Why do people cheat? Who cheats the most: men or women? Do married people cheat more than singles?
I’m referring, of course, to cheating on your taxes. Nearly a decade ago, the Canada Revenue Agency (CRA) released some detailed information on taxpayer compliance, including the results of a study that analyzed confidential CRA data over a number of taxation years for 18 million individual taxpayers.
The study looked at three types of tax compliance: filing compliance (the percentage of taxpayers who file on time), reporting compliance (the percentage of taxpayers who accurately report their income and expenses) and payment compliance (the percentage of taxpayers who made their tax payments on time.)
The results showed reporting compliance was the highest at 95 per cent, filing compliance was slightly lower at 93 per cent and payment compliance was the lowest at 91 per cent.
When it comes to reporting compliance or honestly reporting all your income and/or expenses, the study found that males are more likely to underreport their tax owing than females. It also found that underreporting is highest among taxpayers aged 35 to 54 and lowest among taxpayers under 35. Underreporting of tax was also lowest for taxpayers who are married and highest for those who are separated, with single taxpayers somewhere in between.
Not surprisingly, underreporting of tax is higher among taxpayers whose main source of income is either capital gains or self-employment income versus taxpayers whose main source of income is wages, where most of the tax is withheld at source by the employer.
It’s well-known that Canada’s tax system is one of self-reporting and the CRA simply doesn’t have the resources or ability to audit every expense each taxpayer claims. That’s why, from time to time, some taxpayers seek to “bury” questionable expenses on their returns, playing the “audit lottery” and hoping they don’t ever get chosen for closer scrutiny by the tax man. Or, if they do get audited, they pray that their inappropriate expenses don’t get discovered.
Yet each year, some taxpayers do get audited and their expenses get challenged by the tax man, landing the taxpayer in Tax Court. Here are two 2018 cases, one from Canada and one from the U.S., in which taxpayers disguised certain expenses on their returns in ultimately unsuccessful attempts to fly under the tax authorities’ radar.
The Calgary market dealer
The first case involved a Calgary taxpayer, employed as a market dealer with a capital management company. In each of 2012 and 2013, the taxpayer paid $12,000 as a salary to his wife for administrative support and deducted the payments as employment expenses on his tax returns. In filing his statement of employment expenses for those years, the $12,000 was not separately identified as “salary paid to his assistant,” but rather was put under the heading of “office equipment.”
While the taxpayer’s employer provided support to him at the office in the form of an assistant, his wife performed numerous administrative tasks that were “essential in allowing him to devote his efforts to building a customer base and earning his commission and bonuses.”
Yet despite this, on the Form T2200 “Declaration of Conditions of Employment” which his employer completed, the answer was “no” to the question of whether his contract of employment required the employee to pay for an assistant.
The CRA therefore denied the employment expense deduction for each year and the judge agreed, finding there was “nothing in (the taxpayer’s) testimony that supports any such implicit requirement (to hire an assistant).”
The Oregon accountant
The second case involved a U.S. tax preparer’s own returns. During the years under review, 2012 to 2014, the taxpayer lived in Oregon and prepared at least 50 tax returns for others in each of those years.
Naturally, he also prepared his own returns and on those claimed a variety of personal expenses as business deductions related to his tax return preparation business.
When his own returns were selected for audit, the Internal Revenue Service (IRS) determined the taxpayer had unreported gross income of over US$111,000 for the three years in question, along with various disallowed deductions, which resulted in understated tax liabilities totaling US$60,000.
It turns out that the taxpayer claimed 50 per cent of his personal residence expenses as home office deductions, yet failed to attach the required U.S. Form 8829, “Expenses for Business Use of Your Home” to any of his returns for the years in question. When asked by the judge why he failed to include this form with his returns, his brazen response was that doing so “would be a red flag for audit.”
The IRS imposed fraud penalties against the taxpayer and the judge found that the taxpayer’s “pattern of unreported income and overstated deductions, failure to keep or produce records, and failure to cooperate with the IRS” justified a fraud penalty on the entire US$60,000 of tax owing, amounting to an additional US$45,000.
Lessons learned
From a practical point of view, it’s very hard for the CRA to ultimately detect questionable expenses. It’s certainly much easier for the tax authorities to compare self-reported income with income reported from third parties (employers, investments, etc.) through computer matching.
That being said, the CRA has been taking a closer look at tax compliance in recent years, hiring more auditors and releasing various studies estimating our “tax gap,” which represents the difference between the total amount of taxes that would be paid if each and every Canadian fully reported all their income properly, took only appropriate expense deductions and properly claimed only the tax credits to which they were entitled, compared to the tax actually paid and collected by the CRA. The 2015 tax gap was $8.7 billion or 6.4 per cent of total 2014 personal income tax revenues.
So, if you’re taking chances with your tax filing in the hopes that you don’t get caught, your time may be running out.