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The authors relate the stories of a Manhattan couple who spent $1 million a month to maintain their lifestyle yet never paid income tax, a California couple who provided sport utility vehicles for their children at taxpayers' expense, an entrepreneur in Costa Rica who shows Americans how to hide their money in clandestine accounts offshore, and computer technicians at America's largest corporations who live tax-free.
Barlett and Steele describe how the Internet has democratized tax cheating, as proliferating Web sites and their often mysterious operators offer every service imaginable to escape taxes. They discuss the double standard the IRS employs in tax audits--one for the rich and well-connected and another for everyone else--and how the Justice Department tries to jail powerless citizens accused of tax law violations while allowing the wealthy and influential to go free. This book also documents how Congress is deliberately undermining the income tax in order to replace it with a system that will provide the largest windfall ever for the richest Americans--and increase the burden on everyone else. And it spells out how executives like Kenneth L. Lay bankrolled campaigns to institute such a tax system, based on accounting principles eerily similar to those employed at Lay's Enron Corporation. Finally, the authors consider our chances for reestablishing what was once the fairest tax system in the world.
The Tax Cheat Next Door
$1 Million a Month and No Tax Return
Scenes from the new America:
A woman forms a company to conduct "research" for the benefit of her minor children and writes a monthly "rent" check to her husband to cover use of the space in their home occupied by her new "business." Coincidentally, the "rent" equals the mortgage payments on their home. She writes another check to lease a car the family car, as it happens and then deducts both expenditures as "business expenses" on the couple's joint tax return.
A fast-food-franchise owner whose family enjoys a typical middle-class lifestyle instructs his accountant to prepare a tax return showing that he owes no income tax. The accountant obliges. He shaves income, inflates expenses, and creates mythical deductions.
A young man shows up at a designated street corner in Phoenix, Arizona, where illegal immigrants line up to wait for curbside interviews by affluent individuals and contractors seeking hired help. The jobs range from lawn care to housekeeping to construction. The workers are all paid in cash. No taxes deducted. No questions asked.
A Fortune 500 company hires a computer programmer from India to work on a specific task for a fixed period of time. The programmer is employed by a consulting firm that specializes in placement of foreign workers. The programmer receives a tax-free paycheck no withholding for U.S. income tax, Social Security or Medicare taxes, state or local taxes.
What are all these people doing? Cheating ontheir taxes, of course.
Tax fraud is exploding in the United States. In ways large and small, Americans are cheating like never before. One of every three people, perhaps as many as one of every two, is doing it. It's one of Washington's dirty little secrets, a ticking time bomb with the potential to destroy the country's tax system and to undermine essential government programs like Social Security. Disguised by a robust economy and record tax collections, fraud is growing at an exponential pace among all groups, with more and more income concealed from the IRS each year.
How bad is it? No one can put a precise number on lost tax revenue. But it's bad, and getting worse. Even the IRS, which doesn't like to acknowledge this problem for fear it will only encourage more taxpayers to cheat, admitted in 1999 that the "tax gap," its euphemism for fraud and error, is now up to $195 billion a year.
But that estimate is based on tax data from the 1980s and does not remotely reflect current events. A more reasonable count of the revenue lost every year is upwards of $300 billion the equivalent of the total income taxes paid annually by all individuals and families earning less than $75,000. And even that figure does not include lost taxes from illegal income such as drug trafficking, money laundering, gambling, and prostitution.
If Tax Dodging Inc. were a business, it would be the nation's largest corporation, eclipsing General Motors, which sits atop the Fortune 500 with revenue of $189 billion.
How do people escape paying the taxes they owe? They inflate their itemized deductions for everything from medical bills to charitable contributions. They manufacture deductions to cover expenses never incurred. They understate their income. Or they do both. They ship their money to foreign tax havens. They claim illegal refunds. They speculate in the stock market and don't report their gains. They charge off their personal living costs as business expenses.
And many don't even bother to file tax returns at all. For this group, April 15 is just like any other day of the year. There are no endless forms to fill out, no hurried visits to the accountant, no frantic search for receipts, no mad dash to the post office. Best of all, no taxes to be paid. Those who don't file are participants in the ultimate tax dodge. Their numbers are soaring. Superficial IRS studies turned up 3.4 million individual nonfilers in the 1985 tax year. Two years later, the number jumped 24 percent, to 4.2 million. By 1991, it was 6.5 million. Incredibly, 74,000 of them had incomes of more than $100,000.
How many nonfilers are there today? The IRS doesn't have a clue. In part, that's because Congress has slashed the agency's budget, halting the kind of audits that would make even crude projections possible. Informally, government tax authorities say there are 10 million nonfilers. In truth, there are many more, and here's why:
The IRS identifies a nonfiler as a person who fails to submit a tax return even though a third party has filed an earnings statement (W-2) or information return reporting interest or dividends (Form 1099) that shows the person received income during the year. This narrow definition ignores all those who leave no paper trail. These are the people for whom there are no W-2s or 1099s, no record of wages, annuities, gambling winnings, pensions, interest, dividends, or money flowing in from foreign trusts and bank accounts.
In addition to these people who deal only in cash, there is another larger group whose numbers have soared. They are wealthy Americans and foreign citizens who live and work in the United States and in other countries multinational wheeler-dealers, independent businesspeople, entertainers, fashion moguls and models. They have multiple passports or global residences and therefore insist they are exempt from the U.S. income tax.
People like the Wildensteins of New York City. That would be Alec and his former wife Jocelyne, who became a staple of the New York tabloids during an unseemly divorce that raged from the fall of 1997 until the spring of 1999.
Alec, born in 1940, is an heir to his family's century-old, intensely private, multibillion-dollar international art business. Jocelyne, four years his junior, is best known for having undergone countless plastic surgery procedures that make her look more feline, permanently, than any member of the cast of Cats. Her bizarre appearance inspired the tabloids to dub her "The Bride of Wildenstein."
For the Wildensteins, the once impenetrable curtain that had protected the family from prying eyes for generations was unexpectedly pierced on the night of September 3, 1997, when Jocelyne returned to the couple's opulent Manhattan home after a visit to the family's 66,000-acre ranch in Kenya. Walking into the six-story townhouse on East 64th Street, next door to the Wildenstein gallery, a few minutes after midnight, she found her husband in bed with a nineteen-year-old, long-legged blonde.
Alec hastily wrapped himself in a towel, grabbed a 9mm handgun, and pointed it at his wife and her two bodyguards. "I wasn't expecting anyone," he screamed with a touch of understatement. "You're trespassing. You don't belong here."1 The bodyguards summoned the police, who arrested Alec and charged him with three counts of second-degree menacing.
So it was that the French-born, aristocratic Alec Nathan Wildenstein, having traded his towel for an Armani suit and a monogrammed shirt, spent the night in the Tombs prison with some of New York's low life. If nothing else, the incarceration gave him time to plot his revenge. When he got out the next day, he moved quickly. He canceled his wife's credit cards. He cut off her telephone lines, locked all the rooms in the townhouse except for her bedroom and sitting room, shut off her access to bank accounts, directed the chauffeur to stop driving her around, fired her accountant, and, in one final act of retribution, ordered the household chefs to stop cooking for her, which proved a major inconvenience because she had never learned how to operate the stove.
Jocelyne responded by turning up the temperature a few hundred degrees on what had been one of the quietest divorce proceedings ever among the rich and discreet. As a result, life among the Wildensteins a family that for more than a century had guarded its privacy with a pathological obsession went on public display.
Jocelyne demanded a $200,000 monthly living allowance, payment of her personal staff's salary and expenses, and a $50 million security deposit pending distribution of the marital property. Alec pleaded poverty. He insisted that he had no money of his own and that the millions they spent came from his father.
