THE $150 BILLION TAX CHEATS THEY COST YOU $1,932 IN EXTRA TAXES EACH YEAR. WHY CAN'T THE IRS CATCH THEM?
By TERESA TRITCH PHOTOGRAPHS BY ROBBIE MCCLARAN REPORTER ASSOCIATE: KELLY D. SMITH

(MONEY Magazine) – On or before April 17, some 117 million of your fellow citizens will, like you, voluntarily turn over some $555 billion to Uncle Sam and sign their return below the words, "I declare that.to the best of my knowledge and belief [this return] is true, correct and complete." One problem: Roughly one out of 12 who sign that declaration will be lying. Another 7 million or so will not bother to file a return at all. All told, individuals and corporations are expected to shortchange their fellow taxpayers by an estimated $150 billion this filing season. That adds $1,932 to the average tax bill of every honest taxpaying U.S. household.

Even more disturbing, most of these tax cheats will get away with it. Tax thieves who end up in jail--like former salesman Norman Levy, pictured at right--are the rare exceptions. Despite receiving more than $1 billion from Congress since 1981 for new compliance initiatives, the IRS has consistently failed to boost voluntary tax payments above 83% of the total income tax that the agency figures it is owed. Enforcement efforts narrow the gap by no more than another 3.5%.

The epidemic of tax cheating is more than just an imposition on the law abiding among us. A nation hobbled by a $200 billion budget deficit clearly cannot afford to leave $150 billion in unpaid taxes on the table each year. Furthermore, if cheaters are allowed to prosper, voluntary compliance could drop off as even honest people conclude that only fools play fair. Aware of the danger, the IRS set a new goal of raising compliance to 90% by the end of 2001. "The IRS has its work cut out," says Sen. John Glenn, member and past chairman of the Committee on Governmental Affairs, which oversees the IRS.

To come anywhere near 90% compliance, the IRS must overcome a series of fundamental problems--some external and some self-inflicted. Primary among them is the question of adequate resources. Budget pressures from without and mismanagement from within have consistently forced the IRS to spend money earmarked for improving compliance on other purposes, such as processing returns and paying employees. Last year was particularly bleak: Of $115 million targeted for 11 compliance efforts, only $10 million was spent, in just two areas: international tax law compliance and electronic refund fraud. The remaining $105 million went to cover pay raises mandated by Congress for government workers.

Such bureaucratic miscues have undercut compliance programs for years. For even though the compliance rate failed to improve between 1981 and 1994, the audit rate for individuals decreased by 39%, from 1.8% to 1.1%. And the number of reviews of computer-identified income discrepancies--in which figures reported on a W-2 or 1099, say, are matched to the income reported on a return--have dropped from 9 million in 1991 to 4.2 million in 1994. Says Glenn: "I've fought tooth and toenail to get the IRS the tools it needs to reach its 90% compliance goal. Past efforts to close the gap haven't been enough."

An even more intractable obstacle for the IRS is the depressingly diverse profile of people who don't pay their fair share. Some who shortchange the IRS do so through honest mistakes. Others, like Jim Melton (pictured on page 121), fail to file because of personal problems, such as divorce. They fall under the category of taxpayers having a very bad year. Then there are the deliberate con artists who file fraudulent returns to pocket undeserved refunds.

For the most part, however, cheating is a function of opportunity. The nation's 112 million salaried employees, for example, are highly compliant: As a group they voluntarily report 99.5% of their salary. "A typical middle-class employee has income recorded on a W-2, taxes withheld and no business deductions," says Ann Dryden Witte, professor of policy and management at Florida International University in Miami. "There's simply little or no opportunity to cheat."

The self-employed, on the other hand, have ample chances to underpay--and many take full advantage of them. According to the U.S. General Accounting Office, sole proprietors accounted for more than $37 billion of the tax gap in 1992, the latest year for which a breakdown is available. Indeed, among some self-employed workers, compliance runs as low as 29%. Around $30 billion of the shortfall originated in service industries, where business is often conducted in cash. The prime offenders, accounting for roughly $15 billion, were so-called informal suppliers, such as moonlighters and sidewalk vendors, who earn their income off the books. "The reason I have my sideline business is to make extra cash," explains a tax-evading vending-machine owner who also has a full-time salaried job. "The government doesn't deserve any of it. They take plenty from my salary." In other words, he cheats--and he's proud of it.

