The Internal Revenue Service does not always recognize and properly investigate signs of tax fraud, according to a new report, foregoing at least millions of dollars in potential fraud penalties.

The report, from the Treasury Inspector General for Tax Administration, found that the IRS may be missing opportunities to further promote voluntary compliance and enhance revenue. For its report, TIGTA reviewed a statistical sample of 100 office audits, closed between October 2009 and September 2010 that involved high-income and sole proprietor taxpayers agreeing they owed additional taxes of at least $10,000. Of the 100 office audits reviewed, TIGTA identified 26 audits with fraud indicators that were not recognized and investigated in accordance with some key IRS procedures and guidelines.

The IRS agreed with TIGTA’s findings and conclusions that fraud was not adequately considered and investigated in all 26 of these audits.  TIGTA estimates that additional assessments totaling approximately $5.8 million in civil fraud penalties may have been avoided by taxpayers.

“The failure to accurately identify and appropriately investigate indicators of fraud is a serious concern,” said TIGTA Inspector General J. Russell George in a statement. “Civil fraud penalties should be considered when appropriate because they discourage taxpayers from willfully underreporting substantial tax liabilities.”

The IRS relies on its examiners and their first-line managers to ensure that the civil fraud penalty is adequately considered. Yet IRS records show that the civil fraud penalty is rarely recommended for office audits.  Specifically, during fiscal years 2008 through 2011, examiners recommended, on average, that 96 taxpayers be assessed a civil fraud penalty out of the approximately 127,100 office audits closed each year.

While there are layers of management controls in place to guide examiners through the consideration of fraud, TIGTA’s results indicate that additional steps are needed at the examiner and first-line manager levels to ensure that potential fraud is adequately recognized and properly investigated.

IRS management partially agreed with TIGTA’s two recommendations. “Based on your recommendations, we will standardize the process for office audit examiners’ documentation of fraud consideration,” said Faris R. Fink, commissioner of the IRS’s Small Business/Self-Employed Division, in response to the report. “We will also issue additional guidance emphasizing the importance of and when a discussion should be held between the examiner and first-line manager about potential fraudulent activity of the taxpayer.”

While the IRS plans to take corrective actions for both recommendations, TIGTA believes the IRS’s planned corrective action for one of the recommendations is not adequate and it is unlikely to be effective.