassifications of workers, or noticing patterns like repeated cash payments. Upon establishing firm indicators of fraud, the agent must typically suspend the civil tax audit without explanation.
3. Referral to IRS Criminal Investigation (CI): The examiner then submits Form 2797 ("Referral Report of Potential Criminal Fraud Cases") with comprehensive evidence—like unusual financial statements, bank checks, and the agent's analysis of alleged fraud. After managerial approval, CI decides whether to assign the matter to a Special Agent for potential criminal tax prosecution.

In short, first indicators of employment tax fraud can develop into firm indicators once the agent gathers enough incriminating evidence. At that point, the civil side of the payroll tax audit effectively halts while criminal authorities gear up.

Examples of Employment Tax Violations Leading to Potential Prison Time

Paying Employees in Cash
Some employers pay wages entirely in cash, hoping to evade standard withholding requirements. Such practices often constitute willful failure to collect or pay over taxes (IRC § 7202) or even willful failure to file a return (IRC § 7203) if these wages never appear on required filings. Furthermore, if an employer tries to mask or hide these cash transactions by not issuing 1099's or W2's, aiding and abetting the income tax evasion of the company' employees can be charged, attempts to obstruct or impede tax administration (IRC § 7212(a)) can also be alleged.

Misclassifying Employees
Labeling full-time employees as independent contractors may appear cost-effective, but it triggers parallel inquiries by the IRS, state income tax agencies, unemployment agencies, and workers' compensation boards. A pattern of deceit may give rise to willful violations under IRC §§ 7202, 7203, or 7206(1) for submitting false statements or tax returns. Where deliberate misclassification is found, felony tax charges are likely.

Failing to File or Pay
Neglecting to submit Form 941 altogether, or paying only a fraction of required amounts, commonly results in a 100% Trust Fund Recovery Penalty (TFRP) under IRC § 6672—plus interest and civil fines. If deemed willful under IRC § 7202 or IRC § 7203, this can escalate to criminal tax prosecution. Sometimes, employers even fail to deposit withheld taxes into the special trust account mandated by IRC §§ 7215 and 7512(b), inviting strict liability and additional criminal tax penalties.

Filing False Payroll Tax Returns
Underreporting wages or distorting employee compensation can initially seem to lower immediate tax bills, but repeated shortfalls become "firm indications of fraud." Such willful submission of a false statement under IRC § 7206(1) invites a criminal tax referral. Once labeled fraudulent, the matter may morph into a felony with severe civil and criminal tax penalties and potential prison time.

Pyramiding
Skipping payroll deposits quarter after quarter drastically expands the government's total loss, resulting in stiffer potential prison sentences if charged. The IRS categorizes these repeated lapses—especially post-warning—as willful acts in violation of IRC § 7202 or IRC § 7203, highlighting an affirmative intent to evade. Combined with "badges of fraud," pyramiding can become a key factor in determining sentencing severity. Switching from entity 1 to entity 2 to entity 3 to hide this pattern can exponentially increase your exposure.

Employee Leasing Scams
Third-party leasing entities sometimes withhold employment taxes but fail to remit them, then dissolve to dodge liability. Under IRC § 7202 or IRC § 7203, the original client and any "responsible persons" can face both civil and criminal tax sanctions if they ignored red flags or otherwise facilitated the scheme. Willfulness is often inferred when no steps were taken to verify that withheld sums reached the Treasury.

A taxpayer might assume that if the IRS halts the audit, it signifies success. In reality, IRM policy often instructs the agent to provide no reason for suspending the examination once it has located firm indicators of fraud. Meanwhile, IRS Criminal Investigation (CI) may be constructing a case. By the time you discover the matter has escalated, you might have lost crucial time to prepare a defense.

Owners who use questionable tactics—paying employees off the books or employing "creative" recordkeeping—risk having innocent mistakes interpreted as willful acts. Any attempt to "explain away" discrepancies might inadvertently confirm the examiner's suspicions. This is how a federal civil tax audit can shockingly become a criminal tax matter.

Defenses and Limited Excuses
Courts rarely accept claims like "we were short on funds" or "we needed the money to keep the business alive" as valid excuses. Only extraordinary events—such as theft, embezzlement, or catastrophic bank failure—that occur before the tax deposit are typically considered valid defenses. A consistent failure to investigate or rectify known payroll tax issues can meet the government's standard for willfulness, leaving little room for leniency.

Defend Yourself Against Employment Tax Crimes and Prison Time – Contact David W. Klasing Today
Strict liability under Form 2841, the TFRP at 100%, and felony charges under IRC § 7202 amplify the risk of incarceration. If you're behind on payroll deposits, suspect an agent is testing your "first indicators of fraud," or want to correct questionable worker classifications, time is of the essence. Each day of delay heightens the likelihood of the IRS or DOJ treating your shortfalls as life-altering felony indictments.

At the Tax Law Office of David W. Klasing, our dual-licensed Employment Tax Attorneys and CPAs bring nearly three decades of experience assisting businesses and individuals on a broad range of federal, California state, and international tax issues. From employment and payroll tax audits to potential criminal tax charges arising from alleged falsifications in audits, our team excels at devising and executing robust defense strategies that protect our clients' livelihoods and personal freedoms. We have consistently earned a stellar "A+" rating from the Better Business Bureau and a flawless 10.0 from AVVO, underscoring our unwavering commitment to premier tax representation. David W. Klasing is among the fewer than 24,000 professionals nationwide who are dually licensed as both an Attorney and CPA, having distinguished himself by earning a master's in taxation—credentials that enable him to handle high-risk civil and criminal tax controversies at the highest level of sophistication. Whether you are grappling with a high-risk eggshell or reverse eggshell tax audit by agencies like the IRS, EDD, CDTFA, or FTB—especially amid red flags like unfiled returns, underreported income, or badges of fraud—our blend of legal advocacy and advanced tax expertise will help you navigate the potential threat of prison time if your matter escalates to a criminal tax investigation.

We have introduced a flexible scheduling option to meet the demands of our diverse clientele—ranging from small businesses worried about payroll compliance to larger corporations under scrutiny for suspected misclassification of employees or failure to remit withheld taxes. Clients can reserve a four-hour slot at one of our satellite offices. Mr. Klasing—an instrument-rated private pilot—will personally travel in the firm's fast and efficient Cirrus SR22 to meet with you in person at no added travel cost. This approach ensures that individuals and businesses facing potential felony-level exposure in employment tax matters receive the immediate and comprehensive defense they need before civil tax audits evolve into exponentially more intense criminal tax investigations—a scenario that can bring severe negative public attention and potentially life-altering prison sentences. Call us at (888) 904-4096 or contact us online to set up a reduced-rate initial consultation today.

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Public Contact: Dave Klasing Esq. M.S.-Tax CPA, [email protected]

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