Truth or Dare? : It’s a Fine Line Between Legal Tax Avoidance and Larceny
It is tax season, and taxpayers of every stripe, from the morally upstanding to the criminally inclined, wonder how far they can stretch the tax code before it breaks--or before they get caught.
Along with deadline pressure, tax time means recurring uncertainty over just what constitutes “honesty” in the context of a complex and imprecise tax law. Will deductions that make sense to you appear larcenous to the Internal Revenue Service? Will anyone even notice?
The uncomfortable truth is that the line between legal tax avoidance and larceny is thin--and often wavy. What’s an allowable deduction for one is a indictable offense for another. It’s not always clear--even for the professionals--where the boundaries are drawn.
“Every situation gives rise to different applications of the tax law,” says Mary Sprouse, a Van Nuys tax accountant and author of “The Money 1995 Income Tax Handbook.”
“Even after 20 years of practicing tax law, there are situations where I am not sure whether something is deductible or not. If you can present a cogent reason why you think something is deductible, I don’t see how the IRS can say that’s fraudulent. You have to make your best guess.”
While the distinction between legal and illicit may confound taxpayers every year, it is taking on greater significance today as the IRS grapples to close a $120-billion gap between the taxes it believes are due and the sum that is actually paid. Bolstered by increasingly sophisticated computers and new compliance programs, the agency is pulling out the stops to catch individuals and companies that fudge on their returns.
“We are much better than we used to be at catching people who cheat,” says Paul M. Miyahara, deputy assistant commissioner of criminal investigations for the IRS. “And we are working on systems to become better still.”
Of course, chasing after Americans for alleged tax avoidance is nothing new. Remember the Boston Tea Party? Remember Ozzie and Harriet? (More below on their tangle with the tax collector.)
Don’t want to get caught in a tax morass? Read on.
Tax Fraud: What You Don’t Want to Commit
Fraud is willfully cheating the government out of tax money. It is not making an error. It is not forgetting some dividend or interest income. It is not a matter of claiming an “aggressive” deduction. It is intentional underpayment. You must know what’s right and, nonetheless, do what’s wrong.
“Fraud should not be a gray area,” says Martin Horwitz, a Cincinnati tax attorney and the author of “Survive Your IRS Crisis.”
“Fraud is a willful, intentional act,” he said.
How many people defraud the government out of money? No one knows for sure. Some experts believe a relatively small number of high rollers do the vast majority of cheating. Others say most taxpayers push the envelope at one time or another.
One telling statistic: In 1987, the government began to require Social Security numbers for dependents claimed on tax returns; in an instant, 7 million dependents disappeared.
“My experience has shown that there is larceny in most of our citizens,” says Robert S. Fink, a New York tax lawyer who fights the IRS in tax disputes. “Some people estimate their charitable contributions a little higher than proper. Others may write off a magazine they never bought--or stretch on deductible items.”
These small-time scofflaws may not feel guilt, Fink adds, “but in absolute terms, what they’re doing is no different than leaving off a great deal of cash income.”
About one in every 100 returns is audited--and many of those are kicked back by the IRS with demands for more taxes--but only a token number of individuals are prosecuted for fraud.
Last year, 3,573 people were indicted for tax crimes related to 1993 returns, the IRS says. That’s an infinitesimal fraction of 1% of the millions of people believed to be cheating.
“You have a greater chance of being hit by lightning on a sunny day than being prosecuted for a tax crime,” says Robert E. McKenzie, partner at the law firm of McKenzie & McKenzie in Chicago.
Why so few? It’s tough to prove intent. In absence of a confession, the IRS must show that a taxpayer’s wrongful actions are so methodical that they could not have happened by accident. The agency tends to prosecute only the most egregious cases--situations in which there is a long history of hiding income, falsifying deductions or otherwise underpaying tax.
The penalties for those few who get caught are severe.
“If they catch you, you are left with barely your shoes and socks,” says Tom Kabaker, analyst at Commerce Clearing House, a Chicago-based publisher of tax information.
Besides prison time for criminal tax fraud, civil penalties typically include fines that can amount to several times the tax owed. The monetary penalty for willfully failing to pay tax is 75% of the amount owed, plus interest. And since there are few limitations on how long the IRS can pursue you for fraud, those interest charges can accrue for years.