The Wildenstein family circus that followed established conclusively, one more time, that the rich are very different from the rest of us, beyond the fact that they often pay comparatively little or no taxes. But first, some background on this intriguing family.
Alec is the son of Daniel Wildenstein, the patriarch of the enormously rich French clan. Daniel, born in 1918, controls the Wildenstein billions through a web of secret trusts and intertwined corporations. The Manhattan townhouses, for example, are owned in the name of the Nineteen East Sixty-Fourth Street Corporation, which in turn is controlled by "intermediate entities held in trust."2 He continues to operate the private, secretive art business started by his grandfather in the nineteenth century, with galleries in New York, Beverly Hills, Tokyo, and Buenos Aires, catering to private collectors, museums, and galleries. And while he spends a lot of his time in Paris, a good chunk of his money resides in secret Swiss bank accounts.
Tucked away in family storerooms, notably in New York, is reportedly the world's largest private collection of the works of the masters valued at $6 billion to $10 billion. The inventory includes thousands of paintings by Renoir, Van Gogh, Cézanne, Gauguin, Rembrandt, Rubens, El Greco, Caravaggio, da Vinci, Picasso, Manet, Bonnard, Fragonard, Monet, and others. Many have never been displayed publicly.
In 1990, Daniel's sons Alec and Guy took over management of the New York gallery. Their families maintained separate living quarters in the East 64th Street townhouse. They shared the swimming pool in the basement, the informal and formal dining rooms, the foyer, elevator, and the entrance to the townhouse.3 Alec and Jocelyne lived on the third floor, their two children had bedrooms on the fifth floor, and Jocelyne used the sixth floor as an office. In addition to the Manhattan townhouse, they maintained a castle, the Chateau Marienthal, outside Paris, an apartment in Switzerland, and the Kenya ranch.
Wherever they happened to be, the Wildensteins pursued a lifestyle that was lavish even by the standards of the rich and famous. The details, as they poured from Jocelyne's lips in the divorce proceeding, told the story of a family of seemingly unlimited wealth and no hesitation about spending it. According to her, she and Alec "routinely wrote checks and made withdrawals" from their Chase Manhattan Bank checking account "for $200,000 to $250,000 a month." Jocelyne said that over the last twenty years they did "millions of dollars worth of renovations of the Paris castle and Kenya ranch," and she directed the management, hiring and staffs of those properties. The routine operating costs of the ranch alone ran $150,000 a month.
In New York, Jocelyne's staff payroll at the 64th Street townhouse included $48,000 a year for a chambermaid; $48,000 for a maid who tended the dogs; $60,000 each for a butler and chauffeur; $84,000 for a chef; $102,000 for an assistant with an MBA; and $102,000 for a secretary.
In Kenya, their vast Ol Jogi ranch, with its two hundred buildings spread over an area five times the size of Manhattan, required nearly four hundred employees to look after the grounds and the animals.
In France, the resident staff at the chateau, "the largest private home of its type within a fifteen-minute drive of Paris," included five gardeners, three concierges and three maids.4
Talk did not come cheap for the Wildensteins. The annual telephone bill in Manhattan alone sometimes ran as high as $60,000. And then there were all the other necessities, like $547,000 for food and wine; $36,000 for laundry and dry cleaning; $60,000 for flowers; $42,000 for massages, pedicures, manicures, and electrolysis; $82,000 to insure her jewelry and furs, and $60,000 to cover the veterinarian bills, medication, pet food, beds, leashes, and coats for their dogs. As for miscellaneous professional services, $24,000 went for a dermatologist, $12,000 for the dentist, and $36,000 for pharmaceuticals. Her American Express and Visa card bills for one year totaled $494,000.
Some of these bills were paid out of the couple's Chase Manhattan account. Some were paid out of "other bank accounts in New York, Paris and Switzerland." And some bills, Alec confirmed, were paid from "the Wildenstein & Co." account, "the Wildenstein & Co. Special Account, and family businesses."5 Sort of like having your employer pick up the cost of your clothing, pets, and vacations.
And then there were Jocelyne's personal expenditures. Over the years, she accumulated jewelry valued at $10 million, including a thirty-carat diamond ring and custom pieces from Cartier. She attended fashion shows in Paris. Her annual spending on clothing and accessories ran to more than $800,000. She once spent $350,000 for a Chanel outfit that she helped to design. All told, according to papers filed in the divorce case, the couple's personal and household expenditures added up to well over $25 million in 1995 and 1996 alone.
With all those tens of millions of dollars flowing out over the years to maintain a lifestyle beyond comprehension to most people $60,000 in dog bills exceeds the annual income of three-fourths of all working Americans who pay taxes you might think that Alec and Jocelyne also forked over millions of dollars to the Internal Revenue Service. But you would be wrong.
They didn't pay a penny in U.S. income tax.
In fact, they never filed a federal tax return.6
These admissions by a family accountant are spelled out in records of the acrimonious divorce and also entered into court opinions. They lived the tax-free life even though, by Jocelyne's account, they resided in the Manhattan townhouse for nineteen years, from shortly after their Las Vegas wedding in 1978 until the rancorous divorce proceedings began in 1997. Their children were born in New York and went to school in New York. Alec conducted the family art business through Wildenstein & Company Inc., a New York corporation, from the gallery next door. He had a U.S. pilot's license. He sued and was sued in the courts of New York and other states. He signed documents moving millions of dollars between Wildenstein companies, some located in the tax havens of the world. He transacted business in New York and other states. He was vice president of Nineteen East Sixty-Fourth Street Corporation, which owns the townhouse, gallery, and other properties. His New York pistol license identified him as an officer of Wildenstein & Company. And following his arrest for pointing the weapon at Jocelyne and her bodyguards, he insisted that he should be released on his own recognizance because of his substantial ties to the community.
Nonetheless, he filed no federal tax returns. And no one in Washington or New York noticed. Or cared. Under ordinary circumstances, even the complex tax returns of the very wealthy that are filed go unchecked. That's due to a deliberate decision by Congress to starve the IRS, both in operating funds and in manpower and expertise to conduct such audits. So forget about ferreting out serious nonfilers among the rich and prominent. That task doesn't even register on the tax fraud radar screen. Not surprisingly, representatives of Alec Wildenstein declined to discuss his tax affairs. Jocelyne's lawyer said she doesn't know anything about taxes, since Alec controlled the money. And the IRS can't comment on the tax matters of private citizens. Or in this case, the non-tax matters.
In the divorce case, Alec argued that he was not a resident of the United States, that he had a Swiss passport and visited this country on a tourist visa, and that he did not have a green card permitting him to work. Furthermore, he contended that he had "less than $75,000 in bank accounts" and that "my only earnings are approximately $175,000 per year."7 On a net-worth statement, Alec listed his occupation as "unpaid personal assistant to father Daniel Wildenstein."8 That stirred the ire of State Supreme Court Judge Marilyn G. Diamond, who presided over the hostilities. "He fails to explain why he is 'unpaid,'" said Diamond, adding that "this contention insults the intelligence of the court and is an affront to common sense."9
Judge Diamond was also angered that Alec never bothered to attend the divorce hearings. Shortly after Jocelyne began unveiling intimate details of the couple's private life, he fled the country. He ignored repeated court dates, failing to appear to answer either the gun charges or his wife's allegations. At one hearing, an irritated Diamond excoriated Wildenstein in absentia for his refusal to obey court orders and to attend depositions. His attorney, Raoul L. Felder, the New York celebrity divorce lawyer, offered an explanation for his client's behavior:
"It may not be his disinclination to appear before the court. You are aware there are substantial tax problems we believe created by the plaintiff."10
Judge Diamond agreed. "There are going to be more substantial tax problems," she said. "There are more substantial potential tax problems by people continuing to take certain positions. Make no mistake about it."11
If this conjures up visions of battalions of vigilant IRS agents engaged in a relentless search to identify tax scofflaws and, when they do so, dun them for the taxes they owe, assess interest and penalties, seize their bank accounts and cars, freeze their assets, and auction off their possessions, well, that's what they are, visions at least when it comes to the very rich. For the double standard is to tax-law enforcement what rock is to roll.
