Phantom Children

(Page 2 of 3)

The earned income tax credit (EITC) is one of the few antipoverty programs to survive from the 1970s that has won praise from Republicans and Democrats alike.

President Ronald W. Reagan, a Republican, called it "the best antipoverty, the best pro-family, the best job-creation measure to come out of Congress."

President Clinton, a Democrat, asserted that "this is not a handout.... It gives some breathing room to people who day in and day out have done everything they could to take care of their families, to make their own way, to be self-supporting taxpayers."

Although Congress has amended and expanded the program in the years following its enactment in 1975, its purpose has remained the same: to use the tax system to encourage the poor to seek employment rather than welfare, and to offset the impact of Social Security taxes on low-income workers with families.

Most qualified working individuals and families receive a check for the amount of the credit. Others reduce or eliminate the income tax they owe, depending on the number of eligible children and the amount of their income from jobs.

For example, for tax year 1998, workers who had two children and who earned between $9,390 and $12,260 received a maximum credit of $3,756. The credit phased out by the time someone's income reached $30,095.

Curiously, as the nation moved from recession at the beginning of the 1990s to a period that economists and politicians have labeled the best of all times, with a stock market that went in only one direction - up - tax returns with the earned income credit rose sharply instead of plunging, as might have been expected in a robust economy. From 1990 to 1997, returns filed by people claiming the credit - meaning they worked but said they didn't earn enough to maintain even a poverty-level existence - soared 56 percent, from 12.5 million to 19.5 million. Returns claiming an EITC refund check went up even faster, climbing 78 percent, from 8.7 million to 15.5 million. A majority of the returns were by heads of household; most were age twenty-five to forty-four.

Astonishingly, returns filed by all other individuals and families reporting wage income barely moved during the period, edging up a scant 1 percent - from 84 million to 85 million. Thus, in the eight years from 1990 to 1997, the number of tax returns by all other working taxpayers went up just 1 million.

This during a time when 14 million men and women joined a burgeoning workforce that grew by 13 percent, from 109 million to 123 million.

This during a time when personal consumption expenditures jumped 45 percent, from $3.8 trillion to $5.5 trillion.

This during a time described repeatedly by President Clinton as the "longest peacetime economic expansion in our history."

How is it possible for the ranks of the working poor to shoot up during such a time? For the amount of EITC refunds paid out by the IRS to surge 400 percent, from $5 billion to $25 billion?

Two words account for much of the increase: runaway fraud. As many as 5 million earned income credit returns are fabricated or contain errors that favor the filer. That's the equivalent of every taxpayer in Arkansas, Delaware, Kansas, Nevada, Nebraska, and Wyoming filing a bogus or inflated return. The cost of the fraud: an estimated $8 billion. That's comparable to all the taxes paid by every taxpayer who earns less than $50,000 a year in Minnesota and Michigan. Think of it as a direct transfer, from workers in those two states to earned-income tax cheats.

The fraud takes many forms. Men "borrow" a child or two from the women they live with or date. Grandmothers claim the tax credit for their grandchildren, when mothers of the children are not eligible for it. Some invent children but use actual Social Security numbers. Some fabricate children and Social Security numbers. Some parents with children don't work, but submit mythical W-2 forms showing income from phantom jobs. In border cities like El Paso and Brownsville, where Mexicans cross legally each day to work in the United States and return home at night or on weekends, they file U.S. tax returns, claim their children as dependents, and collect the credit even though the children live in Mexico.

Tax statistics confirm that border states and other states with large numbers of illegal immigrants account for a disproportionate share of EITC returns. For the nation as a whole in 1997, 19 percent of all tax returns with wage income claimed the credit. In New Mexico, it was 28 percent. In Texas, 26 percent. Florida, 24 percent. Arizona and California, 21 percent. By way of comparison, in New Hampshire, a state with few illegal immigrants, just 12 percent of the returns sought the credit.

The variety and extent of the fraud are limited only by the imagination and ingenuity of those seeking the "refunds," or the tax preparers who encourage them to do so. In many cities, independent tax firms working out of storefronts have recruited people to file EITC returns and pocketed a percentage of the refund. The fraud has also been abetted by electronic filing, which eliminates paperwork and speeds up the refund.

But don't blame the IRS for all the earned-income fraud. Blame Congress, which gave what essentially is a welfare program to the tax collector to administer. Sort of like asking your lawyer to perform your root canal.

In this case, the fraud is the kind that, absent an investigation of each individual return, is nearly impossible to prove. As the General Accounting Office put it, EITC "eligibility, particularly related to qualifying children, is difficult for IRS to verify through traditional enforcement procedures, such as matching return data to third-party information reports. Correctly applying the residency test... for example, often involves understanding complex living arrangements and child custody issues."

