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] Compared to other countries, Americans are more likely to pay their taxes fairly, honestly, and on time.[2]

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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. For example, a person can legally avoid some taxes by refusing to earn more taxable income, or by buying fewer things subject to sales taxes. 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.[3]

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.[4]

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).[5]

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.[6][7] A belief that the Federal income tax is invalid or unconstitutional is not a misunderstanding caused by the complexity of the tax law,[8] and is not a defense to a charge of "willfulness", even if that belief is genuine and is held in good faith.[9][10]

Occurrence

Nearly all Americans believe that cheating on taxes is morally and ethically unacceptable.[11] The voluntary compliance rate (a technical measurement of taxes being paid both on time and voluntarily) in the US is generally around 81 to 84%.[11] This is one of the highest rates in the world. By contrast, Germany's voluntary compliance rate is 68%, and Italy's is 62%.[11]

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.[12] A recent survey found that the amount of unreported income for 2016 in the United States numbered at US $214.6 billion, with one in four Americans not reporting the money made on side-jobs.[13]

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.[14]

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
See also: Taxation of illegal income in the United States

U.S. citizens are required to report unlawful gains as income when filing annual tax returns (see e.g., James v. United States[15]) 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[16]
Year Revenue lost
(US$ billion)
2010 305
2009 304
2008 357
2007 376
2006 376[17]
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.[18] For 2006, the tax gap is estimated to be $450 billion.[19]

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.[20] Thus, 18 to 19 percent of total reportable income is not properly reported to the IRS.[21]

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".[22] 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.[23] However, critics point out numerous problems with the tax gap measure.[24] The IRS direct audit measures of noncompliance are augmented by indirect measurement methods, most prominently currency ratio models[25]

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.[26]

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.[27] 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.[22]

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.[28] The cash method was approved in 1989 in United States v. Hogan.[29]

Bank deposit cash expenditure method

First approved by the Eighth Circuit in 1935 in Gleckman v. United States,[30] 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.[31]

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.[32] 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,[33] 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.[34]

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.[35] Under this program, a taxpayer may file a lawsuit in court if he or she does not receive a deserved award.[34]

Historical U.S. tax evasion cases

The IRS publishes the number of civil and criminal penalties in the IRS Data Book (IRS Publication 55B)[36] and makes these available online. Table 17 shows tabulated data on civil penalties and Table 18 shows data on criminal investigations.[37] In 2012, the IRS assessed civil penalties in 37,910,493 cases and 4,994,926 abatements.[37] In 2012, the IRS initiated 5,125 investigations; of 3,701 which were referred to prosecution, 2,634 resulted in conviction.[37] 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.[38]

