Big lessons from 3 small business fraud cases

The recent IRS expansion discussed in last week’s post is aimed at wealthy individuals and large corporations. However, that doesn’t mean they’ve become complacent toward small businesses.

The IRS press releases are littered with stories of small businesses that, knowingly or unknowingly, ran afoul of the IRS and paid stiff penalties. This week, we’ll take a look at those cases and what can be learned from them.

Let’s go!

A Double Whammy

A temp agency owner in Massachusetts deposited client payments into an account only she controlled and paid her employees through a combination of checks and cash. The cash payments allowed her to hide over $3.2 million in payroll and avoid more than $800,000 in payroll taxes.

She also fudged payroll numbers to obtain workers’ compensation at lower premium rates. She was found guilty in April of this year and could face decades in prison when sentenced.

Not much could have prevented this since the owner seemed intent on committing the crime. However, honest business owners can still learn lessons if they have unscrupulous employees.

First, implement a system of checks and balances.

No individual should control all aspects of an account or financial transaction. Different employees should be responsible for receiving payments, depositing funds, and handling payroll.

Also, run frequent internal and external audits. This will help detect irregularities early and avoid IRS audits.

Embezzlement

A chief financial officer for a Kansas company embezzled at least $3.1 million before the IRS stopped him. He also helped another employee steal $325,000 from the company.

The CFO perpetrated the fraud by writing company checks to pay his personal expenses and recorded them in improper accounts.

His plea agreement includes forfeiture of his home and restitution to the company. He also owes the IRS $867,000 and faces up to 23 years in federal prison.

So, what can be done to discourage this kind of behavior?

Like the previous case, a system of checks and balances would have helped. If separate persons had the responsibility for writing checks, approving payments, and recording transactions, this fraud would have been more difficult to perpetrate

Whistleblower policies and fraud awareness training may have helped as well. Employees may know about fraud but not know how to report it or avoid reporting for fear of retaliation.

Good policies, backed by leadership, can help alleviate this problem.

Kickback schemes

A company based in New York with warehouses in Maryland suffered losses for eight years when two of its warehouse managers launched an elaborate kickback scheme.

The company used drums to transport its products, and the two managers oversaw all drum purchases and storage. They also had the authority to review invoices and authorize payments to drum vendors.

The managers entered into an agreement with a drum vendor who would charge the company for more drums than he sold them. The two managers kept 75% of the excess, while the drum vendor kept 25%. During the eight years the scheme occurred, the managers falsely invoiced more than $20 million. The drum vendor made $2.3 million in the scheme.

Like the other frauds, a segregation of duties could have helped prevent this. The two managers had too much authority. It would have been better to separate ordering, receiving, and payment authorizations among other employees.

Rotating those responsibilities and having a good data and analytics monitoring system to monitor purchase patterns would also have severely hampered the fraudsters.

Finally, it would have been good to have a vendor verification system and a stable of vendors to rotate through.

Essentially, the more variables introduced into an accounting process, the more complicated it becomes to game it.

The Bottom Line

Fraud can occur at any business level and among just about any employee, so having accounting and workflow protocols in place is critical. Take the time to study more of these cases and talk to your CPA about how you can stop this type of behavior in your company before it starts.