Translation: Unless the IRS sends an army of agents into the field to confirm the existence of children named on returns, and determine whether the filers actually supported the children and are otherwise eligible, there's no way to document individual fraud. Obviously, this kind of wholesale, intrusive investigation has never been an option. Even if the IRS had the personnel to do so, Congress, fearing public backlash, would never allow it. And that was before lawmakers in 1998 ordered the IRS to become a taxpayer-friendly, service-oriented agency, and to tone down its image as a tough enforcer.

Even before Congress curbed the IRS's enforcement powers, the GAO had concluded that "the incentive to file problematic returns is likely to increase as IRS' capability to verify information on the return decreases."

Secrets of the System

The IRS's limited ability "to verify information" extends well beyond the tax returns of the working poor. Another growing bloc of tax dodgers consists of people who have structured their personal and business lives in a way that allows them to ignore the tax collector.

They do this through endless schemes. They move money between U.S. and foreign bank accounts to disguise its source and destination. They use other names on bank and brokerage accounts. They shift assets and money in a dizzying maze involving U.S. and foreign corporate entities. They arrange for third parties to pay their bills from tax havens. They buy stock at bargain-basement prices offered to insiders and sell it for large gains without reporting the income. They intermingle personal and business expenses. And when questioned about their finances, they offer explanations that are as disorienting as their deals. To unravel such a bewildering array of transactions and estimate the amount of tax owed would require a task force of IRS agents - one for each person or family.

Unlike the Wildensteins, whose very existence was unknown to the IRS, these people are well known to the agency. They are everywhere. Many are your next-door neighbors. People like Stanley and Jean Schulman.

The Schulmans, who until 1999 lived in a three-quarter-million-dollar house in a gated community in Bell Canyon, California, thirty miles northwest of downtown Los Angeles, have led a comfortable life. He's an investment consultant. She's a former computer analyst who retired from Blue Cross about 1986. They travel in Europe. They drive late-model vehicles. They have provided cars for their six children. They entertain. In 1994, Schulman said his yearly income had averaged about $300,000 from 1984 until that time. That would have placed him among the top 1 percent of the nation's taxpayers - if, that is, Schulman had paid taxes. But he hadn't, not in any of those years. As he explained in May 1994 during a deposition in a lawsuit filed against him by a businessman seeking to collect a money judgment: "I have not paid income taxes since 1968 and I cannot discuss my income taxes because I don't pay them.... I don't have any income that is taxable, so I don't pay income taxes."

But then he paid income tax in another country, right? Wrong. "I have paid no taxes to any sovereign entity in the world since 1968. I have minimized my tax liability," Schulman said.

Minimized indeed. But how? In part, by shuffling "large sums of money between various offshore accounts." In part, by having offshore companies pay personal expenses.

Schulman worked as a consultant for a company called Albemarle Investments Limited, which maintained an office in London but was organized on Guernsey Island. Guernsey is one of several tiny islands in the English Channel that have been notorious tax havens for decades. Schulman once explained Albemarle's business this way: "It is a full-service financial company.... It provides each and every type of service that any full-service financial corporation would for individuals and corporations throughout the world."

As for his role, Schulman said, "I arrange for them to invest money in various companies around the United States, England, Canada, Europe, and I help manage investments. I arrange individual clients to open accounts with them for tax limitation purposes." In other words, he sets up deals so clients can drastically reduce or eliminate their taxes.

Schulman said he received about $250,000 a year from Albemarle, and that he pulled in another $50,000 for providing similar services to a second offshore company called Coubert Dennis Limited in Ireland. From both, he received shares of stock as payment for his work, which he sold to generate cash.

To appreciate how the Schulmans lived the tax-free life, let's take a look at their household expenses. Typically, individuals and families work to save money for a down payment to buy a house. That money, naturally, represents earnings on which taxes have been paid. After moving into the new home, they pay the monthly mortgage charge, as well as utility bills, with wage income earned, once again, after taxes. Or more accurately, after the taxes have been withheld from paychecks. That's how the system works for most people.

Not so for the Schulmans and millions of others like them. In Stanley Schulman's case, Albemarle Investments, his self-described "employer," decided to take a flyer in California real estate late in 1993 because "everybody felt that the market was coming back and there would be a big upsurge in property value."

In one of those happy coincidences, the Schulmans just happened to be in the market for a new home at the time. Stanley scouted out the area and settled on a $600,000 five-bedroom, four-and-a-half-bath home on a 2.65-acre lot in Bell Canyon, complete with spa and horse corral. On orders of Albemarle Investments of Guernsey, a California corporation was formed with the identical name, Albemarle Investments Limited, to hold title to the real estate. Schulman was president of California Albemarle.

