Tax Evasion Found at All Income Levels

The recent arrest of former Tyco International Ltd. chairman L. Dennis Kozlowski on charges of evading $1 million in sales taxes is throwing light on a shadowy subject: Americans who try to gain an edge--legally or illegally--on the tax collector.

Some wealthy Californians sail to international waters to buy yachts tax-free. Many waiters, waitresses, beauticians and parking valets don’t report all their tip income, accountants say. Some small-business owners fail to ring up cash sales, playing poor for tax purposes, while some philanthropists overstate the value of charitable contributions to pad itemized deductions.

“Many people cheat on their taxes all the time,” said Steve Toscher, a partner at Beverly Hills law firm Hochman Salkin Rettig Toscher & Perez. “I don’t know that you can say that rich people cheat more than poor people, but there’s certainly more inducement and opportunity to cheat.”

Almost anyone can find a way to chisel if they want to, tax accountants say.

The tax-avoidance strategy Kozlowski is charged with using is among the most common--on a much smaller scale--because of the big differences in state tax rates.

Kozlowski is charged with evading $1 million in New York state and city sales taxes on artwork by having dealers ship empty boxes to his offices in New Hampshire, where there is no state sales tax.

But when it comes to sales tax avoidance, almost any consumer can participate. Many shop in no-tax and low-tax states and never think about filing a so-called use tax form, which is required for those who buy something in a lower-tax state--or by catalog or over the Web--and take it back home.

And sometimes business owners offer to forgo sales tax when the consumer pays in cash--a conspiratorial fraud that probably saves the merchant from reporting--and paying income tax on--the sale.

“New Yorkers go to New Jersey; Northern Californians go to Oregon,” said Clint Stretch, director of tax policy at accounting firm Deloitte & Touche. “Avoiding the payment of sales and use taxes borders on being a national sport.”

Towns along borders between low- or no-tax states and high-tax states often become busy retail centers, said Bill Ahern, spokesman for the Tax Foundation in Washington.

“On the Maryland-Delaware border, there are roughly 125 stores,” Ahern said. Delaware has no sales tax, while Maryland’s rate is 5%. “Delaware is simply filled with retail outlets catering to out-of-state buyers.”

There are even greater incentives to avoid so-called sin taxes, imposed on alcohol and cigarettes, Ahern said. The tax rate on alcohol sales ranges from $1.50 a gallon in the District of Columbia to nearly $6.50 in Florida.

“You can legally bring back one bottle from D.C. to Virginia,” Ahern said. “But you see people outside Central Liquor [near the state line] loading up their trunks.”

Other illegal tax-shaving strategies include understating the purchase price of a used car bought from a private party, Toscher said.

Car dealers collect sales taxes at the time of purchase. But anyone buying an auto from a private party must pay sales tax when the vehicle is registered. Too often, buyers will tell the Department of Motor Vehicles that a $10,000 car cost only $7,000 to shave $240 off the tax bill, Toscher said.

“It’s really nuts, but people do it all the time,” he said.

Wealthy boaters join the tax-avoidance party by sailing offshore to complete their yacht purchases, said Robert Schriebman, a tax attorney in Rolling Hills Estates. The broker then takes the buyers home and sails the yacht to Mexico for a few months, to meet some technical requirements that can allow the owner to avoid paying sales taxes, he said. The process may seem burdensome, but yachts can sell for $500,000 to $1 million, so avoiding sales tax saves tens of thousands of dollars.

“You can buy a condominium for what you save on the sales taxes,” Schriebman said. “And then you get a tax shelter with the condominium.”

When it comes to cheating on income taxes, the pockets of opportunity are rare for many employees, but numerous for small-business owners and workers who deal in cash, experts say.

Companies report employee wages directly to the IRS, which then matches what employers say with what workers report on their tax returns. That makes it almost impossible for someone with primarily wage income to understate their earnings, said Jerry Feffer, partner with Washington law firm Williams & Connolly.

But people who earn tips are mostly on the honor system when it comes to reporting how much cash they receive. Most restaurants include a minimal amount of estimated tip income on W-2 forms for their waiters and waitresses, but experts believe many servers don’t tell the IRS that they earned more.

Small-business owners--from retailers to contractors--often skirt the tax system by not ringing up and reporting cash sales, experts add.

“I was buying a cell phone the other day and the guy says to me, ‘If you pay me in cash, I don’t have to charge you sales tax,’ ” said Joel Isaacson, a tax accountant in New York. “I know what he’s doing and I’m thinking, ‘I like paying taxes. I like it when you pay taxes. Then we all pay our fair share.’ But it happens all the time.”

Even though there are no hard numbers on how many Americans cheat on their taxes, tax officials suspect that tax fraud has increased sharply in recent years. The IRS used to estimate cheating by conducting random line-by-line audits.

However, the agency hasn’t had the staff or congressional support to conduct these audits in more than a decade. A limited version of the program is planned, but analyzing the results could take years.

Some accountants believe that today’s historically low audit rates almost encourage the unscrupulous to cheat on their income taxes, because the chance of getting caught is minuscule.

In 1995, for example, about 2% of taxpayers earning more than $100,000 faced in-person audits. Today, the in-person audit rate for these filers is less than one-half of 1%. To put it another way, although two in 100 high-income taxpayers grappled with face-to-face audits in 1995, now it’s fewer than one in 200.

“People who are guided by risk-reward ratios rather than pure ethics will make a judgment that cheating has less cost associated with it,” said Phil Holthouse, partner at Holthouse Carlin & Van Trigt, a Los Angeles tax law and accounting firm.

There are other issues, too. The U.S. tax system has some clear definitions for which deductions are legitimate--such as contributions to retirement plans--and which deductions are fraudulent--such as characterizing your personal purchases as deductible business expenses.

But there are shades of gray. There can be legitimate disagreement over whether certain expenses can be classified as deductions--and how much to deduct if the item’s value isn’t apparent.

Tax accountants and lawyers consistently find passages in the tax code that can be interpreted two ways--one that benefits the government and the other that benefits the taxpayer.

“You see people hire individuals to give you opinions that say the law of probability is in your favor that [the tax shelter] is kosher,” Schriebman said. It’s not really cheating; it’s taxpaying on the edge.”

That kind of complexity can create an incentive to push the envelope, experts say.

“Whenever you have high marginal tax rates, the pressure to cheat increases. Whenever you have complexity, the ability to cheat increases. And when you have no confidence that everybody else is paying their fair share, you have more motivation to cheat,” said Grover Norquist, president of Americans for Tax Reform.

“One of the things that the government can do to increase compliance--outside of lecturing everybody about playing by the rules--is have lower rates and simpler rules,” he said.

Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com. For past Personal Finance columns visit The Times’ Web site at www.latimes.com /perfin.