Friday, April 13, 2018

Cheat on Your Taxes?

Cheat on your taxes, don't be a fool - What's that you said about a golden rule?

A reader asks whether people cheat on their taxes a lot, and if so, how - and what are "audit bait" types of things that the IRS looks for.   I am not sure what the reader is asking for - a roadmap to tax evasion?   If so, look elsewhere!

But it is a valid question.  One reason people hate our existing tax system is that it can be complicated and leave you with a FOMO situation - where you think other people are cheating and maybe you should be, too.  Or that you are trying to be as honest as possible, but will be caught by the IRS for making some stupid math error, and then crucified in the public square as an example to others.

The reality is, of course, that for most of us, cheating on taxes, in any big way, is nearly impossible to do.   And under the new tax law, there is even less incentive to do so.

But in order to understand this, you have to understand how it is possible (and nearly impossible) to cheat on your taxes.   There are basically two ways - under-report income, or over-report deductions (or tax credits, or dependents).  In both cases, the IRS can easily check this, so it makes no sense to attempt it.

For us salary-slaves in the middle-class, our income is reported to the IRS on a form W-2.   Income from investments and the like is reported on a form 1099.   Even for self-employed people, income gets reported by the people who pay you, on a form 1099-MISC.   So, for example, in my law practice, about 3/4ths of my income gets reported by my clients to the IRS by 1099-MISC forms they file.  And they file these forms, as they want to claim my fees as a business expense, and they can't do that unless they report these on a 1099!  So it is a closed ecosystem - not much income doesn't get reported.

But what about that other 1/4 of my income?   Well, I get paid by check or direct deposit or credit card - all of which leave a paper trail.   And since I want to track my clients' invoices and make sure I am getting paid, I have my own records of these payments on Quickbooks.   So even though this isn't reported to the IRS, there are records which can be easily obtained by the IRS during an audit.   So there is little point in trying to "hide" this income - you are just setting yourself up for a fall.

You see, there are two levels of penalty for cheating the government.  If you make a mistake on your taxes and forget to carry the three or slip a decimal point, they can assess a penalty for late payment of your taxes - plus interest.  That hurts, but it's just money.   But if you intentionally try to cheat the government, then you may face criminal charges and go off to jail, like Leona Helmsley did.   So it makes no sense to intentionally try to cheat the government - although a lot of people try, every year, and fail.

People with cash businesses - like small corner convenience stores - often keep cash from transactions and fail to report it.  These are the folks whose homes get broken into and are held hostage until they open the home safe and give the thieves tens of thousands of dollars.  Sort of a Karma thing there - ain't it?   But it goes beyond that.  Even if you could hoard this money and not report it to the IRS, it would be hard to spend.   Any transaction over $10,000 has to be reported to the IRS - and trying to avoid this rule by making deposits for $9,999 is called "structuring" and is also illegal.  You can't win at cheating, so why bother?

This is why I say, even if you "found" a million dollars in a sack by the side of the road, it would be damn hard to spend any of it - without declaring it as income and paying the IRS first.  And organized crime does this - using retail businesses as money-laundering venues, passing cash into the business and then declaring it as legitimate income.  Casinos work the same way - you take cash in, buy some chips, then cash out.  They give you a check, and you declare it as "gambling winnings" and pay taxes on it.   These are the "whales" the Casinos talk about - not real winners, but likely money launderers.   But the government is cracking down on even that.

So not declaring income is really problematic.  And in terms of audit-bait, the number one sure way to be audited is to file a return that does not declare income that the IRS has already received a 1099 on.  The computer will simply spit it out.   If it is a small amount (like $150 you got in interest payments and forgot to claim) they may simply amend your return for you and adjust your refund - as happened to me once.   Again, they IRS understands the difference between "honest mistake" and "outright fraud" - but the fear of the IRS is something that is useful to them, so they don't go out of their way to tamp down stories about the big, mean, IRS taking away people's money.

And by the way, most of the stories you read along those lines are about people who intentionally tried to hide income or take bogus deductions and really had it coming to them.  When you cheat on your taxes, big time, for ten years in a row, well, why should we feel sorry for you?

But getting back to cheating - deductions are the far more common way of "cheating" and a little harder for the IRS to detect.  But the new tax law, which doubles the standard deduction, may make this a moot point.  What's the point of claiming bogus charity deductions if your standard deduction is so much higher?

Again, there are "red flags" that can trigger an audit if you make too many of the wrong kind of deductions.   For example, if you make donations to charity under a certain limit (I believe $500 - check with your accountant, as tax law is fluid) you are not required to show a receipt to prove this.  So a lot of people who itemize will put down $450 in clothing donations or whatnot.   And I suspect the IRS knows this is bogus but doesn't care.  Because in the greater scheme of things, it means an adjustment to your taxes of maybe a couple hundred bucks, tops.   And if you can make the person filing taxes feel nervous that somehow they cheated - even a little bit that helps keep them in line.

But even a lot of deductions are reported to the IRS or are part of your bank records.  Your mortgage interest, for example, is reported on a form.   Your Obamacare subsidies and payments are reported on a form.   So the big deductions are hard to fake.   And even smaller ones - you should be able to produce a cancelled check, bank record, or receipt, should you be audited.

Of course, there are really stupid ways of cheating, such as trying to claim your dog as a dependent.  This sort of nonsense will land you in a world of woe, as if you are ever audited, it is a pretty simple matter to prove you cheated and moreover did it intentionally.  Again, intent is the key.  The tax code isn't simple.   I've taken several semesters of Calculus and even Number Theory, and still the numbers seem to float off the page if I tried to do taxes myself.  In previous years, I used TurboTax.  This year, I hired my late Dad's accountant, as she handled the taxes on my Mother's small trust.  Her fees were not much more than TurboTax charged - and a lot less hassle.  And I felt better having a "second set of eyes" on my taxes.

