How Tax Evasion Works

There are two ways to underreport income. The first is to tell the Internal Revenue Service (IRS) that you made less money that you did during the tax year; and the second is to claim more deductions, exemptions and tax credits than you really deserve. Underreporting of income is the single largest contributor to the tax gap, making it America's favorite form of tax evasion. Just about 80 percent of the $441 billion tax gap, or $352 billion, is attributed to underreporting of income [source: IRS].

Who is most likely to underreport income to the IRS? According to the non-compliance statistics from 2011-2013, individual filers — not corporations — are the biggest tax evaders, underreporting income by $314 billion, equal to 71 percent of the total tax gap [source: IRS]. Interestingly, the biggest culprits among individual filers are folks who own their own businesses. Underreporting of business income accounts for $110 billion missing from individual income tax returns, while non-business income —normal wages and salary from a job — only add to $57 billion of the tax gap [source: IRS].

Wage and salary employees are more likely to pay their full income tax bills because their earnings are regularly reported to the IRS by a third party: their employers. Employers are required to withhold Social Security and Medicare contributions from each employee paycheck and hand that money over to the feds throughout the year. When an employee receives a W-2 in January, he or she knows that the IRS receives an identical copy. That's why only 1 percent of wage and salary income was underreported in 2006, while folks with no third-party reporting requirement — like self-employed workers or sole proprietors of small businesses — had a 56 percent underreporting rate [source: Sahadi].

Jobs that pay primarily in cash are ripe targets for tax evasion. The IRS estimates that waiters and waitresses underreport their cash tips by an average of 84 percent [source: Nolo]. Cash doesn't leave a paper trail — check stubs, deposit slips, invoices and the like — that can be tracked by IRS investigators. If an employer pays a worker "under the table" in cash, it means that the employer doesn't have to pay unemployment tax or payroll taxes for that employee, and the worker can easily get away with not paying income tax on those earnings.

This brings up an important distinction. In many cases, non-compliance with the tax code is due to ignorance of the law or innocent mathematical errors. That's called negligence. If you underreport your cash income because you honestly didn't know that tips counted as income, then the IRS might penalize you for your mistake, but you won't be tried for tax evasion. But if IRS investigators can prove that you knowingly and willingly tried to circumvent the tax law, that qualifies as tax evasion and you could be subject to a criminal prosecution.

Next we'll look at another popular tactic for cheating the IRS: hiding money.

The Internal Revenue Service (IRS) can only tax income that it knows about. For a bold segment of the taxpaying public, this is an invitation to hide as much money from the IRS as possible. Hiding money is a form of underreporting income in which there is no question that the perpetrator is committing tax evasion. You don't "accidentally" deposit millions of dollars in gambling winnings in an untraceable offshore account. This type of tax evasion requires a knowing intent to cheat the system and is punishable by significant jail time.

Money laundering is a prime example of evading taxes by hiding the source and amount of income. Money laundering is an attempt to disguise illegal income — from a drug operation, illegal gambling ring or other form of organized crime — as legitimate income, or to erase evidence of the income altogether.

In the past, money laundering was primarily accomplished through a front, or shell company, two terms describing an incorporated legitimate business with no real function other than to "clean" dirty money from an illegal activity [source: Legal Information Institute]. The classic example is a beauty salon or a dry cleaning business that never seems to be open. The money launderers draw up fake invoices and receipts to create the appearance of a thriving business. But instead of earning real income, the money launderers deposit funds earned from the illegal activity. The downside of traditional money laundering is that criminals still have to pay taxes on this phony income.

Today, thanks to a largely electronic banking system, modern money launderers have become experts in hiding both the source and destination of money through complex international banking transactions. For example, a money launderer can set up hundreds of separate bank accounts around the world in different names. He can then deposit small amounts of dirty money in each account so as not to draw attention. This is called layering. Withdrawals from these accounts are equally complex and layered, making it hard for investigators to follow the paper trail.

Foreign or "offshore" bank accounts are a popular place to hide both illegal and legally earned income. By law, any U.S. citizen with money in a foreign bank account must submit a document called a Report of Foreign Bank and Financial Accounts (FBAR) [source: IRS]. But that doesn't stop millions of Americans from secretly funneling money into untraceable offshore accounts.

