The Tax Cheat Next Door

$1 Million a Month and No Tax Return

Scenes from the new America:

• A woman forms a company to conduct "research" for the benefit of her minor children and writes a monthly "rent" check to her husband to cover use of the space in their home occupied by her new "business." Coincidentally, the "rent" equals the mortgage payments on their home. She writes another check to lease a car - the family car, as it happens - and then deducts both expenditures as "business expenses" on the couple's joint tax return.

• A fast-food-franchise owner whose family enjoys a typical middle-class lifestyle instructs his accountant to prepare a tax return showing that he owes no income tax. The accountant obliges. He shaves income, inflates expenses, and creates mythical deductions.

• A young man shows up at a designated street corner in Phoenix, Arizona, where illegal immigrants line up to wait for curbside interviews by affluent individuals and contractors seeking hired help. The jobs range from lawn care to housekeeping to construction. The workers are all paid in cash. No taxes deducted. No questions asked.

• A Fortune 500 company hires a computer programmer from India to work on a specific task for a fixed period of time. The programmer is employed by a consulting firm that specializes in placement of foreign workers. The programmer receives a tax-free paycheck - no withholding for U.S. income tax, Social Security or Medicare taxes, state or local taxes.

What are all these people doing? Cheating on their taxes, of course.

Tax fraud is exploding in the United States. In ways large and small, Americans are cheating like never before. One of every three people, perhaps as many as one of every two, is doing it. It's one of Washington's dirty little secrets, a ticking time bomb with the potential to destroy the country's tax system and to undermine essential government programs like Social Security. Disguised by a robust economy and record tax collections, fraud is growing at an exponential pace among all groups, with more and more income concealed from the IRS each year.

How bad is it? No one can put a precise number on lost tax revenue. But it's bad, and getting worse. Even the IRS, which doesn't like to acknowledge this problem for fear it will only encourage more taxpayers to cheat, admitted in 1999 that the "tax gap," its euphemism for fraud and error, is now up to $195 billion a year.

But that estimate is based on tax data from the 1980s and does not remotely reflect current events. A more reasonable count of the revenue lost every year is upwards of $300 billion - the equivalent of the total income taxes paid annually by all individuals and families earning less than $75,000. And even that figure does not include lost taxes from illegal income such as drug trafficking, money laundering, gambling, and prostitution.

If Tax Dodging Inc. were a business, it would be the nation's largest corporation, eclipsing General Motors, which sits atop the Fortune 500 with revenue of $189 billion.

How do people escape paying the taxes they owe? They inflate their itemized deductions for everything from medical bills to charitable contributions. They manufacture deductions to cover expenses never incurred. They understate their income. Or they do both. They ship their money to foreign tax havens. They claim illegal refunds. They speculate in the stock market and don't report their gains. They charge off their personal living costs as business expenses.

And many don't even bother to file tax returns at all. For this group, April 15 is just like any other day of the year. There are no endless forms to fill out, no hurried visits to the accountant, no frantic search for receipts, no mad dash to the post office. Best of all, no taxes to be paid. Those who don't file are participants in the ultimate tax dodge. Their numbers are soaring. Superficial IRS studies turned up 3.4 million individual nonfilers in the 1985 tax year. Two years later, the number jumped 24 percent, to 4.2 million. By 1991, it was 6.5 million. Incredibly, 74,000 of them had incomes of more than $100,000.

How many nonfilers are there today? The IRS doesn't have a clue. In part, that's because Congress has slashed the agency's budget, halting the kind of audits that would make even crude projections possible. Informally, government tax authorities say there are 10 million nonfilers. In truth, there are many more, and here's why:

The IRS identifies a nonfiler as a person who fails to submit a tax return even though a third party has filed an earnings statement (W-2) or information return reporting interest or dividends (Form 1099) that shows the person received income during the year. This narrow definition ignores all those who leave no paper trail. These are the people for whom there are no W-2s or 1099s, no record of wages, annuities, gambling winnings, pensions, interest, dividends, or money flowing in from foreign trusts and bank accounts.

In addition to these people who deal only in cash, there is another larger group whose numbers have soared. They are wealthy Americans and foreign citizens who live and work in the United States and in other countries - multinational wheeler-dealers, independent businesspeople, entertainers, fashion moguls and models. They have multiple passports or global residences and therefore insist they are exempt from the U.S. income tax.

