Taxes: 10 Ways to Cheat Like a Pro

Feb. 23, 2009— -- Before bowing out as nominee for health czar, Thomas A. Daschle explained as best he could how he managed to overlook $340,000 of income on his 2005 through 2007 tax returns. His reason: The income (some cash and a lot of chauffeuring) didn't show up on his 1099s. These are the forms self-employed people such as influence peddlers receive instead of W-2 wage statements.

The former Senate majority leader seems to have something in common with his fellow citizens -- or at least those who contribute to the $345 billion annual gap (as of 2001) between what the Internal Revenue Service estimates taxpayers owe and what they voluntarily cough up.

Tax filers own up to nearly all the income the IRS can double-check against documents sent to it by employers, brokers and banks. But people are for some reason very neglectful when it comes to income and deductions that the IRS can't easily cross-check. They pay only 45 percent of the taxes owed in their noncheckable lives.

Click here to learn the 10 tips for taming the tax cops at our partner site, Forbes.com.

"I run into it with clients all the time. The current system has built a mentality that if there is no W-2 or 1099, it's not reportable income," says Phoenix CPA Edward Zollars.

Daschle should have known better, but maybe it's understandable if ordinary folks think this way. Over the past two decades the number of 1099s and other information returns sent to the Internal Revenue Service has doubled -- to a projected 1.95 billion this year. IRS computers match most against individual returns and spit out 3 million-plus CP 2000 notices to taxpayers a year demanding an explanation for discrepancies.

Meanwhile, the ranks of IRS revenue agents (who perform the "field" audits that might find, say, unreported cash income) have shrunk 25 percent and the IRS has been busy battling dicey tax shelters, wacky tax protesters and hidden offshore accounts. The result: The IRS conducted field audits of only one in 440 taxpayers last year, half the rate in 1998. "The IRS doesn't have the resources now to do anything besides document matching for the bulk of the population," observes attorney Lawrence B. Gibbs, a Miller & Chevalier partner who was IRS commissioner in the late 1980s.

Yes, but don't get too cocky. As the table shows, the IRS is now using its shrunken field force to go after the better off. And it has ramped up use of a low-cost technique to attack deductions and credits claimed by ordinary folks: "correspondence," or by-mail, audits. Last year the IRS sent 1.1 million letters declaring deductions of some kind would be denied unless taxpayers mailed back acceptable documentation. "This paper tiger can make people's lives miserable," says Claudia Hill, a Cupertino, Calif. tax pro who edits CCH's Journal of Tax Practice & Procedure.

Here are some ways for the law-abiding (and the less so) to minimize IRS grief.

Study the charity rules. Congress has tightened rules on charitable deductions, making this a prime area for mail audits, says Hill. Gone are the days when Bill and Hillary Clinton could deduct $75 for giving a suit with ripped pants to the Salvation Army. You can't write off donations of small items in less than good condition and need receipts or canceled checks for any cash gift, even $10 put in the church collection plate.

For donations of $250 or more, you must have a letter from the charity before filing your tax return. Last year a Tax Court judge ruled that Ruth M. and Daniel Gomez of El Paso, Tex. couldn't deduct $6,100 they tithed in 2005 to their church, even though they had canceled checks and a 2008 letter acknowledging the donations. "We didn't know the law," admits Ruth, 33. "We know so many people do cheat the system. We were doing the right thing and we got red-flagged."

Document employee expenses. Unreimbursed employee business expense deductions are another mail audit magnet. In 2007 hundreds of Secret Service agents received letters disallowing deductions for various job expenses, including oversize suits they bought to fit over bulletproof vests. (You can't deduct clothes you'd otherwise wear off the job.)

William Stevenson, a Merrick, N.Y. tax accountant representing dozens of agents in Tax Court, says the IRS appears to be conceding the big-suit issue, but is being picky on substantiation. "There's no wiggle room. You can't even use credit card statements; you have to have the actual receipts," he warns. (Note that upper-middle-class folks who pay the alternative minimum tax can't deduct employee expenses anyway.)

Use an honest tax preparer. If your tax preparer suggests inflating deductions or winks at unreported income, find another one. The government has targeted sleazy preparers; it goes after them in court and then audits their clients en masse. If you're inclined to finagle, get an honest CPA for cover -- just don't tell him what you're up to.

For a field audit, hire a lawyer. If you've been naughty and are selected for a face-to-face audit, send a representative in your place, advises Charles Rettig, a Beverly Hills tax litigator. If the IRS agent asks a loaded question -- say, about cash receipts -- and a taxpayer lies, he has just committed the felony of making a false statement to a federal official.

"If he asks me a tough question, my answer is 'I'll find out,'" Rettig confides. Plus, he says, thanks to currency transaction reports banks and others must now file, the agent is more likely than ever to know you're lying. To be extra safe, send a lawyer instead of a CPA; what you tell a lawyer has more protection in the event the case turns criminal.

Close secret offshore accounts. The government's efforts to get UBS to turn over the names of 19,000 Americans with Swiss accounts have been much publicized. What's less well known is that Congress has beefed up rewards for squealing to the IRS, giving clerks at every two-bit offshore bank an incentive to copy all the names onto a flash memory stick and rat them out.

Failing to disclose a foreign account is a felony. The government doesn't bring many criminal cases. But the civil penalties are potentially confiscatory. Taxpayers who amend their returns before the IRS gets their names are likely to avoid criminal prosecution and the heaviest penalties. (Hire a lawyer to do this.)

Stay right with your nanny. The IRS doesn't have an easy way to find folks who don't pay the required payroll tax for domestic workers, and filings of nanny tax forms have been dropping. But field agents routinely ask if you have such help. And clients of Independence, Mo. tax preparer Michael Martin discovered another risk, when they fired their off-the-books nanny and she applied for state unemployment benefits. It cost them $3,460 in back taxes, interest and penalties -- three times what they would have owed.

Who files nanny returns? The forms are quite popular among residents of Washington, D.C., where the filing rate is six times the national average. That tells you two things: (1) Every other person in the capital is hoping for an appointment to a position that requires Senate confirmation. (2) Elsewhere, a lot of cheating is going on.