Everyone can legally save on taxes. So why do so many people cheat on their taxes? Donna Bobek Schmitt joins Tom to discuss her research into why clients and tax professionals act unethically and break the law. This episode also reveals options you have when confronted with unethical behavior.
Announcer: This is The WealthAbility® show with Tom Wheelwright. Way more money, way less taxes.
Tom Wheelwright: Welcome to the WealthAbility® Show where we’re always discovering how to make way more money and pay way less taxes. Hi, this is Tom Wheelwright your host, founder and CEO of WealthAbility®. So why would you ever cheat on your taxes when you can save taxes legally? So today you’re going to learn how to reduce your taxes and still sleep at night. And to have this discussion, we’ve got a very distinguished Professor, Donna Bobek Schmitt from the University of South Carolina who has spent a good part of her career. As I understand that, Donna, I’m really looking at why people cheat on their taxes and tax preparers who actually allow it or encourage it. So Donna, could you just give us 30 seconds of your background?
Donna Bobek Schmitt: Sure. I’ve been a professor for 25 years. I was at the University of Central Florida for 17 years, and now I’m at the University of South Carolina for five years. Almost all of the time I’ve been teaching graduate tax classes. I’ve taught a bunch of different graduate tax classes. And before that I worked in Public Accounting and other places before I got my Doctorate at the University of Florida. And I do a lot of research on tax compliance and tax professional behavior. And I work with a lot of CPAs who were my students and then now work in Public Accounting.
Tom Wheelwright: That’s awesome. So thank you for that, and thank you so much for being on the show. So the big question in my mind is why do people cheat? I mean, is it just… Everybody wants to reduce taxes, but why do people do it? Why do they cheat to reduce their taxes?
Donna Bobek Schmitt: Well, there’s a few reasons. I’ll start with just saying from an economic perspective. So there’s a lot of academic research on this and from an economic perspective, the puzzle really has been why don’t people cheat more? And the reason for that is because given our current audit rates and penalty rates, the chance of being detected is quite low if it’s income that’s not subject to third party reporting. And so actually from economics of crime perspective, people comply much more so than you would expect.
Donna Bobek Schmitt: Nevertheless, there’s a $400 billion a year tax gap and most of that relates to income not subject to third party reporting. So on the one hand, why do people cheat? A lot of researchers are trying to figure out what are the reasons that keep people from cheating when they can cheat and not get detected.
Donna Bobek Schmitt: And people do see paying taxes as an ethical issue, and so to the extent that they see it as an ethical issue, they’re not going to cheat. Just like if you go into a store, you could probably put something in your pocket and not be caught, but you wouldn’t do that because it’s wrong. And so a lot of people don’t cheat because it’s… They believe it’s unethical.
Donna Bobek Schmitt: On the other hand, some people don’t see paying taxes as an ethical issue and they can rationalize cheating for a variety of reasons. One being that, Hey, everybody does it or two, the rich people don’t pay enough taxes, that kind of thing. So there is a big ethical component to tax compliance and people vary on their perspective related to tax.
Tom Wheelwright: Speaking of that perspective, that reminds me, I was in Barcelona, Spain a couple of years ago and met up with a friend of mine that I first met in Russia. He was Russian and had actually immigrated to Barcelona. And we were talking about taxes in Russia because when I’d been in Russia, I noticed that pretty much everybody cheats on their taxes in Russia. And I said, “So why is that?” And he says, “Well, you have to understand in Russia we look at laws as a suggestion.” And he was serious about that, and that’s a very different view than what I think most Americans have.
Donna Bobek Schmitt: Well there, there’s definitely a cultural component to it, and there’s also a component of it so that you do see wide variety of compliance across different countries and cultures. And in addition to that, you have to have some faith in your institutions. And if you don’t, then you’re unlikely to comply. So you see this a lot in developing countries where they don’t have faith in the institutions, and so therefore they don’t comply.
Donna Bobek Schmitt: And then it’s kind of a… I don’t know if the word self-fulfilling prophecy or, but if people don’t pay taxes and the government can’t do what it’s supposed to do, so then the government’s not doing it. And if you think… Here’s an example that relates to the… Even in the United States, one of the areas where there’s a lot of noncompliance and there’s been a lot of laws, but new rules put in place has to do with tip income. Right? And so it’s a known thing that people don’t report all their tips.
