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Affluent avoid scrutiny taxes Original Source Link: (May no longer be active)
http://bernie.house.gov/documents/articles/20020408164855.asphttp://bernie.house.gov/documents/articles/20020408164855.asp
Published on 4/7/2002 in the New York Times
Affluent Avoid Scrutiny on Taxes Even as I.R.S. Warns of Cheating
by David Cay Johnston
The government looks for tax cheating by wage earners far more carefully than it looks for cheating by people whose money comes from their own businesses, investments, partnerships and trusts. This is true despite many warnings by federal tax officials that cheating is becoming far more common among affluent Americans.
Even as Congress finances a crackdown on tax cheating by the working poor, it is appropriating little money to detect abuses by people, usually among the wealthiest Americans, who do not rely entirely on wages for their income.
Executives at the Internal Revenue Service have mentioned this discrepancy in several reports to Congress. They have not focused attention on how little they can do about it. But an examination by The New York Times of I.R.S. statistics including audit rates and staff deployment figures, as well as interviews with current and former I.R.S. officials, shows that the agency can identify at best only a tiny percentage of the cheats and pursue even fewer of them.
That the I.R.S. audits the working poor more frequently than wealthy people is well known. What has not been discussed is that the agency does not track nonwage income as closely as wage income — and in some cases does not verify it at all, even as the I.R.S. says that cheating on nonwage income is rising.
The greater scrutiny of wage earners begins with their employers, who must report wages in detail to the Internal Revenue Service on W-2 and 1099 forms. Banks report interest earned on savings accounts and paid on home mortgages. Churches and charities must issue receipts on donations of more than $249.99. A Social Security number is required to take a child as an exemption.
I.R.S. computers then compare every one of these 1.4 billion independent reports to the entries on each individual income tax return. When the numbers do not match, computers automatically send the taxpayer a notice.
Congress requires even more of the 19 million Americans who apply for the Earned Income Tax Credit, a payment from the government of as much as $4,008 for a low-income working family. Some of them are required to produce marriage licenses, school report cards to prove the existence of a child in the home and other evidence.
But a much smaller group of Americans — almost all of them among the wealthiest 5 percent — are subjected to less rigorous standards. Among them are people who own their own businesses, collect rents from tenants and reap gains on their stocks and other investments, including partnerships.
The government trusts these people to report every dollar of income or profit. Business owners and landlords can report whatever they want, with no institution to contradict them. For them, there is no third party — like an employer or a bank — to verify what they put on their tax returns.
Investors can also fudge their numbers. That is because brokerage firms are required to report to the I.R.S. only the total amount received when stock or other securities are sold, leaving it to the investor to determine and report how much was taxable profit. To cheat, an investor simply overstates the amount he paid for the security, thus reducing the taxable profit.
When people who know each other conduct private transactions for collectibles and other property, the sales are often never reported.
Even when a third party independently reports a person's income to the I.R.S. — like income from partnerships, limited liability companies and trusts — the I.R.S. has never matched these reports to individual income tax returns, said Dale Hart, an I.R.S. deputy commissioner.
The reason, she said, is that historically the I.R.S. saw little evidence of cheating by taxpayers with partnership and trust income. That is no longer true, she said.
"We believe we have seen a change in the population," she said. A proliferation of what the I.R.S. calls abusive trust schemes is one reason, she said.
Another reason is the widespread knowledge among sophisticated taxpayers that the I.R.S. has never matched income from partnerships, known as K-1 income, to individual tax returns, said Jerry Curnutt, a retired I.R.S. expert on partnerships.
A few accountants and tax advisers have been caught in recent years helping business owners cheat on their taxes by exploiting these weaknesses. More commonly, though, family members or longtime business associates conspire, making it difficult for the I.R.S. to detect fraud.
Cheating on partnership income illustrates weaknesses in stopping abusive tax avoidance among the affluent. Three-fourths of partnership income goes to 2 percent of taxpayers, those making more than $200,000 annually.
