How Tax Evasion Works


Gangster Al Capone sits in a train car on his way to serve a federal prison sentence for tax evasion, in October 1931. See more pictures of public enemies.
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Here's a little factoid that may provide you a little comfort as tax day approaches: According to the Internal Revenue Service (IRS), paying income tax in the United States is voluntary. Seriously? It's true, but before you run your 1040 through the shredder and go lead your neighbors in a confetti parade, let's define "voluntary." The official term is voluntary compliance, and it means that the U.S. government doesn't calculate your income tax for you and send you a bill. It is up to the individual to voluntarily and honestly comply with the U.S. tax code -- all 4,500 pages of it.

And for the most part, the voluntary thing seems to work. According to the 2011 "Taxpayer Attitude Survey" conducted by the IRS, 72 percent of respondents "completely agree" that "it's every American's civic duty to pay their fair share of taxes," citing "personal integrity" as the greatest motivator, not the fear of an audit [source: Internal Revenue Service].

Yes, voluntary compliance seems to work... for the most part. When answering the question, "How much, if any, do you think is an acceptable amount to cheat on taxes?" an impressive 84 percent of respondents to the IRS survey said "Not at all," but a disturbingly significant 8 percent said, "As much as possible" [source: Internal Revenue Service]. Any attempt by a taxpayer to knowingly cheat the system, either by underreporting income, exaggerating expenses, hiding money or failing to file a tax return, is called tax evasion. And tax evasion is big business.

Tax evasion creates something called the tax gap, which is the difference between the total revenue the IRS is owed in taxes and the amount it actually receives. For the 2006 tax year (the most recent year for complete statistics), the tax gap was $450 billion. The voluntary compliance rate in 2006 was 85.5 percent, which doesn't mean that 14.5 percent of Americans didn't pay their taxes. It means that American taxpayers as a whole underpaid their taxes by 14.5 percent [source: Internal Revenue Service]. Since federal income tax revenue helps pay for items on the federal budget -- like defense and Social Security -- that missing $450 billion equals 16.6 percent of the total 2006 federal budget.

So who are these wily tax evaders and why isn't anyone stopping them? The fact is that the IRS doesn't have the manpower to catch every last tax cheat. There are slightly more than 22,000 employees working in IRS tax enforcement, and Americans filed around 146 million individual and corporate tax returns in 2010 [source: Sahadi]. That's 6,636 returns for each IRS agent. The result is that the IRS only audits 1 percent of tax returns, leaving plenty of room for "error."

Keep reading as we dig deeper into the different forms of tax evasion -- underreporting, underpayment, money laundering, offshore accounts -- and explain the difference between benign negligence and criminal tax fraud.

Underreporting Income

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. More than 83 percent of the $450 billion tax gap, or $376 billion, is attributed to underreporting of income [source: Internal Revenue Service].

Who is most likely to underreport income to the IRS? According to the non-compliance statistics from 2006, individual filers -- not corporations -- are the biggest tax evaders, underreporting income by $235 billion, equal to 52 percent of the total tax gap [source: Internal Revenue Service]. Interestingly, the biggest culprits among individual filers are folks who own their own businesses. Underreporting of business income accounts for $122 billion missing from individual income tax returns, while non-business income -- normal wages and salary from a job -- only add to $68 billion of the tax gap [source: Internal Revenue Service].

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.

Hiding Money

Hotelier Leona Helmsley meets with attorney Alan Dershowitz about her trial for tax evasion, in March 1990.
Hotelier Leona Helmsley meets with attorney Alan Dershowitz about her trial for tax evasion, in March 1990.
Joe McNally/Getty Images

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: Internal Revenue Service]. But that doesn't stop millions of Americans from secretly funneling money into untraceable offshore accounts.

The IRS initiated a voluntary offshore disclosure program in 2009, promising limited penalties and no criminal prosecution to people who come clean about unreported money in foreign banks. So far, it has collected $4.4 billion in back taxes from 33,000 separate voluntary disclosures [source: Internal Revenue Service]. 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: Internal Revenue Service].

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

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 $122 billion, or 27.1 percent of the total $450 billion tax gap [source: Internal Revenue Service]. 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 $57 billion of income. When you add that to underreported business income, you have 40 percent of the tax gap tied to small business owners and self-employed sole proprietors [source: Internal Revenue Service].

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 $67 billion of the tax gap, or 14.8 percent. Of that underreported corporate income, 71 percent is committed by corporations with assets greater than $10 million [source: Internal Revenue Service].

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 $15 billion in employment taxes in 2006 [source: Internal Revenue Service]. 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.

Investigating and Prosecuting Tax Evaders

Former Ohio congressman James Traficant arrives at court for sentencing on tax evasion and other charges, in July 2002.
Former Ohio congressman James Traficant arrives at court for sentencing on tax evasion and other charges, in July 2002.
Laura Farr/Getty Images

The Internal Revenue Service (IRS) employs more than 22,000 people in its Compliance and Enforcement division. Approximately 13,000 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. In 2011, the IRS conducted 1,564,690 audits of individual tax returns, representing 1.11 percent of the total. Interestingly, the IRS audited 12.48 percent of tax returns reporting income of more than $1 million [source: Internal Revenue Service]. That's one out of every eight 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 2,698 IRS special agents work in four separate areas:

  • Legal source tax crimes – Tax fraud committed by taxpayers who falsely report or underpay taxes on legal income
  • Illegal source tax crimesMoney laundering schemes to "clean" money obtained by other criminal activity
  • Narcotics-related financial crimes – Money laundering investigations with a special focus on drug syndicates
  • Counterterrorism financing – IRS agents help the FBI track money that is being funneled to overseas terrorist groups

Due to the nature of modern financial crimes, CI agents must be adept at recovering information from encrypted computer systems and global networks [source: Internal Revenue Service]. 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: Internal Revenue Service]. The DOJ then determines whether or not to pursue the case.

The CI unit of the IRS has one of the highest conviction rates in federal law enforcement [source: Internal Revenue Service]. In 2011, CI initiated 4,720 investigations, brought indictments in almost 3,000 cases and imposed sentences in 2,730 cases. Clearly, not all of the sentences were for investigations initiated in 2011. But if you look back over the past decade, the IRS initiates an average of 4,000 cases each year. To land convictions and sentences in more than half of those cases is remarkable [source: Internal Revenue Service].

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 on the next page.

Author's Note

I have a healthy fear of the IRS, and writing this article did little to change that. Even though I make a very modest income, I don't mess around with my 1040. You might even say that I'm a little too cautious. For example, I spend way too much time with a tape measure and a calculator trying to figure out the exact percentage of my guest room that is occupied by my home office. Does the IRS really care about the difference between 15 square feet and 18 square feet? I'm not about to risk a felony conviction to find out. The good news about researching an article about tax evasion is that it's clear that the feds only go after the big fish. Still, the less attention this guppy gets from the IRS, the better.

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Sources

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