Donna Bobek Schmitt: And I remember I had a student years ago and she worked at Cracker Barrel I think. And she told me that she reported all of her tips because for her it was a moral thing. She thought it was the right thing to do and she said, but the people she worked with made fun of her because it’s like, why are you so dumb? You’re paying more taxes than you need to pay.
Tom Wheelwright: Wow. Yeah.
Donna Bobek Schmitt: As an example. And that’s nothing against… I might not even be Cracker Barrel. So nothing, that’s not… I’m not saying anything about Cracker Barrel. Just I think that’s widespread.
Tom Wheelwright: Oh there’s no question, and how many times have you had a contractor or somebody that you know was going to wash your windows or whatever and I’ll give it to you less if you pay cash, right?
Donna Bobek Schmitt: Yes, absolutely. I actually had a big argument with my husband over that.
Tom Wheelwright: No, it’s true. We facilitate it and we look the other way, and when I wrote my book, Tax Free Wealth, the whole premise is you really don’t have to cheat. There’s so many incentives in the line. I mean, look at this last 2017 Tax Act and you have bonus depreciation and you have all of these tax benefits, the qualified business income deduction, you’ve got home office deduction.
Tom Wheelwright: I mean you’ve got all these legitimate tax benefits that I always wonder why do people cheat? And I wonder if it’s not just because it’s being lazy. Is that part of it that… The part of it is that the internal revenue code is so complex that it just takes a lot of effort to actually comply and reduce your taxes as opposed to just cheating to reduce your taxes.
Donna Bobek Schmitt: Well, I mean, I think it depends, right? So if you’re talking about business income versus non-business income or in some and there is, I would agree with you some level of non-compliance. That’s out of ignorance, and I think that as a tax professional sometimes have a difficult time trying to explain things, being the messenger of bad news to their clients. That’s not how this works. Or you should’ve done this differently, but now you’re bringing it to me in January and there’s nothing I can do to change the situation.
Donna Bobek Schmitt: I personally probably wouldn’t use the word lazy. I would probably just say it’s more of a… Taxes make people nervous. They just don’t understand them. They think they’re complicated. I mean, I do tax returns for people that are like the simplest tax returns ever, but it just makes them feel so much better for me to do them for them. And so there’s like this barrier that it just seems very complicated and some of it is hard to understand. So and I’m sure some people are lazy and just like every other law, ignorance of the law is not a defense. So…
Tom Wheelwright: Right. So let’s talk about tax prepares for a minute. So I know you do a lot of research into why tax preparers sometimes allow or facilitate cheating. Do you see that as a prevalent challenge in the US?
Donna Bobek Schmitt: I do not, and let me just add a caveat that it depends on who you’re talking about. When you’re talking about CPAs, my experience with CPAs and my research with CPAs has led me to the conclusion that the vast majority of CPAs are ethical people trying to do the right thing by the law and by their clients. So I don’t have evidence that see that there’s an issue with CPA Tax Professionals.
Donna Bobek Schmitt: Now when you go to… There’s a lot of people and a lot of them are very ethical. But for instance, the IRS, I don’t know if they still do this, but when I used to teach a tax research class where we, part of the class was about professional responsibility and so I used to go to the IRS website where they would have all their criminal activity, the number of people, tax professionals that they had filed criminal charges against and you know, 90% of those were not CPAs.
Donna Bobek Schmitt: So I would say that most of the tax professional aided non-compliance is not coming through CPAs. On the other hand, there are some CPA firms, large CPA firms that have gotten in trouble. Even some people that have gone to jail for helping their clients do things, their big clients do things that were wrong. But I think that’s more the exception than the rule. Some of the research that I have done recently has shown that tax professionals are very thoughtful about this and they’d rather fire a client then not be able to sleep at night.
Tom Wheelwright: Well, I always tell my clients, actually even when I’m speaking on stage, so one of my big goals in life is to never be anybody’s girlfriend.
Donna Bobek Schmitt: Yeah, you’re kidding.