At closing, Guernsey Albemarle wired $320,000 into a Bank of America account of California Albemarle for the down payment, and financed the $300,000 balance with a private loan. Did Schulman know how the offshore Albemarle came up with the $320,000? "No, I don't," he said.

To sum up: Schulman selected a house for California Albemarle to purchase as an investment for Guernsey Albemarle, and signed all the papers as president of the California company. In addition to being an "investment," the house also would be the Schulman family homestead, as well as the address for several businesses.

What does the rest of the California Albemarle investment portfolio look like? Not much. In fact, the Schulman house was Albemarle's only investment. But it wasn't the company's only expense. When the monthly gas, water, and electric bills and homeowner's fee arrived, all were paid out of an Albemarle checking account at the Bank of America, thereby relieving the Schulmans of the need to spend after-tax dollars on mortgage and housing expenses, as other people must.

Guernsey Albemarle was quite generous in other ways. The Channel Island company leased two cars in 1994 for Schulman and his wife - a 1994 Lincoln and a 1994 Ford Explorer, sparing the family yet another expenditure. Schulman received the cars, he said, "in exchange for the services" he provided to Albemarle. And that wasn't all. Guernsey Albemarle also leased six additional Ford Explorers. Listen to this exchange during a deposition in March 1995 between Schulman and a lawyer representing one of his creditors, as the lawyer seeks to learn the whereabouts of the mini-fleet of vehicles:

Attorney:	Does Albemarle Investments have any other automobiles?
Schulman:	Yes.
Attorney:	Can you tell me what those are?
Schulman:	Ford Explorers.
Attorney:	They have Ford Explorers? How many?
Schulman:	Approximately six.
Attorney:	Approximately six. Do you know where they are located?
Schulman:	... Well, in L.A.
Attorney:	All in Los Angeles? Do you have any idea who is in possession of them?
Schulman:	Yes.
Attorney:	Can you tell me who that is?
Schulman:	My children.
Attorney:	Your children. How many children do you have again, I'm sorry?
Schulman:	Six.

Schulman later explained that five of his children drove Ford Explorers leased by Albemarle, and the sixth car was on loan to a friend. His sixth child drove a Cadillac originally leased by Coubert Dennis. Why would a Guernsey Island company lease sport utility vehicles for Schulman's children, who did no work for that company?

Because the president of Albemarle, one William Daniel Dane, authorized it to do so. Schulman recounted events leading up to the leases: "The company owed me a fee at the time and [Dane asked] 'How do you want it?' I said, 'Well, why don't we just authorize the company to lease cars for my kids.' And he said, 'Go do it.'"

Inside the Schulman house, Guernsey Albemarle provided the Macintosh computer and Coubert Dennis furnished the fax machine. The two companies also paid the monthly charges on Schulman's MasterCard and Visa accounts. On occasion, Schulman wrote the corporate checks on the California Albemarle bank account - at the direction of Guernsey Albemarle, of course, and as an agent of the company. As one might gather by now, Schulman owned nothing in his own name. He maintained no records of financial transactions. He wrote no personal checks. He destroyed all documents.

How did Schulman arrange his affairs so that he paid no income tax? A walk through one of his financial transactions is enlightening.

In late summer 1993, one of the brokerage accounts he maintained sold stock in Medgroup Inc. for $19,332. The company described itself as an operator of physical therapy clinics in California and Arizona. Schulman had received the stock from Albemarle in return for services he performed for Medgroup on Albemarle's behalf. Yet he never saw the cash. The $19,332 was routed back to the United Kingdom and into an Albemarle bank account that paid his credit card charges, car, and other personal bills.

Schulman also resorted to other tax-free practices. But let him explain:

"You have two things that you have to look at. If I take you to dinner and spend $300, I'll pay cash for it because nobody will ever know I spent the cash. If I buy a pair of shoes, I'll bill it to the company, because people can see the shoes."

Schulman allowed that he did pay some personal expenses out of his pocket. "I pay for the dry cleaning, clothing ... the vet bill on my dogs and cats. Just having one of our cats operated on ... was $700 estimated.... I pay for my granddaughter's tutoring monthly.... It's just normal living expenses." And he paid the tuition, books, and health insurance for one daughter attending UCLA.

Sometimes even basic needs - such as food - were mysteriously provided for, as this exchange between Schulman and a lawyer during a deposition in June 1995 demonstrates:

Attorney:	Between March and today, how have you made a living?
Schulman:	I haven't.
Attorney:	You haven't made any payments toward living?
Schulman:	None.
Attorney:	You purchased any food in the past three months?
Schulman:	My wife has.
Attorney:	How does she make those payments?
Schulman:	She has some cash in the bank and I believe she borrowed some money.
Attorney:	When she was last here I recall that she testified while you were sitting here that she received all her money from you.
Schulman:	Yes.

