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The Hidden Cost of Cheating

The Cajuns who settled Louisiana’s bayous have a distinct culture that goes beyond French words and spicy food. Forced long ago from their Canadian homes, separated by language and religion from the society that grew around them, the Cajuns, for the most part, wanted government to leave them alone.

Like a lot of other Americans who think of government as “them” rather than “us,” they saw little shame in working off the books. The fishermen who plied the Gulf and the inland waterways built an industry based on tradition, handshakes and a great deal of cash.

The downside of this laissez faire approach has suddenly become clear, thanks to the massive oil spill that has closed much of the Gulf fishery. BP has begun compensating fishermen and other residents of the region for their lost income — but it wants proof that income actually has been lost.

That requirement is a problem for anyone whose aim until now has been to conceal revenue rather than document it.

“I took a shot at a claim, but all I had in terms of documents was a fishing license, a bait license and a marina license,” said Michael Turgeau, a Louisiana marina owner. “Trouble is, people around here live differently — always have.”

St. Bernard Parish President Craig Taffaro argues that the government should offer amnesty for those in the Gulf fishing industry who have dodged their taxes in the past, with the understanding that those who participate will report their income properly in the future. “There needs to be a separation between tax obligation and the ability to validate appropriate compensation to these fishermen,” Taffaro claims.

In other words, we should assume that people who have lied to the government for years about their income will tell the truth to BP when they seek compensation. And we should further assume that these same folks will, henceforth, report all their income to the Internal Revenue Service, because they have learned their lesson.

We had “liar loans” in the mortgage industry until recently. Now we can have “liar relief.” Is that progress?

The IRS estimates there was a gross tax gap of $345 billion in 2005, the most recent figure available. This gap results from everything from street vendors selling “I ? NY” mugs off card tables to taxi owners renting their cabs to other drivers under the table. I take the government’s tax gap estimates with a grain of salt, because the IRS often interprets the tax laws more aggressively than the courts will support, but clearly a lot of people underpay a lot of taxes.

Beyond the fact that tax evasion is a crime, failing to report earnings can have other consequences, as deckhands and marina operators in the Gulf are now learning. It is nearly impossible for anyone to be properly compensated for losing income that, on paper, they have no history of having received.

Small business owners also face consequences if they habitually keep income off the books. When it comes time to sell the business, or to seek compensation for a fire or other event that interrupts normal operations, the income history will be impossible to verify. The result can be a lower price for the business or a lower insurance settlement than the owner should have been entitled to collect.

“The seller cannot have it both ways,” says Richard Parker, the owner of a company that specializes in buying businesses. “If they averted paying the taxes on the income, then they cannot expect to yet again benefit from it in a sale.” Pocketing extra cash might seem smart in the short term, and it’s easy to rationalize the practice as “something everyone does,” but small business owners end up cheating themselves as well as the government.

Of course, it is not only freelance workers and entrepreneurs who skip out on their taxes by using unreported cash transactions, and they are not the only ones who can inadvertently cause trouble for themselves down the line.

Imagine you buy an expensive string of pearls, and the jeweler offers to allow you to pay in cash, waiving the sales tax. With no receipt of the sale, convincing an insurance company to honor your claim in the event the pearls are damaged or stolen may be difficult. Or perhaps the string of pearls costs $4,000, but the jeweler issues you a receipt for $1,000, allowing you to pay the rest in cash, again to avoid sales tax. If the insurance company investigates a claim on the pearls, you may risk being accused of insurance fraud as well as tax evasion.

It goes without saying that sales tax evasion of this kind has serious consequences, but the practice is remarkably widespread, especially with high-end purchases like jewelry and art. In 2004, art consultant Thea Westreich and her company pleaded guilty to failing to collect New York sales tax on more than $5 million worth of art sales. She was one of several dealers to be caught using the so-called “box trick.” Vendors often are not required to collect tax on sales that are shipped out of state, so art sellers sell the painting, ship an empty box out of state, and the customer takes the piece home.

The bottom line? Though it may cost money to be honest, it is by far the best bargain in the long run.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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