A Queen and Her Dungeon
It was the fines that really took a chunk out of Leona Helmsley, the “Queen of Luxury Hotels” or the “Queen of Mean”--depending on whether you got her royal title from company press kits or personal detractors.
Helmsley was convicted of cheating the government out of $1.7 million by claiming bogus deductions on her 1983, ’84 and ’85 tax returns. By her 1992 sentencing, the bill, including interest and penalties, exceeded $8 million--more than four times the claimed tax shortfall. Helmsley was also sentenced to four years in prison and 750 hours of community service.
The hotelier’s illegal deductions involved personal expenditures ranging from the multimillion-dollar renovation of her Greenwich, Conn., mansion to her designer underwear. But it’s worth noting that the items Helmsley was found to have illegally deducted might be absolutely proper for other taxpayers in other circumstances.
For instance, it may be perfectly legitimate to call underwear a business expense--if you’re an underwear designer, say, or a stripper and you can prove these particular clothes were unsuitable for other use. Underwear is also deductible if you give it to charity, as President Clinton once did with a $15 pair of long johns.
Until it is given away, clothing--whether outer- or underwear--is usually not deductible, except for uniforms that cannot or typically would not be worn on the street. But, as with nearly everything related to the tax code, there are exceptions.
Ozzie Nelson’s Football Sweater
In 1966, tax authorities said Oswald (Ozzie) G. Nelson and Harriet Hilliard Nelson had improperly deducted more than $39,000 in clothing expenses between 1954 and 1962, while they were producing “The Adventures of Ozzie and Harriet” for television.
The Nelsons and their sons portrayed an average American family. The clothes they wore on the show were “in fashion and suitable for personal wear,” U.S. Tax Court records state. Tax agents argued that clothing which was “suitable” for street wear was not deductible, regardless of whether it was or wasn’t worn on the street.
The Tax Court disagreed.
A judge ruled that the clothing Ozzie deducted was purchased solely for the TV show and was not worn off the set--except once, when Ozzie borrowed a heavy sweater to go to a football game.
Ozzie and Harriet also maintained good records. Most of the Nelson’s clothing deductions were upheld.
(Sons Ricky and David apparently were less meticulous about separating business from personal use; their clothing expenses were ruled not deductible.)
Ozzie and Harriet’s Excellent Adventure
Where the Nelsons lost was on deductions for an August, 1954, vacation. During the trip, they sought to sell their program to British and Scandinavian TV authorities; subsequently, they deducted $6,853.42--all the expenses for their travel in countries where some business was conducted.
The IRS said only the all-business New York portion--$2,154.40--was deductible. The Tax Court added $550 for expenses in London, where the television discussions were extensive. But deductions for the rest of the trip were disallowed.
Why? The deductibility of travel and related entertainment expenses depends on the purpose of the trip and the amount of business conducted, tax experts say.
If you undertake a trip for legitimate business purposes and spend the bulk of your time conducting business, you can write off the cost of travel, says accountant Philip J. Holthouse, partner at Holthouse Carlin & Van Trigt in Los Angeles. However, if you sandwich a business meeting into a personal trip, only the expense of that meeting--not the entire trip--is deductible.
Travel expenses also must be “ordinary and necessary” to the business activity, and your costs must be properly substantiated, says Horwitz. And be forewarned: Claiming such expenses is widely believed to be an “audit trigger” that kicks your return out for closer IRS scrutiny.
All that Glitters Isn’t Deductible
Despite significant limitations on home office deductions, you can still write off portions of your personal residence if you can substantiate the business use, accountants say.
The pertinent example here is Liberace, the flamboyant pianist.
According to a 1970 Tax Court case, Walter V. Liberace was suffering a period of waning popularity in the late 1950s that was attributed to overexposure on television. So Liberace decided to go mainstream. He moved from a Sherman Oaks home with a piano-shaped pool into an apartment and “discarded his elegant image in favor of a more conservative one,” the court record says.
It didn’t help. Liberace’s income from concerts, records and personal appearances dropped to about $6,000 per week from more than $50,000, according to the Tax Court documents.
The musician and his business managers decided it was time to bring back the glitz.
Liberace’s corporation, International Artists Ltd., bought a $93,000 home in the Hollywood Hills (this was more than 30 years ago) and spent $250,000 refurbishing and redecorating it. They invited the press on publicity tours, used the house for rehearsals and meetings and made it the storage place for Liberace’s extensive stage wardrobe, seven pianos, an organ, several violins and numerous candelabra.