Suppose you earn $40,000 a year and don't file a return. When the IRS catches up with you, it prepares a substitute return, estimates your income, calculates the tax you owe, tacks on interest and penalties, and sends you the bill. If you don't like their numbers, you must prove that they're incorrect. What's more, the agency may seize your bank accounts, your car, and whatever else you have of value.
Not so with the truly prosperous. First, the agency mails out a computer-generated letter asking the nonfiler to submit a return. When the reluctant recipient fails to respond, a second letter goes out. And then another. And another. If the silence persists, IRS resorts to another tactic: the telephone. It tries to find the number of the missing nonfiler and place a series of calls. When all that proves futile it generally does nothing.
That was a finding of a 1991 study by the General Accounting Office (GAO), the investigative arm of Congress, that examined the IRS's handling of affluent nonfilers: "IRS does not fully investigate high-income nonfilers, which creates an ironic imbalance. Unlike lower income nonfilers in the Substitute for Returns program, high-income nonfilers who do not respond to IRS' notices are not investigated or assessed taxes. Even if high-income nonfilers eventually file tax returns, their returns receive less scrutiny than those who file returns on time."12
What's the IRS's explanation for the double standard? Incredibly, it told the GAO that it does not prepare a substitute return for rich nonfilers, as it does for middle-income people, because it fears that it might "understate taxes owed." In other words, no loaf is better than half a loaf. So do nothing. Second, the GAO said, "to pursue more high-income cases, IRS would need additional staff."13 Which, of course, is precisely what Congress refuses to provide.
But things have changed since that critical 1991 audit tried to prod the IRS to act, right? Indeed they have. With each passing year, the number of affluent nonfilers has gone up while Congress has continued to slash the service's auditing capabilities. There is no better evidence of the agency's breakdown than the fact the Wildensteins went two decades without filing a tax return and the IRS knew nothing about it.
The Wildensteins also illustrate one of the weaknesses of the federal government's tax statistics. According to IRS data, more than 1,000 individuals and families with income over $200,000 paid no federal income tax in 1996. But the IRS counts only those people who actually file returns. The Wildensteins didn't. Nor did others in their class. As you might guess, the official estimates of the nontaxpaying rich are on the low side.
Dodging taxes, of course, is hardly a new phenomenon. For as long as there has been an income tax, there have been people who have sought by every imaginable means, and some means not so imaginable, to avoid paying it.
In fact, as far back as 1916 just three years after the income tax was enacted newspapers across the country published a syndicated series titled "The United States Income Tax Steal!" The first article began: "Three hundred and twenty million dollars of your money was stolen last year through income tax frauds and evasions, involving thousands of wealthy and prominent citizens and thousands of the most profitable American corporations."14
In the late 1930s, when the income tax still applied only to the more prosperous, and before it reached into the pockets of every working American through withholding, many of the wealthiest citizens devised various schemes to escape it. The top rate back then, by the way, was 79 percent on taxable income over $5 million. That's a rate that would double the tax bills of tens of thousands of today's billionaires and millionaires, like Bill Gates, Warren Buffett, and Wal-Mart's Walton family.
On June 8, 1937, Henry Ellenbogen, a Democratic congressman from Pittsburgh, took to the floor of the House to denounce the avoiders and evaders. "A few extremely wealthy individuals have resorted to every trick and every device which their lawyers could conceive to avoid the payment of taxes justly due by them," he said.
What kind of "tricks" was Ellenbogen talking about sixty years ago? He explained:
[One] American millionaire organized no less than ninety-six personal holding companies all over the country so as to make it difficult, if not impossible, for the Treasury Department to follow his complicated financial transactions.
Some of our multimillionaires have incorporated their yachts and their landed estates so that they can deduct the expenses for their upkeep from their incomes and escape a tax thereon. . . . Let me remind you that the ordinary citizen is not involved in these tax schemes.15
And thus it has been ever since. For more than eighty years, newspapers, magazines, and books have chronicled the stories of citizens who fail to pay their taxes. But these scofflaws represented an insignificant portion of the population until the 1970s, when tax cheating began to move gradually into the mainstream.
In November 1979, Senator Lloyd M. Bentsen Jr., the Texas Democrat who would go on to become President Clinton's first Treasury Secretary, expressed concern that "an alarming trend" was emerging: Otherwise honest citizens were cheating on their taxes.16
In April 1983, then IRS Commissioner Roscoe L. Egger Jr., talking about tax evasion, said that "all the signs are that it has been growing and is continuing to grow."17
In April 1984, the Wall Street Journal reported that "the IRS is losing the battle against tax cheats. Its high-tech wizardry and strengthened legal arsenal can't keep pace with an ever-growing army of tax evaders hiding in a jungle of complex laws."18
What's the difference between 1916, 1938, 1984, and this first decade of the twenty-first century?
Just this: That "army of tax evaders," its ranks swollen by legions of fresh recruits, is on the verge of declaring victory. While once upon a time tax dodgers could be counted in the hundreds of thousands or a few million, they now number in the tens of millions and account for between one-third and one-half of the taxpaying population.
One reason for the dramatic increase: Lower- and middle-income taxpayers are frustrated with a system that is overly complex and that favors the wealthy. Congress has arranged the tax code in a way that allows those at the top to escape payment of taxes in lawful ways that are not available to average working people. Hence the attitude "If someone who makes twenty times or a hundred times or as much as a thousand times more than I do can legally reduce their taxes courtesy of Congress, why shouldn't I do the same illegally?"
This inequity between income classes has grown more pronounced over the last two decades, especially when federal, state, and local taxes combined are factored in. That's because Congress and the White House have shifted the cost of programs once funded by the federal government to the states and cities. Those governments traditionally have relied on taxes, such as sales taxes, whereby the burden falls as income rises. In addition, the explosive growth in self-employment has further aggravated tax disparities. The self-employed must pay both the employer and employee shares of Social Security and Medicare taxes or 15.3 percent right off the top.
To better understand the inequities, consider the tax bills of two households: a single, self-employed health care worker living in Philadelphia, and Bill and Hillary Clinton of Washington, D.C.
On their 1998 tax return, the Clintons reported adjusted gross income of $509,345. They paid a total of $112,496 in local, state, and federal taxes. Their overall tax rate: 22 percent.
A Philadelphia woman working as a self-employed home health care attendant that year who earned $25,000 paid a total of $8,129 in local, state, and federal taxes. Her overall tax rate: 33 percent.
Thus, while the Clintons' total income was twenty times greater than that of the Philadelphia worker, her tax rate was 50 percent higher than that of the president and first lady.
To be sure, the Clintons' tax rate was held down because of hefty charitable contributions. But even Vice President Al Gore and his wife, Tipper, with an income of $224,376 and average charitable contributions, paid overall taxes at a rate of 24 percent still 9 percentage points under the Philadelphia health care worker's.
Given a president whose tax rate is less than that of a working woman whose income is one-twentieth of his, and with people like the Wildensteins, who spend more money on food and wine alone in one year than most taxpaying families earn in ten years and who don't even file a return, it is inevitable that millions of people at the low end of the economic spectrum would be inspired to file returns and secure refunds fraudulently.
The earned income tax credit (EITC) is one of the few antipoverty programs to survive from the 1970s that has won praise from Republicans and Democrats alike.
