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Five reasons not to cheat on your taxes

6 min read

6 min read

June 01, 2017

Jim Buttonow

Each year, taxpayers make a reasonable attempt to comply with the tax law for a few reasons. In an IRS Oversight Board survey, taxpayers identified third-party information reporting (62 percent), the fear of an audit (59 percent) and belief that others are honestly paying their taxes (51 percent) as three main reasons to file honestly. But, the IRS still loses almost a half-trillion dollars annually due to taxpayer noncompliance. When a taxpayer makes an inadvertent error on their tax return, that’s OK. The IRS will rarely penalize taxpayers for an honest mistake. But that’s not the case when a taxpayer purposely files an incorrect return. That’s called tax fraud, and there’s no time limit on the IRS to prosecute it.

Here are five reasons to walk the straight and narrow on the tax return:

#5: The penalty for recklessness can be high.

For taxpayers who walk the fine line between not filing a correct return but not stepping over the line to commit tax fraud, the IRS assesses the accuracy penalty. And it’s costly. Taxpayers who act recklessly will owe 20 percent of the taxes they underpaid. In 2016, the IRS assessed this penalty a half-million times out of the 148 million individual taxpayers who filed returns that year. In the past 10 years alone, the IRS has increased the number of accuracy penalties by 760 percent.

#4: The penalty can be higher in cases of tax fraud.

When taxpayers step over the line to intentionally filing an incorrect tax return, the penalty increases to 75 percent of the amount of taxes they underpaid. The fraud penalty is saved for the most egregious of cases, such as getting caught for intentionally not reporting a substantial amount of income. This is a civil penalty, not a criminal penalty for fraud (see #3). In 2016, the IRS assessed this penalty 3,219 times on individual taxpayers.

#3: The penalty can be jail time.

Saved for the most egregious of tax-evasion violations, Section 7201 of the Internal Revenue Code states that any person who willfully attempts to evade or defeat any tax is guilty of a felony and can face up to five years of imprisonment. Fortunately, the IRS doesn’t use this stick much. In fact, in 2016, the IRS investigated only 3,395 suspected tax cheats and convicted only 2,672 taxpayers. And many of these convictions started because of other crimes, such as drug offenses. But, when the IRS pursues criminal tax evasion, the IRS means business; almost 80 percent of all convicted tax evaders serve jail time.

#2: The IRS will eventually catch up to cheaters.

The IRS tests the accuracy of a tax return in many ways – and they don’t all start with an audit. Here are a few arrows in the IRS quiver:

Information statements

Every year, millions of people make income as employees (Form W-2) and/or as independent contractors (Form 1099). Form W-2 and Form 1099 are two common examples of information statements that report income – to the taxpayer and the IRS. The IRS actually gets 36 types of information statements reporting taxpayers’ financial transactions – and more than 2 billion total information statements a year. What does the IRS do with all that information? It matches the statements against the tax return, to see if the return is correct and to detect possible noncompliance.

For example, the IRS receives information about mortgage interest paid (Form 1098) and the amount a taxpayer has in an IRA (Form 5498). If a taxpayer made a large IRA contribution and also reports high amounts of mortgage interest paid, but reports little income on their return to support the expenses, the IRS may suspect that they’re hiding income and start asking questions about the return.

Foreign bank account information

The IRS has always targeted taxpayers who hide money in foreign bank accounts. In recent years, the IRS has stepped up its efforts by making many agreements with foreign countries to get tax information on U.S. citizens. Now, the IRS is using this information to chase taxpayers with unreported foreign bank accounts.

The whistleblower program

Internal Revenue Code Section 7623 provides a monetary reward for taxpayers to turn in tax cheats. “Whistleblowers” can send specific information to the IRS to help it build cases for tax evasion. Whistleblowers can use Form 3949-A, Information Referral, to “turn someone in” to the IRS. Turning someone in has not been popular in the past – with only about 28,000 whistleblowers to the IRS from 2011 to 2016. Worse yet, the IRS has approved rewards to only 2 percent of all whistleblowers. However, the whistleblower award averaged 18 percent of what the IRS collected as a result of the information provided.

State and local taxing authority comparisons

Sharing tax information with anyone is usually a no-no for the IRS. However, Internal Revenue Code Section 6103(d) authorizes the IRS to enter into agreements with state and local tax authorities to disclose federal tax information for tax administration purposes. For example, the IRS partners with state taxing authorities to share audit results, individual and business return information and employment tax information. States and the IRS use the information to identify and address noncompliance.

The Form 1099-K

The IRS knows that small businesses are more likely to file inaccurate tax returns and fail to report income. Since 2012, the IRS has started receiving a new information statement aimed at tracking the electronic flow of income: Form 1099-K, Payment Card and Third Party Network Transactions. Payment card companies, such as credit and debit cards and third-party payment companies, such as PayPal, now report monthly and annual payments made to a person or business that accepts payment cards or third-party settlement payments. In 2016, the IRS was projected to receive almost 11 million Forms 1099-K that help it determine whether taxpayers, especially small businesses, properly reported all their income. One sure red flag for audit: businesses that haven’t reconciled the Form 1099-K income to their tax returns.

Audits in a taxpayer’s network

IRS auditors are trained to “follow the money.” When the IRS audits individuals and businesses, the IRS often traces payments made to third parties to see whether the third parties correctly reported the income on their tax returns. The IRS especially uses this procedure if the person or business paying a taxpayer doesn’t file a Form W-2 or 1099 to report the income. This is a sure way to get caught red-handed not reporting the income. Many IRS fraud cases have started with the auditor simply following the money.

#1: Lawfully paying taxes is the right thing to do.

On top of IRS headquarters in Washington, D.C., is an old quote from former Supreme Court Justice Oliver Wendell Holmes: “Taxes are what we pay for a civilized society.” To this extent, most 94 percent of taxpayers agree that that paying their taxes is their moral and civic obligation. In fact, per the IRS Oversight Board, civic duty is overwhelmingly the number one reason taxpayers pay their taxes. It’s the foundation of the U.S. tax system: voluntary compliance.

Taxpayers shouldn’t have any sleepless nights if they made a reasonable attempt to properly file an accurate tax return. But, when they cross the line to intentionally cheating on their taxes, the cost can be high and the chances of getting caught only increase over time. The moral of the story: Do the right thing and file a correct tax return. Want to make sure? See a tax pro. He or she can help, and taxpayers will sleep easy knowing they are in good standing with the IRS.

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