Much of the IRS enforcement effort against the self-employed has focused on independent contractors, generally defined as self-employed service providers. The GAO estimates that as many as 1.6 million workers may be erroneously classified as independent contractors--giving them the same opportunity to cheat as sole proprietors--and should be subject to withholding taxes like other employees. The misclassification accounts for as much as 12%--$3.5 billion--of the tax gap associated with service providers.

To clip the wings of these evaders, the IRS since 1988 has conducted more than 11,370 employment tax audits of companies that classify their work force as independent contractors. Like other IRS dragnets, these investigations catch innocent employers along with the guilty; for them the experience can border on the Kafkaesque. (For one example, see "Guilty Until Proved Innocent" on page 123.) But occasionally the IRS scores big. Take the case of Norman Levy, a 61-year-old husband and the father of three adult daughters, currently serving a 12-month sentence at Federal Prison Camp in Pensacola, Fla. His crime: omitting $546,000 of income from returns he filed between 1987 to 1991.

At the time he was working as an independent contractor selling plastic identification cards, luggage tags and rulers for Continental Plastic Card Co. in Coral Springs, Fla. But neither Levy's employer, Robert G. Kerner, nor Levy ever reported the vast bulk of Levy's commissions to the IRS. "I knew it was wrong, but I was making good money," says Levy, who holds a bachelor's degree in marketing and advertising from Brooklyn College. "And since I was 59, 60 years old, I didn't want to try to find another job." Jeffrey Levenson, the assistant U.S. attorney who prosecuted Levy's case, takes a harder-edged view: "The employer created the opportunity for the crime by not reporting his employees' income to the IRS, and Levy and many of his co-workers chose to go for it."

In addition to the back taxes, which he hopes to pay off in installments, Levy also owes the IRS $112,000 in interest. On top of all that, he must pay a civil fraud penalty equal to roughly 75% of his back taxes. His legal fees ran to another $30,000, which he paid for by cashing in his savings account and IRA. But the personal toll is the heaviest: "The fact is I'm guilty and have to be punished," Levy says. "But the guilt of hurting my wife and three daughters is the worst of all." Levy's boss Kerner was not prosecuted for tax evasion but paid a $2.6 million fine and served two years in jail under a plea bargain.

Not all tax cheats file fraudulent returns, of course. Some 7 million rob the Treasury of an estimated $7 billion to $10 billion a year by not filing any return at all. They are not all criminal schemers. IRS research has shown that many fail to file in a year when personal trauma, such as job loss or divorce, has clouded their judgment. And after they fail to file one year, fear of the consequences leads to repeated nonfiling.

Jim Melton, 39, a supervisor for a heating and air-conditioning company in Salem, Ore., is a classic example of an honest citizen who ended up on the wrong side of the tax law. His four-year string of nonfiling began in 1990, the year he and his first wife divorced. "We knew we had to file our taxes, but we weren't communicating," recalls Melton. "Things just slipped away for a couple of years, and then I started to worry about the interest I would have to pay or that I might be hauled off to jail."

Before Melton remarried in July 1993, his fiancee at the time, Debi, 32, urged him to come clean. "We didn't want this hanging over us as we started our new life," Melton says. (For what to do if you suspect your spouse is cutting tax corners, see the box at left.) Ultimately, his fear of filing proved unfounded: Three years' worth of returns yielded refunds totaling $932, which he used to pay what he owed on a fourth return: back taxes of $285, plus interest and a penalty totaling $286.

In its efforts to lure these halfhearted deadbeats back into the taxpaying fold, the IRS anticheating squad has scored some points. The secret: kinder, gentler collection tactics. (For what to do if you haven't filed, see the box on page 121.) Between October 1992 and September 1994, the IRS added some $4 billion to the Treasury coffers from some 3 million prodigal nonfilers.

Unfortunately, the agency's success with nonfilers like Melton has been more than upstaged by rapid growth of an old scam with a new twist. For years a small band of income tax outlaws have deliberately submitted fabricated returns to claim bogus refunds. With the introduction of electronic filing, the total loss from such fraud--much of which may never be detected--now may run as high as $5 billion a year.

The problem: Electronic filing allows refunds to be paid within about two weeks, vs. five weeks for a paper return. Unfortunately, two weeks is not enough time to screen returns for fraud. Con artists have taken full advantage: In the five years that electronic filing has been available nationwide, the number of fraudulent electronically filed refund claims detected by the IRS exploded from 411 to 33,644. In 1994 they accounted for 79%, or $33.9 million, of the total amount of fraudulent refunds paid by the IRS.

