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?
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 5 percent of their annual revenues to fraud. Many times these frauds have gone on for years before they’re discovered.
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.
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 if 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 forms 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.