Part 2 of a 2-part series

[an error occurred while processing this directive] Flying Under IRS Radar - Tax Cheating Made Easy [an error occurred while processing this directive] As IRS attempts to use computer matching to enforce compliance, tax cheats have learned to fly beneath IRS radar by engaging in transactions that are not detected by its computers. The cash economy, which deals in cash and without receipts; the underground economy, which deals mainly in illegal activities, such as drugs; and the barter economy where goods of equal value are exchanged for services and other goods, all can exist and flourish without much fear of IRS detection. Although these transactions are supposed to be reported, there is not a viable enforcement mechanism in place to ensure compliance.

More nefarious and sophisticated tax-cheating involves use of phony trusts and entities to hide income, which can be used in conjunction with off-shore banks and credit cards to further eliminate a paper trail.

IRS has begun a crackdown on trusts and off-shore banking, but the results thus far have not been impressive. In contrast, the illegal trust-scam industry seems to be thriving. IRS apparently believes that criminal prosecution will deter promoters of these schemes, but despite an impressive conviction rate, millions, if not billions, of tax dollars are escaping the system. It takes years to successfully prosecute and convict a tax scam promoter and by that time, many taxpayers will have used their phony trusts and other arrangements to escape taxation.

In addition, there is a sophisticated tax-cheating industry flourishing on the Web, including phony identification numbers and shopping baskets full of off-shore companies, credit cards and banks ready to assist the tax cheat. One can even own an off-shore bank with which to launder your income, for the right price. Thus far, IRS has refused to crack down on Internet-based tax cheating services, citing First Amendment (freedom of speech) concerns, although the Food and Drug Administration has had no such First Amendment qualms shutting down websites that promote illegal or harmful products.

In his testimony before Congress, IRS Commissioner Charles Rosatti has made it clear that he intends to rely on criminal prosecution of trust scam promoters (he calls them "abusive trust" promoters) as the main deterrent, rather than taking swift action against website that advertise and sell tax-cheating packages. Notably, however, IRS recently has begun filing civil lawsuits aimed at shutting down some of the more notorious scams.

Of course, a prerequisite to tax cheating is generating income that is not reported on a W-2 or Form 1099. This usually means business income generated by self-employed workers or small companies, illegal income (which probably would not be reported in the first place) or income from rents, royalties or investments (held outside the U.S.).

Billions in Tax Cheating Goes Undetected [an error occurred while processing this directive] The willingness of affluent Americans to cheat on partnership income, limited liability companies and trusts coupled with the complete disregard by IRS of these exploitations, illustrate the weaknesses in stopping abusive tax avoidance.

Michael Brostek, director of tax issues for the General Accounting Office, says that according to government estimates, between $20 and $40 billion was lost to offshore schemes alone in 2000, with as many as 505,000 taxpayers taking part. IRS believes there could be 1 million to 2 million U.S. citizens holding credit or debit cards issued by offshore banks. The agency located 235,000 such accounts issued through 28 banks located in three countries. It is estimated that these accounts cheat the government, and the American people, of at least $70 billion annually.

At least another $2.9 billion was lost to abusive trusts used for the express purpose of sheltering income from taxes; and frivolous claims for refunds resulted in another $4.9 billion loss. As Senator Max Baucus of Montana has said, ". . . it is clear that tax cheats punish not only honest taxpayers by forcing them to shoulder the burden, but cost our government literally tens of billions of dollars each year."

If the taxes on K-1 income alone were collected, it is estimated that it would be enough to exempt from income tax the 62.5 million taxpayers who made less than $508 a week, with $29 billion left over.

IRS Amnesty Program Nets $16 Billion in Phony Losses [an error occurred while processing this directive] Although hardened by years of battle against the ever-changing world of tax-shelter schemes, IRS officials were evidently rocked by the size and scope of recent disclosures. According to Wall Street Journalist John D. McKinnon, the broadest depiction yet of abusive tax shelters by wealthy individuals and big corporations involved more than $16 billion in improper tax deductions - $16 billion! And the IRS is worried about waiters' tips?

To smoke suspected tax violators out of the woodwork, IRS recently initiated a four-month amnesty program, encouraging taxpayers to voluntarily disclose tax shelters in exchange for immunity from IRS tax penalties that would otherwise be due on monies owed. Officials expect that the actual cost is likely much higher than $16 billion because many taxpayers failed to list the amounts of their deductions.

Sophisticated tax shelters typically generate big artificial investment losses which become tax deductions. Deductions by participants ranged from $10 million to $300 million according to IRS officials, and the tax avoided averages one-third the amount of the deduction -- a $300 million tax deduction reduces taxes by roughly $100 million.