President Ronald W. Reagan, a Republican, called it "the best antipoverty, the best pro-family, the best job-creation measure to come out of Congress."19
President Clinton, a Democrat, asserted that "this is not a handout. . . . It gives some breathing room to people who day in and day out have done everything they could to take care of their families, to make their own way, to be self-supporting taxpayers."20
Although Congress has amended and expanded the program in the years following its enactment in 1975, its purpose has remained the same: to use the tax system to encourage the poor to seek employment rather than welfare, and to offset the impact of Social Security taxes on low-income workers with families.
Most qualified working individuals and families receive a check for the amount of the credit. Others reduce or eliminate the income tax they owe, depending on the number of eligible children and the amount of their income from jobs.
For example, for tax year 1998, workers who had two children and who earned between $9,390 and $12,260 received a maximum credit of $3,756. The credit phased out by the time someone's income reached $30,095.
Curiously, as the nation moved from recession at the beginning of the 1990s to a period that economists and politicians have labeled the best of all times, with a stock market that went in only one direction up tax returns with the earned income credit rose sharply instead of plunging, as might have been expected in a robust economy. From 1990 to 1997, returns filed by people claiming the credit meaning they worked but said they didn't earn enough to maintain even a poverty-level existence soared 56 percent, from 12.5 million to 19.5 million. Returns claiming an EITC refund check went up even faster, climbing 78 percent, from 8.7 million to 15.5 million. A majority of the returns were by heads of household; most were age twenty-five to forty-four.
Astonishingly, returns filed by all other individuals and families reporting wage income barely moved during the period, edging up a scant 1 percent from 84 million to 85 million. Thus, in the eight years from 1990 to 1997, the number of tax returns by all other working taxpayers went up just 1 million.
This during a time when 14 million men and women joined a burgeoning workforce that grew by 13 percent, from 109 million to 123 million.
This during a time when personal consumption expenditures jumped 45 percent, from $3.8 trillion to $5.5 trillion.
This during a time described repeatedly by President Clinton as the "longest peacetime economic expansion in our history."21
How is it possible for the ranks of the working poor to shoot up during such a time? For the amount of EITC refunds paid out by the IRS to surge 400 percent, from $5 billion to $25 billion?
Two words account for much of the increase: runaway fraud. As many as 5 million earned income credit returns are fabricated or contain errors that favor the filer. That's the equivalent of every taxpayer in Arkansas, Delaware, Kansas, Nevada, Nebraska, and Wyoming filing a bogus or inflated return. The cost of the fraud: an estimated $8 billion. That's comparable to all the taxes paid by every taxpayer who earns less than $50,000 a year in Minnesota and Michigan. Think of it as a direct transfer, from workers in those two states to earned-income tax cheats.
The fraud takes many forms. Men "borrow" a child or two from the women they live with or date. Grandmothers claim the tax credit for their grandchildren, when mothers of the children are not eligible for it. Some invent children but use actual Social Security numbers. Some fabricate children and Social Security numbers. Some parents with children don't work, but submit mythical W-2 forms showing income from phantom jobs. In border cities like El Paso and Brownsville, where Mexicans cross legally each day to work in the United States and return home at night or on weekends, they file U.S. tax returns, claim their children as dependents, and collect the credit even though the children live in Mexico.
Tax statistics confirm that border states and other states with large numbers of illegal immigrants account for a disproportionate share of EITC returns. For the nation as a whole in 1997, 19 percent of all tax returns with wage income claimed the credit. In New Mexico, it was 28 percent. In Texas, 26 percent. Florida, 24 percent. Arizona and California, 21 percent. By way of comparison, in New Hampshire, a state with few illegal immigrants, just 12 percent of the returns sought the credit.
The variety and extent of the fraud are limited only by the imagination and ingenuity of those seeking the "refunds," or the tax preparers who encourage them to do so. In many cities, independent tax firms working out of storefronts have recruited people to file EITC returns and pocketed a percentage of the refund. The fraud has also been abetted by electronic filing, which eliminates paperwork and speeds up the refund.
But don't blame the IRS for all the earned-income fraud. Blame Congress, which gave what essentially is a welfare program to the tax collector to administer. Sort of like asking your lawyer to perform your root canal.
In this case, the fraud is the kind that, absent an investigation of each individual return, is nearly impossible to prove. As the General Accounting Office put it, EITC "eligibility, particularly related to qualifying children, is difficult for IRS to verify through traditional enforcement procedures, such as matching return data to third-party information reports. Correctly applying the residency test . . . for example, often involves understanding complex living arrangements and child custody issues."22
Translation: Unless the IRS sends an army of agents into the field to confirm the existence of children named on returns, and determine whether the filers actually supported the children and are otherwise eligible, there's no way to document individual fraud. Obviously, this kind of wholesale, intrusive investigation has never been an option. Even if the IRS had the personnel to do so, Congress, fearing public backlash, would never allow it. And that was before lawmakers in 1998 ordered the IRS to become a taxpayer-friendly, service-oriented agency, and to tone down its image as a tough enforcer.
Even before Congress curbed the IRS's enforcement powers, the GAO had concluded that "the incentive to file problematic returns is likely to increase as IRS' capability to verify information on the return decreases."23
Secrets of the System
The IRS's limited ability "to verify information" extends well beyond the tax returns of the working poor. Another growing bloc of tax dodgers consists of people who have structured their personal and business lives in a way that allows them to ignore the tax collector.
They do this through endless schemes. They move money between U.S. and foreign bank accounts to disguise its source and destination. They use other names on bank and brokerage accounts. They shift assets and money in a dizzying maze involving U.S. and foreign corporate entities. They arrange for third parties to pay their bills from tax havens. They buy stock at bargain-basement prices offered to insiders and sell it for large gains without reporting the income. They intermingle personal and business expenses. And when questioned about their finances, they offer explanations that are as disorienting as their deals. To unravel such a bewildering array of transactions and estimate the amount of tax owed would require a task force of IRS agents one for each person or family.
Unlike the Wildensteins, whose very existence was unknown to the IRS, these people are well known to the agency. They are everywhere. Many are your next-door neighbors. People like Stanley and Jean Schulman.
The Schulmans, who until 1999 lived in a three-quarter-million-dollar house in a gated community in Bell Canyon, California, thirty miles northwest of downtown Los Angeles, have led a comfortable life. He's an investment consultant. She's a former computer analyst who retired from Blue Cross about 1986. They travel in Europe. They drive late-model vehicles. They have provided cars for their six children. They entertain. In 1994, Schulman said his yearly income had averaged about $300,000 from 1984 until that time. That would have placed him among the top 1 percent of the nation's taxpayers if, that is, Schulman had paid taxes. But he hadn't, not in any of those years. As he explained in May 1994 during a deposition in a lawsuit filed against him by a businessman seeking to collect a money judgment: "I have not paid income taxes since 1968 and I cannot discuss my income taxes because I don't pay them. . . . I don't have any income that is taxable, so I don't pay income taxes."24
But then he paid income tax in another country, right? Wrong. "I have paid no taxes to any sovereign entity in the world since 1968. I have minimized my tax liability," Schulman said.25
Minimized indeed. But how? In part, by shuffling "large sums of money between various offshore accounts."26 In part, by having offshore companies pay personal expenses.
Schulman worked as a consultant for a company called Albemarle Investments Limited, which maintained an office in London but was organized on Guernsey Island. Guernsey is one of several tiny islands in the English Channel that have been notorious tax havens for decades. Schulman once explained Albemarle's business this way: "It is a full-service financial company. . . . It provides each and every type of service that any full-service financial corporation would for individuals and corporations throughout the world."27
As for his role, Schulman said, "I arrange for them to invest money in various companies around the United States, England, Canada, Europe, and I help manage investments. I arrange individual clients to open accounts with them for tax limitation purposes."28 In other words, he sets up deals so clients can drastically reduce or eliminate their taxes.
