Tax evasion in the United States

Under the federal law of the United States of America, tax evasion or tax fraud, is the purposeful illegal attempt of a taxpayer to evade assessment or payment of a tax imposed by Federal law. Conviction of tax evasion may result in fines and imprisonment.[1]

Tax evasion is separate from "tax avoidance", which is the legal utilization of the tax regime to one's own advantage in order to reduce the amount of tax that is payable by means that are within the law. Tax evasion is illegal while tax avoidance is legal.

In Gregory v. Helvering the US Supreme Court concurred with Judge Learned Hand's statement that: "Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." However, the court also ruled there was a duty not to illegally distort the tax code so as to evade paying one's legally required tax burden.[2]

Definition

The tax code, 26 United States Code section 7201, provides:

Sec. 7201. Attempt to evade or defeat tax
Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.[3]

To prove a violation of the statute, the prosecutor must show (1) the existence of a tax deficiency (an unpaid federal tax), (2) an affirmative act constituting an evasion or attempted evasion of either the assessment or payment of that tax, and (3) willfulness (connoting the voluntary, intentional violation of a known legal duty).[4]

A genuine, good faith belief that one is not violating the Federal tax law based on a misunderstanding caused by the complexity of the tax law is a defense to a charge of "willfulness", even though that belief is irrational or unreasonable.[5][6] A belief that the Federal income tax is invalid or unconstitutional is not a misunderstanding caused by the complexity of the tax law,[7] and is not a defense to a charge of "willfulness", even if that belief is genuine and is held in good faith.[8][9]

Occurrence

The Internal Revenue Service (IRS) has identified small business and sole proprietorship employees as the largest contributors to the tax gap between what Americans owe in federal taxes and what the federal government receives. Small business and sole proprietorship employees contribute to the tax gap because there are few ways for the government to know about skimming or non-reporting of income without mounting more significant investigations.

The willful failures to report tips, income from side-jobs, other cash receipts, and barter income items are examples of illegal cheating. Similarly, those persons who are self-employed (or who run small businesses) evade the assessment or payment of taxes if they intentionally fail to report income. One study suggested that the fact that sharing economy firms like Airbnb, Lyft, and Etsy do not file 1099-K forms when participants earn less than $20,000 and have fewer than 200 transactions, results in significant unreported income.[10]

The typical tax evader in the United States is a male under the age of 50 in the highest tax bracket and with a complicated return, and the most common means of tax evasion is overstatement of charitable contributions, particularly church donations.[11]

Foreign tax havens

Main article: Tax haven

Jurisdictions which allow for limiting taxation, known as tax havens, may be used for both legally avoiding taxes and illegally evading taxes. In 2010, the Foreign Account Tax Compliance Act was passed to better enforce taxation in foreign jurisdictions.

Illegal income

U.S. citizens are required to report unlawful gains as income when filing annual tax returns (see e.g., James v. United States[12]) although such income is typically not reported. Suspected lawbreakers, most famously Al Capone, have been successfully prosecuted for tax evasion when there was insufficient evidence to try them for their non-tax related crimes. Reporting illegal income as earned legitimately may be illegal money laundering.

Estimates of lost government revenue

U.S. Federal Revenue Lost
to Tax Evasion[13]
Year Revenue lost
(US$ billion)
2010 305
2009 304
2008 357
2007 376
2006 376[14]
2005 314
2004 272
2003 257
2002 269
2001 290
Total revenue lost: $3.44 trillion

In the United States, the IRS estimate of the 2001 tax gap was $345 billion.[15] For 2006, the tax gap is estimated to be $450 billion.[16]

A more recent study estimates the 2008 tax gap in the range of $450 to $500 billion, and unreported income to be approximately $2 trillion.[17] Thus, 18 to 19 percent of total reportable income is not properly reported to the IRS.[18]

