It shouldn't be shocking to hear that cheating on your taxes is a crime. Nevertheless, the number of Americans convicted of tax crimes is astonishingly tiny. And the number of convictions for tax crimes has decreased over the years.
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%.
Most people cheat by deliberately underreporting income. A government study found self-employed restaurateurs, clothing store owners, and car dealers did the bulk of the underreporting of income. Telemarketers and salespeople came in next, followed by doctors, lawyers, accountants, and hairdressers.
Self-employed taxpayers who over-deduct business-related expenses, such as car expenses, came in a 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're caught cheating by an auditor, the auditor can either slap you with civil fines and penalties or, worse, refer your case to the IRS's criminal investigation division.
Auditors are trained to look for tax fraud (a willful act done with the intent to defraud the IRS) in 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 don't 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 add a 20% penalty to your tax bill. While not good, this sure beats the cost of tax fraud—a 75% civil penalty.
However, the line between negligence and fraud is not always clear, even to the IRS and the courts.
While auditors aren't detectives, they're 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 & Stephen Fishman (Nolo).