IRS was surprised at the number of individuals involved. In the past, IRS focused their attention and resources on deals promoted to major corporations. Of the 577 taxpayers tallied thus far in this program, about 400 are individuals.

Even with administration backing, congressional advocates admit they face an uphill battle in promoting tax-shelter legislation to go after tax-scam promoters. Major accounting firms and investment banks, assisted by major law firms lend confidence to taxpayers seeking shelter from tax bills.

Generally, taxpayers face little financial risk in attempting to thwart IRS. Even without the amnesty program, taxpayers are shielded from basic IRS penalties by lawyers' opinion letters approving the deals. Also, IRS can't exact separate penalties for failure to comply with disclosure agreements. All the waiters need is really big tips so that they can afford the accounting firms and lawyers.

IRS Audit vs. Death by Accident - Here are the Odds [an error occurred while processing this directive] IRS reluctance or inability to fairly and equitably enforce income tax reporting and compliance results in discriminatory auditing as well. For example, the working poor last year had a 1 in 47 chance of being audited compared with a 1 in 145 chance for taxpayers making $100,000 or more. Contrast the audit odds for the working poor with the lifetime odds of anyone dying in a motor vehicle accident which are 1 in 81 almost twice as high; or any accidental death of any kind of 1 in 36. In other words, if you are poor, it is twice as likely that you will receive an IRS audit than you will be killed in a car crash.  See the comparison chart.

Continuing the theme, people with small businesses with revenue of less than $25,000 are more than twice as likely to be audited as those with revenue of $100,000 or more.

But for those who earn greater than $100,000, the odds are far greater, more than 4 to 1, that they could die from an accident than of ever being audited by IRS.

Better yet, if you own an S-Corporation, like many professionals such as doctors and lawyers, you stand a chance of audit of only 1 in 233. Chances of being killed by a firearm are close, 1 in 299; but you have a greater chance of being killed (homicide odds are greater at 1 in 197) than receiving an audit notice for an S corporation!

Partnerships and Limited Liability Companies fare best of all in avoiding IRS audits with only a 1 in 400 chance. The chance of dying by poison is greater, 1 in 344!

Tax Planning Tip: Sole proprietorships and freelancers earning more than $100,000 a year have a 1:83 chance of audit. Switch your business operations to an S corporation (1:233 chance of audit) and you reduce the chances of audit three times. Better yet, become an LLC (1:400 chance of audit) and reduce your audit risk by a factor of five! Note: the LLC will need at least two or more members to file as a partnership and obtain the 400:1 odds against audit.

A small "C" corporation (separate taxpaying entity) has a 1:49 chance of audit. By converting to an "S" corporation, the odds of audit are reduced almost six-fold to 1:233.

The current manner of policing wage earners more assiduously than higher income investors and business owners undermines our tax system and is grossly unfair - returns are not being equally verified for all Americans.

Where's Congress? [an error occurred while processing this directive] Despite this great imbalance in IRS auditing efforts and the billions of tax dollars escaping the system through cheating by the wealthy, the Congressional committee assigned to oversee IRS has held no hearings on the subject. Representative Amo Houghton of New York, chairman of the subcommittee and the wealthiest member of Congress, in a recent interview, stated that he was unaware of any problem of tax cheating by high-income Americans, unaware of problems with unreported business and investment income. He did however, graciously agree to look into the issue and remarked that more money may need to go to IRS " . . . to do the job at the same level as in the past."

In an effort that sounds like a rebuttal to the New York Times expose on its tax-auditing practices, IRS told congress that it expects a new focus on auditing higher-income taxpayers beginning in 2003. A survey done in 2001 indicated that as many as 24% of taxpayers are comfortable with "some level of cheating;" although serious noncompliance was only sanctioned by 3% to 5% of participants.

IRS Oversight Board Chairman Larry Levitan has stated that he believes voluntary compliance by the general public is beginning to erode at the very time that "the broad decline in enforcement activity increases reliance on voluntary compliance." IRS acknowledged that in 2001, about $3 billion in enforcement revenue was lost due to a drop in compliance activities.

Conclusion: [an error occurred while processing this directive] Tax cheating made easy - just conduct business through a so-called pass-though entity - an S corporation, limited liability company or a partnership, since the odds of an audit range from 233:1 to 400:1. Better yet, form several of these entities and your odds against audit should grow geometrically. Unless IRS gets serious about auditing the wealthy, the burden of tax compliance will remain on the shoulders of wage earners and the poor.

Where is Robin Hood when we need him?

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© 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.