  • 1932–1939: Al Capone served seven years of an 11-year sentence in federal prison on Alcatraz Island for tax evasion. He was let out of jail early while suffering with the advanced stages of syphilis.
  • 1933: Gangster Dutch Schultz was indicted for tax evasion. Rather than face the charges, he went into hiding.
  • U.S. President Harry Truman pardoned George Caldwell, George Berham Parr, and Seymour Weiss for income tax evasion.
  • 1963: Joe Conforte, a brothel owner, served two and a half years in prison, convicted for the crime of income tax evasion.
  • 1971: Martin B. McKneally (R-NY) was placed on one-year probation and fined $5,000 for failing to file income tax return. He had not paid taxes for many years prior.
  • 1972: Cornelius Gallagher (D-NJ) pleaded guilty to tax evasion, and served two years in prison.
  • 1974: Otto Kerner Jr. (D) - Resigned as a judge of the Federal Seventh Circuit Court District after conviction for bribery, mail fraud, and tax evasion while Governor of Illinois. He was sentenced to 3 years in prison and fined $50,000.
  • 1982: Frederick W. Richmond (D-NY) was convicted of tax evasion and possession of marijuana. Served 9 months
  • 1985: Joseph Alioto, a lawyer, confessed that he paid no income taxes during the years he served as Mayor of San Francisco.
  • 1985–1986: Iran–Contra Affair - Thomas G. Clines was convicted of four counts of tax-related offenses for failing to report income from the operations.
  • 1987: Robert Bernard Anderson (R) former United States Secretary of Treasury (1957–1961) pleaded guilty to tax evasion while operating an offshore bank.
  • 1986: Harry Claiborne, Federal District court Judge from Nevada, was impeached by the House and convicted by the Senate on two counts of tax evasion. He served over a year in prison.
  • 1991: Harry Mohney, founder of the Déjà Vu strip club chain, began to serve three years in prison for tax evasion.
  • "Matty the Horse" Ianniello (Mafia) was sent to prison for income tax evasion.[39][40]
  • 1992: Catalina Vasquez Villalpando (R), Treasurer of the United States, pleads guilty to obstruction of justice and tax evasion.
  • 1993: Sam Roti, nephew of Chicago alderman Fred Roti, was indicted on Federal tax charges, which were later dropped.
  • Nicolas Castronuovo is the owner of the Florida pizza parlor where Senator Robert Torricelli was caught on an FBI wiretap soliciting contributions in 1996. Nicolas Castronuovo and his grandson Nicholas Melone later pleaded guilty to evading the government of $100,000 in taxes.
  • 1995: Webster Hubbell, (D) Associate Attorney General, pleaded guilty to mail fraud and tax evasion. He is sentenced to 21 months in prison.
  • 1996: Heidi Fleiss was convicted of federal charges of tax evasion and sentenced to 7 years in prison. After two months she was released to a halfway house, with 370 hours of community service.
  • 2001: U.S. President Bill Clinton pardoned Marc Rich and Pincus Green, indicted by U.S. Attorney on charges of tax evasion and illegal trading with Iran. President Clinton also pardons Edward Downe, Jr., for wire fraud, filing false income tax returns, and securities fraud.
  • 2002: James Traficant (D-OH) was convicted of ten felony counts including bribery, racketeering and tax evasion and sentenced to 8 years in prison.
  • 2002: The Christian Patriot Association, an "ultra-right-wing group", was shut down after convictions for tax fraud and tax evasion.
  • 2005: Duke Cunningham (R-CA) pleaded guilty to charges of conspiracy to commit bribery, mail fraud, wire fraud and tax evasion in what came to be called the Cunningham scandal. He is sentenced to over eight years.
  • 2006: Jack Abramoff, lobbyist, was found guilty of conspiracy, tax evasion and corruption of public officials in three different courts in a wide-ranging investigation. Now serving 70 months and fined $24.7 million
  • 2008: Charles Rangel (D-NY) failed to report $75,000 income from the rental of his villa in Punta Cana in the Dominican Republic and was forced to pay $11,000 in back taxes.[41][42] The House of Representatives voted 333–79 to censure Rangel.[43] It had been 27 years since the last such measure and Rangel was only the 23rd House member to be censured.[44]
  • 2008: Senator Ted Stevens (R-AK) was convicted on 7 counts of bribery and tax evasion just prior to the election. He continued his run for re-election, but lost. However, prior to sentencing, the indictment was dismissed—effectively vacating the conviction—when a Justice Department probe found evidence of gross prosecutorial misconduct.
  • 2013: Big Four accounting firm Ernst & Young agreed to pay federal prosecutors $123 million to settle criminal tax avoidance charges stemming from $2 billion in unpaid taxes from about 200 wealthy individuals advised by four Ernst & Young senior partners between 1999 and 2004.[45]

