Tax evasion in the United States

Money laundering, the term for filtering “dirty money” is believed to have come about when the mafia owned laundromats in the United States. Laundromats had been used to filter large amounts of money from illegal activities including extortion, alcohol, and prostitution. Through leveraging a legal business, a laundromat, illegal earnings from the following activities could be legitimized as earnings gained by the laundromats. While Al Capone was convicted for tax evasion, it is noted how “his conviction may have been the trigger for lifting the money laundering business off the ground” (Dadoo, 2012; Krishna, 2008; “Al Capone: Biography”, 2012). Al Capone, an infamous Prohibition-era crime boss, conducted all of his financial transactions in cash, never having a record of having a bank account. To expand further, the Internal Revenue Service was unable to ever find any records of Al Capone purchasing a single security. Despite Capone being behind several casualties during his time spent as the “mafia boss,” the federal government was unable to connect any evidence to him. Having said this, the government put a great deal of effort toward collecting evidence of Capone neglecting to pay taxes on his income. Capone was charged with 22 counts of tax evasion, but later found guilty of five of the tax evasion charges (Krishna, 2008; “Al Capone: Biography”, 2012). Following Capone's sentencing, Meyer Lansky, often referred to as “The Mob's Accountant,” put his efforts toward finding a better way to get out of paying taxes. Moving forward, Lansky discovered the benefits of Swiss Bank accounts and would go on to become a significant figure for money laundering by using foreign tax havens.

Jurisdictions which allow for limiting taxation, known as tax havens, may be used for both legally avoiding taxes and illegally evading taxes. Tax Havens are able to be utilized by people due to the fact that many other foreign financial institutions are not held to the same requirements of disclosure as those in the United States. This allows for people to hide money with the benefit of not needing to provide access to tax information that is required in the United States but not in the tax haven country. Due to laws put in place in tax havens that limit the amount of information to be shared with the United States the overall amount of tax evasion due to tax havens are not able to be reliably estimated.[16] In 2010, the Foreign Account Tax Compliance Act was passed to better enforce taxation in foreign jurisdictions.

U.S. citizens are required to report unlawful gains as income when filing annual tax returns (see e.g., James v. United States[17]) although such income is typically not reported. Suspected lawbreakers, most famously Al Capone, have been successfully prosecuted for tax evasion when there was insufficient evidence to try them for their non-tax related crimes. Reporting illegal income as earned legitimately may be illegal money laundering.

There are two ways penalties on tax evasion are imposed. These penalties can be imposed on undeclared income or on the evaded tax. Relationships exist between tax rates and tax evasion. An increase in the tax rate will affect tax evasion differently depending on how the penalty is imposed. If the penalty is imposed on undeclared income, then there will be a higher rate of tax evasion. If the penalty is imposed on the evaded tax, then the rate of tax evasion can either increase or decrease. The increase or decrease in tax evasion when the penalty is imposed on evaded tax depends on the magnitude of income.[18]

A person's personal ethics can play a big role in their decision to commit tax evasion. A person who views the correct representation of income and proper filing of taxes as an ethical decision will lead to more compliance to the tax codes and regulations. A person who does not view the correct representation of income and proper filing of taxes on their as an ethical decision are more likely to be influenced by factors surrounding them. For example, if a family is behind on rent, and the taxpayer does not view properly filling out their taxes as an ethical decision, they use that outside event as a justification to evade taxes.[19]

Robert McGee explains the ethics surrounding the act of tax evasion as the “compulsory taking of property by government” (McGee 1994). In simplistic form, taxation represents citizens paying a portion of their income to the government followed by the government using such funds for external purposes. Whether it be for education, law enforcement, or public parks, each situation shares in the relation of the government receiving money, so-called “property” from the taxpayer. Moving forward, the notion of taxation being referred to as “compulsory” stems from the evasion of paying one's taxes is illegal. Hence, the government would punish those who choose to engage in tax evasion. Due to the following, tax evasion is significantly seen as unethical because there is no other option but to pay one's taxes.

Provided that tax evasion is unethical, it is explained that there must be a moral obligation present for one to pay taxes. As noted within the text, “an obligation may be described as “positive,” in the sense that it commands certain actions, while a “negative” obligation only forbids certain actions.”[20] A few positive uses for taxation seen by many may include a contribution to law enforcement or education as these organizations produce a benefit to most members of society. However, the other side of the coin is represented from the negatives, possibly programs that are funded by many, however benefit very few. This difference truly embeds the climax of ethics for, as noted, “it is impossible to determine which types of public goods are necessary, in which quantity, and which unsatisfied needs of one individual imply the duty of another.”[20] It is additionally noted that “one may resort to coercion in order to force other people to share in the costs of the satisfaction of any need one thinks should be satisfied (cite).” To further explain, even if one were to take tax evasion out of the equation, it becomes quite arduous to determine whether allocated tax money meets the needs of the taxpayers. Author John Dryzek is noted within the text for his explanation in regard to how “all political arrangements proposed for ensuring that the redistribution of resources within the society fits the preference scales of its members are, by and large, unsatisfactory (Dryzek 2004, pp. 143–155)” As a whole, the major issue that comes along with the ethics of tax evasion stem from whether taxpayer money really serves the payers that make the contributions. Despite taxpayers feeling a moral obligation to pay, many mainly do so as the only alternative is punishment from the government.

