Why Cheating on Your Taxes Costs More

This past week an old story returned to the surface. A tax office that handles mostly simple tax returns for a very low price and gets paid mostly cash might not be claiming all that income. A previous employee of that firm informed me over $300,000 in cash was kept in a safe in the money cage. 

The final response (and I was thinking the same thing) was, “And I’m sure all that cash was reported.

Cheating on your taxes is as American as apple pie, but a whole lot dumber. If this other tax firm really has that much cash on hand and does not report all their income they lose a lot more than most people expect. 

First, if they get audited and the unreported money is found you can expect more audits. This is a tax on your time and I can’t think of a more usurious tax.

Next are the penalties. Here is a sampling of the penalties that could apply:

1.) Accuracy related penalty (§6662): 20% of the assessment.

2.) Fraud (§6663): 75% of the amount attributable to fraud.

3.) Willful attempt to evade or defeat tax (§7201): Up to a $100,000 fine, five years in prison, or both. This is a felony! If they are a corporation the fine can climb to $500,000.

4.) Willfully making and subscribing to a false return (§7206): Also a felony with a fine up to $100,000, three years in prison, or both. Corporations face fines up to $500,000.

Even worse, with underreported income at those levels it is likely the IRS will seek to bar the owners from ever preparing taxes again. And my guess is they would find a few more penalties to apply to make the financial pain even worse. 

He would probably make the local evening news. Clients would bolt. Clients would face greater scrutiny. There isn’t anything I find acceptable about the risk of underreporting income in their situation.

The odds of getting caught are small, however. And even if they get audited, the IRS may not find the underreported income. 

And none of that matters because there is another cost to cheating on your taxes that costs more than the taxes saved even if you don’t get caught.

S&P 500 10-year chart

Why Cheating on Your Taxes Costs More Than the Tax Avoided

The first time I heard the rumor was at least a decade ago. The firm files a lot of returns. I mean a lot. 

Their fee is the lowest of any firm in their service area of any size. I imagine a few guys working out of their home might do a return for less, but this firm is the lowest fee of any major player locally.

Probably 80% of the firm’s revenues are in cash with the firm pulling around seven figures of revenue annually. The owner could siphon a cool $100k off the top with no problem. 

Cheating on your taxes has a hidden cost. You can’t just deposit the unreported cash into a financial institution. The IRS might be slow, but they ain’t stupid. They will find that quicker than a starving mule finds a load of oats.

If you can’t deposit the money you are left with spending it. (You could launder the money, but that has a cost, too, which is nothing more than a tax paid to a different entity.) And when you spend it you can’t look like you are spending that much. Buy a car with cash and the IRS gets a report. 

I guess you could save it up for retirement, spending some here and there as not to look conspicuous. 

Yet, that isn’t the real problem. The real problem is lost opportunity cost! 

Let’s say the tax on this $100,000 is 40%, federal and state taxes combined. That would leave the business owner with $60,000 after tax.

Yet, if that $60,000 was invested 10 years ago in an S&P 500 index fund it would now be worth nearly three times as much! Even if we take a bit off the top for spending we still have more than $120,000 and in reality closer to $150,000! The best the unreported income can do is maintain $100,000, unless you want to risk some prison time.

Cheating on your taxes never pays! It always costs you more in the long run with serious risks in the short run. If you underreport income by up to 25% the IRS can audit you on that return for up to seven years after you file or from the due date, whichever is longer. This is up from three years when you play it straight. If the underreported income is over 25% that tax return is open for audit forever!

Cheating Uncle Sam costs more than the tax even if you don’t get caught.

Wink, Wink

There is a way to profit from people who do cheat on their taxes. 

When a client offers to pay cash they sometimes do so with a wink. I assume they mean that since they paid me cash I will not report it. Unfortunately, I invoice each client separately so I create a paper trail. It all gets reported. It is how a real business operates. (I’m a real business.)

It has been a long time since I was asked for a discount if I am paid cash. When I was the answer was always no. I use the Seth Godin plan: full price or free.

When purchasing a good or service I might ask for a discount if I pay cash. I remind the business owner they don’t have to pay bank transaction fees. It is a win/win for all parties involved. I never make it a tax cheating issue

Several years ago I was coming home from the office during tax season when a deer attacked my car. Hit the from wheel well. A rural body shop quoted me $800 to fix the damage. It was a really good deal.

I brought cash when I picked up my car, concerned he might not want to accept a check. Without asking, the business owner offered me a $200 discount for cash.

That was a whopping $200 discount; 25%! It was accompanied by the ol’ wink-wink. I took that to mean he would not be reporting the income. (Hey, I’m not here to judge.) 

He traded his tax bracket for a 25% tax paid to me. And my savings were tax free!!! (You don’t pay tax on money you didn’t spend on a service.) By the looks of the place I don’t think his tax bracket was much higher. I enjoyed the discount, but it was still foolish on the business owner’s part if he did so just to not report a small amount of income.

The choice is clear. Cheating on your taxes destroys your wealth even if not caught. Honest pays better!

Tax season is heading into the final stretch as I write this. I hope I made the case for not cheating on your taxes. It isn’t too late to file a superseding return if you left something important off your tax return, like some income.

