Elusive Taxpayers Sidestep the IRS

As millions of Americans push themselves into a fury to pay their income taxes on time, a man standing on line at a San Fernando Valley bank one recent day was engaged in another springtime rite: cheating the IRS.

Let’s call him Jake, a fix-almost-anything contractor in the Valley, and he looks like someone who works with his hands. His jeans are worn and soiled, boots scuffed, fingernails grimy, his baseball cap coated in sawdust.

At the bank he held $1,500 in personal checks, all made payable to “cash,” his pay for replacing car brake pads, installing particleboard and fixing washing machines, and he isn’t going to pay taxes on any of it.

Jake doesn’t trust ATM machines because he only works for clients who pay him cash, or by a check made out to “cash,” and he frets that if he deposits these checks in an ATM a bank employee could grab one and cash it themselves. So Jake endorses the checks, jots down his account number and hands them to a teller.

He has just slid under the radar screen of the Internal Revenue Service, and he plans to keep it that way.

While the IRS likes to freeze taxpayers with fear that they will be caught and the agency has spent heavily to modernize its computers and software, it still collects only 86% of the tax dollars it’s owed--a rate that hasn’t budged in years. Unreported income, bogus deductions and people just not filing income tax returns add up to a $120-billion-a-year tax gap--and these are unpaid taxes from legal work, not profits made in drugs or other illegal businesses.

“Obviously, the [IRS] computers don’t catch everybody,” concedes Richard Speier, head of the IRS criminal investigation division in Los Angeles. “There are going to be a lot of people we aren’t going to get. It’s very frustrating.”

He takes comfort that when a criminal tax case is filed, the conviction rate is 97%--and Leona Helmsley, Heidi Fleiss, Marvin Mitchelson and Darryl Strawberry all came up losers. Speier adds that neighbors, business partners and former lovers often tip the agency about tax cheats, “and that’s where our work load comes tomorrow.”

Counters Jake: “I don’t stay awake at night worrying.” The IRS “is a pain. There’s way, way too much paperwork.”

There are plenty of people such as Jake, elusive taxpayers who cheat the system and so far have gotten away with it.

Jake charges $25 an hour and figures he’s a bargain, given that Sears repair workers charge $45 just to glance at a washing machine, labor rates at car dealers run $65 an hour and a plumber’s hourly tab is $58. Jake’s client list stretches in the dozens and he tells them that if he did everything legally he’d charge them $35 an hour. If anything, he’s overworked and new referrals keep coming. He hauls in about $25,000 a year this way.

Sometimes Jake butts heads with customers who try to cheat the IRS on their own. Such as a homeowner who wanted to pay him by a check drawn on a business account and made out to Jake’s real name, so that the client could deduct it illegally as a business expense. Jake said he’d have to charge more, and in the end he won the argument by adding, “You’re just pushing paper, because after the deductions and difference in pay, it’s a wash.”

Jake does pay some taxes. He does part-time repairs for a real estate firm and he gets a tax statement, which he includes on his income tax return, while ignoring all his under-the-table income, and he doesn’t deduct any expenses for his car and tools to avoid triggering red flags at the IRS.

What are Jake’s chances of getting caught? Slim, according to John A. Knight, an IRS collection officer for 27 years who retired in 1993, and is now in private practice in Woodland Hills and settles cases for people who owe taxes.

“There is a vast underground economy that deals in cash. The IRS probably will never catch him, unless somebody drops the dime on him,” Knight says. “Sometimes people fall into a crack and are not seen for years.”

One such Knight client is a man in his 50s who never filed a tax return as he worked through a stream of clothing sales and other menial jobs, and kept it going, thanks to $750 a month from a trust fund. It took many years, but the tax statements his employers sent finally triggered the IRS’ computers and the agency slapped a levy on his pay. No matter, he’d quit and move to another job.

Now the IRS tally shows the salesman owes $20,000 for the past six years, and he’s being prodded by a lady friend to settle his tax bill. Knight says his client’s assets are “the clothes on his back and $20 in a bank account. He’s on food stamps, living with a girlfriend and he is one inch from the streets.” The girlfriend is willing to pony up $1,000, and Knight figures the IRS will take that offer and write off the rest as uncollectable. “For Uncle Sam, $1,000 is better than a sharp stick in the eye,” he says.

Jake and the salesman are small-time tax cheats. Elliott Kajan, a Beverly Hills tax attorney who charges up to $500 an hour, deals with the luxury end of the tax-cheater kingdom.

Some Kajan clients are Helmsley-types, business owners who divert money from their firm for personal use, such as construction work on their home and then write it off as a business expense. Often the IRS’ fraud squad isn’t after them, but the individuals are nervy because of a falling out with someone close to them, and thus fear becoming an anonymous tip for the IRS.