Schulman said he received about $250,000 a year from Albemarle, and that he pulled in another $50,000 for providing similar services to a second offshore company called Coubert Dennis Limited in Ireland. From both, he received shares of stock as payment for his work, which he sold to generate cash.
To appreciate how the Schulmans lived the tax-free life, let's take a look at their household expenses. Typically, individuals and families work to save money for a down payment to buy a house. That money, naturally, represents earnings on which taxes have been paid. After moving into the new home, they pay the monthly mortgage charge, as well as utility bills, with wage income earned, once again, after taxes. Or more accurately, after the taxes have been withheld from paychecks. That's how the system works for most people.
Not so for the Schulmans and millions of others like them. In Stanley Schulman's case, Albemarle Investments, his self-described "employer," decided to take a flyer in California real estate late in 1993 because "everybody felt that the market was coming back and there would be a big upsurge in property value."29
In one of those happy coincidences, the Schulmans just happened to be in the market for a new home at the time. Stanley scouted out the area and settled on a $600,000 five-bedroom, four-and-a-half-bath home on a 2.65-acre lot in Bell Canyon, complete with spa and horse corral. On orders of Albemarle Investments of Guernsey, a California corporation was formed with the identical name, Albemarle Investments Limited, to hold title to the real estate. Schulman was president of California Albemarle.
At closing, Guernsey Albemarle wired $320,000 into a Bank of America account of California Albemarle for the down payment, and financed the $300,000 balance with a private loan. Did Schulman know how the offshore Albemarle came up with the $320,000? "No, I don't," he said.30
To sum up: Schulman selected a house for California Albemarle to purchase as an investment for Guernsey Albemarle, and signed all the papers as president of the California company. In addition to being an "investment," the house also would be the Schulman family homestead, as well as the address for several businesses.
What does the rest of the California Albemarle investment portfolio look like? Not much. In fact, the Schulman house was Albemarle's only investment. But it wasn't the company's only expense. When the monthly gas, water, and electric bills and homeowner's fee arrived, all were paid out of an Albemarle checking account at the Bank of America, thereby relieving the Schulmans of the need to spend after-tax dollars on mortgage and housing expenses, as other people must.
Guernsey Albemarle was quite generous in other ways. The Channel Island company leased two cars in 1994 for Schulman and his wife a 1994 Lincoln and a 1994 Ford Explorer, sparing the family yet another expenditure. Schulman received the cars, he said, "in exchange for the services" he provided to Albemarle.31 And that wasn't all. Guernsey Albemarle also leased six additional Ford Explorers. Listen to this exchange during a deposition in March 1995 between Schulman and a lawyer representing one of his creditors, as the lawyer seeks to learn the whereabouts of the mini-fleet of vehicles:
Attorney:Does Albemarle Investments have any other automobiles?
Attorney:Can you tell me what those are?
Attorney: They have Ford Explorers? How many?
Attorney:Approximately six. Do you know where they are located?
Schulman:. . . Well, in L.A.
Attorney:All in Los Angeles? Do you have any idea who is in possession of them?
Attorney:Can you tell me who that is?
Attorney: Your children. How many children do you have again, I'm sorry?
Schulman later explained that five of his children drove Ford Explorers leased by Albemarle, and the sixth car was on loan to a friend. His sixth child drove a Cadillac originally leased by Coubert Dennis. Why would a Guernsey Island company lease sport utility vehicles for Schulman's children, who did no work for that company?
Because the president of Albemarle, one William Daniel Dane, authorized it to do so. Schulman recounted events leading up to the leases: "The company owed me a fee at the time and [Dane asked] 'How do you want it?' I said, 'Well, why don't we just authorize the company to lease cars for my kids.' And he said, 'Go do it.'"33
Inside the Schulman house, Guernsey Albemarle provided the Macintosh computer and Coubert Dennis furnished the fax machine. The two companies also paid the monthly charges on Schulman's MasterCard and Visa accounts. On occasion, Schulman wrote the corporate checks on the California Albemarle bank account at the direction of Guernsey Albemarle, of course, and as an agent of the company. As one might gather by now, Schulman owned nothing in his own name. He maintained no records of financial transactions. He wrote no personal checks. He destroyed all documents.
How did Schulman arrange his affairs so that he paid no income tax? A walk through one of his financial transactions is enlightening.
In late summer 1993, one of the brokerage accounts he maintained sold stock in Medgroup Inc. for $19,332. The company described itself as an operator of physical therapy clinics in California and Arizona. Schulman had received the stock from Albemarle in return for services he performed for Medgroup on Albemarle's behalf. Yet he never saw the cash. The $19,332 was routed back to the United Kingdom and into an Albemarle bank account that paid his credit card charges, car, and other personal bills.
Schulman also resorted to other tax-free practices. But let him explain:
"You have two things that you have to look at. If I take you to dinner and spend $300, I'll pay cash for it because nobody will ever know I spent the cash. If I buy a pair of shoes, I'll bill it to the company, because people can see the shoes."34
Schulman allowed that he did pay some personal expenses out of his pocket. "I pay for the dry cleaning, clothing . . . the vet bill on my dogs and cats. Just having one of our cats operated on . . . was $700 estimated. . . . I pay for my granddaughter's tutoring monthly. . . . It's just normal living expenses."35 And he paid the tuition, books, and health insurance for one daughter attending UCLA.
Sometimes even basic needs such as food were mysteriously provided for, as this exchange between Schulman and a lawyer during a deposition in June 1995 demonstrates:
Attorney:Between March and today, how have you made a living?
Attorney:You haven't made any payments toward living?
Attorney:You purchased any food in the past three months?
Schulman:My wife has.
Attorney:How does she make those payments?
Schulman:She has some cash in the bank and I believe she borrowed some money.
Attorney: When she was last here I recall that she testified while you were sitting here that she received all her money from you.
To summarize, Jean Schulman has no income of her own. She gets her money from her husband. But he doesn't have any income either. Yet she pays for the family food that he can't buy because he doesn't have any money. But wait. There's more. Jean Schulman has her very own Bank of America Visa card, and uses it to pay the monthly bills in the same inscrutable way as the grocery bills. Listen to an exchange between a lawyer and Mrs. Schulman during a deposition:
Attorney:Are there outstanding debts on the card?
Attorney:Can you give me a ballpark figure in your estimation?
Mrs. Schulman:Roughly $5,500 because that is the max on it. . . . Uh, $4,000 maybe. I don't know. . . .
Attorney:And you make the monthly payments on that account?
Attorney:No, you don't? But it is your card?
Attorney:Who makes the payments?
The Visa card was but one of the credit cards Mrs. Schulman used. There were at least four others for department and specialty stores. Those bills were handled in the same way as her Visa account. She never saw them. She didn't know the balances. Her husband paid them. She maintained that she had no assets, owned no stocks or bonds, and had no investments.
Amazingly, while Mrs. Schulman was unable to say how much she owed on her credit cards, indeed, that she never even saw the bills because they were paid by her husband, and that she didn't have any income or assets of her own, and that she didn't file state or federal tax returns because she didn't have any income, she did manage to come up with money to engineer the acquisition of a company. Once more, the story is best told through the deposition of her husband. He is explaining that when California Albemarle filed for Bankruptcy Court protection, he once again became president, at least temporarily. Remember, California Albemarle's only holding is the Schulman family home.
Attorney:You're still president of the Albemarle California Company?
Schulman:I am president until the day the bankruptcy is adjudicated at which time the new president is being appointed.
Attorney:How do you know that?
Schulman: The board told me.
Attorney:The board told you that? What does, who comprises the board?