Tom Wheelwright: I mean, we signed the tax return too and it’s under penalties of perjury based on what we know. So if we know that a client’s cheating we’re on the hook for that, and I’ve always tell my clients, you know what? I don’t want you to go to jail and I’m going to tell you if you do, I’m not going to come there with you.
Donna Bobek Schmitt: There are tax professionals in jail right now as we speak, so that is real threat.
Tom Wheelwright: Yeah. Well it is of course because we’re supposed to know better. The client actually gets a little bit of leeway sometimes because-
Donna Bobek Schmitt: If they’re relying on us.
Tom Wheelwright: If they’re relying on us. I mean there’s even penalties they can get out of if they relied on a professional and we have tax opinion letters and so forth like that to make sure that the clients are off the hook and out of these big penalties. How as a CPA, I have to tell you and who runs a network of CPAs. I am very happy to hear that your research shows that CPAs are primarily compliant. And I usually think that’s a big difference in something that the CPA profession perhaps should promote a little more is that if you really want ethical representation then the CPA is probably the surest way to go.
Donna Bobek Schmitt: I mean, of course, I’m a CPA as well, so maybe I’m a little biased, but I would agree tax lawyers also have ethical requirements and things like that. I haven’t done much research with tax lawyers, so I can’t really say a lot about them, but I would guess that they were probably similar to CPAs, although a lot of the really crazy tax shelter stuff, works its way through law firms. And so.
Tom Wheelwright: Well it does. And here’s the thing about tax lawyers is that the challenge with tax lawyers doing your tax return of course, is that lawyers can’t do, they can’t do math. So they’re really good with the words, but they’re not very good at doing the actual numbers. So there are actually a couple of issues that I run into that I want to run by you because I’ve seen this and because we’ve got this network of CPAs, we see a lot of tax returns prepared by other tax preparers.
Tom Wheelwright: And there are a few issues that I think are fairly common where people tend cheat. One is inventory where I’ve actually… So we had a change in Inventory Law in 2017 not discussed very much, but we did have a change in inventory law where small taxpayer, small being under 25 million, doesn’t necessarily have to keep inventory. And for small things they can actually write them off when they buy them. But what I actually had, somebody had heard me talk about this and they went to their CPA and they said we’d really like to do this. What do we have to do to go through this? And they said, “Well we don’t really want to do that because that’s how we manipulate your income from year to year.”
Donna Bobek Schmitt: Wow.
Tom Wheelwright: And I actually had a client, I had to fire them because they would not take a physical inventory at the end of the year. And I knew that there… I mean based on what their sales were and their business, because I knew their business well. There was no way that they could have that kind of inventory. There’s no way they got it down that low at the end of the year, which of course raised their deduction for cost of goods sold. So have you looked at any of the specific areas where people do tend to cheat?
Donna Bobek Schmitt: So, okay. With all cheating. First of all, that’s very interesting, and I find it interesting because inventory is one of those areas that has a lot of regulation about how you’re supposed to keep your records and what you’re supposed to capitalize and what costs are included in inventory and that kind of thing. So there is a lot of substantiation required for inventory, so that’s not really an area that on audit you’re likely to win. You know what I mean?
Tom Wheelwright: Exactly.
Donna Bobek Schmitt: So I think that’s kind of interesting, but if you want to talk about small business, I think, because I feel like you kind of have to segment it [inaudible 00:16:51].
Tom Wheelwright: For sure. Small business.
Donna Bobek Schmitt: But if you’re focusing on small business, if you think about cash income, that’s the easiest place to… Cash income is the easiest place to cheat on, right?
Tom Wheelwright: Right.
Donna Bobek Schmitt: Because it can easily disappear. The other thing is I think small business, you see people running personal expenses through the business.
Tom Wheelwright: Yes.
Donna Bobek Schmitt: When you have these closely held businesses, I think those are two areas where it’s easy. I didn’t really think about manipulating income through inventory, but that makes sense because it’s such a big thing.
Tom Wheelwright: It’s a big number-
Donna Bobek Schmitt: It’s moving all the time.