Measurement

Beginning in 1963 and continuing every 3 years until 1988, the IRS analyzed 45,000 to 55,000 randomly selected households for a detailed audit as part of the Taxpayer Compliance Measurement Program (TCMP) in an attempt to measure unreported income and the "tax gap".[19] The program was discontinued in part due to its intrusiveness, but its estimates continued to be used as assumptions. In 2001, a modified random-sampling initiative called the National Research Program was used to sample 46,000 individual taxpayers and the IRS released updated estimates of the tax gap in 2005 and 2006.[20] However, critics point out numerous problems with the tax gap measure.[21] The IRS direct audit measures of noncompliance are augmented by indirect measurement methods, most prominently currency ratio models[22]

After the TCMP audits, the IRS focused on two groups of taxpayers: those with just a small change in the balance due, and those with a large (over $400) change in the balance due. Taxpayers were further partitioned into "nonbusiness" and "business" groups and each group was divided into five classes based on total positive income. Using line items from the auditor's checksheet, discriminant analysis, and a scoring mechanism, each return was awarded a score, known as a "Z-score". Higher Z-scores were associated by IRS personnel with a higher risk of tax evasion. However, the Discriminant Index Function (DIF) system did not provide examiners with specific problematic variables or reasons for the high score and so each filing had to be manually examined by an auditor.[23]

Investigatory procedures

The IRS may carry out investigations to determine the correctness of any tax return and collect necessary income tax, including requiring the taxpayer to provide specific information such as books, records, and papers.[24] The IRS whistleblower award program was created to assist the IRS in obtaining necessary information. While these investigations can lead to criminal prosecution, the IRS itself has no power to prosecute crimes. The IRS can only impose monetary penalties and require payment of proper tax due. The IRS performs audits on suspicion of noncompliance but has also historically performed randomly selected audits to estimate total noncompliance; the former audits have much higher chance of noncompliance.[19]

Net worth and cash expenditure methods of proof

Under the net worth and cash expenditure methods of proof, the IRS performs year-by-year-by-year comparisons of net worth and cash expenditures to identify under reporting of net worth. While the net worth method and the cash accrual method may be used separately, they are often used in conjunction with one another. Under the net worth method, the IRS chooses a year to determine the taxpayer's opening net worth at year’s end. This provides a snapshot of the taxpayer's net worth at a particular point in time.

The snapshot includes the taxpayer’s cash on hand, bank accounts, brokerage (stocks and bonds), house, cars, beach house, jewelry, furs, and other similar items. Generally the IRS learns about these items through very thorough and in-depth investigations, sometimes casing the suspected fraudulent taxpayer. In addition, the IRS also assesses the taxpayer’s liabilities. Liabilities include expenses such as the taxpayer’s mortgage, car loans, credit card debts, student loans, and personal loans. The opening net worth is the most critical point at which the IRS must assess the taxpayer's assets and liabilities. Otherwise, the net worth comparison will be inaccurate.

The IRS then evaluates new debts and liabilities accumulated in the next year, and assesses the taxpayer’s new net worth at the next year’s end. In addition, the IRS reviews the taxpayer’s cash expenditures throughout the tax year. The IRS then compares the increase in net worth and the cash expenditures with the reported taxable income over time in order to determine the legitimacy of the taxpayer’s reported income.

The net worth method was first used in the case of Capone v. United States.[25] The cash method was approved in 1989 in United States v. Hogan.[26]

Bank deposit cash expenditure method

First approved by the Eighth Circuit in 1935 in Gleckman v. United States,[27] the bank deposit cash expenditure method identifies tax evasion through review of the taxpayer’s bank deposits. This method of investigation primarily focuses on whether the taxpayer’s total bank deposits throughout the year are equal to the taxpayer’s reported income. This method is most appropriate when the majority of the taxpayer’s income is deposited in the bank and most expenses are paid by check.[28]

This method is most commonly used for surveillance of tipped employees and is combined with statistical analysis to determine what a tipped employees actual wages are. Information gathered through this method is most successful when the credibility of tipped employees can be destroyed. This method is used less frequently now for tipped employees because the IRS negotiates with hotels or casinos, the largest employers of tipped employees, to identify a tip estimate. If the tipped employee reports the minimal amount agreed upon, he is not questioned by the IRS. However, it is recommended for corroborating other methods of proof.[29] Given the uncertainty of this method, this method likely could not be used in criminal prosecutions where the guilt must be found beyond a reasonable doubt.