People like the Wildensteins of New York City. That would be Alec and his former wife Jocelyne, who became a staple of the New York tabloids during an unseemly divorce that raged from the fall of 1997 until the spring of 1999.

Alec, born in 1940, is an heir to his family's century-old, intensely private, multibillion-dollar international art business. Jocelyne, four years his junior, is best known for having undergone countless plastic surgery procedures that make her look more feline, permanently, than any member of the cast of Cats. Her bizarre appearance inspired the tabloids to dub her "The Bride of Wildenstein."

For the Wildensteins, the once impenetrable curtain that had protected the family from prying eyes for generations was unexpectedly pierced on the night of September 3, 1997, when Jocelyne returned to the couple's opulent Manhattan home after a visit to the family's 66,000-acre ranch in Kenya. Walking into the six-story townhouse on East 64th Street, next door to the Wildenstein gallery, a few minutes after midnight, she found her husband in bed with a nineteen-year-old, long-legged blonde.

Alec hastily wrapped himself in a towel, grabbed a 9mm handgun, and pointed it at his wife and her two bodyguards. "I wasn't expecting anyone," he screamed with a touch of understatement. "You're trespassing. You don't belong here." The bodyguards summoned the police, who arrested Alec and charged him with three counts of second-degree menacing.

So it was that the French-born, aristocratic Alec Nathan Wildenstein, having traded his towel for an Armani suit and a monogrammed shirt, spent the night in the Tombs prison with some of New York's low life. If nothing else, the incarceration gave him time to plot his revenge. When he got out the next day, he moved quickly. He canceled his wife's credit cards. He cut off her telephone lines, locked all the rooms in the townhouse except for her bedroom and sitting room, shut off her access to bank accounts, directed the chauffeur to stop driving her around, fired her accountant, and, in one final act of retribution, ordered the household chefs to stop cooking for her, which proved a major inconvenience because she had never learned how to operate the stove.

Jocelyne responded by turning up the temperature a few hundred degrees on what had been one of the quietest divorce proceedings ever among the rich and discreet. As a result, life among the Wildensteins - a family that for more than a century had guarded its privacy with a pathological obsession - went on public display.

Jocelyne demanded a $200,000 monthly living allowance, payment of her personal staff's salary and expenses, and a $50 million security deposit pending distribution of the marital property. Alec pleaded poverty. He insisted that he had no money of his own and that the millions they spent came from his father.

The Wildenstein family circus that followed established conclusively, one more time, that the rich are very different from the rest of us, beyond the fact that they often pay comparatively little or no taxes. But first, some background on this intriguing family.

Alec is the son of Daniel Wildenstein, the patriarch of the enormously rich French clan. Daniel, born in 1918, controls the Wildenstein billions through a web of secret trusts and intertwined corporations. The Manhattan townhouses, for example, are owned in the name of the Nineteen East Sixty-Fourth Street Corporation, which in turn is controlled by "intermediate entities held in trust." He continues to operate the private, secretive art business started by his grandfather in the nineteenth century, with galleries in New York, Beverly Hills, Tokyo, and Buenos Aires, catering to private collectors, museums, and galleries. And while he spends a lot of his time in Paris, a good chunk of his money resides in secret Swiss bank accounts.

Tucked away in family storerooms, notably in New York, is reportedly the world's largest private collection of the works of the masters - valued at $6 billion to $10 billion. The inventory includes thousands of paintings by Renoir, Van Gogh, Cézanne, Gauguin, Rembrandt, Rubens, El Greco, Caravaggio, da Vinci, Picasso, Manet, Bonnard, Fragonard, Monet, and others. Many have never been displayed publicly.

In 1990, Daniel's sons Alec and Guy took over management of the New York gallery. Their families maintained separate living quarters in the East 64th Street townhouse. They shared the swimming pool in the basement, the informal and formal dining rooms, the foyer, elevator, and the entrance to the townhouse. Alec and Jocelyne lived on the third floor, their two children had bedrooms on the fifth floor, and Jocelyne used the sixth floor as an office. In addition to the Manhattan townhouse, they maintained a castle, the Chateau Marienthal, outside Paris, an apartment in Switzerland, and the Kenya ranch.

Wherever they happened to be, the Wildensteins pursued a lifestyle that was lavish even by the standards of the rich and famous. The details, as they poured from Jocelyne's lips in the divorce proceeding, told the story of a family of seemingly unlimited wealth and no hesitation about spending it. According to her, she and Alec "routinely wrote checks and made withdrawals" from their Chase Manhattan Bank checking account "for $200,000 to $250,000 a month." Jocelyne said that over the last twenty years they did "millions of dollars worth of renovations of the Paris castle and Kenya ranch," and she directed the management, hiring and staffs of those properties. The routine operating costs of the ranch alone ran $150,000 a month.