To summarize, Jean Schulman has no income of her own. She gets her money from her husband. But he doesn't have any income either. Yet she pays for the family food that he can't buy because he doesn't have any money. But wait. There's more. Jean Schulman has her very own Bank of America Visa card, and uses it to pay the monthly bills in the same inscrutable way as the grocery bills. Listen to an exchange between a lawyer and Mrs. Schulman during a deposition:

Attorney:	Are there outstanding debts on the card?
Mrs. Schulman:	Yeah.
Attorney:	Can you give me a ballpark figure in your estimation?
Mrs. Schulman:	Roughly $5,500 because that is the max on it.... Uh, $4,000 maybe. I don't know....
Attorney:	And you make the monthly payments on that account?
Mrs. Schulman:	No.
Attorney:	No, you don't? But it is your card?
Mrs. Schulman:	Right.
Attorney:	Who makes the payments?
Mrs. Schulman:	Stan.

The Visa card was but one of the credit cards Mrs. Schulman used. There were at least four others for department and specialty stores. Those bills were handled in the same way as her Visa account. She never saw them. She didn't know the balances. Her husband paid them. She maintained that she had no assets, owned no stocks or bonds, and had no investments.

Amazingly, while Mrs. Schulman was unable to say how much she owed on her credit cards, indeed, that she never even saw the bills because they were paid by her husband, and that she didn't have any income or assets of her own, and that she didn't file state or federal tax returns because she didn't have any income, she did manage to come up with money to engineer the acquisition of a company. Once more, the story is best told through the deposition of her husband. He is explaining that when California Albemarle filed for Bankruptcy Court protection, he once again became president, at least temporarily. Remember, California Albemarle's only holding is the Schulman family home.

Attorney:	You're still president of the Albemarle California Company?
Schulman:	I am president until the day the bankruptcy is adjudicated at which time the new president is being appointed.
Attorney:	How do you know that?
Schulman:	The board told me.
Attorney:	The board told you that? What does, who comprises the board?
Schulman:	My wife.
Attorney:	Your wife. How long has your wife acted as the board of Albemarle California?
Schulman:	Approximately since May of this year, when she acquired the company. I believe that she has sold the company, I'm not certain.
Attorney:	Oh, she sold the company already?
Schulman:	I'm not certain....
Attorney:	Currently, as president you're not certain if the company has been sold?
Schulman:	Y ep. Not my business.
Attorney:	How did ... your wife acquire the company?
Schulman:	She bought it.
Attorney:	She paid money for the company?
Schulman:	She advanced funds to the company....
Attorney:	And she did that with, she advanced the company whose funds or just, is it a loan or ... ?
Schulman:	As a loan....
Attorney:	As a loan. Was she to receive interest?
Schulman:	I don't know. I wasn't a party to any of the transactions.

To summarize once more, Mrs. Schulman, who by her reckoning had no income or investments and got her money from her husband, who himself had no income, advanced $67,000 to the company that owned the family home.

The Schulmans are just one example of why the federal tax system is crumbling. They enjoy a comfortable lifestyle in an upscale neighborhood, yet pay no income tax. To determine how much they owe would require a costly audit by teams of IRS agents. Multiply this one case by the millions and you get some idea why the words tax law and enforcement have become non sequiturs.

Not that the IRS hasn't tried to audit the family's finances. But by Stanley Schulman's own account, the efforts have been to no avail. "They try. They throw up their hands and they say, 'What do we do? We have no documents.'" In his skirmishes with the IRS that he related in 1994, Schulman said: "Right now they're willing to settle for three years of tax returns, even if I give them a zero balance, and I'm not quite sure that I want to do that. That's my current status with the IRS."

In April 1996, two years after Schulman boasted under oath that he paid no income tax, the IRS finally got around to filing liens against him, saying he owed $369,447 for 1990 through 1993. As of the summer of 1999, the liens were still outstanding.

Also that summer, the Schulmans and Albemarle sold the Bell Canyon house and moved to a new home in Devore, fifty-six miles east and north of Los Angeles. As a local business publication recounted the arrival of the newcomers:

A horse ranch in Devore is now the headquarters of Albemarle Investments Ltd., a venture capital firm that looks for promising start-ups and helps them with financing, management and eventually takes them public. The firm's headquarters are essentially embodied in Stanley Schulman, its founder and public representative. Schulman bought a five-acre ranch in Devore and moved from Ventura County in September. The business came with him.