Beginning in 1963 and continuing every 3 years until 1988, the IRS analyzed 45,000 to 55,000 randomly selected households for a detailed audit as part of the Taxpayer Compliance Measurement Program (TCMP) in an attempt to measure unreported income and the "tax gap".[27] The program was discontinued in part due to its intrusiveness, but its estimates continued to be used as assumptions. In 2001, a modified random-sampling initiative called the National Research Program was used to sample 46,000 individual taxpayers and the IRS released updated estimates of the tax gap in 2005 and 2006.[28] However, critics point out numerous problems with the tax gap measure.[29] The IRS direct audit measures of noncompliance are augmented by indirect measurement methods, most prominently currency ratio models[30]

After the TCMP audits, the IRS focused on two groups of taxpayers: those with just a small change in the balance due, and those with a large (over $400) change in the balance due. Taxpayers were further partitioned into "nonbusiness" and "business" groups and each group was divided into five classes based on total positive income. Using line items from the auditor's checksheet, discriminant analysis, and a scoring mechanism, each return was awarded a score, known as a "Z-score". Higher Z-scores were associated by IRS personnel with a higher risk of tax evasion. However, the Discriminant Index Function (DIF) system did not provide examiners with specific problematic variables or reasons for the high score and so each filing had to be manually examined by an auditor.[31]

Under the net worth and cash expenditure methods of proof, the IRS performs year-by-year-by-year comparisons of net worth and cash expenditures to identify under reporting of net worth. While the net worth method and the cash accrual method may be used separately, they are often used in conjunction with one another. Under the net worth method, the IRS chooses a year to determine the taxpayer's opening net worth at year's end. This provides a snapshot of the taxpayer's net worth at a particular point in time.

The snapshot includes the taxpayer's cash on hand, bank accounts, brokerage (stocks and bonds), house, cars, beach house, jewelry, furs, and other similar items. Generally the IRS learns about these items through very thorough and in-depth investigations, sometimes casing the suspected fraudulent taxpayer. In addition, the IRS also assesses the taxpayer's liabilities. Liabilities include expenses such as the taxpayer's mortgage, car loans, credit card debts, student loans, and personal loans. The opening net worth is the most critical point at which the IRS must assess the taxpayer's assets and liabilities. Otherwise, the net worth comparison will be inaccurate.

The IRS then evaluates new debts and liabilities accumulated in the next year, and assesses the taxpayer's new net worth at the next year's end. In addition, the IRS reviews the taxpayer's cash expenditures throughout the tax year. The IRS then compares the increase in net worth and the cash expenditures with the reported taxable income over time in order to determine the legitimacy of the taxpayer's reported income.

The net worth method was first used in the case of Capone v. United States.[33] The cash method was approved in 1989 in United States v. Hogan.[34]

First approved by the Eighth Circuit in 1935 in Gleckman v. United States,[35] the bank deposit cash expenditure method identifies tax evasion through review of the taxpayer's bank deposits. This method of investigation primarily focuses on whether the taxpayer's total bank deposits throughout the year are equal to the taxpayer's reported income. This method is most appropriate when the majority of the taxpayer's income is deposited in the bank and most expenses are paid by check.[36]

This method is most commonly used for surveillance of tipped employees and is combined with statistical analysis to determine what a tipped employees actual wages are. Information gathered through this method is most successful when the credibility of tipped employees can be destroyed. This method is used less frequently now for tipped employees because the IRS negotiates with hotels or casinos, the largest employers of tipped employees, to identify a tip estimate. If the tipped employee reports the minimal amount agreed upon, he is not questioned by the IRS. However, it is recommended for corroborating other methods of proof.[37] Given the uncertainty of this method, this method likely could not be used in criminal prosecutions where the guilt must be found beyond a reasonable doubt.

In addition to the methods of proof the IRS has developed, the Tax Relief and Health Care Act of 2006 created the IRS Whistleblower Office,[38] which allows anonymous whistle blowers to receive 15 to 30 percent of any recovery by the IRS which comes to at least $2 million including all penalties, interests and any other monies collected from the government. The whistle blower program seeks information based on evidence and analysis which can provide a solid basis for further investigation rather than speculation and hearsay.[39]

The program is designed to provide incentive to ordinary citizens to inform on tax cheats. The program provides far greater incentives for whistle blowers than previous programs because under prior programs the government was not required to compensate whistleblowers.[40] Under this program, taxpayers who do not receive a deserved award may file a lawsuit.[39]

Established by the Tax relief and Health Care Act of 2006, the IRS Whistleblower Offices processes tips received from eligible individuals who spot tax problems in their workplace, in their day-to-day personal business, or anywhere else. After determining the degree of credibility, an appropriate IRS office is assigned the case for further investigation. The IRS office assigned varies by the type of issue that the whistleblower alerted it to.[41]