As much as $1 in $5 from partnerships is not reported on individual tax returns, said Charles O. Rossotti, the former computer industry executive who has been commissioner of internal revenue for nearly five years. Senator Max Baucus, the Montana Democrat who is chairman of the Senate Finance Committee, said that if the estimate proved accurate "then it is clear that tax cheats punish not only honest taxpayers by forcing them to shoulder the burden but cost our government literally tens of billions of dollars each year."
The lost taxes on K-1 income this year range from $9 billion to $64 billion, based on figures supplied by different I.R.S. executives.
The larger sum, if collected, would be enough to exempt from income taxes the 62.5 million taxpayers — half of all those who file — who made less than $508 a week. And there would still be $29 billion left.
Next month, the I.R.S. plans to start comparing some of the 24 million K-1 reports with partners' tax returns. But only 142,000 tax returns will be examined this year.
The project is fraught with problems, not least of which is that the 14 income lines on K-1 forms do not line up perfectly with the lines on Form 1040 individual income tax returns. In addition, the I.R.S. is examining only K-1's reporting taxable income, officials said. It is ignoring those reporting losses even though the losses may have been fraudulently calculated.
When unreported partnership income is found, the I.R.S. will send notices demanding taxes or an explanation. But the I.R.S. was given no additional money for "the actual casework to follow up" when unreported income is found, Mr. Rossotti said.
After analyzing federal and state tax data at the request of The Times, Mr. Curnutt estimated that by spending just $9 million the I.R.S. could recover $1.8 billion in taxes on partnership income alone, a ratio of $200 of revenue for each dollar of added expense, before counting interest and penalties.
Tens of billions more are lost through other forms of cheating, such as secreting money in tax havens like the Bahamas. Jack Blum, a money-laundering expert and I.R.S. consultant, has estimated that offshore accounts alone cheat the government of at least $70 billion annually. Perhaps $160 billion is lost in the underground economy, in which people are paid in cash and report little or no income, based on I.R.S. estimates.
But the focus of Congressional action on tax cheats since 1995 has been on those among the working poor who actually file tax returns.
The I.R.S. employs 2,200 people to stop what is at most $9 billion in cheating by these low-income wage earners applying for the special tax credit. It employs only about eight times that many people to hunt for all other kinds of cheating, which some experts estimate at more than $300 billion annually.
As a result, the chance of being audited if one applied for the special credit for the working poor was 1 in 47 last year. But the chance was much less for high-income taxpayers — 1 in 145 for people earning more than $100,000. It was even less for a business arrangement favored by lawyers, doctors and other professionals, called an S-Corporation: 1 in 233. And the chance of an audit was less still for partnerships: 1 in 400.
S-Corporations and partnerships provide two opportunities to cheat. The entity can understate its taxable profits or even report a loss. The entity then has more money left for its owners or partners. Those people can then understate their own income from the entity because, unlike wage income, the I.R.S. does not verify it.
The I.R.S. has also sharply reduced audits of people who work for themselves, especially those making the most money. People with tiny businesses with revenue of less than $25,000 are more than twice as likely to be audited as those whose businesses have revenue of $100,000 or more.
"The system is broken," said J. J. McNabb, an insurance analyst in Bethesda, Md., who tracks tax cheats as a hobby. "It used to be everyone knew someone who was being audited and it kept people honest. Now hardly anyone is getting audited."
Mr. Rossotti said in a report to Congress that policing wage earners more closely than those with business and investment income undermines the tax system because "the effect may be perceived as, and will in fact be, unfair because higher-income taxpayers will not have their returns verified to the same degree as middle-income taxpayers."
The principal Congressional committee assigned to oversee the I.R.S., the oversight subcommittee of the House Ways and Means Committee, has held no hearings on tax cheating by the wealthiest Americans.
The chairman of the subcommittee is the wealthiest member of Congress, Representative Amo Houghton, a New York Republican and former chairman of Corning Glass. In an interview last week, he said he was unaware of any problem of tax cheating by high-income Americans, except for recent newspaper reports of people using credit cards to tap secret accounts in Caribbean tax havens.
Mr. Houghton said that he had not heard of problems with unreported business and investment income but that he would look into them. He said hearing that there was official concern about cheating by higher-income Americans made him ponder whether "we have enough money going to the I.R.S. to do the job at the same level as in the past."
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