In New York, Jocelyne's staff payroll at the 64th Street townhouse included $48,000 a year for a chambermaid; $48,000 for a maid who tended the dogs; $60,000 each for a butler and chauffeur; $84,000 for a chef; $102,000 for an assistant with an MBA; and $102,000 for a secretary.

In Kenya, their vast Ol Jogi ranch, with its two hundred buildings spread over an area five times the size of Manhattan, required nearly four hundred employees to look after the grounds and the animals.

In France, the resident staff at the chateau, "the largest private home of its type within a fifteen-minute drive of Paris," included five gardeners, three concierges and three maids.

Talk did not come cheap for the Wildensteins. The annual telephone bill in Manhattan alone sometimes ran as high as $60,000. And then there were all the other necessities, like $547,000 for food and wine; $36,000 for laundry and dry cleaning; $60,000 for flowers; $42,000 for massages, pedicures, manicures, and electrolysis; $82,000 to insure her jewelry and furs, and $60,000 to cover the veterinarian bills, medication, pet food, beds, leashes, and coats for their dogs. As for miscellaneous professional services, $24,000 went for a dermatologist, $12,000 for the dentist, and $36,000 for pharmaceuticals. Her American Express and Visa card bills for one year totaled $494,000.

Some of these bills were paid out of the couple's Chase Manhattan account. Some were paid out of "other bank accounts in New York, Paris and Switzerland." And some bills, Alec confirmed, were paid from "the Wildenstein & Co." account, "the Wildenstein & Co. Special Account, and family businesses." Sort of like having your employer pick up the cost of your clothing, pets, and vacations.

And then there were Jocelyne's personal expenditures. Over the years, she accumulated jewelry valued at $10 million, including a thirty-carat diamond ring and custom pieces from Cartier. She attended fashion shows in Paris. Her annual spending on clothing and accessories ran to more than $800,000. She once spent $350,000 for a Chanel outfit that she helped to design. All told, according to papers filed in the divorce case, the couple's personal and household expenditures added up to well over $25 million in 1995 and 1996 alone.

With all those tens of millions of dollars flowing out over the years to maintain a lifestyle beyond comprehension to most people - $60,000 in dog bills exceeds the annual income of three-fourths of all working Americans who pay taxes - you might think that Alec and Jocelyne also forked over millions of dollars to the Internal Revenue Service. But you would be wrong.

They didn't pay a penny in U.S. income tax.

In fact, they never filed a federal tax return.

These admissions by a family accountant are spelled out in records of the acrimonious divorce and also entered into court opinions. They lived the tax-free life even though, by Jocelyne's account, they resided in the Manhattan townhouse for nineteen years, from shortly after their Las Vegas wedding in 1978 until the rancorous divorce proceedings began in 1997. Their children were born in New York and went to school in New York. Alec conducted the family art business through Wildenstein & Company Inc., a New York corporation, from the gallery next door. He had a U.S. pilot's license. He sued and was sued in the courts of New York and other states. He signed documents moving millions of dollars between Wildenstein companies, some located in the tax havens of the world. He transacted business in New York and other states. He was vice president of Nineteen East Sixty-Fourth Street Corporation, which owns the townhouse, gallery, and other properties. His New York pistol license identified him as an officer of Wildenstein & Company. And following his arrest for pointing the weapon at Jocelyne and her bodyguards, he insisted that he should be released on his own recognizance because of his substantial ties to the community.

Nonetheless, he filed no federal tax returns. And no one in Washington or New York noticed. Or cared. Under ordinary circumstances, even the complex tax returns of the very wealthy that are filed go unchecked. That's due to a deliberate decision by Congress to starve the IRS, both in operating funds and in manpower and expertise to conduct such audits. So forget about ferreting out serious nonfilers among the rich and prominent. That task doesn't even register on the tax fraud radar screen. Not surprisingly, representatives of Alec Wildenstein declined to discuss his tax affairs. Jocelyne's lawyer said she doesn't know anything about taxes, since Alec controlled the money. And the IRS can't comment on the tax matters of private citizens. Or in this case, the non-tax matters.

