The Devil You Don’t Know…

The underreporting of income carries civil penalties of 20% to 75% on the portion of the underpayment resulting from the severity of misconduct.

The day Al Capone was convicted of tax evasion represented a proud moment for accountants everywhere. The Chicago gangster of the 1920s was known in the Prohibition era for evading the authorities for years, although his illegal activities also included gambling, liquor, prostitution and even murder. Unable to make any other substantial case against Capone, the government finally proved its tax evasion case. He was sentenced to 11 years in Federal prison, fined $50,000 and charged $7,692 for court costs, in addition to $215,000 plus interest on back taxes. A three percent inflationary rate of $272,692 from 1931 would equal to $2,578,110 in today’s dollars. Professionals still boast, “Only an accountant could capture Al Capone.”

Capone, like some business owners today, underreported his income. Capone’s business involved many cash transactions, some of which did not hit the books. Additionally, Capone bartered for some of his business, trading goods and services for goods and services. Even if the fair market value of the goods and services received was not in the form of cash, it was considered part of a taxpayer’s “gross income.” As in Capone’s case, when the value received is not reported to the Internal Revenue Service, it is commonly referred to as “skimming,” the technical term being “underreporting of income.”

Exposure of skimming

Underreporting of income is discussed in Section 6662 and Section 6663 which carries civil penalties of 20 percent to 75 percent on the portion of the underpayment resulting from the severity of misconduct. The federal interest, which is calculated at a compounded rate monthly, is added on top of the penalty and original tax. Those taking a gamble on funds loaned from the IRS would have had better rates from Al Capone himself!

However, the exposure of underreporting of income does not end with mere civil penalties. Section 7201 could create criminal penalties for underreported income. Specifically, the rule applies to a taxpayer’s willful attempt to evade or defeat a tax payment. The criminal penalties are $100,000 ($500,000 for a corporation) and/ or imprisonment for five years, combined with the cost of the prosecution.

The key element is the word “willful.” The term willful is often confused with motive. Willfulness is “voluntary intentional violation of a known legal duty.” (U.S. v. Pomponio, 429 US 10, 16 1976). Motive is why a person performs an act. The motive need not be of questionable character, such as the buying of drugs; instead, it could be to pay for a child’s operation. Regardless, the taxpayer need only knowingly violate the tax law to be subjected to the criminal sanctions under Section 7201.

The term willful has also been described as the intention to mislead or conceal. Some examples given by the court include keeping two sets of books, making false entries, destruction of books or records, concealment of assets or masking sources of income, handling of one’s affairs to avoid making the records normally made in a transaction of that kind and any conduct which would likely mislead or conceal. (Spies v. U.S., 317 US 492, 499 1943)

Are you safe if your books match your tax returns?

Some business owners may feel they are much like Al Capone holding the belief that if the income never hits the books, and if the books match the tax returns, the IRS is none the wiser regarding their income. However, the IRS utilizes methods to find underreported income in these cases. The methods are used when either of the following exists: 1) the internal books and records are consistent with the tax returns, but neither are accurate, or 2) when books and records are unavailable. Business owners may not realize the use of methods such as the net worth method and the cash expenditures method can result in identifying underreporting of income.

Net worth method

If a business owner is not reporting the company’s total revenue, the result could be an increase in his or her personal net worth (i.e., improvements in the home, vehicles, second home, gifts, jewelry, etc.).

The net worth method holds any increase in net worth from the beginning of a period to the end of a period, adjusted for nondeductible expenditures and nontaxable receipts, as income. Following the computation of net worth, an inference for the source of income must also be established. For example, the IRS can establish a likely source of income which, for a business owner, can be through the skimming of receipts from the business. This was the case in Holland v. US, a Supreme Court ruling which validated the net worth method (348 US 121, 1954). In Holland, the IRS showed the taxpayer’s hotel business increased during the years in question, whereas the books and tax returns showed revenues decreased and profits fell to one-quarter of the amount declared by the previous management in a comparable period. The bottom line is, even though your books are consistent with your tax returns, both must be consistent with your standard of living.

Cash expenditures method

Not every business owner skimming receipts off the top may be increasing personal net worth. Some may also be spending the excess on a lifestyle filled with expensive meals, vacations and gifts. The motive for this spending may even be genuine – such as paying for a child’s lavish wedding, private or secondary education.

If expenditures exceed the amount the taxpayer reports as income, assuming the net worth remains consistent, the conclusion is the tax return shows less than what was actually received. The IRS may necessitate use of the cash expenditure method as opposed to the net worth method if the business owner purchases durable goods instead of tangible property. For example, the business owner’s net worth would not change if the business owner was spending his or her income on vacations, food, travel, gifts, alcohol, gambling (losses) or drugs.

Evidence utilized by the IRS

The IRS may use a number of sources to prove the net worth method or cash expenditure method. The investigation is thorough and may include a review of the following sources: public records and filings, bank records, real estate records, litigation documents (such as divorce filings), IRS records (even third party records), prior net worth statements submitted to the government or financial institutions, witness testimony and stock brokerage and investment records.

The IRS will also examine defenses of the taxpayer for nontaxable income sources, such as loans, gifts and inheritances allegedly received by the taxpayer; this is accomplished via interviews and confirmations through loan documents, probate records and gift and estate tax returns. According to the Internal Revenue Manual, when the taxpayer claims a family member or close friend provided loans enabling his or her spending, the IRS will often prove this friend or family member was “financially unable to lend the amount claimed.” (Internal Revenue Manual Section It should also be noted that loans from a closely held company to the taxpayer run the risk of being reclassified as income when not executed and maintained at arms length with formalities such as an agreement and fair interest paid on a timely basis.

Fork in the road

What are business owners trying to accomplish by skimming receipts off the top? Whether it is to pay for their child’s college education, their new car or reinvest in their employees’ futures, they are looking for a way to minimize their tax burdens. Unfortunately, they are utilizing potentially expensive and/or criminal means. Business owners lull themselves into a false sense of security by believing that as long as their internal books match their tax returns, they can continue to skim if they never get caught. Perhaps they will be able to pass the ticking time bomb to the next generation, where it will likely explode! Unfortunately, the Fifth Amendment privilege against self-incrimination applies only to individuals, not corporations.

Fortunately, the IRS does not control every branch of government. Legislators create laws for various reasons; one such reason is to stimulate small businesses, accomplished through the tax law. The burden rests on the taxpayer to find these opportunities throughout the tax code. The forms the IRS develops are to promote administrative simplicity; oftentimes however, they do not alert the taxpayer of lawful tax minimizing opportunities. With a tax code and accompanying regulations longer than the Bible, what small business owner has time to comb through and apply the hieroglyphics to his or her business? This is why tax planning professionals exist. Unfortunately, many business owners do not contact these professionals until it is time to develop a defensive plan. This strategy is similar to attempting to win a game after the final buzzer has sounded, and then arguing the referee’s calls.

The best way to save regarding taxes is by proactively engaging in strategic tax planning. Hiring a coach to design a game plan and run the plays throughout the year will maximize the score of the game at the end of the year. In life, just as in any game, the correct time to contact your professional is not when the IRS shows up on your doorstep. Make sure your future generations remember you as a successful business owner, not the next Al Capone.