The risks are too high for anyone serious about accumulating wealth. The math doesn’t add up. Cheating on your taxes will bite you in the tail regardless the outcome. Audits waste a lot of time and are not fun. (You can make more money, but ya can’t make more time.)

The lost opportunity cost of wasted time hiding money from the government and the lack of ability to invest all your money optimally make it real clear: cheating will always cost you.

Worse, you could have enjoyed a few posts around this blog and saved as much or more legally than you potentially saved cheating. (What are the chances traffic to this blog will spike now?)

I know you will do the right thing.

 

More Wealth Building Resources

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

 

Keith Taxguy, EA

Keith started his tax practice in 1982 and went full-time in 1989. An enrolled agent (licensed tax professional) since 1992, Keith has focuses on helping businesses and individuals pay the least amount of tax allowed by law.

6 Comments

  1. charlie @ doginvestor.com on March 30, 2021 at 7:54 am

    agreed I don’t get it. Especially for folks that do rent in cash only. Now you got a big wad of cash – I suppose you spend it on groceries or buying stuff from other folks, but I hate too much cash.

  2. Karl Strube on March 30, 2021 at 5:23 pm

    Fantastic as always Keith. I truly appreciate the acknowledgement that the risk of getting caught is generally low (absent making large cash deposits or large cash purchases).

    You really drove well to the heart of the issue. It limits your options in the future for that money. And then you’re also always looking over your shoulder.

    For me personally, it’s a matter of faith as well. Cheating on my taxes would implicitly say that I don’t trust God enough to provide for my family’s needs. I’d rather have an abundance mindset (that there’s more earning potential available) than a scarcity mindset (that I need to hoard every dollar I can).

    • Keith Taxguy on March 30, 2021 at 6:11 pm

      Well said, Karl. There are moral, ethical and even religious considerations as well. Our behavior says a lot about who we are.

  3. Paul Saunders on April 2, 2021 at 6:10 pm

    Just curious if you know about surrogacy income? My wife is a surrogate this year and we do plan on using a tax professional for our 2022 return, but I see a lot of stuff online from “tax professional” that says you do or don’t have to claim it, or that there aren’t clear IRS rules for it. I feel the default answer would simply be to claim it.

    • Keith Taxguy on April 2, 2021 at 8:41 pm

      Paul, I take the position surrogacy income is includable for taxes under §61(a)(1) and Revenue Ruling 2007-19.

      Surrogate.com provides three reasons why some tax professionals don’t include the income. I disagree with their position. Income is reportable whether you receive a 1099-MISC or not. Surrogacy income is not a gift; you received payment for a service. (No surrogacy; no gift.) Pain and suffering rules apply to accidents and damages. If you are providing a service, surrogacy, then the pain and suffering exclusion does not apply. If it did, every employee would want their paycheck tax free. Finally, there is no such thing as “pre-birth” child support as it applies to surrogacy.

      The real question is this: Is the payment self-employment income or other income. As funny as it sounds, the hobby rules might provide guidance here. That means no deduction for expenses, but no self-employment tax either. Facts and circumstances will determine your course.

      As for there being no Tax Court cases: The dearth of cases means the issue isn’t common and the IRS has not taken an interest in surrogacy income. The fear the IRS might have is the deductibility of expenses. If they set a precedent they could find themselves locked into a position they don’t want. Or, they just don’t have the manpower to fight every issue. The answer is probably somewhere in the middle. There are Tax Court ruling on surrogacy issues, but a large portion involve deducting the medical expenses of the surrogate. The Court has ruled against that repeatedly.

      You are right about one thing. It is a complex issue with answers less than satisfying. For most cases I feel the income is reportable as “other income” on Schedule 1 and medical expenses are deductible on Schedule A, if it helps.

  4. Robert on June 1, 2021 at 2:05 pm

    While there is certainly a moral aspect to cheating on one’s taxes, I don’t see much of a downside of modest cheating from a purely financial point of view. And I say I don’t see much of a downside because I have been looking closely for a long long time. At a lot of people. The barber. The flea market vendors. The mom & pop store owner. The guy who mows your lawn. All are occupations in which business owners receive a lot of cash payments. The only time I’ve seen it bite them in the butt is when they want to get a home mortgage, as that unreported income isn’t allowed to be counted when applying for a loan.

    Now mind you, I’m not talking about the big-time cheats. I’m talking about the folks who skim off maybe 10% of their receipts. They still show a believable profit. It’s just that last $10,000 of profit gets lost in the shuffle. It gets pocketed, and spent to buy dinner at Applebee’s for the family, an oil change, and a perhaps some tools for the home workshop. You can still pay cash to fill your tank, and nobody thinks twice about it.

    And then there’s the bottom-feeder cheat: the welfare class who make up imaginary income, such as $12,000 cleaning houses for people, so as to qualify for the EITC, which is enough to cover the SS tax on their imaginary earnings (and qualifies them for some SS benefits) plus enough give them spending money on top. And the EITC doesn’t interfere with their welfare benefits.

    The IRS has a very large pool of easy-to-catch cheaters it could nail to the wall, but it simply doesn’t bother. Only the most extreme of the cheaters out there ever gets any attention from the IRS. Moral of the story: tax cheating is like alcohol consumption — as long as you do it in moderation, there shouldn’t be any negative consequences.

Leave a Comment