We all know the cliché – there are only two things in life we can't escape: death and taxes. But as long as there have been taxes, there have been those who've tried to skirt them, whether through legal maneuvering or outright tax evasion. As a result, the Internal Revenue Service (IRS) has devoted significant resources to catching tax cheats – and they've made a habit of changing the tax code to make everyone pay their fair share. (If you report a tax evader to the IRS, you could be eligible for a reward. Learn how by checking out Reporting A Tax Cheat.)
Here's a look at a couple of ways tax avoiders and evaders have changed the tax code in the U.S.:
The Difference Between Avoidance And Evasion
You may be surprised to know that U.S. income tax is a relatively new tradition – the latest iteration of income taxes was only introduced in 1913 following the ratification of the 16th amendment. The swift changes in the financial world have left lawmakers playing catch-up to creative and crooked individuals who want to minimize their tax liabilities. But things are significantly different now.
When it comes to shorting Uncle Sam on your tax bill, remember this key: the difference between tax avoidance and tax evasion. You see, tax avoidance is completely legal; it just means that you're using legal means to minimize your tax burden. Tax evasion, on the other hand, is the use of illegal tactics to pay less than you owe.
Believe it or not, the IRS actually targets both types of tax skirting, albeit in different ways. For tax avoiders, the IRS works to close legal tax loopholes that give some people unfair advantages. For tax evaders, the IRS's enforcement arm gets put to work. (Tax loopholes are shrinking, but there are still plenty of viable prospects. Get the big picture in Pros And Cons Of Offshore Investing.)
Dependent Name: Fido
Dependent fraud was once one of the most popular forms of tax cheating – after all, you could trim your reported income by $3,650 (based on 2009 exemption amounts) for each dependent you added to your tax return. But dependent fraud is now largely a thing of the past – a problem remedied by simply requiring filers to provide Social Security numbers for each dependent.
In 1987, the first year Social Security numbers were required, 7 million dependents vanished from the tax rolls. It turns out that scores of taxpayers had been improperly claiming dependents who were either ineligible to be claimed, family pets or completely fabricated.
There has been no shortage of people who've attempted to argue away their tax burden. But wacky tax arguments won't get you very far with the IRS. In fact, making frivolous arguments can end up costing you $25,000 in fines and court-imposed penalties.
Because income taxes are a relatively new phenomenon - only a few generations old - one of the most popular arguments has been the suggestion that the federal government isn't constitutionally allowed to collect taxes. That's patently untrue. So is the idea that taxes are voluntary, or that certain income sources don't count as income.
Hiding Income Offshore
Offshore bank accounts have long been a favorite hiding spot for assets of the rich and famous. Unfortunately for them, they're not very good ones anymore. Tax code requires that any income you earn – including income earned abroad – is subject to U.S. tax (with a few exceptions). That means that even when you stash your cash offshore, you still have to pay tax on your interest and dividends. You also have to pay taxes on the principal when you earn it.
Recent tax scandals involving Swiss banks have led to increased scrutiny over funds that Americans try to hide abroad. In other words, if you try to hide your assets offshore, chances are you'll get caught.
Phony Income Documents
One of the biggest advances hasn't been in the tax code, but rather in how it's enforced. Thanks to computers, it's a very bad idea to claim you earned less money than is reported on forms like your W-2 or 1099. That's because the people and companies who pay you send duplicate copies to the IRS – which checks the numbers against the ones you report. Mismatched numbers is one of the best ways to trigger an audit. (Keeping thorough records and knowing the penalties make an IRS audit easier than you'd expect. Find out how in Surviving The IRS Audit.)
The Truth Shall Set You Free
Not everyone who shorts the IRS is a tax cheat; millions of Americans make honest mistakes come tax time. But when that happens, it's best to pay the piper – and pay him quickly. Thanks to tax crooks and "creative accountants", tax codes have been designed to eliminate loopholes and catch those who try to skirt their annual payments to the government.
You don't want to get on Uncle Sam's bad side.
We give you seven guidelines to help you keep more of your money in your pocket. See Tax Tips For The Individual Investor.)