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According to the IRS, 75% of the tax cheating is done by individuals—mostly
middle-income earners. Most of the rest of the cheating is done by
businesses. Cash-intensive businesses and service providers, from self-
employed handypeople to doctors, are the worst offenders.
How People Cheat on Their Taxes
Most cheating is from deliberate—actual or willful—underreporting of
income. This is called tax evasion—the most commonly charged tax crime. A
government study found the most underreporting of income was by self-
employed restaurateurs, clothing store owners, and—you’ll no doubt be
shocked—car dealers. Telemarketers and salespeople came in next, followed
by doctors, lawyers (heavens!), accountants (heavens, again!), and
hairdressers.
Business owners who over-deduct business-related expenses—such as car and
entertainment—came in a distant second on the cheaters hit parade.
Surprisingly, the IRS contends that only 6.8% of deductions are overstated
or just plain phony.
If You Are Caught Cheating
Tax crimes are most likely to be first spotted during an audit. If you are
caught in a tax lie by an auditor, she can either slap you with a penalty or
refer your case to the IRS’s criminal investigation division (CID). In the
vast majority of cases, the auditor won’t call in the CID.
The Auditor Suspects You of Fraud
Auditors are trained to look for signs of tax fraud, which is a form of tax
evasion. Tax fraud is defined as a willful act done with the intent to
defraud the IRS—that dark area beyond honest mistakes. Using a false Social
Security number, keeping two sets of financial books, or claiming a blind
spouse as a dependent when you are single are all blatant examples of tax
fraud. While auditors look for fraud, however, they do not routinely suspect
it. They know the tax law is complex and expect to find a few careless
mistakes in every tax return. They will give you the benefit of the doubt
most of the time.
Even if the auditor does not refer suspected fraud to the CID, she can
impose fines, called civil penalties, if you omitted a chunk of income on
your tax return. Overstated or phony deductions and exemptions can also be
punished by the fraud civil penalty—for example, claiming exemptions for
dependents who have long since left home, died, or were never born. Fraud
penalties can also be added for exaggerating deductions, such as adding a
zero to $200 making it $2,000, or by claiming a casualty loss for a
nonexistent accident.
Fraud or Negligence?
A mistake on your tax return might get you a 20% penalty tacked on to your
tax bill. While not good, this sure beats the cost of tax fraud—a 75% civil
penalty. The line between negligence and fraud is not always clear, however
, even to the IRS and the courts.
Auditors are trained to spot common types of wrongdoing, called “badges of
fraud.” Examples include a business with two sets of books or without any
records at all, freshly made false receipts, and checks altered to increase
deductions. Altered cancelled checks are easy to spot by comparing written
numbers with computer coding on the check or bank statements.
The Internal Revenue Manual directs auditors suspecting criminal tax fraud
to contact the IRS criminal investigation division, or CID. In reality,
auditors make very few criminal referrals. Making a fraud referral is too
much paperwork. If auditors find a couple of obviously phony receipts, they
usually will quietly disallow them and move on. Fraud referrals are more
often made in special project audits. These are targeted audits of
particular industries and professions, such as building contractors or
chiropractors.
caution
The auditor will not tell you if she has made a criminal fraud referral. One
indication, however, may be an audit stopping midstream for no apparent
reason. But never assume a fraud referral was made just because months pass
and you don’t hear from the auditor. She is probably just behind in her
work.
Indirect Methods of Proving Fraud
Direct proof of fraud by the IRS typically consists of finding clearly
overstated or phony deductions and exemptions. Direct proof is not usually
found by the IRS for income underreporting. Instead, the IRS relies on
primarily four indirect methods.
Specific items. If you cashed a check received by your business and pocketed
the money without entering it in your books, this check is a “specific
item.” It can be viewed as evidence of fraudulent intent. If the auditor
suspects fraud, she may talk to your business’s customers to compare your
bank account deposits and actual payments you received from customers.
The IRS wants more than just one specific item to make a fraud case—unless
the item was for many thousands of dollars. While you might argue that one
or two items were negligently left off the books (or your computer crashed
or you lost your records), 15 or 20 omitted items shows a pattern of fraud.
Bank deposits. This is the IRS’s favorite indirect method to prove
unreported income, because it is so easy. The auditor simply adds up all
deposits in your bank accounts. If the total exceeds your reported income,
you may be suspected of fraud.
There may be a perfectly legitimate explanation, such as nontaxable sources
of bank deposits—loans, gifts, inheritances, sales of assets, and tax-
exempt income, such as municipal bond interest. Also, transfers from one
bank account to another appear to be multiple deposits under this simplistic
method. Point this out to the suspicious auditor. Or, deposits in your
accounts may belong to relatives or friends who did not use their own
accounts for some reason.
Expenditures. The auditor calculates your living expenses by totaling up the
credit charges you paid, checks you wrote, and adding known or estimated
expenses you paid by cash. If the total is greater than your tax-reported
income, the auditor will suspect fraud. Auditors can refer to statistical
reference books showing average costs of various necessities such as food
and shelter in your community.
To counter this, explain where you got the money to pay your bills. It could
be savings from prior years, selling assets, or receiving loans or gifts.
To figure your living expenses, auditors often ask you to complete IRS Form
4822, Statement of Annual Living Expenses.
tip
Never fill out IRS Form 4822 listing your living expenses. Just say you didn
’t keep track of every penny you spent for the year and don’t want to
guess. Or, diplomatically tell the auditor you will consider it and then
throw the form away. The IRS cannot punish you for refusing to fill out this
form. If an auditor is intent on proving fraud, he will do it with or
without your cooperation. Don’t do his job for him.
Net worth. Under this indirect method, an auditor adds up all of your assets
and deducts all of your liabilities at the start and end of the tax year
under audit. If there was an increase in your net worth—what you own minus
what you owe—without an increase in income from the previous tax year, you
may be suspected of fraud.
Again, there are many valid explanations as to how your net worth can
increase besides unreported income. For example, you may have received
nontaxable gifts or loans or inheritances. Or the auditor may have
mistakenly included appreciation in his calculations.
Penalties for Civil Tax Fraud
You will probably never face criminal fraud penalties. At least 98% of the
time, the IRS punishes fraud with civil penalties—fines of 75% added to the
tax due. For example, if the additional tax due from fraud is $10,000, the
penalty is $7,500, for a total of $17,500. Interest is added on to both the
tax and the fraud penalty, starting on the date the return was due or filed,
whichever is later.
Defending Against Alleged Tax Fraud
The three defenses most often raised against tax fraud allegations are cash
hoard, nontaxable income, and honest mistake. Don’t expect the IRS to
accept any of these defenses at face value. A skilled attorney is better
able to persuade the IRS than you are. Combatting tax fraud, like brain
surgery, is not a do-it-yourself project.
I lived off my cash hoard. This defense can be raised whenever the IRS uses
the bank deposits, expenditures, or net worth methods of proving fraud.
There is no law (not yet, anyway) against having cash of any amount buried
in your back yard or kept in a safe deposit box. The IRS’s only legitimate
concerns with your cash holdings are whether or not it was from taxable
income, and if you reported it and paid tax on it. The IRS understandably is
suspicious of people who hold large amounts of cash rather than putting it
in an interest-bearing account.
I lived off a nontaxable source. The receipt of money is not always taxable
income, as discussed above. You may innocently acquire tax-free wealth by
gift, loans, inheritances, and other ways. This defense can be coupled with
the cash hoard defense.
