Tax evasion investigations

Tax evasion investigations

Under federal law, tax evasion, or tax fraud, is the purposeful illegal attempt of a taxpayer to evade payment of a tax imposed by the federal government. Conviction of tax evasion may result in fines and imprisonment. [26 U.S.C. § 7201.]

The Internal Revenue Service has identified small business and sole proprietorship employees as the largest contributors to the tax gap between what Americans owe in federal taxes and what the federal government receives. Rather than W-2 wage earners and corporations, small business and sole proprietorship employees contribute to the tax gap because there is no way for the government to know about skimming or non-reporting of tips by individuals who are self-employed or run small businesses, without mounting more significant investigations.

The IRS has developed several methods of proof of income tax evasion in an effort to decrease the tax gap. These investigations can be carried out to determine the correctness of any tax return, make a return where none has been made, determine the liability of any person for any income tax or collect any income tax. [26 U.S.C. § 7602.] The IRS has the authority to summons the taxpayer to provide particular information for purposes of investigating and ascertaining the correctness of the tax return. ["Id."] The information requested may include books, records, papers and any other data which may be relevant to the investigation. ["Id."] However, the IRS investigator must follow all proper administrative steps in obtaining the information. While these investigations can lead to criminal prosecution, the IRS itself has no power to prosecute tax evasion crimes. The IRS can only impose penalties and require payment of proper tax due.

Net worth and cash expenditure methods of proof

Under the net worth and cash expenditure methods of proof, the IRS performs year-by-year-by-year comparisons of net worth and cash expenditures to identify underreporting of net worth. While the net worth method and the cash accrual method may be used separately, they are often used in conjunction with one another. Under the net worth method, the IRS chooses a year to determine the taxpayer's opening net worth at year’s end. This provides a snapshot of the taxpayer's net worth at a particular point in time. The snapshot includes the taxpayer’s cash on hand, bank accounts, brokerage (stocks and bonds), house, cars, beach house, jewelry, furs and other similar items. Generally the IRS learns about these items through very thorough and in-depth investigations, sometimes casing the suspected fraudulent taxpayer. In addition, the IRS also assesses the taxpayer’s liabilities. Liabilities include expenses such as the taxpayer’s mortgage, car loans, credit card debts, student loans, and personal loans. The opening net worth is the most critical point at which the IRS must assess the taxpayer's assets and liabilities. Otherwise, the net worth comparison will be inaccurate.

The IRS then evaluates new debts and liabilities accumulated in the next year, and assesses the taxpayer’s new net worth at the next year’s end. In addition, the IRS reviews the taxpayer’s cash expenditures throughout the tax year. The IRS then compares the increase in net worth and the cash expenditures with the reported taxable income over time in order to determine the legitimacy of the taxpayer’s reported income.

The net worth method was first used in the case of "Capone v. United States". [IRA L. SHAFIROFF, INTERNAL REVENUE SERVICE PRACTICE AND PROCEDURE DESKBOOK 14-29 (1998).] The cash method was approved in 1989 in "United States v. Hogan". [886 F.2d 1497 (7th Cir. 1989).]

Bank deposit cash expenditure method

First approved by the Eighth Circuit in 1935 in "Gleckman v. United States", [80 F.2d 394 (8th Circ. 1935).] the bank deposit cash expenditure method identifies tax evasion through review of the taxpayer’s bank deposits. This method of investigation primarily focuses on whether the taxpayer’s total bank deposits throughout the year are equal to the taxpayer’s reported income. This method is most appropriate when the majority of the taxpayer’s income is deposited in the bank and most expenses are paid by check. [D. LARRY CRUMBLEY, LESTER E. HEITGER, G. STEVENSON SMITH, FORENSIC AND INVESTIGATIVE ACCOUNTING 6-19 (2005).] This method is most commonly used for surveillance of tipped employees and is combined with statistical analysis to determine what a tipped employees actual wages are. Information gathered through this method is most successful when the credibility of tipped employees can be destroyed. This method is used less frequently now for tipped employees because the IRS negotiates with hotels or casinos, the largest employers of tipped employees, to identify a tip estimate. If the tipped employee reports the minimal amount agreed upon, he is not questioned by the IRS. However, it is recommended for corroborating other methods of proof. [ [] ] Given the uncertainty of this method, this method likely could not be used in criminal prosecutions where the guilt must be found beyond a reasonable doubt.

Whistleblower Program

In addition to the methods of proof the IRS has developed, the IRS has recently adopted a program which allows anonymous whistleblowers to receive 15 to 30 percent of any recovery by the IRS which comes to at least $2 million including all penalties, interests and any other monies collected from the government. The whistleblower program seeks information based on evidence and analysis which can provide a solid basis for further investigation rather than speculation and hearsay. [ [] ] The program is designed to provide incentive to ordinary citizens to snitch on tax cheats. The program provides far greater incentives for whistleblowers than previous programs because under prior programs the government was not required to compensate whistleblowers. [ [] ] Under this program, a taxpayer may file in court if they are not issued a deserved award. [ [] ]


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