Invisible Workers and Untaxed Profits

(Page 3 of 3)

None of this is to suggest that you need establish a mysterious offshore link and work for companies based in tax havens to avoid paying U.S. income tax. Truth to tell, many people in the computer field, especially programmers and systems analysts at the largest companies in America - from Chrysler Corporation to the Baby Bells, from Bank of America to Unisys - pay not a penny in income or Social Security taxes.

How can this be? Consulting and contracting firms recruit so-called temporary workers in other countries, especially India, and bring them to the United States under a special visa called H-1B. They farm out these foreign programmers to large U.S. companies that do not want to add permanent employees to their payrolls or to replace higher-paid American workers whose jobs have been eliminated. Still other clients are state governments that contract out computer work.

During the 1990s, nearly 1 million foreign computer technicians came to the United States to work for a maximum of six years under this program, and then, in theory, return home. Most decided to stay. If some members of Congress - and computer and software companies like Microsoft, Intel, and Hewlett-Packard - get their way, the ranks of the foreign workers will swell to 2 million this decade.

The reason: Computer companies are lobbying lawmakers to raise the cap limiting the number of such visas to 200,000 a year. Under existing law, the cap was slated to fall from a high of 115,000 in year 2000 to 65,000 in 2002. Fortune 500 companies complain they cannot find enough qualified American workers to fill openings. Critics charge the companies want to drive down wages by hiring cheap foreign labor. A computer industry magazine finds this perfectly acceptable: "Companies have a fiduciary responsibility to keep labor costs low. If U.S. technology companies cannot find highly trained, highly motivated American employees at a competitive cost, then a shortage does exist. And if companies say they want to hire more skilled foreign workers because those workers are cheaper, we should believe them - and increase the number of visas issued."

In addition to their willingness to work for lower salaries - as much as $25,000 lower - many foreign recruits, at least when they first come to this country, enjoy another advantage over American workers competing for the same jobs: They don't pay U.S. taxes.

Visit most any large American company and you will find two people working on the same computer project. One is a permanent company employee who pays taxes through withholding. The other a temporary employee who enjoys the kind of payday that more than 100 million American workers can only dream about - a full paycheck with zero deductions.

Because they are employed by the consulting firm that recruited them, many of these foreign workers are paid either in cash or by check - and no money is withheld for U.S. income tax, Social Security, Medicare, state, or local taxes. What's more, they often live in rent-free apartments with free meals, all courtesy of the consulting firm that hired them. Still others receive a paycheck that is banked in India, and, while they're living and working in this country, they're paid an "allowance" that is also free of all U.S. taxes.

This widespread practice came to light during a little-noticed civil lawsuit in which one consulting firm accused another of raiding its employees from India. The legal action was filed by Tata Consultancy Services, a division of Tata Sons Ltd., of Bombay, against Syntel Inc. of Detroit in U.S. District Court in Detroit in 1990. The dispute dragged on for years, during which time numerous Tata and Syntel employees, most of whom had come to the United States from India on temporary visas, testified about the tax-free life of foreign programmers.

Among those questioned was Sujatha Subramanian, a female programmer from India, who, like others, was brought to the United States by Tata but later left to join Syntel. Technically, she was employed by a company in India called Leading Edge, which subcontracted her to Syntel, which assigned her to computer projects at Ford and Chrysler. She received a paycheck from Leading Edge that was deposited in rupees in a bank in India and she received a living allowance from Syntel in U.S. dollars. The following exchange is with a Tata lawyer.

Attorney:	What other kind of benefits are you receiving?
Subramanian:	None from Syntel.
Attorney:	None? Do you get your cost of living allowance from them?
Subramanian:	Yes. And I'm covered by health, covered for health and medical....
Attorney:	Do you pay taxes here in the United States?
Subramanian:	No.
Attorney:	Only in India?
Subramanian:	Yes....

In one of the cruel ironies that run through the American tax and labor systems, foreign workers who pay little or no U.S. taxes receive health care coverage through the contractors that place them, while millions of American workers in jobs with even lower wages pay taxes but have no health care benefits. Their employers do not provide coverage, and individual policies are too expensive. Yet the taxes they pay go in part to pay for the health care coverage of the poorest of Americans who qualify for Medicaid.