I made an honest mistake. If you make an error on your tax return, it is not
necessarily fraud. For example, you didn’t report profit from a sale of
investment real estate because you believed you had two years to reinvest
the proceeds without tax consequences. In reality, the law only allows you
180 days. Because intent to cheat the IRS is required for fraud, your
mistaken belief is a valid defense to a tax fraud charge—but you may have
to convince a judge or jury that it really was a mistake.
caution
Don’t try to lie your way out of a fraud charge. If in doubt, keep your
mouth closed. Lying to the IRS can make matters worse. The right against
self-incrimination is guaranteed by the Fifth Amendment. You have the
absolute right to remain silent before the IRS whenever there is a
possibility you may be charged with a crime. Lying to an IRS employee can
result in a felony conviction with up to three years in prison and a $100,
000 fine.
Options When the IRS Finds Fraud
If an IRS auditor believes you’ve cheated on your taxes, she has several
options.
Ignore the cheating. If the amount is small, an IRS auditor will overlook it
. Typically, an auditor just wants the file closed and off her desk—
particularly if she has found other significant adjustments. She will likely
leave it at that and never refer your file to the CID.
Impose civil penalties. IRS auditors draw the line at outrageous cheating.
Most will add civil, as opposed to criminal, penalties on to your tax bill,
especially if your case is deemed too small to send to the CID.
In the case of small mistakes, an auditor can add a 20% penalty to your bill
if she finds that your tax error was “accuracy related.” If she concludes
you owe an additional $1,500 of taxes, she can add a penalty of $300,
bringing the bill to $1,800. The IRS imposes civil penalties about 25
million times each year.
If the auditor finds more serious misdeeds, however—particularly if your
omission or overdeduction was fraudulent—she could add a 75% penalty,
bringing your $1,500 tax bill to $2,625. And, interest will be added to both
the penalty and the taxes.
Begin a criminal investigation. If the IRS suspects that you have gone too
far, the CID can investigate.
The CID usually gets information that leads to an investigation from one of
the following sources:
referrals from other IRS divisions, most often from auditors who
discovered unreported income during an examination
tips from law enforcement agencies —the IRS isn’t concerned with the
nontax crime itself, often a drug-related offense, but whether or not the
illegal income was reported.
Example:
When Morgan was arrested for suspected drug trafficking, $150,000 in cash
was in his car’s trunk. After his arrest, the local police notified the IRS
. The CID looked at Morgan’s last few tax returns, where he reported only $
35,000 of income per year. The CID immediately began a formal investigation.
tips from citizens—Ex-spouses or disgruntled employees and business
associates often contact the IRS. These people are called squeals. The CID
usually follows up only on well- documented tips. Many allegations are not
provable and are motivated by spite, and the CID doesn’t waste its time on
them. It may refer the case to the examination division, however.
IRS undercover or sting operations—CID agents often pose as buyers of
businesses to find off-the-books income. Unwary sellers who brag about
second sets of books and how much cash the business takes in get nailed.
Other undercover operations investigate gross discrepancies in reported
income and a taxpayer’s lifestyle. This is how the U.S. government finally
got Al Capone!
Example:
Roy owned a rather seedy looking pawn shop and was featured in a local
newspaper article on successful businesspeople. Roy proudly posed for the
paper in front of his waterfront home and Rolls Royce. Soon thereafter, Roy
was audited. The IRS wanted to know how someone lived so well while
reporting only $20,000 a year income. The audit turned into a lengthy CID
investigation. Two CID agents pored over six years of Roy’s financial
records, business and personal. Eighteen months later, Roy was indicted for
criminal tax evasion.
At the conclusion of the criminal tax investigation, the CID has two options
—drop it forever or recommend that the Justice Department prosecute. The
IRS, a part of the Treasury Department, cannot directly prosecute anyone. If
the investigation is terminated without prosecution, it doesn’t mean you’
ve gotten off completely. Your case will be sent to an auditor, who can
impose civil fraud penalties.
You will be pleased to know that in the great majority of investigations,
the CID does not recommend prosecution. The Justice Department will
prosecute only a select few cases. Therefore, the CID won’t waste its time
referring (and in some cases even seriously investigating) a case unless it
feels it has a sure winner.
If the CID does recommend prosecuting and the Justice Department gets a
conviction, you can be imprisoned, put on probation, fined, or all three.
For example, if you’re convicted of failing to file a tax return for three
separate years, you can be sent to prison for one year and fined up to $25,
000 for each year you didn’t file. The total could be three years in prison
and $75,000 in fines. You will also have a permanent criminal record.
That’s not all. After a criminal conviction, an auditor will slap civil
fraud and other penalties for underpayment of taxes. Combining criminal and
civil punishment does not constitute double jeopardy—a constitutional
guarantee against being tried, convicted, or sentenced more than once for
the same crime.
If you are prosecuted but not convicted, you will nonetheless probably be
audited.
IRS Criminal Investigations
The criminal investigation division, or CID, is the IRS police force. It’s
made up of 4,500 employees, based in Washington, DC. Investigators are
called special agents. They don’t wear uniforms, but they do carry badges
and have guns. Make no mistake—they are detectives highly trained by the
IRS and FBI. If someone identifies himself as an IRS special agent, you or
someone you know is under suspicion. Most special agents travel in pairs,
for their protection and to corroborate oral evidence gathered during an
investigation.
The CID is divided into general and special enforcement sections. Special
enforcement targets organized crime, drugs, and unions. General enforcement
watches ordinary taxpayers and everything else.
Will You Know If You’re Being Investigated?
Unless and until you are formally charged, you may not know that you’re
being investigated by the CID. The IRS does not have to tell you, but often
does. A friend, an employee, your accountant, your tax preparer, your lawyer
, or anyone else contacted by the IRS during the investigation might tell
you first. The IRS cannot legally swear these people to secrecy.
You might be able to find out indirectly if you are under investigation.
When a criminal investigation begins, IRS personnel must complete and file
Form 4135, Criminal Control Notice. This data is entered into your master
file in the IRS computer. Your tax account is frozen, meaning that no
refunds can be made or payments credited to your account.
To find out if Form 4135 has been filed, send a token tax payment for a year
you believe is under investigation—even if you’ve paid the tax already.
If a freeze is in effect, you may receive notice that your payment is being
held in a suspense account. Also request a computer printout of your account
for any year in question by calling 800-829-1040 or visiting your local IRS
office. The printout may indicate a Form 4135 filing or show that the
payment was not credited to your account without explanation.
Alternatively, the IRS may never send your requested statement if it has a
criminal investigation freeze code in the computer. If you call on the phone
to find out, IRS employees are told to not answer if you ask whether or not
a Form 4135 has been filed.
How Special Agents Conduct Investigations
In a recent year, 4,300 individuals were criminally investigated by the CID.
Only if the IRS has strong indications of wrongdoing does it send out its
elite police. Cases involving less than $20,000 in taxes are rarely
investigated. Criminal investigations start with a special agent
interviewing the taxpayer’s friends, business associates, professional
advisers, and anyone else who might have information. Later on the special
agents usually invite the targeted individual to speak to them.
CID investigations work in the reverse order of regular detective probes. “
Columbo,” “NYPD Blue,” or “Miss Marple” start with a dead body—and
then figure out whodunnit. Step 1 is the crime; Step 2 is finding the
culprit. This is the standard solving-the-mystery approach.
In contrast, IRS investigations begin with an allegation from a source,
usually an IRS auditor, collector, or informant, that a tax crime may have
been committed by you. Then special agents work at building a case against
you. Step 1 is the suspect; Step 2 is finding the crime. Special agents are
good at their work, too; they are among the best trained of all federal
employees (FBI Academy). And they have the full resources of the federal
government behind them.
Contacting Everyone Around the Target
CID investigations are unbelievably thorough, often taking a year or more.