Attorney:Your wife. How long has your wife acted as the board of Albemarle California?
Schulman:Approximately since May of this year, when she acquired the company. I believe that she has sold the company, I'm not certain.
Attorney:Oh, she sold the company already?
Schulman:I'm not certain. . . .
Attorney:Currently, as president you're not certain if the company has been sold?
Schulman:Yep. Not my business.
Attorney:How did . . . your wife acquire the company?
Schulman:She bought it.
Attorney:She paid money for the company?
Schulman:She advanced funds to the company. . . .
Attorney:And she did that with, she advanced the company whose funds or just, is it a loan or . . . ?
Schulman:As a loan. . . .
Attorney:As a loan. Was she to receive interest?
Schulman:I don't know. I wasn't a party to any of the transactions.38
To summarize once more, Mrs. Schulman, who by her reckoning had no income or investments and got her money from her husband, who himself had no income, advanced $67,000 to the company that owned the family home.
The Schulmans are just one example of why the federal tax system is crumbling. They enjoy a comfortable lifestyle in an upscale neighborhood, yet pay no income tax. To determine how much they owe would require a costly audit by teams of IRS agents. Multiply this one case by the millions and you get some idea why the words tax law and enforcement have become non sequiturs.
Not that the IRS hasn't tried to audit the family's finances. But by Stanley Schulman's own account, the efforts have been to no avail. "They try. They throw up their hands and they say, 'What do we do? We have no documents.'"39 In his skirmishes with the IRS that he related in 1994, Schulman said: "Right now they're willing to settle for three years of tax returns, even if I give them a zero balance, and I'm not quite sure that I want to do that. That's my current status with the IRS."40
In April 1996, two years after Schulman boasted under oath that he paid no income tax, the IRS finally got around to filing liens against him, saying he owed $369,447 for 1990 through 1993. As of the summer of 1999, the liens were still outstanding.
Also that summer, the Schulmans and Albemarle sold the Bell Canyon house and moved to a new home in Devore, fifty-six miles east and north of Los Angeles. As a local business publication recounted the arrival of the newcomers:
A horse ranch in Devore is now the headquarters of Albemarle Investments Ltd., a venture capital firm that looks for promising start-ups and helps them with financing, management and eventually takes them public. The firm's headquarters are essentially embodied in Stanley Schulman, its founder and public representative. Schulman bought a five-acre ranch in Devore and moved from Ventura County in September. The business came with him.41
Invisible Workers and Untaxed Profits
None of this is to suggest that you need establish a mysterious offshore link and work for companies based in tax havens to avoid paying U.S. income tax. Truth to tell, many people in the computer field, especially programmers and systems analysts at the largest companies in America from Chrysler Corporation to the Baby Bells, from Bank of America to Unisys pay not a penny in income or Social Security taxes.
How can this be? Consulting and contracting firms recruit so-called temporary workers in other countries, especially India, and bring them to the United States under a special visa called H-1B. They farm out these foreign programmers to large U.S. companies that do not want to add permanent employees to their payrolls or to replace higher-paid American workers whose jobs have been eliminated. Still other clients are state governments that contract out computer work.
During the 1990s, nearly 1 million foreign computer technicians came to the United States to work for a maximum of six years under this program, and then, in theory, return home. Most decided to stay. If some members of Congress and computer and software companies like Microsoft, Intel, and Hewlett-Packard get their way, the ranks of the foreign workers will swell to 2 million this decade.
The reason: Computer companies are lobbying lawmakers to raise the cap limiting the number of such visas to 200,000 a year. Under existing law, the cap was slated to fall from a high of 115,000 in year 2000 to 65,000 in 2002. Fortune 500 companies complain they cannot find enough qualified American workers to fill openings. Critics charge the companies want to drive down wages by hiring cheap foreign labor. A computer industry magazine finds this perfectly acceptable: "Companies have a fiduciary responsibility to keep labor costs low. If U.S. technology companies cannot find highly trained, highly motivated American employees at a competitive cost, then a shortage does exist. And if companies say they want to hire more skilled foreign workers because those workers are cheaper, we should believe them and increase the number of visas issued."42
In addition to their willingness to work for lower salaries as much as $25,000 lower many foreign recruits, at least when they first come to this country, enjoy another advantage over American workers competing for the same jobs: They don't pay U.S. taxes.
Visit most any large American company and you will find two people working on the same computer project. One is a permanent company employee who pays taxes through withholding. The other a temporary employee who enjoys the kind of payday that more than 100 million American workers can only dream about a full paycheck with zero deductions.
Because they are employed by the consulting firm that recruited them, many of these foreign workers are paid either in cash or by check and no money is withheld for U.S. income tax, Social Security, Medicare, state, or local taxes. What's more, they often live in rent-free apartments with free meals, all courtesy of the consulting firm that hired them. Still others receive a paycheck that is banked in India, and, while they're living and working in this country, they're paid an "allowance" that is also free of all U.S. taxes.
This widespread practice came to light during a little-noticed civil lawsuit in which one consulting firm accused another of raiding its employees from India. The legal action was filed by Tata Consultancy Services, a division of Tata Sons Ltd., of Bombay, against Syntel Inc. of Detroit in U.S. District Court in Detroit in 1990. The dispute dragged on for years, during which time numerous Tata and Syntel employees, most of whom had come to the United States from India on temporary visas, testified about the tax-free life of foreign programmers.
Among those questioned was Sujatha Subramanian, a female programmer from India, who, like others, was brought to the United States by Tata but later left to join Syntel. Technically, she was employed by a company in India called Leading Edge, which subcontracted her to Syntel, which assigned her to computer projects at Ford and Chrysler. She received a paycheck from Leading Edge that was deposited in rupees in a bank in India and she received a living allowance from Syntel in U.S. dollars. The following exchange is with a Tata lawyer.
Attorney:What other kind of benefits are you receiving?
Subramanian:None from Syntel.
Attorney:None? Do you get your cost of living allowance from them?
Subramanian:Yes. And I'm covered by health, covered for health and medical. . . .
Attorney:Do you pay taxes here in the United States?
Attorney:Only in India?
Subramanian:Yes. . . .43
In one of the cruel ironies that run through the American tax and labor systems, foreign workers who pay little or no U.S. taxes receive health care coverage through the contractors that place them, while millions of American workers in jobs with even lower wages pay taxes but have no health care benefits. Their employers do not provide coverage, and individual policies are too expensive. Yet the taxes they pay go in part to pay for the health care coverage of the poorest of Americans who qualify for Medicaid.
Another programmer, Rengaswamy Mohan, who was contracted out to work for Deloitte Touche in Florida, spoke candidly about his tax and employment status and the interwoven relationships between Syntel and other consulting firms in India. While working in the United States, Mohan received a paycheck from an Indian firm, Mascon, which was deposited in a bank in India, while Syntel gave him a living allowance. When asked during a deposition whether taxes were withheld from the monthly check of $2,270, Mohan replied:
"No. Actually, I was told that these were all the expenses and I was sitting as a consultant from India."44
And a nice place to sit it is, the tax-free life in America. But Mohan also enjoyed another fringe benefit. He received a finder's fee for referring another programmer to Syntel.
Attorney:How much did you get?
Mohan:I don't remember, but, you know, I get like, so long as she is in this [Deloitte Touche] project, 50 cents an hour.
Attorney:Fifty cents an hour for each hour she works on this project?
Attorney:. . . For how long? Is that forever? As long as she keeps working
Mohan:So long as she is in this project.
Attorney:That's a good deal.45
A really good deal, considering the programmer was his wife.
None of this is to suggest that every Syntel programmer pays no taxes. Some eventually go on the company payroll and are treated like other permanent workers taxes are withheld from their paychecks. But court records show that for many, such is not the case. In this, Syntel is not alone.
