The civil fraud penalty is the IRS’s heaviest civil tool in a crypto case. It is also the one the IRS has to work hardest to prove. Understanding both halves of that sentence is how you defend against it.

The statute

IRC 6663(a): if any part of an underpayment of tax required to be shown on a return is due to fraud, there is added to the tax an amount equal to 75 percent of the portion of the underpayment attributable to fraud.

IRC 6663(b) is the part that bites: if the IRS establishes that any portion of an underpayment is attributable to fraud, the entire underpayment is treated as attributable to fraud, except for any portion the taxpayer establishes, by a preponderance of the evidence, is not.

IRC 6663(c) protects spouses: on a joint return, the penalty does not apply to a spouse unless some part of the underpayment is due to that spouse’s fraud.

What fraud is not

It is worth saying plainly, because people in crypto cases often assume the worst. Fraud is not bad record keeping. It is not misunderstanding how staking income works. It is not relying on a software tool that miscalculated basis. It is not failing to report a swap because you thought swaps were not sales.

Those can produce tax, interest and the 20 percent accuracy penalty. They are not fraud, because fraud requires intent to evade tax, and the IRS has to prove that intent by clear and convincing evidence. The IRS fraud handbook itself says the use of digital assets “is not itself an indicator of fraud.” See IRM 25.1.2.11.

If you are worried about fraud, the first question is not “did I get it wrong?” It is “did I get it wrong on purpose, and what would the record show about that?”

The burden is on the IRS

IRC 7454(a) says that in any proceeding involving whether the petitioner has been guilty of fraud with intent to evade tax, the burden of proof on that issue is on the IRS. Tax Court Rule 142(b) adds that the burden “is to be carried by clear and convincing evidence.”

That is a high standard. It is more than the preponderance standard that governs most civil tax issues. Fraud is never presumed. The IRS has to prove it with evidence of intent.

But notice how 6663(b) shifts things once the IRS succeeds on any portion. Then the burden flips for the rest of the underpayment, and you have to prove, by a preponderance, which portions were not fraudulent. Good records of what was an honest mistake are your protection.

How the IRS builds a crypto fraud case

Fraud is about intent, and intent is proved by conduct. The IRS fraud handbook, IRM 25.1.2.11.1, lists indicators specific to digital asset cases. Among them:

  • Intentional failure to report a substantial portion of digital asset transactions over multiple years despite knowledge of a reporting requirement.
  • Reporting activity shown on an information return while intentionally omitting activity with no information return.
  • Reporting activity at some exchanges while intentionally omitting activity at others.
  • Intentionally answering “No” to the digital asset question despite knowing the true answer.
  • Overstating digital asset cost basis to reduce gain or increase loss.
  • Using mixers, privacy coins, CoinJoin, nominee accounts, or exchanges with inadequate KYC to avoid reporting requirements.
  • Submitting altered or false records, or refusing to provide complete records after repeated requests.

The handbook also says that “no one indicator of fraud is determinative,” and that an indicator is a sign, not proof. When an examiner identifies indicators, the handbook directs a referral request for consultation with a Fraud Enforcement Advisor. See IRM 25.1.2.11.1 and the full list of crypto fraud indicators.

Fraud and the statute of limitations

IRC 6501(c)(1) says that for a false or fraudulent return with intent to evade tax, the tax may be assessed at any time. A fraud finding does not just add 75 percent. It removes the time limit for that year. See how far back the IRS can audit crypto.

That is why the IRS sometimes pursues fraud in older crypto years that would otherwise be closed. And it is why the defense of a fraud penalty is often also the defense of the year itself.

How fraud interacts with other penalties

IRC 6662(b) says the 20 percent accuracy penalty does not apply to any portion of an underpayment on which the fraud penalty is imposed. The IRS commonly asserts fraud and, in the alternative, the accuracy penalty, so that if fraud fails, the 20 percent penalty may still apply.

IRC 6664(c)(1) says reasonable cause and good faith can defeat the 6663 penalty for a portion of the underpayment, the same as for 6662. In practice, a taxpayer who truly had reasonable cause and acted in good faith is rarely one the IRS can prove acted with intent to evade.

For a return that was never filed, the fraud concept appears in a different statute: IRC 6651(f), which increases the failure to file addition when the failure is fraudulent. See the fraudulent failure to file penalty.

Approval and production

The 6663 penalty is not in the exception list of IRC 6751(b)(2). It requires timely written supervisory approval of the initial determination. Treas. Reg. 301.6751(b)-1 sets the timing: for a penalty in a notice of deficiency, approval on or before the date the notice is mailed; for a penalty raised in Tax Court after a petition, no later than the date the IRS asks the court to determine it. See supervisory approval rules.

And IRC 7491(c) puts the burden of production for any individual’s penalty on the IRS in court.

Defending a crypto fraud penalty

The defense usually rests on three pillars.

  • Explain the conduct. Many “indicators” have innocent explanations: privacy-focused wallets used for security, an exchange that closed, records lost when a device died. Document them.
  • Separate mistakes from intent. Under 6663(b), you need to prove which portions were not fraud. Organize the underpayment by item and show the facts behind each.
  • Hold the IRS to its burden. Clear and convincing evidence of intent, timely supervisory approval, and evidence supporting each element. If any piece is missing, say so.

If the IRS is even raising fraud, you need a lawyer. Civil fraud findings can overlap with criminal exposure, and what you say during a civil fraud development can matter in both.

The IRM gives a sense of how seriously the IRS manages these cases internally. Fraud Enforcement Advisors serve as a resource and liaison to compliance employees, and they are required to follow up on all cases in fraud development status at least every 60 days. See IRM 25.1.2.1.3 and 25.1.2.1.5. A case in fraud development is being watched.

Joint returns and the innocent spouse

Crypto is often one spouse’s project. If the IRS asserts fraud on a joint return, IRC 6663(c) matters a great deal: the penalty does not apply to a spouse unless some part of the underpayment is due to that spouse’s own fraud. The non-trading spouse may still be liable for the tax on a joint return, which raises separate relief questions, but the fraud penalty itself has to be tied to each spouse’s conduct.

If you are the spouse who did not trade, do not let your case be lumped in with the other spouse’s explanations. Get separate advice if your interests differ.

That separation also helps the trading spouse. A clear record of who did what, and who knew what, keeps the case focused on facts instead of assumptions.