Tax Man Fails to Get His Due

Charter Hughes was known around Santa Barbara as an adept tax attorney, but he had an unusual strategy for his own federal return: He just didn’t file one.

When Internal Revenue Service agents finally caught up with Hughes in 1994, he owed $38,727 in back taxes. Hughes pleaded guilty to federal charges but was sentenced to just 36 months’ probation, and today he is again practicing tax law.

Although the IRS has a reputation as a pit bull when it comes to pursuing tax cheaters, about 6.5 million Americans--including a large number of professionals such as Hughes--ignore the federal tax collector every year.

“People tend to only think of the subculture--drug dealers--but it goes far beyond that,” said Frederick Daily, a San Francisco tax attorney. “It goes from the butcher to the baker to the banker. It is an amazing cross section of America.”

How can so many Americans avoid filing tax returns without running afoul of the IRS for years at a time?

Tax collection officials acknowledge that they don’t have the resources to round up all the scofflaws, let alone send them to prison. Moreover, the agency’s outdated 1960s-era computers have hobbled efforts to smoke out more nonfilers.

Federal prosecutors also complain that legal penalties for not filing a tax return are too weak to intimidate would-be nonfilers. Evading taxes by falsifying a return is a federal felony, while failing to file any return at all is only a misdemeanor.

IRS Commissioner Margaret Milner Richardson insists that her agency is doing an effective job of collecting taxes and that the nation’s system of voluntary compliance--the government collects an estimated 86 cents of every dollar owed--is still the envy of the world.

Although the IRS has recently put greater emphasis on identifying and catching nonfilers, the problem seems to be growing anyway for a variety of reasons, including an increase in the underground economy, the economic squeeze on the American middle class and a renewed tax protest movement.

The IRS has files on 6.5 million individuals and businesses who the agency knows do not file returns. But it is clearly missing many others who operate in a booming underground economy that includes nannies, tree trimmers and musicians--not to mention the illegal sector of drug dealers, prostitutes and car thieves.

IRS policies emphasize gently herding nonfilers back into the tax collector’s fold. The IRS regards the vast majority of nonfilers as congenital procrastinators or luckless deadbeats, not criminals.

Hardly anybody is prosecuted for not filing. In the 1994 tax year, just 240 people or businesses were convicted--less than four of every 10,000 known nonfilers. As a result, many nonfilers have apparently come to regard the IRS with little or no fear.

IRS officials have noticed a huge jump in cases involving high-income nonfilers--people who earn at least $100,000 a year. The agency identified 138,717 such cases in the 1994 tax year, up 39% from 99,693 just the year before.

“We have more attorneys under investigation than I have ever had before,” said Richard Speier Jr., chief of the IRS criminal investigation division in Los Angeles. “I am very active in the investigation of crimes involving doctors and lawyers.”

Check Finds Attorneys

In New York, a cursory check by the IRS turned up 300 attorneys who were not filing in 1993. Some major law firms now require their partners to submit the first pages of their income tax returns to outside accountants each year.

Professionals can escape notice most easily if they are self-employed and their income is not reported independently to the IRS on W-2 forms. By avoiding traditional investments that yield interest or dividend income, which is also reported to the IRS, they can drop out of sight.

Federal officials never disclosed exactly how they caught Hughes, the Santa Barbara attorney. But his guilty plea indicated that he had failed to file returns for three years ending in 1989 and had unreported income of $165,314. Hughes did not return three phone calls seeking comment.

Of the 6.5 million nonfilers, various types of businesses account for about 2.3 million and individuals for about 4.2 million, according to the IRS. Their ranks include bank presidents, fading thespians, surgeons and accountants, according to the attorneys who represent scofflaws.

In one notable example, then-Compton City Councilwoman Patricia Moore was charged last year with failure to file income tax returns, as well as extorting money from a city contractor. She pleaded guilty to both charges but later withdrew the plea and is awaiting trial.

Militants New Factor

Militant tax protesters represent another component of the problem, according to Richardson, the tax commissioner. Only last year a 45-year-old unemployed car salesman and tax protester was arrested for plotting to blow up the IRS service center in Austin, Texas, and Richardson said she was increasingly concerned about the safety of IRS officials.

“There are movements, particularly out West,” Richardson said. “People who are disillusioned or concerned about the role of government generally, and particularly the federal government. Many of them are tax protesters, not filing taxes.”

More often, those who drop out of the tax system are too lazy to open their mail, pay their water bills and balance their checkbooks, experts say.

“Procrastination turns into fear of Big Brother,” said Bruce Hochman, a nationally known criminal tax attorney in Los Angeles. “We have people who started out qualifying for a refund but they didn’t file. Then they became afraid that, if they did file, they would go to jail or the IRS would come to their house and grab their left leg.”