The IRS spends more time investigating a criminal tax case than other police
departments devote to murder cases. This intensive use of federal resources
explains why so few people are charged with tax crimes. The CID recommends
prosecution only when it has built a rock solid case.
If you are under investigation, the special agent may talk to your friends,
family, neighbors, coworkers, employees, business associates, bankers,
insurance agents, and even travel agents and department stores. Even your
spouse may be contacted. Your mail may be monitored, in cooperation with the
Postal Service. While the IRS can’t open mail, it follows leads from
return addresses. The CID may get copies of bills from phone and credit card
companies, trail suspects, or get a court order authorizing a phone tap.
Special agents subtly intimidate businesspeople and bankers into giving
information. Don’t expect even your most trusted advisors to protect you if
the CID comes calling. Even your accountant can be compelled by the IRS to
give criminal evidence against you.
Attorney-Client Privilege
In a criminal matter, the only person who can’t be forced to speak about
you to the IRS is your lawyer. This is a special relationship given
protection under the law—called the attorney-client privilege. Your lawyer
cannot disclose to the IRS anything you tell her that relates to a criminal
tax matter. And, if an accountant is employed by your attorney to help her
render legal advice, the accountant’s work also falls under the attorney-
client privilege and cannot be disclosed to the IRS in a criminal matter.
The limited tax practitioner–client privilege does not extend to criminal
tax matters.
When IRS Special Agents Contact Your Associates and Friends
If you’re contacted by IRS special agents about another person, be wary.
Don’t answer any questions if there is any possibility you could be
connected to the individual under probe, such as a business partner. And
read “connected to” broadly. If you worked as the manager in a shop and
the owner is under investigation, you may not yet be a suspect, but there’s
a chance you will be. Keep quiet until you speak to a lawyer.
In any event, never lie to the CID. The law does not allow you to protect
others by withholding information or lying. It is legal, however, to tell
someone that the IRS was asking about them.
If someone tells you that she has been contacted in an IRS criminal
investigation of you and asks you what to say, don’t give her any
suggestions. It is a separate crime to ask someone to lie to the IRS. Also,
resist the urge to call the CID and ask what’s going on. Instead, call a
tax or criminal lawyer fast. Let them call the IRS.
If the CID Contacts You
If the CID is building a case against you, chances are you will be the last
person interviewed. By the time the CID agents contact you, they may have
looked at thousands of records and spoken to 20 potential witnesses—your
banker, ex-spouse, accountant, former employees, and others with knowledge
of your financial affairs. If the CID still wants to talk to you, more than
likely you are about to be recommended for prosecution. The only purpose for
the CID questioning you is to get a confession or other damaging admission
—the icing on the IRS’s cake.
Once you’re contacted as the target of an investigation, a special agent
must tell you so immediately. He must read to you a version of the Miranda
rights—the right to remain silent, the right to have an attorney, and the
warning that anything you say can be used against you. Believe him, it will
be. Answer only the question, “Are you August Fondue?”
It is highly unlikely that you’ll be arrested on the spot or even invited
to go to the IRS office. Simply state that you want to contact an attorney
and that someone will get back to them. Don’t call an attorney while the
special agents are present, unless they threaten you with immediate arrest,
or something similar, if you don’t cooperate. Wait until they leave, you
have calmed down, and you can speak freely. If you don’t know a criminal-
tax attorney, see Chapter 13 for tips on finding one.
How about trying to talk the special agents out of pursuing their case
against you? Forget it—it’s a terrible mistake. It makes no difference to
them if your mother is dying, you have money problems, or your marriage is
falling apart. Mentioning your problems, only strengthens the IRS’s
position; giving an excuse often shows that you knew what you did was wrong.
Similarly, don’t lie. Lying is as serious a crime as tax evasion.
caution
Keep your mouth shut—take this advice seriously. If you give the CID agents
any opening, you’re dead. They’ll start with soft background questions,
but before you know it, will have trapped you. And many CID questions won’t
be genuine—that is, the special agents already know the answers and are
asking only to see if you will lie or confess.
Questions typically asked by CID agents include:
Have you reported all of your income?
Where are your bank accounts and safe deposit boxes?
Can you tell us about the cars, boats, planes, and real estate that you
own?
Do you gamble?
What is the procedure for reporting sales in your business?
Do you keep a lot of cash on hand?
Who are your business associates?
Have you traveled out of the country recently?
Have you or any of your businesses been audited?
Faced with a barrage of questions from two trained agents who show up
unannounced, most people fall apart. They either blurt out a confession or a
transparent lie within five minutes. This gives the Justice Department the
rope to hang them with.
IRS Considerations in Deciding Whether or Not to Recommend Prosecution
The CID’s chief considerations in deciding to recommend prosecution is how
strong a case it has. If you were caught red-handed or confessed, you can be
sure of prosecution. But remember—for any crime, including a tax crime,
the government must prove your guilt beyond a reasonable doubt. If you keep
your mouth closed, a good criminal-tax lawyer may be able to mount a decent
defense. As a general rule, if you have some facts in your favor, the IRS
may not recommend prosecution and impose civil penalties (fines) instead.
The IRS looks closely at the case’s publicity value—locally or nationwide.
A prominent local doctor or movie star is a juicy plum. The agency firmly
believes that front-page headlines make would-be tax cheaters think twice.
The CID also analyzes personality traits of the individual target, including
age, physical and mental health, and previous criminal record. How would a
jury react to the person? Leona “Only the Little People Pay Taxes”
Helmsley was no doubt selected for prosecution because the IRS guessed she’
d be an unsympathetic figure. The judge and jury (and most Americans)
obviously agreed.
Finally, the CID looks at the amount you cheated the government out of. The
larger your indiscretion, the more likely the agents will recommend
prosecution. The typical amount of taxes owed in criminal cases is over $70,
000 and covers three or more years of cheating.
The bad news: When the CID recommends prosecution, and the Justice
Department accepts the case, the chances of conviction are at least 80%.
More than half of the people convicted go to prison even if they have no
prior criminal record.
The good news: The government is quite concerned with maintaining this high
rate of conviction. For every two people prosecuted, another one person
under suspicion is passed by or just tried in a civil proceeding.
Crimes With Which You Can Be Charged
If the CID recommends prosecution, it will turn its evidence over to the
Justice Department to decide the special charges. Individuals are typically
charged with one or more of three crimes: tax evasion, filing a false return
, or not filing a tax return.
Tax evasion or fraud. Tax evasion is defined as “intentional conduct to
defeat the income tax laws.” Any sort of tax scheme to cheat the government
can fall into this broad category. Tax evasion is a felony, the most
serious type of crime. The maximum prison sentence is five years; the
maximum fine is $100,000. (Internal Revenue Code § 7201.)
Filing a false return. Filing a false return is what it sounds like. Your
tax return contained a material misstatement, such as describing your line
of work as bricklaying when you are a bookie. More people are charged with
filing a false return than with tax evasion because in a filing-a-false-
return case, the government does not have to prove an intent to evade the
income tax laws—only an intent to file a false return. Filing a false
return is a less serious felony than tax evasion that carries a maximum
prison term of three years and a maximum fine of $100,000. (Internal Revenue
Code § 7206 (1).)
Failure to file a tax return. Not filing a return is the least serious tax
crime. It’s defined as intentionally failing to file a return when you were
obligated to do so. Not everyone must file tax returns. For example, only
those people earning above a specified amount must file. The minimum changes
from year to year. Not filing a tax return is a misdemeanor. The maximum
prison sentence is one year in jail and/or a fine of $25,000 for each year
not filed. The vast majority of nonfilers are never prosecuted criminally,
and only hit with civil fines.
Although technically not tax crimes, the CID also investigates and can
recommend prosecution for money laundering and filing false claims against
the IRS. Typically, these crimes are charged in the same case along with tax
crimes against the same individual or entity.