Another programmer, Rengaswamy Mohan, who was contracted out to work for Deloitte Touche in Florida, spoke candidly about his tax and employment status and the interwoven relationships between Syntel and other consulting firms in India. While working in the United States, Mohan received a paycheck from an Indian firm, Mascon, which was deposited in a bank in India, while Syntel gave him a living allowance. When asked during a deposition whether taxes were withheld from the monthly check of $2,270, Mohan replied:

"No. Actually, I was told that these were all the expenses and I was sitting as a consultant from India."

And a nice place to sit it is, the tax-free life in America. But Mohan also enjoyed another fringe benefit. He received a finder's fee for referring another programmer to Syntel.

Attorney:	How much did you get?
Mohan:	I don't remember, but, you know, I get like, so long as she is in this [Deloitte Touche] project, 50 cents an hour.
Attorney:	Fifty cents an hour for each hour she works on this project?
Mohan:	Yes.
Attorney:	... For how long? Is that forever? As long as she keeps working -
Mohan:	So long as she is in this project.
Attorney:	That's a good deal.

A really good deal, considering the programmer was his wife.

None of this is to suggest that every Syntel programmer pays no taxes. Some eventually go on the company payroll and are treated like other permanent workers - taxes are withheld from their paychecks. But court records show that for many, such is not the case. In this, Syntel is not alone.

In 1998, an Indian programmer in Chicago, worried that he might lose his bid for American citizenship, wrote a letter to the U.S. Department of Labor expressing concern over his off-the-books income.

Employed by a computer consulting firm in Chicago and farmed out to Ameritech, the programmer explained that when he came to this country he had been compelled to become part of a complex scheme by the consulting firm to evade taxes. He was not clear on all the elements that made up the fraud, but a key component was that his pay came partly in cash:

They told me that in this way neither they have to pay taxes nor I have to pay taxes on that amount. When I objected it, they told me that most of the other employees are paid in similar way. I asked my couple of colleagues ... everyone communicated that they are paid in same way. Part of the payment [almost 30 percent of the salary] they receive is not taxable and paid to them every month. Now I realize that this practice ... is illegal. I don't want to be part of this system, but presently I do not have any alternatives.

Where, you might ask, is the IRS in all of this? The answer is: Nowhere. "Immigration is a big problem for IRS," confided a former high-level Treasury Department official. "It doesn't know how to track foreign workers."

If Congress has guaranteed that the IRS is incapable of finding people who physically exist, whether they be foreign workers or the Wildensteins of the world, then what are the chances the agency will detect paper profits? Virtually none.

Of all the areas where fraud is easy to commit and most difficult to identify, capital gains income ranks near the top. Here's why.

The IRS receives a notice that you picked up $460,000 from the sale of stock. Let's say 5,000 shares at $92. You originally paid $30 a share, or $150,000. Subtract that sum and your capital gain - the amount on which you must pay taxes - totals $310,000. But the IRS doesn't know what you paid for the stock. They take your word for it. So you put down $75 instead of $30. Magically, $225,000 in taxable income disappears. That's a tax savings of $45,000.

Long before fraud became commonplace, the IRS never came close to collecting all the taxes owed the government from capital gains income. This was partly because of the complexity of the tax code, partly because of tax evasion by those who suspected, quite rightly, that the agency didn't have the resources to aggressively track underreporting.

Now it's much worse. In this first decade of the twenty-first century, the IRS is overwhelmed by securities transactions. Hobbled by inadequate resources, the agency poses little or no threat to people who understate their profits. As a result, capital gains fraud is skyrocketing.

From 1990 to 1997, the average capital gain reported on tax returns went up a modest 32 percent, from $13,400 to $17,700. That growth did not come close to matching the rise in the overheated stock market or the volume of daily stock trades. During those same years, the Dow Jones Industrial Average leaped 200 percent. Trading volume was up even more, spiraling 297 percent.

Other data are even more compelling. In 1990, wage and salary income reported on all tax returns totaled $2.6 trillion. By contrast, the value of all stock trades that year on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ over-the-counter market added up to $1.8 trillion. Thus wage and salary income was 1.4 times greater than the value of stock trades, a pattern that had long been the norm.