In the divorce case, Alec argued that he was not a resident of the United States, that he had a Swiss passport and visited this country on a tourist visa, and that he did not have a green card permitting him to work. Furthermore, he contended that he had "less than $75,000 in bank accounts" and that "my only earnings are approximately $175,000 per year." On a net-worth statement, Alec listed his occupation as "unpaid personal assistant to father Daniel Wildenstein." That stirred the ire of State Supreme Court Judge Marilyn G. Diamond, who presided over the hostilities. "He fails to explain why he is 'unpaid,'" said Diamond, adding that "this contention insults the intelligence of the court and is an affront to common sense."

Judge Diamond was also angered that Alec never bothered to attend the divorce hearings. Shortly after Jocelyne began unveiling intimate details of the couple's private life, he fled the country. He ignored repeated court dates, failing to appear to answer either the gun charges or his wife's allegations. At one hearing, an irritated Diamond excoriated Wildenstein in absentia for his refusal to obey court orders and to attend depositions. His attorney, Raoul L. Felder, the New York celebrity divorce lawyer, offered an explanation for his client's behavior:

"It may not be his disinclination to appear before the court. You are aware there are substantial tax problems we believe created by the plaintiff."

Judge Diamond agreed. "There are going to be more substantial tax problems," she said. "There are more substantial potential tax problems by people continuing to take certain positions. Make no mistake about it."

If this conjures up visions of battalions of vigilant IRS agents engaged in a relentless search to identify tax scofflaws and, when they do so, dun them for the taxes they owe, assess interest and penalties, seize their bank accounts and cars, freeze their assets, and auction off their possessions, well, that's what they are, visions - at least when it comes to the very rich. For the double standard is to tax-law enforcement what rock is to roll.

Suppose you earn $40,000 a year and don't file a return. When the IRS catches up with you, it prepares a substitute return, estimates your income, calculates the tax you owe, tacks on interest and penalties, and sends you the bill. If you don't like their numbers, you must prove that they're incorrect. What's more, the agency may seize your bank accounts, your car, and whatever else you have of value.

Not so with the truly prosperous. First, the agency mails out a computer-generated letter asking the nonfiler to submit a return. When the reluctant recipient fails to respond, a second letter goes out. And then another. And another. If the silence persists, IRS resorts to another tactic: the telephone. It tries to find the number of the missing nonfiler and place a series of calls. When all that proves futile - it generally does nothing.

Nothing?

That was a finding of a 1991 study by the General Accounting Office (GAO), the investigative arm of Congress, that examined the IRS's handling of affluent nonfilers: "IRS does not fully investigate high-income nonfilers, which creates an ironic imbalance. Unlike lower income nonfilers in the Substitute for Returns program, high-income nonfilers who do not respond to IRS' notices are not investigated or assessed taxes. Even if high-income nonfilers eventually file tax returns, their returns receive less scrutiny than those who file returns on time."

What's the IRS's explanation for the double standard? Incredibly, it told the GAO that it does not prepare a substitute return for rich nonfilers, as it does for middle-income people, because it fears that it might "understate taxes owed." In other words, no loaf is better than half a loaf. So do nothing. Second, the GAO said, "to pursue more high-income cases, IRS would need additional staff." Which, of course, is precisely what Congress refuses to provide.

But things have changed since that critical 1991 audit tried to prod the IRS to act, right? Indeed they have. With each passing year, the number of affluent nonfilers has gone up while Congress has continued to slash the service's auditing capabilities. There is no better evidence of the agency's breakdown than the fact the Wildensteins went two decades without filing a tax return and the IRS knew nothing about it.

The Wildensteins also illustrate one of the weaknesses of the federal government's tax statistics. According to IRS data, more than 1,000 individuals and families with income over $200,000 paid no federal income tax in 1996. But the IRS counts only those people who actually file returns. The Wildensteins didn't. Nor did others in their class. As you might guess, the official estimates of the nontaxpaying rich are on the low side.

Dodging taxes, of course, is hardly a new phenomenon. For as long as there has been an income tax, there have been people who have sought by every imaginable means, and some means not so imaginable, to avoid paying it.

In fact, as far back as 1916 - just three years after the income tax was enacted - newspapers across the country published a syndicated series titled "The United States Income Tax Steal!" The first article began: "Three hundred and twenty million dollars of your money was stolen last year through income tax frauds and evasions, involving thousands of wealthy and prominent citizens and thousands of the most profitable American corporations."