In 1998, an Indian programmer in Chicago, worried that he might lose his bid for American citizenship, wrote a letter to the U.S. Department of Labor expressing concern over his off-the-books income.
Employed by a computer consulting firm in Chicago and farmed out to Ameritech, the programmer explained that when he came to this country he had been compelled to become part of a complex scheme by the consulting firm to evade taxes. He was not clear on all the elements that made up the fraud, but a key component was that his pay came partly in cash:
They told me that in this way neither they have to pay taxes nor I have to pay taxes on that amount. When I objected it, they told me that most of the other employees are paid in similar way. I asked my couple of colleagues . . . everyone communicated that they are paid in same way. Part of the payment [almost 30 percent of the salary] they receive is not taxable and paid to them every month. Now I realize that this practice . . . is illegal. I don't want to be part of this system, but presently I do not have any alternatives.46
Where, you might ask, is the IRS in all of this? The answer is: Nowhere. "Immigration is a big problem for IRS," confided a former high-level Treasury Department official. "It doesn't know how to track foreign workers."47
If Congress has guaranteed that the IRS is incapable of finding people who physically exist, whether they be foreign workers or the Wildensteins of the world, then what are the chances the agency will detect paper profits? Virtually none.
Of all the areas where fraud is easy to commit and most difficult to identify, capital gains income ranks near the top. Here's why.
The IRS receives a notice that you picked up $460,000 from the sale of stock. Let's say 5,000 shares at $92. You originally paid $30 a share, or $150,000. Subtract that sum and your capital gain the amount on which you must pay taxes totals $310,000. But the IRS doesn't know what you paid for the stock. They take your word for it. So you put down $75 instead of $30. Magically, $225,000 in taxable income disappears. That's a tax savings of $45,000.
Long before fraud became commonplace, the IRS never came close to collecting all the taxes owed the government from capital gains income. This was partly because of the complexity of the tax code, partly because of tax evasion by those who suspected, quite rightly, that the agency didn't have the resources to aggressively track underreporting.
Now it's much worse. In this first decade of the twenty-first century, the IRS is overwhelmed by securities transactions. Hobbled by inadequate resources, the agency poses little or no threat to people who understate their profits. As a result, capital gains fraud is skyrocketing.
From 1990 to 1997, the average capital gain reported on tax returns went up a modest 32 percent, from $13,400 to $17,700. That growth did not come close to matching the rise in the overheated stock market or the volume of daily stock trades. During those same years, the Dow Jones Industrial Average leaped 200 percent. Trading volume was up even more, spiraling 297 percent.
Other data are even more compelling. In 1990, wage and salary income reported on all tax returns totaled $2.6 trillion. By contrast, the value of all stock trades that year on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ over-the-counter market added up to $1.8 trillion. Thus wage and salary income was 1.4 times greater than the value of stock trades, a pattern that had long been the norm.
By 1997, that ratio had been reversed, as the value of stock trades reached a staggering $10.4 trillion or 2.9 times greater than wage and salary income of $3.6 trillion.
What all this means is that the opportunities for fictional accounting ha ve never been greater. Just how great, you ask? Consider that in 1990, net capital gain income reported on tax returns was 6.8 percent of the value of stocks traded. By 1997, that figure had fallen off by half, to 3.3 percent a seemingly impossible decline during an era of sizzling stock market activity.
What would capital gains income have totaled if the 1990 ratio had been in place in 1997? Over $700 billion, or double the reported sum of $348 billion.
To be sure, tax law changes and other economic factors may account for some of this difference. Also, the stock market is just one slice of the capital gains pie, albeit a large one. Sales of commodities, futures, real estate, and other capital assets must also be factored in. Nevertheless, a chunk of the difference is attributable to tax fraud.
Who's benefiting from this?
While Democrats and Republicans alike talk of the nation's booming economy, and how everyone is in the stock market, the IRS's tax return data tell another story. A comparatively small number of people report taxable income from the sale of capital assets, and only a tiny fraction of those rake in most of the profits.
In 1996, for example, 915,000 individuals and families with incomes of more than $200,000 reported receiving $171 billion from the sale of capital assets. They accounted for only 8 percent of the returns but collected 67 percent of the money.
The Perfect Tax Return: Always a Refund
While tax dodging among investors is rampant, fraud within another part of the population is even more widespread. That would be the fastest-growing segment of the U.S. economy: the self-employed.
Historically, this group has been a major source of taxpayer fraud and error. Studies have shown "they are less compliant" than other taxpayer groups, and that they "appear to be intentionally non-compliant more often" than taxpayers who receive a weekly paycheck.48
What accounts for this reputation? Many of these businesses are operated on a cash basis nail salons, beauty salons, restaurants, mom-and-pop grocery stores, landscapers, child care providers, antiques dealers, independent auto repair shops, plumbing and heating contractors, truckers, painters, and electricians. In addition to depending on cash, these businesses are subject to fewer requirements for information returns, such as the 1099 notices that banks must submit to the IRS reporting interest payments. Also, there's usually no withholding in these or scores of other occupations and professions, such as lawyers, accountants, computer programmers, physicians, and nurses. Again, no paper trail.
That's why one study carried out in the late 1980s and which has never been updated found that even back then the self-employed did not report 25 percent of their income. Evasion and avoidance across the board have escalated since then. In 1994, another study found that fewer than half the self-employed paid the Social Security and Medicare taxes owed.
Let's put this in more personal terms. Suppose the self-employed now report 60 percent of their income, a charitable assumption. Multiply your annual income, say $45,000, which you receive in a weekly paycheck with taxes already deducted, by 60 percent. That comes out to $27,000, which you enter on your Form 1040. With the stroke of a pen, $18,000 of your income disappeared from the taxman's view. The savings: $1,377 in Social Security and Medicare taxes and $2,400 in income tax, thereby providing an extra $3,777 in spending money.
While fraud has always existed in this area, the volume and scope have been shooting up. One reason is the emergence of involuntary self-employed people, like the computer workers at large companies who are replaced by the nontaxpaying foreign computer workers. These displaced workers, who once paid taxes, are forced to go out on their own. They rent themselves out, doing the same work but for less money and no health care or other fringe benefits. These embittered former corporate employees often feel no special obligation to prepare an accurate tax return.
This is especially true when they see the effect their independent status has on their tax bill. It goes up. Remember the health care worker who pays total taxes at a higher rate than the president of the United States? Her largest tax bill is for Social Security and Medicare. She must pay both the employer's and employee's share, which adds up to 15.3 percent of her income. Add to that the federal income tax and state and local taxes.
Not surprisingly, the self-employed are keeping a larger share of their income for themselves than in the past. A Los Angeles economic development official says, "It used to be 'a dollar for the IRS, three dollars [in unreported income] for me.' Now it's 'a dollar for the IRS and eight for me.'"
The data bear this out. From 1980 to 1997, the average amount of receipts reported by the self-employed inched up a meager 10 percent, from $46,000 to $50,700 lagging far, far behind the inflation rate of 95 percent and other economic yardsticks. During the same period, average wage and salary income on all tax returns rose 116 percent. Gross domestic product per capita jumped 148 percent.
These and other statistics suggest that the self-employed are understating their income by upwards of $250 billion a sum that grows yearly. That's a tax loss of $50 billion, the equivalent of the income tax paid by everyone who earned less than $50,000 a year in Connecticut, New Jersey, New York, Ohio, Pennsylvania, Maryland, Massachusetts, Indiana, Virginia, West Virginia, and Delaware. That $50 billion, by the way, is calculated on unreported income only. It does not take into account inflated, phony, or inappropriate deductions that allow business owners to escape billions more in taxes.