From 2009 to 2018, the IRS ran a voluntary offshore disclosure program promising limited penalties and no criminal prosecution to people who come clean about unreported money in foreign banks. In that time, it collected $11.1 billion in back taxes from more than 56,000 separate voluntary disclosures [source: IRS]. Also in 2009, the United States signed a treaty with Switzerland to gain unprecedented access to the Swiss bank accounts of Americans suspected of tax evasion [source: IRS].

Now let's take a closer look at business and corporate tax evasion.

The tools of business and corporate tax evasion are much the same as individual tax payers: underreporting of income, overstating deductions, claiming too many tax credits, and hiding money from the government through laundering or illegal accounting schemes. When we hear the words "corporate tax evasion," we immediately think of the headline-grabbing corporate scandals of the past decade, like Enron or Tyco. But the surprising fact is that the vast majority of business-related tax evasion is committed by smaller unincorporated businesses.

As we mentioned earlier, individuals who own a small business are the largest single contributor to the tax gap. Underreporting of business income accounts for $110 billion, or 24.9 percent of the total $441 billion tax gap [source: IRS]. But even that number might be low, considering that many small-business owners are considered self-employed for tax purposes. According to the IRS, self-employed taxpayers underreported $45 billion of income. When you add that to underreported business income, you have 35 percent of the tax gap tied to small-business owners and self-employed sole proprietors [source: IRS].

Corporations file a different tax return than individuals and corporate income is taxed at a different rate than regular income. Even though corporate misdeeds grab a lot of press, corporate underreporting accounts for only $37 billion of the tax gap, or 8.3 percent. Of that underreported corporate income, 70 percent is committed by corporations with assets greater than $10 million [source: IRS].

Employment taxes are another area that's rife with tax evasion. Employment taxes are taxes that employers pay for each of their employees. These include unemployment tax and payroll taxes. Payroll taxes are the matching contributions that employers make to the Social Security and Medicare trust funds. Employment taxes are a significant expense, so it's not surprising that employers evaded $24 billion in employment taxes each year on average from 2010-2013 [source: IRS]. Paying in cash is one of the easiest ways to avoid employment taxes. Some tax evaders employ a scheme called pyramiding, in which an employer or a payroll contracting company withholds Social Security and Medicare taxes from employees, but never deposits them with the IRS [source: Internal Revenue Service].

Now we'll look at how the IRS catches tax evaders and what the penalties are for this costly crime.

The Internal Revenue Service (IRS) employs fewer than 39,000 people in its Compliance and Enforcement division. Approximately 9,000 of these folks are called revenue agents, and they have the thankless task of conducting tax audits. An audit is a thorough examination -- in person or via mail -- of all financial documents and accounts related to an individual or corporate tax return. An audit can uncover clues that could lead to a formal investigation of tax evasion. From tax years 2010 through 2018, the IRS audited or "examined" (their term) 0.6 percent of individual tax returns and 0.97 percent of corporate returns [source: IRS]. Interestingly, during that same period the IRS audited 9.26 percent of individual tax returns reporting income of more than $10 million [source: IRS]. That's nearly one out of every 10 rich-people returns!

The IRS Criminal Investigation (CI) division is the unit tasked with compiling evidence that can be used to prosecute tax evaders. A team of 2,034 IRS special agents work in four separate areas:

Due to the nature of modern financial crimes, CI agents must be adept at recovering information from encrypted computer systems and global networks. If Criminal Investigations determines that there is sufficient evidence to support a prosecution for tax evasion, it notifies the Tax Division of the U.S. Department of Justice (DOJ) [source: IRS]. The DOJ then determines whether or not to pursue the case.

The CI unit of the IRS has one of the highest conviction rates (90.4 percent) in federal law enforcement [source: IRS]. In 2020, CI initiated 1,598 investigations, recommended prosecutions in 945 cases and imposed sentences in 593 cases. Tax evasion is a felony. If convicted, sentences include the payment of all owed taxes, penalties as high as $100,000 for individuals and $500,000 for corporations, and up to five years in prison [source: Legal Information Institute].

For lots more information on famous tax evaders, the Internal Revenue Service and the dreaded audit, explore the links that follow.