If You Are Prosecuted
Once the Justice Department receives a file recommended for criminal
prosecution, an Assistant U.S. Attorney reviews it. If he feels that the IRS
has a strong felony case, he will seek an indictment from a federal grand
jury, which usually goes along with the prosecution. You can be criminally
charged for a tax misdemeanor—such as not filing a tax return—without a
grand jury indictment.
If formally charged, you will either be arrested or, if you are not deemed a
flight risk, ordered to report before a federal judge to plead guilty or
not guilty. You might be required to post bail or be released on your own
recognizance.
If you ever find yourself in this position and don’t already have a
criminal or tax lawyer, get one immediately. Don’t delay, as the government
has already completed its investigation. Your lawyer will need time to
catch up and learn the government’s case. Keep heart; the government’s
case may be legally defective, or your attorney may recognize defenses to
the charges.
Should You Plead Not Guilty?
Unless you have made a plea bargain with the government before your first
court appearance, you should initially plead not guilty. Remember: The IRS
recommends for prosecution only those cases in which conviction seems a near
certainty. Justice Department weeds these cases out even further. Therefore
, it’s not surprising that over two-thirds of all defendants eventually
plead guilty without going to trial.
Most of these are plea bargains, meaning the accused agrees to plead guilty
if the Justice Department agrees to reduce or drop some charges, or both.
For example, if you are charged with three years of tax evasion, the
government may drop two years for a guilty plea to one year. Sometimes the
government will also agree to a favorable sentencing recommendation. However
, the final sentence will depend on a probation report, federal laws
governing minimum sentences, and the judge’s discretion.
What the Government Must Prove in a Tax Case
If you don’t plead guilty, you will eventually have a trial. At the trial,
the Justice Department and the IRS, working together, must prove you are
guilty of the crimes charged. Essentially, the government must show you
acted intentionally and that you are guilty beyond a reasonable doubt. You
are entitled to a trial by a jury, or you can choose to be tried by the
judge alone.
Intent. The primary element of any tax crime is intent. In legalese, this
intent is called willfulness. If the government can’t prove you acted
intentionally, you can’t be convicted. Put another way, you can’t be
convicted of a tax crime if you only made a mistake, even if it was a big
mistake. For example, if you didn’t file a tax return because you honestly
believed that 65-year-olds didn’t have to file any longer, you did not act
intentionally.
Before you senior citizens get carried away with this example, bear in mind
that to succeed, you will have to convince a jury that your mistaken belief
was honest. Given that most people remember watching their parents or
grandparents fill out returns—and many people, in fact, completed those
returns for their elderly relatives—you will have a hard time convincing
your 12 peers that your omission was an honest mistake. More believable is a
recent immigrant who did not report his income from investments made back
home, which he wrongly thought was tax-exempt.
Beyond a reasonable doubt. All crimes must be proven beyond a reasonable
doubt. If a judge or jury has any degree of doubt that you did what you were
accused of or acted intentionally, the government’s case will fail. For
instance, without additional evidence showing an intent to cheat the IRS, a
juror may not believe beyond a reasonable doubt that the immigrant who
omitted his foreign investment income was filing a false tax return. The
reasonable doubt standard is why the Justice Department prosecutes only
airtight cases.
Your Chance of Being Convicted of a Tax Crime
Not everyone charged with a tax crime is found guilty. For example, keep in
mind the story of Dr. Rudy Mays, a former client whose name has been changed.
Example:
Dr. Mays worked at an inner city clinic. Over 80% of his income was from
Medicare, with the rest paid mostly in cash. He was indicted for income tax
evasion when the IRS found that he had reported $240,000 in total income in
a year in which his Medicare income alone was $280,000.
Dr. Mays was offered a plea bargain —if he’d plead guilty, the charge
would be reduced and he’d receive probation, not a prison term. But this
plea bargain meant that Dr. Mays’ medical license would be revoked, ending
his career. He rejected the offer and went to trial.
Dr. Mays testified that he was a man of medicine, not a businessman. He
relied on his bookkeeper and accountant; he signed whatever they put in
front of him. The prosecuting attorney scoffed at this defense by telling
the jury that everyone bears the responsibility for the accuracy of their
tax returns. The jury sympathized with the good doctor and found him not
guilty.
P.S. Immediately after the trial, the IRS began an audit. Dr. Mays had to
pay thousands of dollars in taxes, interest, and fraud penalties, but at
least he stayed out of jail and kept his medical license.
In another case, Mr. Cheek, an airline pilot, was found guilty of tax
evasion. The U.S. Supreme Court reversed his conviction. (United States v.
Cheek, 498 U.S. 192 (1991).) Mr. Cheek claimed that he had formed a belief,
based on materials provided by a tax protester group, that certain income
tax laws did not apply to him. The trial judge told the jury not to consider
this as a defense to tax evasion. The Supreme Court, however, held that his
mistaken belief was a valid defense, and ordered Mr. Cheek to be retried.
The question in the new trial was whether Mr. Cheek’s belief was a good-
faith misunderstanding of the tax laws or was a criminal intent to evade
paying taxes.
Mr. Cheek wasn’t as lucky his second time around in court as he was his
first. At his new trial, Mr. Cheek raised the Supreme Court-approved defense
, but was convicted by a new jury of several tax crimes, anyway. The judge
sentenced him to one year and one day in prison and fined him $62,000. (Wall
Street Journal, March 25, 1992.)
If You Are Convicted of a Tax Crime
If you are convicted of a tax crime after putting the government to the
trouble of a trial, chances are eight in ten that you will be sent to
federal prison. The Federal Sentencing Guidelines and the judge determine
how long the sentence will be.
If, however, you reach a plea bargain without a trial, chances are better
that you will be fined and/ or placed on probation, given home
confinement, or sent to a halfway house, rather than sent to jail. Added to
the fine may be the costs incurred by the government in prosecuting you.
In general, public figures are most likely to go to jail. Back in the 30s,
President Hoover ordered that our income tax evasion law be used to put away
the notorious Al Capone. This is the only charge ever made to stick on
Scarface, who found his way to Alcatraz.
Today, instead of landing on the Rock, tax convicts are usually sent to a
Club Fed minimum security facility filled with bankers, lawyers, politicians
, and Wall Street sharpies. The average length of time served for a tax
crime is a little less than two years. If this sounds like a breeze, think
twice. Tax alumni of the federal prison system all agree that it was a
humiliating and crushing experience. And licensed professionals—lawyers,
doctors, stockbrokers, and CPAs—lose their professional licenses after
conviction.
Phillip S. Fry, author of Pay No Income Tax Without Going to Jail, was
apparently unclear on the concept. In 1986, he pleaded guilty to tax fraud
and, you guessed it, went to jail. Other tax criminals with whom you are
probably familiar and their prison terms include:
Pete Rose—five months
Chuck Berry—four months
Aldo Gucci—one year
Sun Myung Moon—18 months
Leona Helmsley—four years.
Richard Hatch failed to pay taxes on the $1,000,000 he won on the show
Survivor, but he didn’t survive the IRS police; he was sentenced to 51
months in federal prison.
One of my favorite stars of yesteryear, Sophia Loren, served 17 days in jail
in her native Italy for tax evasion. It appears that big stars get off
lighter in Italy than in the United States. So if you’re thinking of
evading taxes, maybe you want to brush up on your Italian and find a job in
Venice, Florence, or Rome.
Chapter Highlights
Tax fraud is more than carelessness or honest mistakes and can be
punished by the IRS either civilly or criminally or both.
The IRS seldom puts tax cheaters in jail but often imposes heavy fines.
