Negligence Versus Tax Fraud: How the IRS Tells the Difference

The difference between cheating on your taxes and negligently filing them, and how the IRS draws the line.

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It shouldn't come as a shock to hear that it's a crime to cheat on your taxes. In a recent year, however, only 2,472 Americans were convicted of tax crimes -- .0022% of all taxpayers. This number is astonishingly small, taking into account that the IRS estimates that 17% of all taxpayers are not complying with the tax laws in some way or another. And the number of convictions for tax crimes has decreased over the past decade.

According to the IRS, individual taxpayers do 75% of the cheating -- mostly middle-income earners. Corporations do most of the rest. Cash-intensive businesses and service industry workers, from handypeople to doctors, are the worst offenders. For example, the IRS claims that waiters and waitresses underreport their cash tips by an average of 84%.

How People Cheat on Their Taxes

Most people cheat by deliberately underreporting income. A government study found the bulk of the underreporting of income was done by self-employed restaurateurs, clothing store owners, and -- you'll no doubt be shocked -- car dealers. Telemarketers and salespeople came in next, followed by doctors, lawyers (heavens!), accountants (heavens, again!), and hairdressers.

Self-employed taxpayers who over-deduct business-related expenses -- such as car expenses -- came in a far distant second on the cheaters hit parade. Surprisingly, the IRS has concluded that only 6.8% of deductions are overstated or just plain phony.

If you are caught cheating by an auditor, she can either slap you with civil fines and penalties or, worse, refer your case to the IRS's criminal investigation division.

Fraud or Negligence?

Auditors are trained to look for tax fraud -- a willful act done with the intent to defraud the IRS -- that dark area beyond honest mistakes. Using a false Social Security number, keeping two sets of financial books, or claiming a blind spouse as a dependent when you are single are all examples of tax fraud. Although auditors are trained to look for fraud, they do not routinely suspect it. They know the tax law is complex and expect to find a few errors in every tax return. They will give you the benefit of the doubt most of the time and not go after you for tax fraud if you make an honest mistake.

A careless mistake on your tax return might tack on a 20% penalty to your tax bill. While not good, this sure beats the cost of tax fraud -- a 75% civil penalty. The line between negligence and fraud is not always clear, however, even to the IRS and the courts.

While auditors aren't detectives, they are trained to spot common types of wrongdoing, called badges of fraud. Examples include a business with two sets of books or without any records at all, freshly made false receipts, and checks altered to increase deductions. Altered checks are easy to spot by comparing written numbers with computer coding on the check or bank statements.

While the statistical likelihood of your being convicted of a tax crime is almost nil, it does happen to some folks. If you are in the unlucky minority, hire the best tax and/or criminal lawyer you can find.

To learn about the latest business tax breaks, rules, forms and publications, see Tax Savvy for Small Business, by Frederick W. Daily (Nolo).

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