In the late 1930s, when the income tax still applied only to the more prosperous, and before it reached into the pockets of every working American through withholding, many of the wealthiest citizens devised various schemes to escape it. The top rate back then, by the way, was 79 percent on taxable income over $5 million. That's a rate that would double the tax bills of tens of thousands of today's billionaires and millionaires, like Bill Gates, Warren Buffett, and Wal-Mart's Walton family.

On June 8, 1937, Henry Ellenbogen, a Democratic congressman from Pittsburgh, took to the floor of the House to denounce the avoiders and evaders. "A few extremely wealthy individuals have resorted to every trick and every device which their lawyers could conceive to avoid the payment of taxes justly due by them," he said.

What kind of "tricks" was Ellenbogen talking about sixty years ago? He explained:

[One] American millionaire organized no less than ninety-six personal holding companies all over the country so as to make it difficult, if not impossible, for the Treasury Department to follow his complicated financial transactions.

Some of our multimillionaires have incorporated their yachts and their landed estates so that they can deduct the expenses for their upkeep from their incomes and escape a tax thereon.... Let me remind you that the ordinary citizen is not involved in these tax schemes.

And thus it has been ever since. For more than eighty years, newspapers, magazines, and books have chronicled the stories of citizens who fail to pay their taxes. But these scofflaws represented an insignificant portion of the population - until the 1970s, when tax cheating began to move gradually into the mainstream.

In November 1979, Senator Lloyd M. Bentsen Jr., the Texas Democrat who would go on to become President Clinton's first Treasury Secretary, expressed concern that "an alarming trend" was emerging: Otherwise honest citizens were cheating on their taxes.

In April 1983, then IRS Commissioner Roscoe L. Egger Jr., talking about tax evasion, said that "all the signs are that it has been growing and is continuing to grow."

In April 1984, the Wall Street Journal reported that "the IRS is losing the battle against tax cheats. Its high-tech wizardry and strengthened legal arsenal can't keep pace with an ever-growing army of tax evaders hiding in a jungle of complex laws."

What's the difference between 1916, 1938, 1984, and this first decade of the twenty-first century?

Just this: That "army of tax evaders," its ranks swollen by legions of fresh recruits, is on the verge of declaring victory. While once upon a time tax dodgers could be counted in the hundreds of thousands or a few million, they now number in the tens of millions and account for between one-third and one-half of the taxpaying population.

One reason for the dramatic increase: Lower- and middle-income taxpayers are frustrated with a system that is overly complex and that favors the wealthy. Congress has arranged the tax code in a way that allows those at the top to escape payment of taxes in lawful ways that are not available to average working people. Hence the attitude "If someone who makes twenty times or a hundred times or as much as a thousand times more than I do can legally reduce their taxes courtesy of Congress, why shouldn't I do the same illegally?"

This inequity between income classes has grown more pronounced over the last two decades, especially when federal, state, and local taxes combined are factored in. That's because Congress and the White House have shifted the cost of programs once funded by the federal government to the states and cities. Those governments traditionally have relied on taxes, such as sales taxes, whereby the burden falls as income rises. In addition, the explosive growth in self-employment has further aggravated tax disparities. The self-employed must pay both the employer and employee shares of Social Security and Medicare taxes - or 15.3 percent right off the top.

To better understand the inequities, consider the tax bills of two households: a single, self-employed health care worker living in Philadelphia, and Bill and Hillary Clinton of Washington, D.C.

On their 1998 tax return, the Clintons reported adjusted gross income of $509,345. They paid a total of $112,496 in local, state, and federal taxes. Their overall tax rate: 22 percent.

A Philadelphia woman working as a self-employed home health care attendant that year who earned $25,000 paid a total of $8,129 in local, state, and federal taxes. Her overall tax rate: 33 percent.

Thus, while the Clintons' total income was twenty times greater than that of the Philadelphia worker, her tax rate was 50 percent higher than that of the president and first lady.

To be sure, the Clintons' tax rate was held down because of hefty charitable contributions. But even Vice President Al Gore and his wife, Tipper, with an income of $224,376 and average charitable contributions, paid overall taxes at a rate of 24 percent - still 9 percentage points under the Philadelphia health care worker's.

Given a president whose tax rate is less than that of a working woman whose income is one-twentieth of his, and with people like the Wildensteins, who spend more money on food and wine alone in one year than most taxpaying families earn in ten years and who don't even file a return, it is inevitable that millions of people at the low end of the economic spectrum would be inspired to file returns and secure refunds fraudulently.