Tax fraud costs the U.S. government as much as $450 billion per year, according to recent estimates by the Internal Revenue Service (IRS). State and local tax jurisdictions also lose a substantial amount of revenue to tax fraud. The Internal Revenue Code, which addresses tax fraud separately from other fraud offenses, makes it a crime to submit fraudulent or false information regarding a “material matter” in a tax return or other tax-related document. For an individual taxpayer, a single count of tax fraud under federal law can result in a fine of up to $10,000 and up to one year in prison. State laws have similar provisions for false and fraudulent statements regarding state income taxes, property taxes, franchise taxes, and other local taxes.
The U.S. tax system depends to a large extent on taxpayers’ voluntary compliance. Each taxpayer must prepare their own income tax returns and submit them to the IRS by April 15 every year. An analysis by the IRS of the 2006 tax year found that 83.1% of taxpayers sent in tax returns and payments on time. The initial tax gap, meaning the difference between total taxes owed and the amount actually received, for 2006 was $450 billion. After the IRS recovered unpaid taxes and late fees through various enforcement actions, the tax gap dropped to $385 billion.
The IRS identifies three components of the tax gap: “non-filing, underreporting and underpayment.” Tax fraud commonly takes the form of false statements that reduce a taxpayer’s overall tax liability. Much like tax evasion, by which a taxpayer might seek to evade payment of taxes entirely, tax fraud is a substantial factor in the tax gap. The most common acts of tax fraud involve false or fraudulent reporting of income, or of expenses that count as tax deductions.
The Internal Revenue Code allows taxpayers to deduct certain expenses from their gross income before calculating their tax liability. Many tax deductions involve conduct that the government wants to encourage, such as allowing an employer to deduct the cost of certain benefits provided to employees. The more deductions a taxpayer claims, the less tax they owe. Overstatement of tax deductions accounted for only about $17 billion of the 2006 tax gap, according to the IRS, but it is among the most common incidents of tax fraud. For example, the IRS might scrutinize a large charitable contribution, when claimed as a deduction on a tax return, to determine if the claimed amount is accurate.
False reporting of income makes up a much larger component of the tax gap. Taxpayers may inadvertently fail to report certain types of income, such as cash payments received for side jobs or tips received in a service job, and find themselves accused of tax fraud. Many employers provide forms that summarize income, such as a W-2 or a 1099, but every taxpayer is responsible for reporting all income from all sources on their annual tax return. This even includes income derived from illegal activity, which if not disclosed can result in charges of tax fraud or tax evasion.