Tom Wheelwright: And the reality is the IRS doesn’t do a lot of audits, and they are clearly understaffed and they audit inventory a lot, but the point that I always make is, well, but you don’t have to do that because there are ways that are very legal. And these aren’t loopholes, and this is a big issue to me. A hotspot for me is that people talk about loopholes and to me a loophole’s an unintended consequence, not an intended consequence. And so there are a lot of tax benefits that are intended consequences. I mean you certainly wouldn’t call the qualified business income deduction. This 20% pass through deduction as a loophole that was intended to reduce the business owners tax, or you wouldn’t call bonus depreciation a loophole.
Tom Wheelwright: This is something that was intended Section 179, that’s not a loophole that’s intended home office, that’s not a loophole. It’s in the law. So all of these things are not loopholes. They’re really intentional tax benefits, and to me what I find is that the best clients, and the way that I can help my clients actually sleep at night, and I can sleep at night is when I do educate them and give them the tools to reduce their taxes legally so that they don’t have to wonder, well is there something I’m not doing? Because when people come to us, their question is, I don’t know if my CPA or my tax preparer is doing enough to help me reduce my taxes. And so in a lot of cases, I think that’s when they say, well, I’m just I’m going to fudge here and I’m going to fudge their, I’m going to run personal expenses through my business.
Donna Bobek Schmitt: So I completely agree with your perspective on the term loophole. I think it’s a pejorative that’s used for tax benefits that other people get, and I don’t, you know what I mean, that’s a loophole.
Tom Wheelwright: That’s a great definition of it.
Donna Bobek Schmitt: But the other thing I would say is that this is something I see with small business people. And so I’ll tell you a little story about… I get my hair done and I go to a very nice hair salon and pay quite a bit of money for this. And I was taught, and of course my hair salon person knows… My hairdresser knows that about CPA and et cetera. And so she’s talking to me about her taxes, and she said she was dissatisfied with the person she was going to when I said, Oh, well maybe, I could give you some recommendations or whatever.
Donna Bobek Schmitt: She goes, yeah, well I’m only paying $175 and I don’t want to pay more than that. Then I said, What! You get what you pay for. That’s why I come to you and non-super cuts, is because I want, whatever. And she was like really aback by that. But I do think sometimes you, you see that is that people don’t understand the value of… Because they don’t understand it, so they don’t understand the value and then they’re not willing to pay or the kind of advice that they really need. And so that’s when… It’s not free.
Tom Wheelwright: It’s not free, and when people say, well, the rich don’t pay a lot of taxes. Well the rich are doing things that the government wants them to do. They’re investing in real estate, they’re building businesses. And so when I see… And we do have clients, I mean we have clients that are very well to do and they pay very little tax, but they’re doing things like investing in oil and gas wells, they are investing in real estate. They’re investing in their business. They’re, they’re creating new research. They’re putting money into research and development.
Tom Wheelwright: So the way I look at is they’re doing what the government wants them to do. That’s what the government says in the Tax Law. This is what we want you to do, and so that’s what they’re doing. On the other hand, it’s like you say that the loophole is the pejorative for these are tax benefits, somebody else’s getting that.
Tom Wheelwright: I’m not, I’m going, well, here’s the thing though, the tax laws’ fair. I mean everybody can get the same benefits, but sometimes a lot of it is the matter of who are you getting your education from when it comes to your taxes. I mean your single biggest expense is your taxes for most people. And you’re worried about paying $175, that’s a lot of money. And I’m going, well, you know, to me it’s always, do you look at this as a necessary evil to get your taxes done or do you look at as your tax advisor as an asset, somebody who’s going to actually make me money. And so to me, if it’s a necessary evil, I do want to spend the least amount possible. But if it’s something that’s actually going to make me money, I actually want to invest more in that.
Tom Wheelwright: I mean, if it’s a hairstylist that’s going to get you a really good haircut. I mean, I spend money myself on here and because I don’t have a lot of it, so I have to do the best I can with what I’ve got. And so I actually spend some money on a hairstylist who actually has figured out how to cut my hair to look like I actually have some. It’s really a matter of what’s important to you, right? If what’s important to you is paying the least amount of money, then that’s what you’re going to get. If what’s important to you is paying the least amount of tax and you want to do it legally and sleep at night, then that’s a whole… It’s just a very different mindset.