The corporation charged Liberace $300 monthly rent for a bedroom, sitting room, bathroom and closet on the third floor and then depreciated the entire cost of the house, claiming $153,840 in deductions over a three-year period.
The IRS disallowed most of the deductions, claiming that only about 15% of the household expenditures could be claimed as business deductions. The bulk of the home was for Liberace’s personal use, the agency said.
The Tax Court decided on a 50-50 split. The house was purchased for business and was used extensively by the corporation, the court said, but Liberace had access to the entire house, whether he was working or not. And he spread his personal effects--including a collection of dozens of miniature pianos--throughout the house, not just in the rooms he rented.
More recently, case law has further narrowed the definition of a home office in ways that would not allow Liberace to deduct portions of the home that had dual work and personal use.
But in other respects, the Liberace case nicely illuminates the home office conundrum. A home office is deductible if it’s your main place of business, is where people come to meet you and is dedicated space designed and maintained in a businesslike fashion with the ultimate goal of making money.
It’s All Downhill From Here
Some expenses are deductible for people in certain professions that for most of us clearly are leisure activities. Hollywood, for example, is filled with people who can legitimately deduct films they see for business purposes.
Similarly, the cost of recreational sports may be deductible for athletes, who often claim deductions for “off-season athletic conditioning.”
But there are limits.
Frederick Speck was a professional hockey player who lived in Canada but played in the United States during the late 1960s and early 1970s. For the 1971 tax year, he deducted $150 for golf shoes, $80 for golf balls, $120 for greens fees, $25 for a sweat suit, $5 for a swim suit, $9 for running shoes, $20 for tennis balls and similar items.
Speck also claimed that the $82 he spent in the United States on TV and phone expenses was deductible because he watched some hockey games and needed the phone to talk business.
In an extensive 1993 decision, the Tax Court ruled that Speck did not substantiate the business necessity of any of these expenses; all were denied.
Had Speck kept proper records--delineating what portion of his expenses was necessary for business purposes and what portion was personal--he may have been able to deduct at least part of the costs, says Holthouse, the Los Angeles accountant. While many people like to stay in shape, he explains, athletes must.
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How to Get Caught
Accountants say you should never forego a legitimate entry on your tax return for fear of an IRS audit. But the agency’s computers are programmed to kick out a number of items for closer scrutiny by tax agents. If you include these common “audit triggers” on your return, make sure to keep good records.
* Self-employment income. (Reported on Schedule C)
* Barter income (Reported on 1099-B)
* Home office deductions.
* Casualty losses from fire, flood, earthquake, tornado and other disasters
* Earned income credit, for low-income individuals and families
* Bad debt deductions--particularly write-offs of uncollectable loans involving a family member.
* Donations of expensive property to charity--including artwork, real estate or other hard-to-value items
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Who Gets Audited
Tax audits are more common at higher income levels. Percentages of returns audited in 1993, based on income level:
INDIVIDUAL (1040,1040A,1040EZ) Percentage audited
under $25,000: 0.66%
$25,000 to less than $50,000: 0.58
$50,000 to less than $100,000: 0.88
$100,000 and over: 4.03
SELF-EMPLOYED (SCHEDULE C) Percentage audited
under $25,000: 2.24%
$25,000 to less than $100,000: 2.41
$100,000 and over: 3.91
*
Source: Commerce Clearing House Federal Tax Guide
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The Art of Deduction
What’s deductible on your Form 1040? To a degree, the answer depends on who you are. This chart, based on interviews with accountants, shows how the same expense can meet or fail IRS standards, depending on the taxpayer’s profession and the reasons for the expense:
Waitress Clothing: YES (uniforms not suitable for street wear) Movie tickets to “It Could Happen To You”: NO (to learn how to handle tip income) French classes: MAYBE (to learn pronunciation of menu items)
*
Casting Director Clothing: NO (work clothes suitable for street wear) Movie tickets to “It Could Happen To You”: YES (if considering hiring Nicholas Cage and calls Cage’s agent after seeing the film) French classes: MAYBE (preparing for trip to France to scout authentic accents for film in production)
*
Actor Clothing: MAYBE (work clothes suitable for street wear but never worn off set) Movie tickets to “It Could Happen To You”: NO (if bought to take family to his latest film) French classes: YES (to prepare for role in upcoming film)
