The Biggest Tax Cheats: Rich Folks (Who Would Have Thought!)

A new study based on unpublished Internal Revenue Service data shows the rich are different when it comes to paying taxes: They hide more of their income.

The previously unreported study estimates that taxpayers whose true income was between $500,000 and $1 million a year understated their adjusted gross incomes by 21% overall in 2001, compared with an 8% underreporting rate for Americans earning $50,000 to $100,000 and even lower rates for those earning less.

(The "net misreporting rate," as the IRS calls it, includes both underreported income and inflated deductions.)

In all, because of their higher noncompliance rates, those with true incomes of $200,000 or more received 25% of all income but accounted for 40% of net underreported income and 42% of underreported tax in 2001, according to the new analysis.

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The study was written by Joel Slemrod, an economics professor and the director of the Office of Tax Policy Research at the University of Michigan's business school, and Andrew Johns, an IRS researcher. It has not been officially endorsed or even released by the IRS, but it seems sure to add fuel to the election season debate over whether Americans earning $250,000 or more should pay higher tax rates, as Sen. Barack Obama, the Democratic presidential nominee, has proposed.

The Slemrod-Johns analysis uses unpublished data from special research audits the IRS conducted on a sample of 45,000 individual returns filed for 2001. It was the IRS' first such research effort since 1988, and it led the agency to estimate the 2001 gross "tax gap" at $345 billion.

Many of the world's wealthiest people have been suspected of tax evasion, but convictions for cheating the government out of revenue are relatively rare. Click here to see some of the richest recent tax dodgers.

Easier to hide money The main reason for the income-related disparity in cheating: Higher-income folks receive more of their income from sources that are easier to hide, including self-employment earnings; income from rents, partnerships and S corporations; and capital gains.
"The distribution of noncompliance lines up pretty closely with who gets income that's hard (for the IRS) to keep track of,'' Slemrod said. Still, he noted, the distribution of income by source doesn't explain all the increased noncompliance at higher income levels.

In its 2001 tax gap study, the IRS estimated that individuals underreported business income by 43% overall. Sole proprietors, who report self-employment income on schedule C of their tax returns, underreported their incomes by a stunning 57%.

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By contrast, the IRS found, 99% of all wages were reported by individual tax filers. The obvious explanation is that workers have no choice: Their employers report their earnings to the IRS and withhold taxes on them.

Meanwhile, net capital gains for 2001 were underreported by 12%, the IRS estimated. The agency receives reports from brokers of taxpayers' gross sales of stocks and bonds but not of their initial costs and profits. Therefore, it has no way to easily check their reported capital gains. (Last month, as part of the $700 billion bailout bill, Congress mandated that brokers report the basis of any stocks bought in 2011 or later.)

Habits of the superrich

The new study seems to show that the really rich are more tax-compliant than the merely well-off, although not nearly as compliant as middle- and working-class wage slaves. Those earning $2 million-plus had an 11% underreporting rate. But Slemrod said he was "less comfortable" with that finding, noting that the very rich may have made use of techniques that IRS research audits didn't detect.

"I just don't know whether these audits were able to track down really sophisticated noncompliance or Swiss bank accounts. They may underestimate it (noncompliance) at the top,'' Slemrod said.

Who cheats the most
Net misreporting rate
True income
21% $500,000 to $1 million
20% $200,000 to $500,000
16% $1 million to $2 million
13% $100,000 to $200,000

See the full list on Forbes.com

Indeed, in the past several years, the IRS has collected billions in back taxes from wealthy taxpayers who had used dicey tax shelters to manufacture huge phony losses in the late 1990s, 2000 and 2001. But the IRS didn't get a handle on the nature or extent of these shelters until years later and relied on tax shelter promoters' customer lists and special self-disclosure programs, not audits, to find most of the taxpayers involved.

Currently, the government is suing UBS for the names of 18,000 wealthy Americans it believes may have had unreported Swiss bank accounts.

This article was reported and written by Janet Novack for Forbes.com.