See a criminal or tax attorney if the IRS is investigating you for a tax
crime.
middle-income earners. Most of the rest of the cheating is done by
businesses. Cash-intensive businesses and service providers, from self-
employed handypeople to doctors, are the worst offenders.
How People Cheat on Their Taxes
Most cheating is from deliberate—actual or willful—underreporting of
income. This is called tax evasion—the most commonly charged tax crime. A
government study found the most underreporting of income was by self-
employed restaurateurs, clothing store owners, and—you’ll no doubt be
shocked—car dealers. Telemarketers and salespeople came in next, followed
by doctors, lawyers (heavens!), accountants (heavens, again!), and
hairdressers.
Business owners who over-deduct business-related expenses—such as car and
entertainment—came in a distant second on the cheaters hit parade.
Surprisingly, the IRS contends that only 6.8% of deductions are overstated
or just plain phony.
If You Are Caught Cheating
Tax crimes are most likely to be first spotted during an audit. If you are
caught in a tax lie by an auditor, she can either slap you with a penalty or
refer your case to the IRS’s criminal investigation division (CID). In the
vast majority of cases, the auditor won’t call in the CID.
The Auditor Suspects You of Fraud
Auditors are trained to look for signs of tax fraud, which is a form of tax
evasion. Tax fraud is defined as a willful act done with the intent to
defraud the IRS—that dark area beyond honest mistakes. Using a false Social
Security number, keeping two sets of financial books, or claiming a blind
spouse as a dependent when you are single are all blatant examples of tax
fraud. While auditors look for fraud, however, they do not routinely suspect
it. They know the tax law is complex and expect to find a few careless
mistakes in every tax return. They will give you the benefit of the doubt
most of the time.
Even if the auditor does not refer suspected fraud to the CID, she can
impose fines, called civil penalties, if you omitted a chunk of income on
your tax return. Overstated or phony deductions and exemptions can also be
punished by the fraud civil penalty—for example, claiming exemptions for
dependents who have long since left home, died, or were never born. Fraud
penalties can also be added for exaggerating deductions, such as adding a
zero to $200 making it $2,000, or by claiming a casualty loss for a
nonexistent accident.
Fraud or Negligence?
A mistake on your tax return might get you a 20% penalty tacked on to your
tax bill. While not good, this sure beats the cost of tax fraud—a 75% civil
penalty. The line between negligence and fraud is not always clear, however
, even to the IRS and the courts.
Auditors are trained to spot common types of wrongdoing, called “badges of
fraud.” Examples include a business with two sets of books or without any
records at all, freshly made false receipts, and checks altered to increase
deductions. Altered cancelled checks are easy to spot by comparing written
numbers with computer coding on the check or bank statements.
The Internal Revenue Manual directs auditors suspecting criminal tax fraud
to contact the IRS criminal investigation division, or CID. In reality,
auditors make very few criminal referrals. Making a fraud referral is too
much paperwork. If auditors find a couple of obviously phony receipts, they
usually will quietly disallow them and move on. Fraud referrals are more
often made in special project audits. These are targeted audits of
particular industries and professions, such as building contractors or
chiropractors.
caution
The auditor will not tell you if she has made a criminal fraud referral. One
indication, however, may be an audit stopping midstream for no apparent
reason. But never assume a fraud referral was made just because months pass
and you don’t hear from the auditor. She is probably just behind in her
work.
Indirect Methods of Proving Fraud
Direct proof of fraud by the IRS typically consists of finding clearly
overstated or phony deductions and exemptions. Direct proof is not usually
found by the IRS for income underreporting. Instead, the IRS relies on
primarily four indirect methods.
Specific items. If you cashed a check received by your business and pocketed
the money without entering it in your books, this check is a “specific
item.” It can be viewed as evidence of fraudulent intent. If the auditor
suspects fraud, she may talk to your business’s customers to compare your
bank account deposits and actual payments you received from customers.
The IRS wants more than just one specific item to make a fraud case—unless
the item was for many thousands of dollars. While you might argue that one
or two items were negligently left off the books (or your computer crashed
or you lost your records), 15 or 20 omitted items shows a pattern of fraud.
Bank deposits. This is the IRS’s favorite indirect method to prove
unreported income, because it is so easy. The auditor simply adds up all
deposits in your bank accounts. If the total exceeds your reported income,
you may be suspected of fraud.
There may be a perfectly legitimate explanation, such as nontaxable sources
of bank deposits—loans, gifts, inheritances, sales of assets, and tax-
exempt income, such as municipal bond interest. Also, transfers from one
bank account to another appear to be multiple deposits under this simplistic
method. Point this out to the suspicious auditor. Or, deposits in your
accounts may belong to relatives or friends who did not use their own
accounts for some reason.
Expenditures. The auditor calculates your living expenses by totaling up the
credit charges you paid, checks you wrote, and adding known or estimated
expenses you paid by cash. If the total is greater than your tax-reported
income, the auditor will suspect fraud. Auditors can refer to statistical
reference books showing average costs of various necessities such as food
and shelter in your community.
To counter this, explain where you got the money to pay your bills. It could
be savings from prior years, selling assets, or receiving loans or gifts.
To figure your living expenses, auditors often ask you to complete IRS Form
4822, Statement of Annual Living Expenses.
tip
Never fill out IRS Form 4822 listing your living expenses. Just say you didn
’t keep track of every penny you spent for the year and don’t want to
guess. Or, diplomatically tell the auditor you will consider it and then
throw the form away. The IRS cannot punish you for refusing to fill out this
form. If an auditor is intent on proving fraud, he will do it with or
without your cooperation. Don’t do his job for him.
Net worth. Under this indirect method, an auditor adds up all of your assets
and deducts all of your liabilities at the start and end of the tax year
under audit. If there was an increase in your net worth—what you own minus
what you owe—without an increase in income from the previous tax year, you
may be suspected of fraud.
Again, there are many valid explanations as to how your net worth can
increase besides unreported income. For example, you may have received
nontaxable gifts or loans or inheritances. Or the auditor may have
mistakenly included appreciation in his calculations.
Penalties for Civil Tax Fraud
You will probably never face criminal fraud penalties. At least 98% of the
time, the IRS punishes fraud with civil penalties—fines of 75% added to the
tax due. For example, if the additional tax due from fraud is $10,000, the
penalty is $7,500, for a total of $17,500. Interest is added on to both the
tax and the fraud penalty, starting on the date the return was due or filed,
whichever is later.
Defending Against Alleged Tax Fraud
The three defenses most often raised against tax fraud allegations are cash
hoard, nontaxable income, and honest mistake. Don’t expect the IRS to
accept any of these defenses at face value. A skilled attorney is better
able to persuade the IRS than you are. Combatting tax fraud, like brain
surgery, is not a do-it-yourself project.
I lived off my cash hoard. This defense can be raised whenever the IRS uses
the bank deposits, expenditures, or net worth methods of proving fraud.
There is no law (not yet, anyway) against having cash of any amount buried
in your back yard or kept in a safe deposit box. The IRS’s only legitimate
concerns with your cash holdings are whether or not it was from taxable
income, and if you reported it and paid tax on it. The IRS understandably is
suspicious of people who hold large amounts of cash rather than putting it
in an interest-bearing account.
I lived off a nontaxable source. The receipt of money is not always taxable
income, as discussed above. You may innocently acquire tax-free wealth by
gift, loans, inheritances, and other ways. This defense can be coupled with
the cash hoard defense.