Donna Bobek Schmitt: And I would want to make one point that you said about wealthy people. If you look at the distribution of the income tax burden, for sure the highest income people paying more of their proportionate share of the income tax burden. Now one could what… It’s certainly a debatable issue as to whether it should be even more. That’s kind of a preference issue right? Some people might think it should be even more and some people might think it should be less.
Donna Bobek Schmitt: But I think it’s important to recognize that it’s not factual to say that rich people don’t pay a lot of taxes because they do okay. But they also have a lot of opportunities to reduce their taxes as you’re pointing out, and a lot of the opportunities they have are potentially opportunities other people in other situations don’t have. But that’s, and you know, as you say, that’s the way the tax law is. So if you don’t like the tax law then you can try to change it, but it’s not a loophole or whatever.
Tom Wheelwright: Right. So to me, I think you brought up some really good points in a matter of getting education. And some of the challenge with CPAs is while lawyers can’t do math, CPA’s have a tough time speaking English, and it’s getting education for people who actually speak English. I actually had a client who hired me to interpret what their lawyer said laterally because they couldn’t understand what their lawyer was saying. And so they actually hired me as the go-between to interpret it and put it into English for them. And so having somebody on your team that actually does speak English, that will educate you. One my concerns is that a CPA sometimes feel like, well, if I tell my clients what I know, they won’t need me anymore, which is of course with the complexity of the Tax law, ridiculous.
Tom Wheelwright: They’re actually going to need you more because they’re going to be more successful and they’re going to make more money and they’re going to have be more complex and they’re going to need, need you even more. So I think of it very selfishly that if I can educate my clients, then therefore they’re going to need more of me, not less of me. And so I think that education, but I think you bring up a really good point that who you’re going to for your tax advice makes a huge difference. And I think it actually says a lot about the person. And are they willing to invest in their future? Are they willing to invest in their taxes to actually make it a better result for them?
Donna Bobek Schmitt: I think overall, I have a friend who has a consulting business and she’s not intact. She’s that she’s CPA, but she has it like a CEO, kind of a CFO kind of consulting business. And one of the things that she has observed is that in general you would think with all this technology that we would have better processes, better controls, better advice, but there’s a sense amongst people who are entrepreneurs that because they can get QuickBooks online and turbo tax online or whatever, they can do it themselves and it doesn’t really set them up for success. Even though in the front end when they’re strapped for cash, they’re like, Oh, well this is a way to save money. It’s like penny wise and pound foolish basically, and you, so you see that and with accounting in general, with small business, not just with taxes.
Tom Wheelwright: Absolutely. So, to me it comes down to a couple of things. First of all, there’s no need to cheat. You can actually keep your taxes down and sleep at night, if you could do two things. One, you get the education, that’s why I love talking to Professors and I actually was not a real professor. I was an adjunct Professor for 14 years. So you know where we are. We’re like right below the janitor on the pecking order at the University.
Donna Bobek Schmitt: Well, I still think you’re a real professor, but not a well paid one will say that.
Tom Wheelwright: But truly, if we get the education and then we recognize that look, we can reduce our taxes legally. These laws are available to everybody as long as we have somebody that we’re working with that can actually help us produce results. I always say, if you want to change your tax, you need to change your facts. And so if you’re willing to change your facts to do what the [inaudible] wants you to do, you can reduce your taxes and you can sleep at night and you don’t have to worry about the IRS going to come after you because you never have to worry about the IRS because your tax preparer is taking care of that when they prepared the tax return in the first place.
Tom Wheelwright: They’re making sure that everything is ticked and tied as we say in accounting where I’s dotted and T’s crossed as you might otherwise say. So Dr. Schmitt, just been a pleasure to have you on our podcast today WealthAbility®, you’re just a wealth of information. It’s just absolutely been delightful. Thank you so much.
Donna Bobek Schmitt: Thank you very much
Tom Wheelwright: And just remember everyone that when you do get the education and you do have the right tax advisor, and the right tax prepare, then you’re always going to make way more money and pay way less taxes. We’ll see you next time.
Announcer: You’ve been listening to the WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes. To learn more, go to wealthability.com