References
  1. 26 U.S.C. § 7201.
  2. Chun, Rene (2019-03-10). "Why Americans Don't Cheat on Their Taxes". The Atlantic. Retrieved 2020-02-27.
  3. 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).
  4. 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.
  5. 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.
  6. Cheek v. United States, 498 U.S. 192, 203 (1991).
  7. 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).
  8. See generally Dan M. Kahan, "Ignorance of Law Is An Excuse -- But Only for the Virtuous," 96 Michigan Law Review 127, 146 (Oct. 1997).
  9. Lyle Denniston, "Court widens use of ignorance plea in tax cases," Baltimore Sun, Jan. 9, 1991, at .
  10. Cheek, 498 U.S. at 206.
  11. Chun, Rene (2019-03-10). "Why Americans Don't Cheat on Their Taxes". The Atlantic. Retrieved 2019-03-10.
  12. https://www.bostonglobe.com/business/2016/05/23/airbnb-others-pay-out-billions-beneath-irs-radar-study-finds/o57SNCizMzHSEjH0A1MNMM/story.html
  13. McDermott, Jennifer (3 September 2017). "Side hustle and tax evasion: The telling statistics". finder.com. Retrieved 21 September 2017.
  14. Patricia Sabatini, Pittsburgh Post-Gazette, "Tax Cheats Cost U.S. hundreds of billions," http://www.post-gazette.com/pg/07084/772106-28.stm
  15. 366 U.S. 213 (1961), "overruling" Commissioner v. Wilcox, 327 U.S. 404 (1946).
  16. "?" (PDF). Archived from the original (PDF) on June 8, 2012.
  17. https://www.irs.gov/uac/IRS-Releases-New-Tax-Gap-Estimates;-Compliance-Rates-Remain-Statistically-Unchanged-From-Previous-Study
  18. "IRS Updates Tax Gap Estimates". Irs.gov. Retrieved 2011-12-10.
  19. "Tax Gap for Tax Year 2006 Overview Jan. 6, 2012" (PDF). U.S. Internal Revenue Service. Retrieved 2012-06-14.
  20. 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
  21. 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
  22. James Andreoni & Brian Erard & Jonathan Feinstein, 1998. "Tax Compliance," Journal of Economic Literature, American Economic Association, vol. 36(2), pages 818-860, June
  23. Slemrod, Joel. 2007. "Cheating Ourselves: The Economics of Tax Evasion." Journal of Economic Perspectives, 21(1): 25–48.
  24. Toder, E. "What is the Tax Gap?" http://www.urban.org/publications/1001112.html
  25. Feige, Edgar L. (ed.), 1989. The Underground Economies: Tax Evasion and Information Distortion. Cambridge Books, Cambridge University Press, number 9780521262309.
  26. 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.
  27. 26 U.S.C. § 7602.
  28. IRA L. SHAFIROFF, INTERNAL REVENUE SERVICE PRACTICE AND PROCEDURE DESKBOOK 14-29 (1998).
  29. 886 F.2d 1497 (7th Cir. 1989).
  30. 80 F.2d 394 (8th Circ. 1935).
  31. D. LARRY CRUMBLEY, LESTER E. HEITGER, G. STEVENSON SMITH, FORENSIC AND INVESTIGATIVE ACCOUNTING 6-19 (2005).
  32. IRS
  33. Novack, Janet; William P. Barrett (2009-12-14). "Tax Informants Are On The Loose". Forbes.
  34. "Fraud". Irs.gov. Retrieved 2011-03-15.
  35. Scherzer, Lisa (2007-03-13). "IRS will pay you to turn in tax cheaters". Finance.yahoo.com. Retrieved 2011-12-10.
  36. IRS Data Book
  37. SOI Tax Stats - IRS Data Book. IRS.
  38. Current Fiscal Year Tax Fraud and Money Laundering Investigations. IRS.
  39. McShane, Larry (March 4, 2007). "RMatty the Horse's ride could end in prison". usatoday.
  40. Senator Robert Torricelli And The Mafia
  41. de Vogue, Ariane (November 16, 2010). "Rep. Charles Rangel Convicted of Violating House Ethics Rules". ABC News.
  42. Kocieniewski, David (November 16, 2010). "Rangel Found Guilty By Ethics Panel". New York Times. p. A24.
  43. Kane, Paul; Farentholt, David A. (December 2, 2010). "House Censures Rep. Charles Rangel in 333–79 Vote". The Washington Post.
  44. Kleinfield, N. R. (December 3, 2010). "Amid Routine Business, History and Humiliation". The New York Times. p. A28.
  45. Bowers, Simon (3 March 2013). "Ernst & Young to pay US regulators $123m over tax avoidance schemes". The Guardian. Retrieved 23 March 2013.

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