I made an honest mistake. If you make an error on your tax return, it is not
necessarily fraud. For example, you didn’t report profit from a sale of
investment real estate because you believed you had two years to reinvest
the proceeds without tax consequences. In reality, the law only allows you
180 days. Because intent to cheat the IRS is required for fraud, your
mistaken belief is a valid defense to a tax fraud charge—but you may have
to convince a judge or jury that it really was a mistake.
caution
Don’t try to lie your way out of a fraud charge. If in doubt, keep your
mouth closed. Lying to the IRS can make matters worse. The right against
self-incrimination is guaranteed by the Fifth Amendment. You have the
absolute right to remain silent before the IRS whenever there is a
possibility you may be charged with a crime. Lying to an IRS employee can
result in a felony conviction with up to three years in prison and a $100,
000 fine.
Options When the IRS Finds Fraud
If an IRS auditor believes you’ve cheated on your taxes, she has several
options.
Ignore the cheating. If the amount is small, an IRS auditor will overlook it
. Typically, an auditor just wants the file closed and off her desk—
particularly if she has found other significant adjustments. She will likely
leave it at that and never refer your file to the CID.
Impose civil penalties. IRS auditors draw the line at outrageous cheating.
Most will add civil, as opposed to criminal, penalties on to your tax bill,
especially if your case is deemed too small to send to the CID.
In the case of small mistakes, an auditor can add a 20% penalty to your bill
if she finds that your tax error was “accuracy related.” If she concludes
you owe an additional $1,500 of taxes, she can add a penalty of $300,
bringing the bill to $1,800. The IRS imposes civil penalties about 25
million times each year.
If the auditor finds more serious misdeeds, however—particularly if your
omission or overdeduction was fraudulent—she could add a 75% penalty,
bringing your $1,500 tax bill to $2,625. And, interest will be added to both
the penalty and the taxes.
Begin a criminal investigation. If the IRS suspects that you have gone too
far, the CID can investigate.
The CID usually gets information that leads to an investigation from one of
the following sources:
referrals from other IRS divisions, most often from auditors who
discovered unreported income during an examination
tips from law enforcement agencies —the IRS isn’t concerned with the
nontax crime itself, often a drug-related offense, but whether or not the
illegal income was reported.
Example:
When Morgan was arrested for suspected drug trafficking, $150,000 in cash
was in his car’s trunk. After his arrest, the local police notified the IRS
. The CID looked at Morgan’s last few tax returns, where he reported only $
35,000 of income per year. The CID immediately began a formal investigation.
tips from citizens—Ex-spouses or disgruntled employees and business
associates often contact the IRS. These people are called squeals. The CID
usually follows up only on well- documented tips. Many allegations are not
provable and are motivated by spite, and the CID doesn’t waste its time on
them. It may refer the case to the examination division, however.
IRS undercover or sting operations—CID agents often pose as buyers of
businesses to find off-the-books income. Unwary sellers who brag about
second sets of books and how much cash the business takes in get nailed.
Other undercover operations investigate gross discrepancies in reported
income and a taxpayer’s lifestyle. This is how the U.S. government finally
got Al Capone!
Example:
Roy owned a rather seedy looking pawn shop and was featured in a local
newspaper article on successful businesspeople. Roy proudly posed for the
paper in front of his waterfront home and Rolls Royce. Soon thereafter, Roy
was audited. The IRS wanted to know how someone lived so well while
reporting only $20,000 a year income. The audit turned into a lengthy CID
investigation. Two CID agents pored over six years of Roy’s financial
records, business and personal. Eighteen months later, Roy was indicted for
criminal tax evasion.
At the conclusion of the criminal tax investigation, the CID has two options
—drop it forever or recommend that the Justice Department prosecute. The
IRS, a part of the Treasury Department, cannot directly prosecute anyone. If
the investigation is terminated without prosecution, it doesn’t mean you’
ve gotten off completely. Your case will be sent to an auditor, who can
impose civil fraud penalties.
You will be pleased to know that in the great majority of investigations,
the CID does not recommend prosecution. The Justice Department will
prosecute only a select few cases. Therefore, the CID won’t waste its time
referring (and in some cases even seriously investigating) a case unless it
feels it has a sure winner.
If the CID does recommend prosecuting and the Justice Department gets a
conviction, you can be imprisoned, put on probation, fined, or all three.
For example, if you’re convicted of failing to file a tax return for three
separate years, you can be sent to prison for one year and fined up to $25,
000 for each year you didn’t file. The total could be three years in prison
and $75,000 in fines. You will also have a permanent criminal record.
That’s not all. After a criminal conviction, an auditor will slap civil
fraud and other penalties for underpayment of taxes. Combining criminal and
civil punishment does not constitute double jeopardy—a constitutional
guarantee against being tried, convicted, or sentenced more than once for
the same crime.
If you are prosecuted but not convicted, you will nonetheless probably be
audited.
IRS Criminal Investigations
The criminal investigation division, or CID, is the IRS police force. It’s
made up of 4,500 employees, based in Washington, DC. Investigators are
called special agents. They don’t wear uniforms, but they do carry badges
and have guns. Make no mistake—they are detectives highly trained by the
IRS and FBI. If someone identifies himself as an IRS special agent, you or
someone you know is under suspicion. Most special agents travel in pairs,
for their protection and to corroborate oral evidence gathered during an
investigation.
The CID is divided into general and special enforcement sections. Special
enforcement targets organized crime, drugs, and unions. General enforcement
watches ordinary taxpayers and everything else.
Will You Know If You’re Being Investigated?
Unless and until you are formally charged, you may not know that you’re
being investigated by the CID. The IRS does not have to tell you, but often
does. A friend, an employee, your accountant, your tax preparer, your lawyer
, or anyone else contacted by the IRS during the investigation might tell
you first. The IRS cannot legally swear these people to secrecy.
You might be able to find out indirectly if you are under investigation.
When a criminal investigation begins, IRS personnel must complete and file
Form 4135, Criminal Control Notice. This data is entered into your master
file in the IRS computer. Your tax account is frozen, meaning that no
refunds can be made or payments credited to your account.
To find out if Form 4135 has been filed, send a token tax payment for a year
you believe is under investigation—even if you’ve paid the tax already.
If a freeze is in effect, you may receive notice that your payment is being
held in a suspense account. Also request a computer printout of your account
for any year in question by calling 800-829-1040 or visiting your local IRS
office. The printout may indicate a Form 4135 filing or show that the
payment was not credited to your account without explanation.
Alternatively, the IRS may never send your requested statement if it has a
criminal investigation freeze code in the computer. If you call on the phone
to find out, IRS employees are told to not answer if you ask whether or not
a Form 4135 has been filed.
How Special Agents Conduct Investigations
In a recent year, 4,300 individuals were criminally investigated by the CID.
Only if the IRS has strong indications of wrongdoing does it send out its
elite police. Cases involving less than $20,000 in taxes are rarely
investigated. Criminal investigations start with a special agent
interviewing the taxpayer’s friends, business associates, professional
advisers, and anyone else who might have information. Later on the special
agents usually invite the targeted individual to speak to them.
CID investigations work in the reverse order of regular detective probes. “
Columbo,” “NYPD Blue,” or “Miss Marple” start with a dead body—and
then figure out whodunnit. Step 1 is the crime; Step 2 is finding the
culprit. This is the standard solving-the-mystery approach.
In contrast, IRS investigations begin with an allegation from a source,
usually an IRS auditor, collector, or informant, that a tax crime may have
been committed by you. Then special agents work at building a case against
you. Step 1 is the suspect; Step 2 is finding the crime. Special agents are
good at their work, too; they are among the best trained of all federal
employees (FBI Academy). And they have the full resources of the federal
government behind them.
Contacting Everyone Around the Target
CID investigations are unbelievably thorough, often taking a year or more.
The IRS spends more time investigating a criminal tax case than other police
departments devote to murder cases. This intensive use of federal resources
explains why so few people are charged with tax crimes. The CID recommends
prosecution only when it has built a rock solid case.