By 1997, that ratio had been reversed, as the value of stock trades reached a staggering $10.4 trillion - or 2.9 times greater than wage and salary income of $3.6 trillion.

What all this means is that the opportunities for fictional accounting have never been greater. Just how great, you ask? Consider that in 1990, net capital gain income reported on tax returns was 6.8 percent of the value of stocks traded. By 1997, that figure had fallen off by half, to 3.3 percent - a seemingly impossible decline during an era of sizzling stock market activity.

What would capital gains income have totaled if the 1990 ratio had been in place in 1997? Over $700 billion, or double the reported sum of $348 billion.

To be sure, tax law changes and other economic factors may account for some of this difference. Also, the stock market is just one slice of the capital gains pie, albeit a large one. Sales of commodities, futures, real estate, and other capital assets must also be factored in. Nevertheless, a chunk of the difference is attributable to tax fraud.

Who's benefiting from this?

While Democrats and Republicans alike talk of the nation's booming economy, and how everyone is in the stock market, the IRS's tax return data tell another story. A comparatively small number of people report taxable income from the sale of capital assets, and only a tiny fraction of those rake in most of the profits.

In 1996, for example, 915,000 individuals and families with incomes of more than $200,000 reported receiving $171 billion from the sale of capital assets. They accounted for only 8 percent of the returns - but collected 67 percent of the money.

The Perfect Tax Return: Always a Refund

While tax dodging among investors is rampant, fraud within another part of the population is even more widespread. That would be the fastest-growing segment of the U.S. economy: the self-employed.

Historically, this group has been a major source of taxpayer fraud and error. Studies have shown "they are less compliant" than other taxpayer groups, and that they "appear to be intentionally non-compliant more often" than taxpayers who receive a weekly paycheck.

What accounts for this reputation? Many of these businesses are operated on a cash basis - nail salons, beauty salons, restaurants, mom-and-pop grocery stores, landscapers, child care providers, antiques dealers, independent auto repair shops, plumbing and heating contractors, truckers, painters, and electricians. In addition to depending on cash, these businesses are subject to fewer requirements for information returns, such as the 1099 notices that banks must submit to the IRS reporting interest payments. Also, there's usually no withholding in these or scores of other occupations and professions, such as lawyers, accountants, computer programmers, physicians, and nurses. Again, no paper trail.

That's why one study carried out in the late 1980s - and which has never been updated - found that even back then the self-employed did not report 25 percent of their income. Evasion and avoidance across the board have escalated since then. In 1994, another study found that fewer than half the self-employed paid the Social Security and Medicare taxes owed.

Let's put this in more personal terms. Suppose the self-employed now report 60 percent of their income, a charitable assumption. Multiply your annual income, say $45,000, which you receive in a weekly paycheck with taxes already deducted, by 60 percent. That comes out to $27,000, which you enter on your Form 1040. With the stroke of a pen, $18,000 of your income disappeared from the taxman's view. The savings: $1,377 in Social Security and Medicare taxes and $2,400 in income tax, thereby providing an extra $3,777 in spending money.

While fraud has always existed in this area, the volume and scope have been shooting up. One reason is the emergence of involuntary self-employed people, like the computer workers at large companies who are replaced by the nontaxpaying foreign computer workers. These displaced workers, who once paid taxes, are forced to go out on their own. They rent themselves out, doing the same work but for less money and no health care or other fringe benefits. These embittered former corporate employees often feel no special obligation to prepare an accurate tax return.

This is especially true when they see the effect their independent status has on their tax bill. It goes up. Remember the health care worker who pays total taxes at a higher rate than the president of the United States? Her largest tax bill is for Social Security and Medicare. She must pay both the employer's and employee's share, which adds up to 15.3 percent of her income. Add to that the federal income tax and state and local taxes.

Not surprisingly, the self-employed are keeping a larger share of their income for themselves than in the past. A Los Angeles economic development official says, "It used to be 'a dollar for the IRS, three dollars [in unreported income] for me.' Now it's 'a dollar for the IRS and eight for me.'"

