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.