If you are under investigation, the special agent may talk to your friends,
family, neighbors, coworkers, employees, business associates, bankers,
insurance agents, and even travel agents and department stores. Even your
spouse may be contacted. Your mail may be monitored, in cooperation with the
Postal Service. While the IRS can’t open mail, it follows leads from
return addresses. The CID may get copies of bills from phone and credit card
companies, trail suspects, or get a court order authorizing a phone tap.
Special agents subtly intimidate businesspeople and bankers into giving
information. Don’t expect even your most trusted advisors to protect you if
the CID comes calling. Even your accountant can be compelled by the IRS to
give criminal evidence against you.
Attorney-Client Privilege
In a criminal matter, the only person who can’t be forced to speak about
you to the IRS is your lawyer. This is a special relationship given
protection under the law—called the attorney-client privilege. Your lawyer
cannot disclose to the IRS anything you tell her that relates to a criminal
tax matter. And, if an accountant is employed by your attorney to help her
render legal advice, the accountant’s work also falls under the attorney-
client privilege and cannot be disclosed to the IRS in a criminal matter.
The limited tax practitioner–client privilege does not extend to criminal
tax matters.
When IRS Special Agents Contact Your Associates and Friends
If you’re contacted by IRS special agents about another person, be wary.
Don’t answer any questions if there is any possibility you could be
connected to the individual under probe, such as a business partner. And
read “connected to” broadly. If you worked as the manager in a shop and
the owner is under investigation, you may not yet be a suspect, but there’s
a chance you will be. Keep quiet until you speak to a lawyer.
In any event, never lie to the CID. The law does not allow you to protect
others by withholding information or lying. It is legal, however, to tell
someone that the IRS was asking about them.
If someone tells you that she has been contacted in an IRS criminal
investigation of you and asks you what to say, don’t give her any
suggestions. It is a separate crime to ask someone to lie to the IRS. Also,
resist the urge to call the CID and ask what’s going on. Instead, call a
tax or criminal lawyer fast. Let them call the IRS.
If the CID Contacts You
If the CID is building a case against you, chances are you will be the last
person interviewed. By the time the CID agents contact you, they may have
looked at thousands of records and spoken to 20 potential witnesses—your
banker, ex-spouse, accountant, former employees, and others with knowledge
of your financial affairs. If the CID still wants to talk to you, more than
likely you are about to be recommended for prosecution. The only purpose for
the CID questioning you is to get a confession or other damaging admission
—the icing on the IRS’s cake.
Once you’re contacted as the target of an investigation, a special agent
must tell you so immediately. He must read to you a version of the Miranda
rights—the right to remain silent, the right to have an attorney, and the
warning that anything you say can be used against you. Believe him, it will
be. Answer only the question, “Are you August Fondue?”
It is highly unlikely that you’ll be arrested on the spot or even invited
to go to the IRS office. Simply state that you want to contact an attorney
and that someone will get back to them. Don’t call an attorney while the
special agents are present, unless they threaten you with immediate arrest,
or something similar, if you don’t cooperate. Wait until they leave, you
have calmed down, and you can speak freely. If you don’t know a criminal-
tax attorney, see Chapter 13 for tips on finding one.
How about trying to talk the special agents out of pursuing their case
against you? Forget it—it’s a terrible mistake. It makes no difference to
them if your mother is dying, you have money problems, or your marriage is
falling apart. Mentioning your problems, only strengthens the IRS’s
position; giving an excuse often shows that you knew what you did was wrong.
Similarly, don’t lie. Lying is as serious a crime as tax evasion.
caution
Keep your mouth shut—take this advice seriously. If you give the CID agents
any opening, you’re dead. They’ll start with soft background questions,
but before you know it, will have trapped you. And many CID questions won’t
be genuine—that is, the special agents already know the answers and are
asking only to see if you will lie or confess.
Questions typically asked by CID agents include:
Have you reported all of your income?
Where are your bank accounts and safe deposit boxes?
Can you tell us about the cars, boats, planes, and real estate that you
own?
Do you gamble?
What is the procedure for reporting sales in your business?
Do you keep a lot of cash on hand?
Who are your business associates?
Have you traveled out of the country recently?
Have you or any of your businesses been audited?
Faced with a barrage of questions from two trained agents who show up
unannounced, most people fall apart. They either blurt out a confession or a
transparent lie within five minutes. This gives the Justice Department the
rope to hang them with.
IRS Considerations in Deciding Whether or Not to Recommend Prosecution
The CID’s chief considerations in deciding to recommend prosecution is how
strong a case it has. If you were caught red-handed or confessed, you can be
sure of prosecution. But remember—for any crime, including a tax crime,
the government must prove your guilt beyond a reasonable doubt. If you keep
your mouth closed, a good criminal-tax lawyer may be able to mount a decent
defense. As a general rule, if you have some facts in your favor, the IRS
may not recommend prosecution and impose civil penalties (fines) instead.
The IRS looks closely at the case’s publicity value—locally or nationwide.
A prominent local doctor or movie star is a juicy plum. The agency firmly
believes that front-page headlines make would-be tax cheaters think twice.
The CID also analyzes personality traits of the individual target, including
age, physical and mental health, and previous criminal record. How would a
jury react to the person? Leona “Only the Little People Pay Taxes”
Helmsley was no doubt selected for prosecution because the IRS guessed she’
d be an unsympathetic figure. The judge and jury (and most Americans)
obviously agreed.
Finally, the CID looks at the amount you cheated the government out of. The
larger your indiscretion, the more likely the agents will recommend
prosecution. The typical amount of taxes owed in criminal cases is over $70,
000 and covers three or more years of cheating.
The bad news: When the CID recommends prosecution, and the Justice
Department accepts the case, the chances of conviction are at least 80%.
More than half of the people convicted go to prison even if they have no
prior criminal record.
The good news: The government is quite concerned with maintaining this high
rate of conviction. For every two people prosecuted, another one person
under suspicion is passed by or just tried in a civil proceeding.
Crimes With Which You Can Be Charged
If the CID recommends prosecution, it will turn its evidence over to the
Justice Department to decide the special charges. Individuals are typically
charged with one or more of three crimes: tax evasion, filing a false return
, or not filing a tax return.
Tax evasion or fraud. Tax evasion is defined as “intentional conduct to
defeat the income tax laws.” Any sort of tax scheme to cheat the government
can fall into this broad category. Tax evasion is a felony, the most
serious type of crime. The maximum prison sentence is five years; the
maximum fine is $100,000. (Internal Revenue Code § 7201.)
Filing a false return. Filing a false return is what it sounds like. Your
tax return contained a material misstatement, such as describing your line
of work as bricklaying when you are a bookie. More people are charged with
filing a false return than with tax evasion because in a filing-a-false-
return case, the government does not have to prove an intent to evade the
income tax laws—only an intent to file a false return. Filing a false
return is a less serious felony than tax evasion that carries a maximum
prison term of three years and a maximum fine of $100,000. (Internal Revenue
Code § 7206 (1).)
Failure to file a tax return. Not filing a return is the least serious tax
crime. It’s defined as intentionally failing to file a return when you were
obligated to do so. Not everyone must file tax returns. For example, only
those people earning above a specified amount must file. The minimum changes
from year to year. Not filing a tax return is a misdemeanor. The maximum
prison sentence is one year in jail and/or a fine of $25,000 for each year
not filed. The vast majority of nonfilers are never prosecuted criminally,
and only hit with civil fines.
Although technically not tax crimes, the CID also investigates and can
recommend prosecution for money laundering and filing false claims against
the IRS. Typically, these crimes are charged in the same case along with tax
crimes against the same individual or entity.