Individuals must meet qualifications to be eligible to receive the reward and must submit Form 211 with supporting documentation to the Internal Revenue Service Office in Ogden, Utah. To claim eligibility the individual must not be an employee of the Department of Treasury or have been an employee there when they obtained the information, must not have obtained the information through the individual's official duties as an employee of the federal government, or who obtained the information based on a contract with the federal government. Whistleblower incidents happen in greater frequency in the private sector opposed to the government.[41]

The reward can be worth between 15 and 30 percent of the total proceeds that the IRS collects. To claim the reward, the IRS must move ahead based on the information provided and the amount identified, including taxes, penalties, and interests, must be worth more than $2 million. A gross income of $200,000 or more is required if the taxpayer in question is an individual.[42]

The Bipartisan Budget Act of 2018 added subsection 7623(c) which expanded the definition of proceeds for whistleblower awards and was applied to open whistleblower claims. The Taxpayer First Act was signed by President Trump on July 1, 2019. This law made changes surrounding the notification process to whistleblowers and increased protection against retaliation available to whistleblowers. The main goal of the legislation was to improve taxpayer service and to ensure that enforcement of the laws is done in a fair, impartial manner, ultimately supporting the continued success of the nation.[42]

Incorrectly filling out tax documents can also be labeled as tax fraud or tax evasion. While these incorrect filings can be due to neglect or lack of knowledge of the tax code, the IRS will take these matters seriously. Just by looking at the documentation, the IRS cannot determine whether the incorrect filing was an unintentional error or done with intent. If it is determined that the error was unintentional, the IRS will apply 2 common Accuracy-Related Penalties to individuals: Negligence or Disregard of the Rules or Regulations or Substantial Understatement of Income Tax.[43]

Negligence is determined when a reasonable attempt to follow tax laws is not done when preparing tax returns. Disregarding the rules and regulations is classified When the filer carelessly, recklessly, or intentionally ignored the tax rules and regulations. The penalty for both incorrect filing methods is 20% of the portion of the underpayment of tax.[43]

Substantial Understatement of Income Tax applies when the tax liability is understated by the greater of either $5,000 or 10% of the tax required to be shown. The IRS will send a notice letter if an Accuracy-Related Penalty is applicable.[43]

These penalties will be charged interest but can be disputed or removed. The date that interest is charged varies by the penalty but will increase the amount owed until the balance is paid back in its entirety. If the filer acts in good faith and can show reasonable cause for why they were not able to meet the obligation, the IRS will be able to remove the penalty. Interest cannot be reduced or removed unless the penalty is reduced or removed. The IRS offers a toll-free number at the top right corner of the notice letter for the filer to call and dispute. The filer can also write a letter stating their rationale as to why the IRS should reconsider the penalty. When the letter is sent, the filer should also include the notice letter, the penalty to be considered, and an explanation as to why it should be removed.[44]

Ernst & Young from 1999 to 2002 were helping wealthy clients avoid paying taxes that led up to $2,000,000 in taxes. They were using fraudulent tax shelters to lower their client's income tax liability without the change in income/assets. The shelters were named “Cobra” and “CDS”. These names were used from around 1999 to 2002 and helped 200 clients. They looked like real investments that were designed to help lower taxes for the clients, but the shelters had no economic substance, and the sole purpose was to reduce taxes illegally. All of the firm's fraudulent shelters were removed in 2003. Ernst & Young paid a settlement to the IRS of $15,000,000 and an additional $123,000,000 in 2013 to settle federal allegations. The government dropped EY from being criminally prosecuted but the firm needed to abide with strict controls over their tax practice.[55]

KPMG ex-employee David Rivkin lost his job as a partner when a tax evasion scandal led him to plead guilty. He used illegal tax shelters to help lower income tax liability and was the first worker at the firm to confess to doing these criminal acts. These shelters generated false losses up to $11,000,000,000. This illegal act was in full motion starting in 1999 and ending around 2005. His plea consisted of allowing clients to forgo $20,000,000 in taxes that totaled $235,000,000 stolen from the government. This was done through nine clients Rivkin helped. He also promised to help convict the other defendants related to this case. Thirteen of the defendants that did not plead guilty were dismissed due to the prosecutor's unconstitutional actions. These actions were considered coercion by forcing KPMG to not pay legal fees to defendants which violated their rights. Four defendants were tried and acquitted from all charges. David Rivkin was the only KPMG employee who was convicted and punished for the crimes committed and was one of the lesser individuals involved in the whole scandal.[56][57][58]

Walter Anderson was involved in the biggest tax evasion case by a single individual that amounted to $365,000,000 in unreported income. The case stated that Anderson avoided paying taxes on $450,000,000 earned that created a loss of $200,000,000 in government taxes between 1995-1999 but pleaded guilty to a lesser amount. His charges were on two counts of tax evasion and one count of defrauding the DOC for failing to report income. He formed new foreign corporations named Gold & Appel and Iceberg Transport but also had foreign bank accounts none of which were disclosed to the IRS. Anderson tried to hide ownership of these entities that helped earn him $365,000,000 in income. In 1999, Anderson filed a false income tax return for not reporting this income. His sentence was a nine-year imprisonment with a restitution payment due to the DOC.[59][60]