Whistleblower program

In addition to the methods of proof the IRS has developed, the Tax Relief and Health Care Act of 2006 created the IRS Whistleblower Office,[30] which allows anonymous whistle blowers to receive 15 to 30 percent of any recovery by the IRS which comes to at least $2 million including all penalties, interests and any other monies collected from the government. The whistle blower program seeks information based on evidence and analysis which can provide a solid basis for further investigation rather than speculation and hearsay.[31]

The program is designed to provide incentive to ordinary citizens to inform on tax cheats. The program provides far greater incentives for whistle blowers than previous programs because under prior programs the government was not required to compensate whistleblowers.[32] Under this program, a taxpayer may file a lawsuit in court if he or she does not receive a deserved award.[31]

Historical U.S. tax evasion cases

The IRS publishes the number of civil and criminal penalties in the IRS Data Book (IRS Publication 55B)[33] and makes these available online. Table 17 shows tabulated data on civil penalties and Table 18 shows data on criminal investigations.[34] In 2012, the IRS assessed civil penalties in 37,910,493 cases and 4,994,926 abatements.[34] In 2012, the IRS initiated 5,125 investigations; of 3,701 which were referred to prosecution, 2,634 resulted in conviction.[34] The agency also highlights current investigations on its website by various categories, including abusive returns, tax schemes, corporate fraud, money laundering, and various other categories.[35]