The data bear this out. From 1980 to 1997, the average amount of receipts reported by the self-employed inched up a meager 10 percent, from $46,000 to $50,700 - lagging far, far behind the inflation rate of 95 percent and other economic yardsticks. During the same period, average wage and salary income on all tax returns rose 116 percent. Gross domestic product per capita jumped 148 percent.

These and other statistics suggest that the self-employed are understating their income by upwards of $250 billion - a sum that grows yearly. That's a tax loss of $50 billion, the equivalent of the income tax paid by everyone who earned less than $50,000 a year in Connecticut, New Jersey, New York, Ohio, Pennsylvania, Maryland, Massachusetts, Indiana, Virginia, West Virginia, and Delaware. That $50 billion, by the way, is calculated on unreported income only. It does not take into account inflated, phony, or inappropriate deductions that allow business owners to escape billions more in taxes.

Some of the self-employed do their own creative accounting. Others take their make-believe numbers to a tax preparer. Increasingly, accountants say, the business owner tells them how much he or she wants to pay in taxes and instructs the tax preparer to arrive at that figure. Sort of like the ordinary working person deciding how much he or she would like to pay in taxes, and then adjusting income and deductions accordingly.

A veteran IRS examiner confirms the practice is widespread and adds that the goal of many self-employed persons is to pay no taxes at all. As an example, the examiner pointed to the operator of a fast-food franchise who lived with his family in an affluent neighborhood, sent his child to a private school, and paid not a penny in income tax. When the IRS examiner questioned the tax preparer about the return, the preparer replied: "If I don't do what he wants, he won't pay me. He'll go to someone else."

That's the way the system works. If one tax preparer declines to produce a return showing the desired result, some other one will. Opportunities for this kind of fraud have multiplied. Tax returns filed by those who report income from a trade or business have shot up four times as fast as those filed by individuals and families who report wage and salary income, spiraling from 9 million in 1980 to 17 million in 1997.

Not all errors on self-employed returns come from cheating. Some individuals are genuinely confused by the complexity of the Internal Revenue Code and make honest mistakes. For others, their perceptions of what should be considered legitimate deductions or income lead them to make mistakes - almost always in their favor. One way or another, it costs the Treasury and other taxpayers.

So who, exactly, are we talking about here?

These are people like the Los Angeles-area lawyer whose extracurricular horse-breeding business racked up $132,253 in expenses over seven years while bringing in only $752 in income. The lawyer used the $131,501 in losses from the horse venture to offset taxable income from her law practice and reduce her tax bill. Over seven years, she reported that net profits from her law business averaged just under $20,000 a year. In one year, 1995, she reported a loss of nearly $39,000. Expenses of her horse business averaged slightly under $19,000 a year. In addition, the lawyer filed her tax returns from one month to seven years late. And she understated the income from her law practice by $32,000. The IRS concluded - and the U.S. Tax Court agreed - that she owed $34,000 in back taxes and $8,500 in penalties.

A New York opera singer wrote off over five years $70,000 for travel and entertainment, $18,000 for meals, $23,000 in commissions, $7,400 for insurance, and $5,500 in bad debts. In all, he claimed $126,525 in business expenses that the IRS disallowed. That was in addition to $90,825 in other deductions that were disallowed, including $49,839 in employee business expenses. He filed his tax returns from one to five years late. He ignored appointments with tax examiners. He failed to appear at tax court hearings. And he produced no records to substantiate his expenses. The tax court sided with the IRS and disallowed the business and other deductions, ordered the singer to pay $46,000 in additional taxes, and levied a $15,000 penalty.