How do these crooks operate? Ask Frazier Todd Jr., a 36-year-old father of four of Atlanta. Todd carried out an audacious two-year-long scam in which he recruited mostly low-income women to provide him their names and Social Security numbers. He would then obtain valid employer identification numbers from the IRS--a five-minute over-the-phone procedure--which he transcribed onto W-2s counterfeited for the scheme's participants.

The W-2s were used to prepare phony electronic returns and to apply for refund-anticipation loans (loans banks make against a customer's anticipated income tax refund). When the checks came through, the participants split the amount with Todd, who pocketed $511,000 before an informant's tip led to his capture. In addition to 30 months' incarceration, Todd was sentenced to a three-year supervised release.

Scams like Todd's led the Treasury Department last October to halt the IRS practice of supplying lenders with information on loan applicants. No longer able to obtain confirmation from the IRS that a customer does in fact have a refund coming, banks have been forced to clamp down on refund-anticipation loans, which last year were reportedly involved in 92% of the detected fraudulent electronic returns. To do that, they have tightened their credit standards for such borrowers and raised loan fees.

Even if the Treasury's policy succeeds in containing the electronic filing scam, the record suggests that any reduction in the tax gap will be temporary. Judging from the agency's inability to raise voluntary compliance, every IRS success in one area tends to be matched by an increase in cheating elsewhere. For a 90% compliance goal to become more than another exercise in futility, together the IRS and Congress should:

SUPPORT NEW COMPLIANCE INITIATIVES. In October, for example, the IRS will launch a new Taxpayer Compliance Measurement Program, the dreaded line-by-line superaudit from hell that the IRS uses to derive detailed information on cheating and mistakes. A record 153,000 taxpayers will be targeted this year, vs. just 55,000 who were audited during the last TCMP in 1988. The IRS plans to step up its other audits as well. This year, the budget allows for 450,000 additional audits, with the goal of boosting the audit rate from 1.1% to 2.2% for 1995.

Another fledgling initiative, called the Market Segment Specialization audit program, calls for examiners who have developed expertise in specific businesses to write detailed audit manuals for other agents to use. Auditing a lawyer? Check the escrow account for unreported cash. Auditing a mortician? Since many work out of their home, make sure that personal home furnishings are not depreciated on the business return. Tax experts say the program is a valuable addition to the IRS' arsenal.

Gear up--not gut--the IRS $22.3 billion computer-modernization project. Last year Congress slashed more than $300 million from the IRS' $989 million request to upgrade its computers; this year's $1-billion-plus request is also in danger of being whacked. Granted, the agency's modernization effort has been bungled so far, in part because the IRS did not adequately prepare its staff for a new way of doing business. But instead of indiscriminate cutting, Congress should step up oversight of the upgrade to help it progress smoothly. Among many other advantages, more computer capacity would allow the IRS to match Social Security numbers reported on all K-1 partnership returns to personal income tax returns to ferret out nonfiling professionals who are organized in partnerships.

IF A TAXPAYER CALLS, ANSWER THE PHONE. Common sense suggests that giving taxpayers access to free and reliable information could help close the tax gap. "The IRS wavers between good cop/bad cop tactics," says former IRS Commissioner Shirley Peterson. "But with a code that is as complicated as ours, customer service is the only way to head off the underpayment that comes from being uninformed and frustrated." Alas, the IRS customer service record so far is mixed: During a two-week period in February, the GAO placed 1,166 calls to the IRS tax-assistance 800 number but reached a customer service representative within five attempts only 156 times, for a miserable 13% accessibility rate.

KEEP IN MIND THAT OUR PATIENCE SHOULD HAVE LIMITS. Uncle Sam is facing a cash crunch. If the IRS can't do a better job of cracking down on tax cheats and providing the government with more operating income, then Congress should consider radical change, such as replacing the income tax with a national sales tax that would minimize the role of the IRS (see Newsline, page 24).

Remember, taxes are the rent we pay for living in the United States. A system that allows millions of Americans to get a free ride at their fellow citizens' expense is unacceptable. If our neighbors can't keep up the payments on their homes, we don't bail them out. We shouldn't have to pay their debts on income tax day either.