Navigating the aftermath of embezzlement


Guest column by

Michelle McHale and

Carrie VanDerZee of

Plante Moran

It happened. Now how do you report it to the IRS?

Embezzlement, or occupational fraud, occurs in many forms, including fraudulent billing, financial statement misstatements or, more simply, a lack of control over cash. A survey by the Association of Certified Fraud Examiners (ACFE) estimated that U.S. organizations lose 7 percent of their annual revenues to fraud. Many times these frauds have gone on for years before they're discovered.

If you're an employer caught in this position, you likely have a few questions: Are the embezzled funds deductible? Are payments by the perpetrator considered income to the organization? How can the organization report these ill-gotten (and likely unreported) gains by the perpetrator to the IRS?

Yes, They're Deductible

Embezzlements are deductible as theft losses that are reported as "other expenses." Losses are deductible in the year of discovery regardless of the year the losses were sustained. The year of discovery is the year in which a reasonable person in similar circumstances would have discovered the fact of the theft loss. For example, let's imagine that your controller has written unauthorized checks to herself/himself since 2004, but the theft is not discovered until your tax preparer points out a financial discrepancy in 2009 that leads to the discovery. The organization is allowed a theft loss deduction in 2009. However, if your tax preparer had warned company representatives of financial discrepancies related to the embezzlement for years, the organization could lose some of the deduction and may have to amend earlier years' returns.

Losses may only be deducted if the embezzled proceeds were previously reported as income (or the embezzled funds were not previously deducted). Further, the loss is reduced by any insurance reimbursement or repayment by the perpetrator.

Yes, Repayments Are Considered Income

Repayments by the current or former employee are taxable in subsequent years after the year the act was discovered. There are certainly exceptions, such as a repayment plan classified as a loan with interest, whereby the payments would be a reduction of debt with the interest reported as income.

Informing the IRS

The tax code stipulates that all of an individual's income and gains are includible in gross income, whether it was derived from legal or illegal means. While embezzled funds are taxable to the embezzler, the likelihood of the perpetrator reporting this type of income is slim. So what options does the victim have to ensure that the IRS is informed of illegal gains by a current or former employee?

Though employers may wish to report the income on Form W-2 or Form 1099-MISC, the best option is to use Form 3949A. This is an Information Referral form for reporting potential violations of the Internal Revenue laws. The victimized organization can provide information about the embezzler such as name and address, social security number, alleged violation (i.e., unreported income), suspected amount of unreported income by year, and any additional comments. The informant may also indicate whether the books and/or records are available to substantiate the claim, the name of the bank used by the taxpayer, and whether the taxpayer is presumed dangerous. Further, under the Whistleblower Law, if the IRS uses this information and it results in collection of taxes, penalties, and interest in excess of $2 million, the Whistleblower may be awarded 15 to 30 percent of the amount collected.

Why not use W-2 or 1099-MISC to report the unauthorized and unearned embezzled funds? These forms do not meet the required criteria. W-2s are submitted to report compensation from work performed and Form 1099-MISC is intended to be used to report payments made to a "non-employee" for fees, commissions, prizes and awards. Further, by issuing a Form 1099-MISC to a current or former employee who is also receiving a W-2 from the same organization can cause a conflict to occur at the governmental agency level that could result in a rejection of one or both of the form submissions.

Words of Wisdom

We've all heard the phrase, "An ounce of prevention is worth a pound of cure." While there's no way to completely eliminate the potential for fraud in an organization, implementing specific antifraud controls can reduce a company's exposure to it. Carefully monitoring your staff members' behavioral traits can offer helpful data as well; according to the ACFE, 39 percent of perpetrators were living beyond their apparent means and 34 percent were experiencing financial difficulties at the time they committed fraud. For more information on how to guard against embezzlement, how to uncover it, or what to do after it's occurred, feel free to give us a call.

Michelle McHale is Plante Moran's Senior Manager, Forensic & Valuations Services; reach her at michelle.

Carrie VanDerZee, Staff, Forensic & Valuation Services, Plante Moran; her e-mail is carrie.vanderzee@plante

Published: Fri, Nov 20, 2009