If You Are Prosecuted
Once the Justice Department receives a file recommended for criminal
prosecution, an Assistant U.S. Attorney reviews it. If he feels that the IRS
has a strong felony case, he will seek an indictment from a federal grand
jury, which usually goes along with the prosecution. You can be criminally
charged for a tax misdemeanor—such as not filing a tax return—without a
grand jury indictment.
If formally charged, you will either be arrested or, if you are not deemed a
flight risk, ordered to report before a federal judge to plead guilty or
not guilty. You might be required to post bail or be released on your own
recognizance.
If you ever find yourself in this position and don’t already have a
criminal or tax lawyer, get one immediately. Don’t delay, as the government
has already completed its investigation. Your lawyer will need time to
catch up and learn the government’s case. Keep heart; the government’s
case may be legally defective, or your attorney may recognize defenses to
the charges.
Should You Plead Not Guilty?
Unless you have made a plea bargain with the government before your first
court appearance, you should initially plead not guilty. Remember: The IRS
recommends for prosecution only those cases in which conviction seems a near
certainty. Justice Department weeds these cases out even further. Therefore
, it’s not surprising that over two-thirds of all defendants eventually
plead guilty without going to trial.
Most of these are plea bargains, meaning the accused agrees to plead guilty
if the Justice Department agrees to reduce or drop some charges, or both.
For example, if you are charged with three years of tax evasion, the
government may drop two years for a guilty plea to one year. Sometimes the
government will also agree to a favorable sentencing recommendation. However
, the final sentence will depend on a probation report, federal laws
governing minimum sentences, and the judge’s discretion.
What the Government Must Prove in a Tax Case
If you don’t plead guilty, you will eventually have a trial. At the trial,
the Justice Department and the IRS, working together, must prove you are
guilty of the crimes charged. Essentially, the government must show you
acted intentionally and that you are guilty beyond a reasonable doubt. You
are entitled to a trial by a jury, or you can choose to be tried by the
judge alone.
Intent. The primary element of any tax crime is intent. In legalese, this
intent is called willfulness. If the government can’t prove you acted
intentionally, you can’t be convicted. Put another way, you can’t be
convicted of a tax crime if you only made a mistake, even if it was a big
mistake. For example, if you didn’t file a tax return because you honestly
believed that 65-year-olds didn’t have to file any longer, you did not act
intentionally.
Before you senior citizens get carried away with this example, bear in mind
that to succeed, you will have to convince a jury that your mistaken belief
was honest. Given that most people remember watching their parents or
grandparents fill out returns—and many people, in fact, completed those
returns for their elderly relatives—you will have a hard time convincing
your 12 peers that your omission was an honest mistake. More believable is a
recent immigrant who did not report his income from investments made back
home, which he wrongly thought was tax-exempt.
Beyond a reasonable doubt. All crimes must be proven beyond a reasonable
doubt. If a judge or jury has any degree of doubt that you did what you were
accused of or acted intentionally, the government’s case will fail. For
instance, without additional evidence showing an intent to cheat the IRS, a
juror may not believe beyond a reasonable doubt that the immigrant who
omitted his foreign investment income was filing a false tax return. The
reasonable doubt standard is why the Justice Department prosecutes only
airtight cases.
Your Chance of Being Convicted of a Tax Crime
Not everyone charged with a tax crime is found guilty. For example, keep in
mind the story of Dr. Rudy Mays, a former client whose name has been changed.
Example:
Dr. Mays worked at an inner city clinic. Over 80% of his income was from
Medicare, with the rest paid mostly in cash. He was indicted for income tax
evasion when the IRS found that he had reported $240,000 in total income in
a year in which his Medicare income alone was $280,000.
Dr. Mays was offered a plea bargain —if he’d plead guilty, the charge
would be reduced and he’d receive probation, not a prison term. But this
plea bargain meant that Dr. Mays’ medical license would be revoked, ending
his career. He rejected the offer and went to trial.
Dr. Mays testified that he was a man of medicine, not a businessman. He
relied on his bookkeeper and accountant; he signed whatever they put in
front of him. The prosecuting attorney scoffed at this defense by telling
the jury that everyone bears the responsibility for the accuracy of their
tax returns. The jury sympathized with the good doctor and found him not
guilty.
P.S. Immediately after the trial, the IRS began an audit. Dr. Mays had to
pay thousands of dollars in taxes, interest, and fraud penalties, but at
least he stayed out of jail and kept his medical license.
In another case, Mr. Cheek, an airline pilot, was found guilty of tax
evasion. The U.S. Supreme Court reversed his conviction. (United States v.
Cheek, 498 U.S. 192 (1991).) Mr. Cheek claimed that he had formed a belief,
based on materials provided by a tax protester group, that certain income
tax laws did not apply to him. The trial judge told the jury not to consider
this as a defense to tax evasion. The Supreme Court, however, held that his
mistaken belief was a valid defense, and ordered Mr. Cheek to be retried.
The question in the new trial was whether Mr. Cheek’s belief was a good-
faith misunderstanding of the tax laws or was a criminal intent to evade
paying taxes.
Mr. Cheek wasn’t as lucky his second time around in court as he was his
first. At his new trial, Mr. Cheek raised the Supreme Court-approved defense
, but was convicted by a new jury of several tax crimes, anyway. The judge
sentenced him to one year and one day in prison and fined him $62,000. (Wall
Street Journal, March 25, 1992.)
If You Are Convicted of a Tax Crime
If you are convicted of a tax crime after putting the government to the
trouble of a trial, chances are eight in ten that you will be sent to
federal prison. The Federal Sentencing Guidelines and the judge determine
how long the sentence will be.
If, however, you reach a plea bargain without a trial, chances are better
that you will be fined and/ or placed on probation, given home
confinement, or sent to a halfway house, rather than sent to jail. Added to
the fine may be the costs incurred by the government in prosecuting you.
In general, public figures are most likely to go to jail. Back in the 30s,
President Hoover ordered that our income tax evasion law be used to put away
the notorious Al Capone. This is the only charge ever made to stick on
Scarface, who found his way to Alcatraz.
Today, instead of landing on the Rock, tax convicts are usually sent to a
Club Fed minimum security facility filled with bankers, lawyers, politicians
, and Wall Street sharpies. The average length of time served for a tax
crime is a little less than two years. If this sounds like a breeze, think
twice. Tax alumni of the federal prison system all agree that it was a
humiliating and crushing experience. And licensed professionals—lawyers,
doctors, stockbrokers, and CPAs—lose their professional licenses after
conviction.
Phillip S. Fry, author of Pay No Income Tax Without Going to Jail, was
apparently unclear on the concept. In 1986, he pleaded guilty to tax fraud
and, you guessed it, went to jail. Other tax criminals with whom you are
probably familiar and their prison terms include:
Pete Rose—five months
Chuck Berry—four months
Aldo Gucci—one year
Sun Myung Moon—18 months
Leona Helmsley—four years.
Richard Hatch failed to pay taxes on the $1,000,000 he won on the show
Survivor, but he didn’t survive the IRS police; he was sentenced to 51
months in federal prison.
One of my favorite stars of yesteryear, Sophia Loren, served 17 days in jail
in her native Italy for tax evasion. It appears that big stars get off
lighter in Italy than in the United States. So if you’re thinking of
evading taxes, maybe you want to brush up on your Italian and find a job in
Venice, Florence, or Rome.
Chapter Highlights
Tax fraud is more than carelessness or honest mistakes and can be
punished by the IRS either civilly or criminally or both.
The IRS seldom puts tax cheaters in jail but often imposes heavy fines.
See a criminal or tax attorney if the IRS is investigating you for a tax
crime.
