The Financial Crimes Enforcement Network (“FinCEN”) has issued a notice entitled “FinCEN Calls Attention to Payroll Tax Evasion and Workers’ Compensation Fraud in the Construction Sector” (the “Notice”). According to the Notice, “state and federal tax authorities [annually] lose hundreds of millions of dollars to these schemes, which are perpetrated by illicit actors primarily through banks and check cashers.”
The Notice describes these combined schemes as follows. Individuals create a shell company whose sole purpose is to allow construction contractors to avoid paying workers’ compensation premiums as well as state and federal payroll taxes. The operators of the shell company will take out a minimal workers’ compensation policy and “rent” or sell the policy to construction contractors that employ a much larger number of workers than the policy is designed to cover. The insurance policy enables the shell company to apply for and receive official business registration status. The shell company operators will include the business license and tax documents in the package “rented” to the contractors. This is the insurance fraud aspect. Although insurance fraud is a state and local crime, it easily can be charged federally through use of the mail and wire fraud statutes. Mail and wire fraud also can serve as predicate offenses – more precisely, “Specified Unlawful Activities” – underlying federal money laundering charges.
The contractors also will use the shell company to pay their workers “off the books,” and without paying the required state and federal government payroll taxes. The contractors will “write checks payable to the shell company which creates the façade that the shell company is performing construction projects.” The shell company operators will either deposit these checks into a bank account and make bulk cash withdrawals, or it will cash them at a check casher (which is a “money service business” and therefore a “financial institution” [“FI”] covered by the Bank Secrecy Act [“BSA”] which is obligated to file Suspicious Activity Reports [“SARs”] and Currency Transaction Reports [“CTRs”]). The shell company operators will return the cash to the contractor after deducting a percentage fee for participation in the scheme. Alternatively, the shell company operators will write out checks directly to each worker working for the contractor. This is the payroll tax fraud aspect, because the contractor will reduce or avoid its own payroll tax and insurance duties.
According to the Notice, such schemes often involve undocumented workers as well as undocumented individuals creating and operating the shell companies. Knowingly employing an undocumented worker is also a federal crime.
The Notice sets forth 11 “red flags” identified by FinCEN, in coordination with the Internal Revenue Service-Criminal Investigation (IRS-CI) and Homeland Security Investigations (HSI), to assist FIs in detecting, preventing, and reporting suspicious transactions associated with shell companies perpetrating payroll tax evasion and workers’ compensation fraud in the construction industry. Although the red flags cover a range of activity, they tend to assume a relatively substantial degree of knowledge by the FI – or a substantial degree of inquiry by the FI – of the subject customer’s business and activity. For example, here is one red flag:
The company’s recently acquired workers’ compensation insurance policy, which may be verifiable through an official state website, was issued within the last year and covers only a small number of employees. However, a high volume of transactions is observed in the company’s bank accounts, which is not commensurate with a construction company of that size.
Presumably, the above information will never be known by a check casher, as opposed to a bank. This highlights a tension presented by the Notice: although a check casher very likely will have more direct interaction than a bank with a customer committing the scheme(s) at issue in the Notice, many of the red flags pertain to information that would be available only to a bank (perhaps, as part of its Customer Due Diligence Rule obligation, or due to its transaction monitoring requirements). But a bank likely will have less direct interaction with the customer than a check casher, but will have more general information about the customer’s transactions.
And even for banks, the red flags listed in the Notice will be difficult to assess in the real world. The red flags and the Notice repeatedly use the term “shell company,” a phrase that the government loves to invoke. But the fact remains that there are tens of millions of “shell” LLCs and other entities in the United States which exist for entirely legitimate purposes. The phrase “shell company” often reflects a pejorative value judgment, and whether a seemingly mundane corporate entity is being used for illegitimate purposes is often hard to determine – even for the Department of Justice and federal criminal investigators, who, unlike banks, have grand jury subpoena and search warrant powers, and the luxury of conducting multi-year investigations which are not second-guessed by bank examiners. Having said that, the bottom line import of the Notice appears to be that FIs should be wary of construction companies and, perhaps, should subject many of them to enhanced due diligence simply because of their status as construction companies. This may not have been the intent of the Notice, but it may be the practical consequence. The listed red flags also suggest that construction companies which open accounts with individuals using non-U.S. passports, or which cash substantial amounts of checks, or which have little to no Internet presence, should be the subject of additional scrutiny by a FI.
Clearly, IRS-CI had a large role in the creation of the Notice. As we previously blogged, FinCEN’s Year in Review for FY 2022 emphasized that IRS-CI is a key consumer of BSA reports filed by FIs – i.e., SARs and CTRs. According to the Year in Review, over 83% of IRS-CI investigations recommended for prosecution during FY 2020 to FY 2022 involved a primary subject referenced by a related BSA filing. Perhaps more importantly, because the following involves “investigative leads” initiating investigations (vs. special agents in ongoing investigations searching FinCEN’s BSA filing database for any “hits” on previously-identified subjects), almost 16% of all IRS-CI investigations “were the direct result of BSA data.” The Notice provides a new SAR filing instruction for the activity at issue in the Notice: filing FIs “should select SAR Field 34(z) (FRAUD-Other) as the associated suspicious activity type and include the term ‘Payroll tax evasion’ and/or ‘workers compensation’ in the text box.”
Generally, payroll tax schemes have been a focus of criminal and civil tax enforcement for many years. In a footnote, the Notice lists six criminal cases since 2021 involving alleged payroll tax and workers’ compensation fraud schemes. It is possible that IRS-CI and FinCEN believed that the specificity of the combined payroll and insurance fraud schemes described in the Notice would render them easier for FIs to detect, relatively speaking, than a “generic” and simpler cash-under-the-table tax payroll scheme. Such schemes are widespread, and do not require the existence of so-called “shell companies.” Indeed, any construction company that directly pays its workers “under the table,” or keeps certain workers completely “off the books,” almost surely will be simultaneously committing workers’ compensation insurance fraud: insurance rates typically are established in part by a review of payroll records, which will be false.
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