by Jim Marasco, The Daily Record, June 2014

Most of us know someone who seems to live well beyond their means, yet isn’t drowning in debt. There’s a good chance, they may not be reporting all of their income. According to a 2013 Tax Foundation study, the amount of unreported income to the U.S. Treasury is estimated at $270 billion annually.

Obvious consequences 

According to the Tax Foundation study, 79% of Americans indicated that they believe it is morally wrong to cheat on their tax reporting. It could also be criminal. Failure to report and pay your income tax obligations could lead to substantial fines and penalties. If the amounts are high enough, a prison sentence could also be imposed. Over the years, there have been a few high profile individuals and celebrities that have fallen into this trap.

Other considerations 

Based on 2011 data from the Internal Revenue Service, nearly half of all U.S. taxpayers paid no income tax. While most of these individuals legitimately fall into this category, many place themselves here fraudulently. Besides committing tax fraud and risking criminal prosecution, there are some other consequences that most people don’t consider and can affect situations involving:

•       Disability – individuals who regularly underreport their income will be disadvantaged if they become disabled. If they have disability insurance or attempt to collect social security disability, their payments or their dependents will be based on the income they have historically reported, which could be minimal. At that point, it’s too late to change the course of action and their payments will be fixed at those amounts.
•       Death – while underreporting your income won’t affect your death benefit, your spouse and kids could qualify for survivor benefits. These amounts could be adversely affected by understating your income, similar to the disability payments.
•        Business Insurance – for those who are self-employed and/or operate their own business, hiding income could prove costly. If the business is affected by a flood, fire or other interruption, the claim is going to be adversely impacted. The insurance company is going to base their settlement or income protection payments on the historical reported earnings of the business. Although claimants may produce information supporting higher amounts, insurance companies will pay based on what they are able to validate, which in most cases, involves what was historically reported to the government. 
•       Unemployment – working “under the table” or “off the books” and underreporting your earnings could backfire if your job is lost and you need to collect unemployment insurance. The Department of Labor is going to base their remuneration based on what was previously reported.
•       Business Transactions – while a business owner may not plan to sell their business in the near-term, a health crisis or lifestyle change might dictate otherwise. In this circumstance, buyers are typically very skeptical about paying a “premium” for historical earnings they can’t readily verify. As a result, a historically profitable business may be sold for less than fair value because they consistently underreported their income to the government.  

Hard lessons 

Early on in my career as a certified public accountant, an insurance friend brought a young distraught widow to my office. Her husband had just taken his own life at 30 years of age leaving her with two young children. He had a small life policy that paid out, but she received disappointing news from Social Security. Her survivor benefits were nominal since his reported earnings from his pizza shop were less than $5,000/year. She offered that the shop was very successful and wanted prior payroll and income tax returns amended showing additional income, in hopes they would subsequently boost her payments. She was also trying to sell the business and was getting less than attractive offers due in part to the historical financial records he had maintained. I’m not sure how she made out in her quest as I wasn’t able to help her, but it made quite an impression.  Another situation involved a couple who owned a convenience store. The store recently experienced a devastating fire destroying the building they leased and shuttering the business. As we assisted the insurance company with validating their claim for business interruption we observed the business to be marginally profitable at best. Although the owners had somehow maintained a comfortable living for the last few years from this store, their reported earnings were nominal. Unfortunately, with the business gone and the landlord slow to rebuild, their income protection payments from the insurance company were probably a fraction of what they were used to making. As a result, they were forced to pick up all types of odd jobs at all hours to make ends meet.  It’s easy for some people to justify hiding income from the government. They may use all types of excuses like they pay their fair share or the government doesn’t need any more money to waste, etc. However, as demonstrated, when unforeseen circumstances occur, and help is needed, these practices may backfire. At that point, it’s most likely too late and may have a lasting impact into the future.

James Marasco, CPA, CIA, CFE, is a partner at EFPR Group, Certified Public Accountants and Business Consultants.