Everyone Does It

When you get to be my age it seems like all your friends are getting divorced. One of my recently divorced friends told me that she made a deal with her ex-husband to accept some of her child support in bill payments instead of cash. For instance, he would pay her electric bill each month and reduce her child support payment by that amount. That way he could run the payments through his business and take a tax deduction for them.

That’s tax evasion. An individual is committing tax evasion when he knowingly fails to file a return, files a false return, or hides money in foreign countries. Individuals convicted of tax evasion face fines, the payment of back taxes and possible jail time. It’s a felony.

Just because your return is wrong does not mean you’ve committed tax evasion. Tax evasion is willful and deliberate. Many taxpayers make mistakes. The tax code is complex. While you may face penalties for underpayment of tax due to a mistake, the penalties are much less severe.

We are, however, all entitled to tax avoidance. Tax avoidance is legally conducting your business to avoid a tax liability. One example would be the payment of the 4^th quarter estimated tax payment in December even though it’s not due until January in order to take the deduction a year earlier. Another example would be structuring a sale of appreciated property as a like-kind exchange. It’s a provision of the Internal Revenue Service Code, is therefore legal, and yet avoids tax.

Another way to think of it is that tax evasion is evading a tax that is already owed, while tax avoidance avoids the creation of a tax liability in the first place.

Interestingly, in the United States, income earned by illegal means is taxable. You are required to report your drug trafficking, prostitution, murder for hire and any other unlawful revenue received. Failure to do so can result in conviction for tax evasion when the government has insufficient evidence for the non-tax related crimes. Al Capone is the most famous case, but he has a lot of company.

Most of us voluntarily pay all the tax that we owe. The IRS estimates the compliance rate to be approximately 84%. What about the rest? That’s the tax gap, or the difference between the amount of tax legally owed and the amount actually collected by the government. Understated income and overstated expenses account for 82% of the total tax gap. Some people call this the “shadow economy.”

Much of the gap stems from small businesses like my friend’s ex-husband’s company. Historically, some businesses are more prone to tax fraud. Salons, bars, restaurants and car dealers come to mind. But you don’t have to be self-employed to cheat. Inflating the charitable contributions is cheating. Not reporting your tips is cheating. I have a feeling that there’s a lot of cheating going on with the Earned Income Credit. Let’s not forget hobby losses reported as business losses. That’s cheating.

One interesting case involved stealing the neighbors’ dependents. Well, not the actual children, just their social security numbers. A client filed their tax return, but it was rejected. The IRS notified them that the dependents on their return were already claimed by another taxpayer. In the resulting back and forth with the IRS, it was learned that the taxpayer that had claimed the children first was right up the street and had been in their home as a guest. That was a shocking development!

The tax gap increases as tax rates go up, as the unemployment rate rises, as the level of income goes up, and with dissatisfaction with the government. The United States has a small tax gap by global standards. High-tax nations have higher tax gaps.

Why does it matter? It matters because it costs the rest of us. Honest taxpayers pay more to cover the tax gap. It takes resources to collect the tax gap. So we cover the gap and then we pay for collection efforts. People who cheat shift the burden to the rest of us.

Cheating is evasion. It’s a fraud, and a felony.

Gina Bliss, CPA, CFE, is a senior manager at EFP Rotenberg, LLP, Certified Public Accountants and Business Consultants, who specializes in internal audit, fraud audit, and forensic accounting. She may be reached at (585) 295-0536 or by e-mail at gblissefprotenberg [dot] com