An aging Hollywood screenwriter and his actress-wife wrote off expenditures made to revive their dormant careers. They reported business income of $1,574 and expenses of $34,942. A net loss of $33,368 offset other income and reduced their taxes. Among their deductions: $3,120 for trips to Branson, Missouri, and Las Vegas and Laughlin, Nevada, where they watched country and gospel performers to inspire him to write song lyrics. He didn't sell any. They deducted $1,140 for tickets to movies, concerts, and plays because he planned to write the book and lyrics for a Broadway musical comedy. He didn't. They wrote off $4,615 to cover the cost of research trips to Alaska and Mexico. The purpose of the Alaska trip was to obtain onsite photos - taken by the wife - and collect other material for a screenplay. The trip to Mexico was to meet a comedienne for whom he hoped to write material. Neither worked out. They wrote off $2,480 for business use of their travel trailer - including campground fees, repairs, insurance, and registration - and $8,540 for use of their 1970 Ford truck on business trips. They wrote off $5,132 in home office expenses, including pool service, cable television, home improvements, and yard service. They deducted $1,114 for their home telephone, including all long distance calls. They wrote off $569 for two television sets, a VCR, and videotapes. And they carried over a net loss from the previous year of $15,892. The tax court disallowed all these deductions. Over five years, the couple claimed net losses of $142,000 from their "business."

By now, you get the idea of the pleasant tax advantages enjoyed by the self-employed, at least those who never see an IRS examiner, which is the vast majority. Unlike average paycheck-drawing Americans, they often write off personal expenses incurred by everyone and label them business expenses, and they engage in hobbies masquerading as businesses that seldom earn a profit. These expenses and losses, in turn, are subtracted from other income, thereby reducing or eliminating the taxes they owe.

One of the more brazen cases that shows how pervasive fraud has become among the self-employed is the story of Gail Carlette Dixon of East Palo Alto, California. Dixon was a tax preparer who also provided property management and notary services. From 1990 to 1992, her income from this work totaled $368,000, or about $123,000 a year. That should have placed her among the top 5 percent of tax-return filers. But it didn't. Dixon did not file returns for those three years. She was one of more than a million self-employed nonfilers - one of the few to get caught.

As it turned out, Dixon's personal fraud was incidental to her contribution to the great American tax dodge. People who turned to her Cozy Home-Dixon Tax Service for professional tax help in those years were never disappointed. In fact, they must have felt like they had won the lottery.

In one of those tax miracles that occur far more frequently than the IRS, the Treasury Department, and Congress will ever let on, Dixon achieved the equivalent of pitching not one perfect baseball game, but a perfect game every day of the season for her clients. Every single person who walked into her office in 1990 carrying tax papers walked out with a return showing a refund owed by the IRS: 2,336 returns in all. It was Dixon's best performance. In the next two years, 99 percent and 98 percent of her clients collected refunds.

The returns were models of ingenuity, with phony claims for the earned income tax credit, as well as child and dependent care credits, and phantom deductions for mortgage interest, real estate taxes, charitable contributions, medical and dental bills. The amount of the false claims ranged from $375 to $17,599, and totaled more than $200,000 overall.

This impeccable refund record finally attracted the attention of the IRS. An agency spokesman observed with some understatement at the time that "a 100 percent rate would be unusually high." The IRS raided Dixon's office and seized sixty boxes of records. She subsequently was indicted and convicted on fourteen counts of aiding and abetting the filing of false returns. After eighteen months in a minimum-security facility, Dixon was released with the understanding that she would file her personal returns for 1990, 1991, and 1992. She owed $92,000 in back taxes, plus $28,000 in penalties, bringing her total tax bill to $120,000.

Tax preparer Dixon said she failed to file her own tax returns because she was "too distraught over her husband's death" in October 1990, and that she was taking a lot of medication while under a physician's care for stress. But apparently not so much stress as to interfere with production on her refund assembly line. In 1991 alone, she managed to prepare 2,765 tax returns.

Let us review. Tax preparers who craft phony returns for others and don't bother to file themselves. Self-employed persons who write off their personal expenses or deduct their hobby losses from their income. Concealed capital gains from the sale of stocks. Immigrant workers who live tax free. Independent businesspeople whose living expenses are paid for by offshore corporations. Poor people - and some not so poor - who collect earned income tax credit refund checks to which they are not entitled. Rich people who file returns and don't pay taxes. Rich people who don't even file.

As for the IRS cracking down on these schemes, there's not much chance, given the agency's current level of funding. That's really good news for those who are engaged in the latest mass tax-dodging craze: stashing money and assets in secret accounts in the tax havens of the world - beyond the reach of the IRS.