For people who are self-employed or run small businesses, there are more temptations.   Leona Helmsley went to jail in part because she did stupid things like try to claim her girdle as a "uniform" expense.   And she said out loud, in front of her maid, that she knew this was wrong.  Again, making an honest mistake might result in a penalty and interest, intentionally defrauding the IRS can result in jail time.

I've always been pretty conservative in taking deductions for business expenses.  Others are not.  My accountant always nags me to find more deductions.   The IRS uses certain ratios of expenses to deductions to flag returns for audit (in addition to random returns that are flagged).   So if you claim a huge amount of deductions relative to income, you may be audited.

A friend of mine who was a real estate agent was also an auditor for the IRS.  And the deductions he took, scared me to death.  But he wasn't worried - not because he had an "in" with the agency (indeed, I suspect they are hardest on their own) but because he knew the rules and the trip-wires that would trigger an audit.

So, for example, he leased a brand-new Range Rover and deducted the entire cost as an expense of his Real Estate business - he needed the car to show prospective clients around.  And this is a legitimate expense, too.   But it does illustrate the fallacy of chasing deductions in the tax code.  He still had to pay for that overwrought POS British-made car (whose air suspension never worked right - the car would go down the road tilted sideways).   The tax code is not an investment guide and you can't deduct your way to wealth.   I suspect he would have been better off buying a more plebian car and putting the difference into an IRA or 401(k) - both of which, by the way, are deductions also.

But it is expected that if you have your own business, you may deduct telephone and internet expenses - which may be personal expenses otherwise.  And a home office is no longer "audit bait" in this modern era of people who work from home.   Unless, of course, you are not self-employed.  If you have a W-2 and a home office deduction, you may be in trouble - consult your accountant!

Similarly, setting up a "hobby business" for the purposes of deducting your life expenses is sure audit-bait, no matter what some click-bait sites claim.  My Mother fell into this trap with her bookstore, which lost money nearly every year.  After five years or so, the IRS audited her (again, another tripwire - a business that loses money for several years and never shows a profit).   She was incensed when the auditor mentioned "hobby business".   Mother thought this was a personal attack on her store, not a term of art used in the tax business.   Lesson learned - show a profit every few years and avoid an audit.  And you can do this by not claiming some deductions you are entitled to.

But even that will not protect you from audit if you have a real "hobby business" - that is to say, taking a personal hobby and trying to use it for the purposes of deductions.  For example, Clem likes old cars. He has '57 Chevy in the garage.  He claims to have a "business" in old cars, and claims deductions for travel expenses to car shows and auctions, as well the cost of gas, insurance, and parts for his car (which he depreciates as an asset).  This offsets his income as a Dentist, so it reduces his taxes.   But unless he actually sells something and makes money at this, it really is just a "hobby business" for tax purposes - taking a personal hobby and trying to claim it as a deduction.  This is illegal and I would not suggest it!

On the other hand, if he makes replica trim pieces for '57 Chevies and sells them at car shows and online, and occasionally makes a profit at this, he may be able to legitimately claim this as a business.  Again, consult your tax adviser - there is a fine line here you can cross between legitimate and hobby business.

Now that I am retired, I don't have to worry much about taxes.  With no mortgage interest to pay and a huge standard deduction (Thank you President Trump?) I no longer have to itemize my taxes.  And indeed, since I am living largely on after-tax income, I have little income on which to pay taxes.  The net result is, there is little incentive for me to "hide" income - and indeed, I cannot realistically hide it, as every investment firm I am with reports everything on 1099 forms.   And since I take the standard deduction, I have no incentive to be "creative" in taking deductions.

And maybe that was the point of the new tax law - to make taxes simpler for the masses, and also so they didn't feel they were "cheating" with deductions or that they were "missing out" by not taking some sketchy deduction.  If so, it was a clever law.   You no longer have to feel guilty about something when you file your tax return!

UPDATE: There are, of course, ways to avoid taxes if you are in the higher brackets.  I illustrated before how I bought investment properties, fixed them up and rented them out for a decade, taking a depreciation deduction which offset my income as a lawyer.  All perfectly legal - there are even forms for it.  When the time came to sell the property, I rolled it over in a Starker deferred exchange to another property.  If I converted that property to a personal residence later on, I would avoid paying capital gains taxes - and a personal residence (at least for use middle-class Joes) is not taxable.

There are other "loopholes" of course. If you are Elon Musk rich, you can "borrow" against your stock and live off that, tax-free, as loans are not taxable, and your stock is not taxed until you sell it.  It is a tricky business, as if your stock price goes down, your bank may call your "loan" and loans usually have interest payments as well.

Then there are really sketchy things like offshore accounts or offshore licensing.  The first is tax evasion and illegal.  The latter is, well, it should be illegal.  You put all your "Intellectual Property" in a shell company in Ireland and then structure your US company so it makes no money (and pays no taxes) but pays huge licensing fees to the shell company in Ireland which has a 100% profit ratio, but of course, is taxed very little in that tax-haven country.  I am told this is legal and Apple and Google and all the other big players do this.  But it is not within the scope of this article.

If you make taxes onerous enough, people find ways to cheat - legally or illegally.  If you create a "Yacht Tax" in California (which the plebes eat up!) the wealthy simply register their yachts in Mexico, where it is cheaper to dock them and where they go fishing anyway (and labor is cheaper as well!).   You enact this populist tax to go after "rich people" and they do a neat end-run on your tax.

Meanwhile, Joe Middle-Class with his 30-foot fishing boat gets a hefty tax bill.  California - go figure!