Some of the self-employed do their own creative accounting. Others take their make-believe numbers to a tax preparer. Increasingly, accountants say, the business owner tells them how much he or she wants to pay in taxes and instructs the tax preparer to arrive at that figure. Sort of like the ordinary working person deciding how much he or she would like to pay in taxes, and then adjusting income and deductions accordingly.
A veteran IRS examiner confirms the practice is widespread and adds that the goal of many self-employed persons is to pay no taxes at all. As an example, the examiner pointed to the operator of a fast-food franchise who lived with his family in an affluent neighborhood, sent his child to a private school, and paid not a penny in income tax. When the IRS examiner questioned the tax preparer about the return, the preparer replied: "If I don't do what he wants, he won't pay me. He'll go to someone else."49
That's the way the system works. If one tax preparer declines to produce a return showing the desired result, some other one will. Opportunities for this kind of fraud have multiplied. Tax returns filed by those who report income from a trade or business have shot up four times as fast as those filed by individuals and families who report wage and salary income, spiraling from 9 million in 1980 to 17 million in 1997.
Not all errors on self-employed returns come from cheating. Some individuals are genuinely confused by the complexity of the Internal Revenue Code and make honest mistakes. For others, their perceptions of what should be considered legitimate deductions or income lead them to make mistakes almost always in their favor. One way or another, it costs the Treasury and other taxpayers.*
So who, exactly, are we talking about here?
These are people like the Los Angeles—area lawyer whose extracurricular horse-breeding business racked up $132,253 in expenses over seven years while bringing in only $752 in income. The lawyer used the $131,501 in losses from the horse venture to offset taxable income from her law practice and reduce her tax bill. Over seven years, she reported that net profits from her law business averaged just under $20,000 a year. In one year, 1995, she reported a loss of nearly $39,000. Expenses of her horse business averaged slightly under $19,000 a year. In addition, the lawyer filed her tax returns from one month to seven years late. And she understated the income from her law practice by $32,000. The IRS concluded and the U.S. Tax Court agreed that she owed $34,000 in back taxes and $8,500 in penalties.
A New York opera singer wrote off over five years $70,000 for travel and entertainment, $18,000 for meals, $23,000 in commissions, $7,400 for insurance, and $5,500 in bad debts. In all, he claimed $126,525 in business expenses that the IRS disallowed. That was in addition to $90,825 in other deductions that were disallowed, including $49,839 in employee business expenses. He filed his tax returns from one to five years late. He ignored appointments with tax examiners. He failed to appear at tax court hearings. And he produced no records to substantiate his expenses. The tax court sided with the IRS and disallowed the business and other deductions, ordered the singer to pay $46,000 in additional taxes, and levied a $15,000 penalty.
An aging Hollywood screenwriter and his actress-wife wrote off expenditures made to revive their dormant careers. They reported business income of $1,574 and expenses of $34,942. A net loss of $33,368 offset other income and reduced their taxes. Among their deductions: $3,120 for trips to Branson, Missouri, and Las Vegas and Laughlin, Nevada, where they watched country and gospel performers to inspire him to write song lyrics. He didn't sell any. They deducted $1,140 for tickets to movies, concerts, and plays because he planned to write the book and lyrics for a Broadway musical comedy. He didn't. They wrote off $4,615 to cover the cost of research trips to Alaska and Mexico. The purpose of the Alaska trip was to obtain onsite photos taken by the wife and collect other material for a screenplay. The trip to Mexico was to meet a comedienne for whom he hoped to write material. Neither worked out. They wrote off $2,480 for business use of their travel trailer including campground fees, repairs, insurance, and registration and $8,540 for use of their 1970 Ford truck on business trips. They wrote off $5,132 in home office expenses, including pool service, cable television, home improvements, and yard service. They deducted $1,114 for their home telephone, including all long distance calls. They wrote off $569 for two television sets, a VCR, and videotapes. And they carried over a net loss from the previous year of $15,892. The tax court disallowed all these deductions. Over five years, the couple claimed net losses of $142,000 from their "business."
By now, you get the idea of the pleasant tax advantages enjoyed by the self-employed, at least those who never see an IRS examiner, which is the vast majority. Unlike average paycheck-drawing Americans, they often write off personal expenses incurred by everyone and label them business expenses, and they engage in hobbies masquerading as businesses that seldom earn a profit. These expenses and losses, in turn, are subtracted from other income, thereby reducing or eliminating the taxes they owe.
One of the more brazen cases that shows how pervasive fraud has become among the self-employed is the story of Gail Carlette Dixon of East Palo Alto, California. Dixon was a tax preparer who also provided property management and notary services. From 1990 to 1992, her income from this work totaled $368,000, or about $123,000 a year. That should have placed her among the top 5 percent of tax-return filers. But it didn't. Dixon did not file returns for those three years. She was one of more than a million self-employed nonfilers one of the few to get caught.
As it turned out, Dixon's personal fraud was incidental to her contribution to the great American tax dodge. People who turned to her Cozy Home-Dixon Tax Service for professional tax help in those years were never disappointed. In fact, they must have felt like they had won the lottery.
In one of those tax miracles that occur far more frequently than the IRS, the Treasury Department, and Congress will ever let on, Dixon achieved the equivalent of pitching not one perfect baseball game, but a perfect game every day of the season for her clients. Every single person who walked into her office in 1990 carrying tax papers walked out with a return showing a refund owed by the IRS: 2,336 returns in all. It was Dixon's best performance. In the next two years, 99 percent and 98 percent of her clients collected refunds.
The returns were models of ingenuity, with phony claims for the earned income tax credit, as well as child and dependent care credits, and phantom deductions for mortgage interest, real estate taxes, charitable contributions, medical and dental bills. The amount of the false claims ranged from $375 to $17,599, and totaled more than $200,000 overall.
This impeccable refund record finally attracted the attention of the IRS. An agency spokesman observed with some understatement at the time that "a 100 percent rate would be unusually high."50 The IRS raided Dixon's office and seized sixty boxes of records. She subsequently was indicted and convicted on fourteen counts of aiding and abetting the filing of false returns. After eighteen months in a minimum-security facility, Dixon was released with the understanding that she would file her personal returns for 1990, 1991, and 1992. She owed $92,000 in back taxes, plus $28,000 in penalties, bringing her total tax bill to $120,000.
Tax preparer Dixon said she failed to file her own tax returns because she was "too distraught over her husband's death" in October 1990, and that she was taking a lot of medication while under a physician's care for stress.51 But apparently not so much stress as to interfere with production on her refund assembly line. In 1991 alone, she managed to prepare 2,765 tax returns.
Let us review. Tax preparers who craft phony returns for others and don't bother to file themselves. Self-employed persons who write off their personal expenses or deduct their hobby losses from their income. Concealed capital gains from the sale of stocks. Immigrant workers who live tax free. Independent businesspeople whose living expenses are paid for by offshore corporations. Poor people and some not so poor who collect earned income tax credit refund checks to which they are not entitled. Rich people who file returns and don't pay taxes. Rich people who don't even file.
As for the IRS cracking down on these schemes, there's not much chance, given the agency's current level of funding. That's really good news for those who are engaged in the latest mass tax-dodging craze: stashing money and assets in secret accounts in the tax havens of the world beyond the reach of the IRS.
|Preface to the Paperback Edition|
|Prologue: An American Original||3|
|Ch. 1||The Tax Cheat Next Door||11|
|Ch. 2||Treasure Islands||51|
|Ch. 3||The Internet: Avoidance Made Easy||83|
|Ch. 4||Congress's Hidden Agenda||119|
|Ch. 5||Pursuing the Powerless||157|
|Ch. 6||A Culture of Deceit||201|
|Ch. 7||Congress's Plan to Raise Your Taxes||231|
|Epilogue: Starting Over||261|