Robert S. Fink, a New York attorney who has written several books on IRS litigation, cited the case of a surgeon who went five years without filing tax returns. The IRS intended to prosecute, but the surgeon showed that he was so inept with complex forms that he had also failed to bill insurance companies for $400,000 worth of surgeries that he had performed.

“The behavior permeated his entire lifestyle,” Fink said. The IRS declined to prosecute.

In Financial Straits

At the other extreme are families in such financial straits that they have nothing left for the tax collector. They do not necessarily take fancy vacations or own expensive cars. What income they have may be eaten up by illnesses or other emergencies.

Nonfilers win little sympathy from prosecutors, who believe that the federal laws that classify these cases as misdemeanors are too weak to deter the crime.

“A misdemeanor? Get real,” said Nora M. Manella, the U.S. attorney in Los Angeles. “It wouldn’t be much of a deterrent even if you prosecuted all the nonfiler cases if they are a misdemeanor.”

And the government is a long way from universal prosecution. Although the Justice Department will not discuss it, defense attorneys in California say that the government does not bother to prosecute tax cases involving less than $80,000 in unreported income.

The misdemeanor for nonfiling carries a maximum sentence of one year in prison, compared with five years for the felony of tax evasion. The IRS can also slap nonfilers with civil penalties of up to 47.5% of back taxes owed; accrued interest can add still more.

Ronald Rhodes, director of the IRS’ tax collection division, said the agency was not sure how much taxes it loses to nonfilers, but an out-of-date estimate in the early 1990s set the figure at $10 billion a year.

Though a huge sum, it’s still just a fraction of the $150 billion to $400 billion (enough to balance the federal budget) that tax cheating of all varieties costs the government every year, according to Rep. Jim Ross Lightfoot (R-Iowa), chairman of the House Appropriations subcommittee that controls the IRS budget.

The IRS began putting greater emphasis on nonfilers in the early 1990s and ended a major initiative in September 1995, declaring the effort a success. But the data would seem to indicate mixed results.

The IRS originally thought that 10 million Americans were nonfilers but, after looking at the inventory of cases more closely, categorized half of them as bogus. But it also unearthed evidence of 1.5 million nonfilers it had not known about, bringing the total to 6.5 million.

Only about one-third of those cases were under any form of review by IRS field offices.

“We had more nonfilers cases being created than we had resources to devote to it,” said Rhodes, the IRS collection chief. “We consider much of what we did a success.”

Structural Problem

The very structure of the U.S. tax system makes the IRS’ job tough. The agency has no way of knowing, for example, when a person loses a job and no longer meets minimal criteria for filing a return. Neither does it have any way of knowing when people die.

Although the public may think the IRS has enormous amounts of information on them, federal laws strictly limit the agency’s freedom to gather data on individuals.

“We don’t have a file on every taxpayer in the country with information on how they live their lives,” Rhodes said. “The disclosure and privacy laws won’t let us.”

Congressional critics worry, however, that the IRS is wasting its resources. Lightfoot has charged that IRS efforts to install new computers so far amounts to a $4-billion fiasco. Outside experts agree that antiquated computers hobble the agency’s enforcement efforts.

“If the IRS had a 20th century computer system, the nonfiling of tax returns would be a crime of history,” said Fink, the New York attorney.

Lightfoot envisions a powerful nationwide computer network that would routinely match tax returns against lists of driver’s licenses and voter registration rolls, among other data bases. Such a system would easily expose nonfilers without keeping dossiers on individuals.

“You can’t beef up tax compliance until you have a better computer system,” Lightfoot said. “There are a lot of people out there trying to skip paying taxes. Compliance is falling through the cracks. They don’t have good data bases that they can access.”

But in many cases, it takes an extraordinarily long time and some old-fashioned detective work to root out the tax outlaws, according to Speier, the IRS criminal investigation chief.

“There can be a lot of gumshoe work,” Speier said. “It is not a real intelligent crime to commit. It is an individual who is attempting to play audit roulette.”

The IRS pursues nonfiler cases by first making sure that an individual is really ducking the legal requirement to file a return. The IRS system begins with mailing reminders to taxpayers who stop filing returns. Typically, those reminders are sent one to two years after the first failure to file.

Ultimately, the IRS has a right to prepare a tax return--a so-called substitute-for-return form--for individuals who continue to refuse to file. Then the collections division can begin dunning the individual for taxes owed.

It may be still years later that the IRS finally sends a criminal investigator after the scofflaw.

“We go right to their house, knock on their door,” Speier explained.

The tax man cometh.