It’s said that ignorance is bliss, but business owners are wise to learn enough about tax law to understand how it applies to their businesses. Lack of knowledge generally doesn’t exempt you from paying taxes, a lesson many small business owners have learned the hard way. However, as the case of Richard Mathews demonstrates, it is possible to be too ignorant to intentionally evade taxes, especially when the IRS also makes mistakes.
Mr. Mathews left a big chunk of income off his tax returns for 2004 through 2008, and even did a stint in jail for those problems. However, he managed to escape paying over $40,000 in tax and penalties for his 2007 and 2008 returns because the judge at the Tax Court determined that he was too ignorant about tax law to be intentionally evading tax.
Mr. Mathews had a tenth-grade education and supported himself by operating and working in a number of multi-level marketing companies. During the years that the IRS audited, he operated several multi-level marketing companies that required him to pay out 90% of his gross receipts to other members of his organizations. He was sure that deductible expenses wiped out the remaining 10% that he kept.
When he filed his tax returns for 2004 through 2008, he omitted the majority of his income, including all of the income for the multi-level marketing companies he operated. An IRS criminal investigation agent analyzed his bank deposits and determined that he had underreported his income by $223,099.
In his dealings with an IRS revenue agent and the criminal investigation agent, he appeared evasive, and seemed to be actively concealing his income. When his house was searched, he claimed to have only $20 in cash on hand, but two safes containing $13,000 in cash were found. He had also created a trust in Belize, which he believed would exempt all his multi-level marketing income from US tax, though he never actually did anything with that trust.
In 2011, he was indicted for tax evasion and filing false tax returns, and was sentenced to 27 months in prison.
However, the IRS wasn’t quite done with him yet. Part of the normal process of the IRS is to issue notices of deficiency when a taxpayer hasn’t paid enough tax. For mysterious reasons, the IRS never issued notices of deficiency for 2004 through 2006, and did not file notices of deficiency for 2007 and 2008 until 2015, which was more than three years after Mr. Mathews filed those tax returns.
Normally, the IRS has three years after a return is filed to assess a deficiency, unless they can demonstrate fraudulent intent. If fraudulent intent can be proven, there is no statute of limitations. So in order to collect the $40,000 assessed on those tardy deficiency notices, the IRS would have to prove Mr. Mathews had fraudulent intent.
During his Tax Court trial, Mr. Mathews conceded that he had underreported his income for 2007 and 2008. But he also appeared sincerely and honestly confused about how he should have reported that income.
Because of Mr. Mathews’ honest confusion and utter ignorance about tax law, the judge determined he was not capable of fraudulent intent, despite the fact that he had already served time in prison for just that. With the statute of limitations expired, the judge ruled that Mr. Mathews was not liable for the additional tax and penalties for 2007 and 2008.
Mr. Mathews cut a lucky break when the IRS failed to file those notices of deficiency within the usual three years. Most business owners won’t be so fortunate. This underlines the importance of basic financial literacy and knowledge of tax law for business owners. Working with a competent advisor can ensure that any gaps in your knowledge won’t result in prison time or hefty penalties.
Are you wondering about how tax law affects your business? Contact our office today so we can help you stay on the right side of the law!