Tax evasion

SIGNIFICANCE: Although tax evasion is a felony offense punishable by fines and imprisonment, as well as civil penalties, the scale of the crime is immense because as many as one in five Americans admits to cheating on income tax returns.

In 1913, the Sixteenth Amendment to the U.S. Constitution gave the U.S. Congress the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the states, and without regard to any census or enumeration. To implement that power, Congress passed the Internal Revenue Code (IRC) or tax code. That code provides that any person who willfully attempts, in any manner, to evade or defeat a tax imposed by the code is guilty of a felony and subject to fine, imprisonment, or both. Another section of the code also makes it a felony to fail to file required tax returns.

Responsibility to Pay Income Tax

Any person who willfully makes and submits a return, statement, or other document that contains any false information is guilty of tax evasion under the code. It is also a crime willfully to aid or assist other persons or corporations to evade a legally due tax. Among specific types of violations possible under the tax code are deliberately underreporting or omitting income, overstating deductions, keeping multiple sets of books, making false entries in books and records, claiming personal expenses as business expenses, claiming false deductions, and hiding or transferring assets or income.

The federal tax code relies on the concept of voluntary compliance by taxpayers. It is thus the responsibility of individual taxpayers to file correct returns in a timely fashion and to determine and pay the correct amounts of taxes that are due. The vast majority of Americans recognize that responsibility by properly reporting and paying their tax obligations. However, the Internal Revenue Service (IRS), which collects federal income taxes, estimates that 17 percent of all taxpayers do not comply with the tax laws in one way or another.

The IRS further estimates that individual taxpayers—mostly middle-income earners—do 75 percent of the cheating, and corporations do most of the rest. Cash-intensive businesses and service industry workers are considered as the worst offenders. For example, the IRS claims that restaurant waiters underreport their tips by an average of 84 percent. According to the IRS, most cheaters deliberately underreport income, while only 6.8 percent of deductions that are claimed are overstated or simply false. Tax cheating done by self-employed people approaches 100 percent, but much of such cheating may be trivial. For example, using a postage stamp for which a business deduction is taken to mail a personal letter is technically a form of tax cheating.

The loss from minor instances of cheating such as these, however, is small compared to that from tax evasion by businesses and by the very wealthy, who may avoid paying taxes on their full income by depositing some part of it in an account in a country with low or no taxes for foreign individuals and businesses. These countries, known as tax havens, also generally provide little or no financial information to the tax authorities in the account-holder's native country. According to a 2020 estimate, the US government loses $90 billion per year in tax avoidance and evasion.

The federal tax code is complex and is amended annually. In 2022, the complete code was more than four million words long. The sheer size and complexity of the code naturally creates many situations in which it is not clear how a tax law should be applied. As a consequence, honest differences in interpretation lead to frequent disputes between taxpayers and the IRS.

Part of the confusion in tax laws arises from the fact that some tax rules are written for purposes other than raising revenue for the government. For example, the federal government tries to help alleviate housing problems of poor citizens by giving special tax breaks to those who invest in low-income housing. The government also attempts to stimulate manufacturing industries by allowing rapid tax write-offs to buyers of new business equipment. There are also many special interest groups, such as oil and insurance companies, that have successfully lobbied for tax laws designed to give them special treatment. Indeed, the special provisions of the federal tax code outnumber the laws of general application.

Honest Disputes

Honest disputes and misinterpretations of provisions of the complex tax code are not considered tax evasion. In federal criminal tax cases, the statutory willfulness requirement is the voluntary, intentional violation of a known legal duty. Federal courts have held that it is not the purpose of the law to penalize frank differences of opinion or innocent errors made despite the exercise of reasonable care. In one case, for example, a US district court held that a taxpayer’s reliance on a certified public accounting firm’s assurance that it would either file the taxpayer’s income tax return before the due date or file a request for an extension of time to file constituted “reasonable cause” for the taxpayer’s failure to file the return. The court in that case refused to adopt a per se rule that a taxpayer has a nondelegable duty to file a tax return when due. However, while reliance on the firm’s assurance was sufficient to protect the taxpayer from criminal liability, the taxpayer was still required to pay a civil penalty for the failure to file the return on time.

Tax avoidance is the minimization of an individual’s tax liability by taking advantage of legally available tax saving opportunities. The difference between tax avoidance and tax evasion is that the latter entails the reduction of tax liability by using illegal means.

Arguments that some provisions of the tax code are unconstitutional does not excuse the failure to comply with the tax code requirements for filing returns, providing required documents, or failing to pay required taxes. The courts have held that taxpayers cannot ignore the duties imposed by the IRC without risking criminal prosecution. Taxpayers who refuse to comply with those duties must take the risk or being wrong. It makes no difference whether the claims of invalidity are frivolous or have substance.

Investigation

When IRS tax auditors find evidence of possible tax violations, they forward the suspect documents to the criminal investigation unit of the IRS. That unit is directed at taxpayers who willfully and intentionally violate their responsibilities to pay income, employment, and excise taxes. The criminal investigation division’s general fraud program encompasses a wide variety of investigations involving tax crimes and money laundering perpetrated by individuals and organizations from small business owners and self-employed persons to large corporations. General fraud cases constitute the main component of the criminal investigation division’s efforts to force taxpayer compliance with the Internal Revenue Code.

The IRS also has an Illegal Source Financial Crimes Program. This program attempts to recognize illegal source proceeds that are part of the untaxed underground economy and are considered threats to the voluntary tax compliance system. The federal government considers that failure to investigate these cases would erode public confidence in the tax system. Within the guidelines of the Illegal Source Financial Crimes Program, the criminal investigation division commits resources to investigations that involve proceeds derived from illegal sources. The program covers tax and tax-related violations set forth in the US Code, as well as money laundering and currency violations. Linked to the investigation of the criminal charges within this program is an emphasis for the effective utilization of the forfeiture statutes to deprive individuals and organizations of illegally obtained assets.

Prosecution

The IRS uses informers in its efforts to find and prosecute tax evaders and pays them about 8 percent of the first $100,000 it collects and 1 percent of the balance. (Rewards received by informers are taxable income.) Identities of informers are kept secret, but tax cheats usually know who has reported them. In most cases, informers are former spouses and disgruntled business associates. In a recent year, the IRS paid out a total of only $1.5 million for tips, on $72 million collected. The IRS places low priority on investigating tips and has been accused of looking for ways to avoid paying rewards.

Penalties and Punishments

Tax evasion is a felony that is punishable by fine and/or prison. Careless mistakes on tax returns may add 20 percent penalties to taxpayers’ tax bills. Deliberate fraud may add 75 percent civil penalties and also subject taxpayers to criminal liability. However, the line between negligence and fraud is not always clear, even to the IRS and the courts. The maximum punishments for tax evasion crimes are generally five years imprisonment and $100,000 in fines for each act of tax evasion. Civil penalties can range as high as 100 percent of the taxes legally due.

Bibliography

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