References

  1. ↑ 26 U.S.C. § 7201.
  2. ↑ Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935).
  3. ↑ 26 U.S.C. § 7201. For an individual, the $100,000 fine prescribed in this statute can be increased to a maximum of $250,000. See subsection (b), paragraph (3) of 18 U.S.C. § 3571.
  4. ↑ See generally Steven R. Toscher, J.D., Dennis L. Perez, J.D., Charles P. Rettig, J.D., LL.M. & Edward M. Robbins, Jr., J.D., LL.M., Tax Crimes, U.S. Income Portfolios, Vol. 636 (3rd ed. 2012), Bloomberg BNA.
  5. ↑ Cheek v. United States, 498 U.S. 192, 203 (1991).
  6. ↑ Steven R. Toscher, Dennis L. Perez, Charles P. Rettig & Edward M. Robbins, Jr., Tax Crimes, Tax Management Portfolio, Volume 636, Bloomberg BNA (3d ed. 2012).
  7. ↑ See generally Dan M. Kahan, "Ignorance of Law Is An Excuse -- But Only for the Virtuous," 96 Michigan Law Review 127, 146 (Oct. 1997).
  8. ↑ Lyle Denniston, "Court widens use of ignorance plea in tax cases," Baltimore Sun, Jan. 9, 1991, at .
  9. ↑ Cheek, 498 U.S. at 206.
  10. ↑ http://www.bostonglobe.com/business/2016/05/23/airbnb-others-pay-out-billions-beneath-irs-radar-study-finds/o57SNCizMzHSEjH0A1MNMM/story.html
  11. ↑ Patricia Sabatini, Pittsburgh Post-Gazette, "Tax Cheats Cost U.S. hundreds of billions," http://www.post-gazette.com/pg/07084/772106-28.stm
  12. ↑ 366 U.S. 213 (1961), "overruling" Commissioner v. Wilcox, 327 U.S. 404 (1946).
  13. ↑ "?" (PDF). Archived from the original (PDF) on June 8, 2012.
  14. ↑ http://www.irs.gov/uac/IRS-Releases-New-Tax-Gap-Estimates;-Compliance-Rates-Remain-Statistically-Unchanged-From-Previous-Study
  15. ↑ "IRS Updates Tax Gap Estimates". Irs.gov. Retrieved 2011-12-10.
  16. ↑ "Tax Gap for Tax Year 2006 Overview Jan. 6, 2012" (PDF). U.S. Internal Revenue Service. Retrieved 2012-06-14.
  17. ↑ Richard Cebula and Edgar Feige, "America’s Underground Economy: Measuring the Size, Growth and Determinants of Income Tax Evasion in the U.S" https://ideas.repec.org/p/pra/mprapa/29672.html
  18. ↑ Richard Cebula and Edgar Feige "America’s Underground Economy: Measuring the Size, Growth and Determinants of Income Tax Evasion in the U.S" https://ideas.repec.org/p/pra/mprapa/29672.html
  19. 1 2 James Andreoni & Brian Erard & Jonathan Feinstein, 1998. "Tax Compliance," Journal of Economic Literature, American Economic Association, vol. 36(2), pages 818-860, June
  20. ↑ Slemrod, Joel. 2007. "Cheating Ourselves: The Economics of Tax Evasion." Journal of Economic Perspectives, 21(1): 25–48.
  21. ↑ Toder, E. "What is the Tax Gap?" http://www.urban.org/publications/1001112.html
  22. ↑ Feige, Edgar L. (ed.), 1989. The Underground Economies: Tax Evasion and Information Distortion. Cambridge Books, Cambridge University Press, number 9780521262309.
  23. ↑ Nigrini, Mark (June 2011). "Forensic Analytics: Methods and Techniques for Forensic Accounting Investigations". Hoboken, NJ: John Wiley & Sons Inc. ISBN 978-0-470-89046-2.
  24. ↑ 26 U.S.C. § 7602.
  25. ↑ IRA L. SHAFIROFF, INTERNAL REVENUE SERVICE PRACTICE AND PROCEDURE DESKBOOK 14-29 (1998).
  26. ↑ 886 F.2d 1497 (7th Cir. 1989).
  27. ↑ 80 F.2d 394 (8th Circ. 1935).
  28. ↑ D. LARRY CRUMBLEY, LESTER E. HEITGER, G. STEVENSON SMITH, FORENSIC AND INVESTIGATIVE ACCOUNTING 6-19 (2005).
  29. ↑ IRS
  30. ↑ Novack, Janet; William P. Barrett (2009-12-14). "Tax Informants Are On The Loose". Forbes.
  31. 1 2 "Fraud". Irs.gov. Retrieved 2011-03-15.
  32. ↑ Scherzer, Lisa (2007-03-13). "IRS will pay you to turn in tax cheaters". Finance.yahoo.com. Retrieved 2011-12-10.
  33. ↑ IRS Data Book
  34. 1 2 3 SOI Tax Stats - IRS Data Book. IRS.
  35. ↑ Current Fiscal Year Tax Fraud and Money Laundering Investigations. IRS.
  36. ↑ McShane, Larry (March 4, 2007). "RMatty the Horse's ride could end in prison". usatoday.
  37. ↑ Senator Robert Torricelli And The Mafia
  38. ↑ de Vogue, Ariane (November 16, 2010). "Rep. Charles Rangel Convicted of Violating House Ethics Rules". ABC News.
  39. ↑ Kocieniewski, David (November 16, 2010). "Rangel Found Guilty By Ethics Panel". New York Times. p. A24.
  40. ↑ Kane, Paul; Farentholt, David A. (December 2, 2010). "House Censures Rep. Charles Rangel in 333–79 Vote". The Washington Post.
  41. ↑ Kleinfield, N. R. (December 3, 2010). "Amid Routine Business, History and Humiliation". The New York Times. p. A28.
  42. ↑ Bowers, Simon (3 March 2013). "Ernst & Young to pay US regulators $123m over tax avoidance schemes". The Guardian. Retrieved 23 March 2013.

Further reading

External links

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