For one client, Kajan did all the math and told the client that if he turned himself in he’d owe $750,000 in taxes and penalties--if the IRS caught him, it may be even worse. For that hefty sum, the client said, “The hell with it. I’ll take my chances,” Kajan recalls, adding that his client “is going to play the audit lottery and take the chance that the person who is mad today will not be mad at them tomorrow.”

Why don’t more taxpayers get caught? Speier, head of the IRS’s criminal unit, has 31 more investigators than three years ago, but “we could use many more.” How many agents does Speier have in L.A.? “I hesitate to get into that. I will underwhelm you with numbers.” Knight says the IRS’ computers, while improving, are “still outdated. I’ve heard they are the equivalent of Model A’s.” And the IRS has its own money worries; its budget is $7.35 billion this year, down from $7.48 billion a year ago.

Mind you, the IRS does have weapons. The agency is more adept at checking phony Social Security numbers on tax returns, and it tracks points paid on mortgages, cash deposits over $10,000, dividends and interest paid by banks and stock brokerages. The IRS has also beefed up its Market Segment Specialization Program, target groups it pays extra attention to, such as attorneys, entertainers, morticians, gas stations, cab drivers and truckers. Some IRS manuals for its own auditors have been made public and make interesting reading. One IRS audit booklet advises: “Many self-employed attorneys have enough income to afford the luxury of very expensive hobbies. These hobbies will often turn up on tax returns as some sort of business expense . . . hobby expenses found to be deducted involved a charter fishing boat, polo ponies and antique cars.”

All told, 118 million tax returns will be filed this year, and 1.7 million will be audited, a 1.4% audit rate. If you earn more than $100,000 you are about four times more likely to be audited than somebody earning $50,000.

One reason the IRS doesn’t trap more thieves is the agency depends on a primitive statistical formula, says Amir Aczel, professor of statistics at Bentley College in Massachusetts and author of “How to Beat the IRS at Its Own Game.”

Aczel was audited several years ago. It was an infuriating experience, what with his auditor calling at 5 a.m., and in the end the IRS owing Aczel a refund of a couple hundred dollars. So inspired, he collected from tax preparers around the country 1,289 tax returns, half of which were audited, and Aczel ran the numbers through a supercomputer.

Aczel expected the IRS’ secret audit code to be some state of the art methodology, such as a neural-network, where computers mimic human thought patterns--such as Deep Blue, IBM’s chess-playing computer--by using interlinking levels of communication, where one answer can prompt many possible responses.

Instead, Aczel says, the IRS uses a statistical method dating back to the 1930s called discriminant analysis, where precise “norms” are set and any numbers past those levels trigger audits. The IRS’ formula, he says, “is obsolete.”

Most audits occur, Aczel found, when deduction rates are high on three key tax forms: Schedule A for itemized deductions; Schedule C, profit or loss from a business, and Schedule F for farm income. (On Schedule A, Aczel says the caution zone begins when deductions match 35% of your adjusted gross income; the danger zone is above 44%.)

The IRS, however, continues to make changes, and this year a new form is Schedule H, for household employment taxes, to try and slow Nanny tax fraud.

One entertainment executive who lives in the Valley employs a housekeeper/baby-sitter from El Salvador and he pays her $7.50 an hour, and up to $7,000 a year. Will the executive file Schedule H and pay 15% extra in Social Security and Medicare taxes? “Hell no. And I don’t feel too bad about it. She can file income taxes if she wants to.”

But his housekeeper, also a Valley resident, is more likely to be nabbed by the INS than the IRS. Years ago the housekeeper proudly showed off a laminated work permit, but the entertainment executive is sure it’s a phony. The housekeeper works for a half-dozen Valley families, so if she loses one job she has others to lean on and brags of earning $600 a week, and she doesn’t pay taxes either. Occasionally, she claims to pad her weekend income by smuggling people from Mexico into the country. Her technique calls for loading up a car with women and babies. She places children on pillows on the floor, hides others in the pillows, and with the kids screaming a customs agent looks in her trunk and waves her car through. She charges $800 a body.

Will this entertainment executive get nabbed on Nanny tax? Probably not, Knight says, unless he gets divorced. “The IRS loves former spouses. They love to scream about their husbands.”

One thing is clear: When the IRS does find a tax cheat, its grip is vise-like.

In 27 years with the IRS, Knight has seized lots of property, once even a cemetery, “including all the occupants,” he says, then sold the business for $50,000 to cover unpaid taxes.

On one job Knight went to a business to start hauling out equipment, but the owner and tax cheat went ballistic and tried to get his Saint Bernard to bite Knight.

The dog was friendly, but Knight wasn’t. “We took his car with his dog still in it.” As the tow truck started rolling off with the dog in the car’s back seat and the businessman screaming, Knight did some quick math. “What’s a Saint Bernard worth? A hundred bucks?”

So Knight changed his mind, ordered the tow truck driver to stop. “I let the guy have his dog back. It was a close call,” he remembers.

And who says the IRS doesn’t have a heart.