David Cay Johnston: The key way the super rich avoid taxes -- and a simple way to close their tax loopholes once and for all

Our investigative series The Koch Papers illustrates many deep problems in America’s creaky, century old-income tax system, especially how our Congress has, through favors to donors, transformed it into has two tax systems, separate and unequal.

These dual systems pose a threat to our nation’s social stability, to our national security and to America remaining a nation of equality under law. But there is a simple solution to this, as we shall see. It requires only that Congress stand up for honest and fair tax law enforcement, not the interests of those major campaign donors who cheat.

One of the most significant lessons applies to William Ingraham Koch and his company whether or not, as his former chief tax executive claims, the IRS failed to curb massive income tax "fraud." That’s because if Koch did find a way to lawfully collect more than $100 million in tax-free profits annually it is just as much a public issue as if he did it by cheating.

Congress, Are You Listening?

No reasonable person can defend a system under which workers laboring all year for the $7.25 federal minimum wage pay more than a dollar a day in income taxes while billionaire business owners pocket millions in profits tax-free.

Nor is there any reasonable defense for hamstringing our tax police by requiring them to intensely audit the working poor while cutting resources to audit the well to do and the corporations they own.

America’s federal income tax system was long regarded as the most efficient and effective in the world, studied by tax administrators from Argentina to Zimbabwe. China’s system was designed four decades ago with American advice. Britain’s was reformed a quarter century ago to be more like America’s.

But today we suffer because our Congress has failed in its duty to ensure that our federal tax system flows from the economy instead of cutting against it while making sure that the tax police—the IRS—enforce our tax laws equal shares of fairness and vigor. The Koch Papers series illuminates all of these problems and more.

The creation of two tax systems grows from Congress treating Americans differently depending on how they earn their daily bread.

Congress does not trust those in the first system—workers, pensioners and investors who collect dividends and interest.

For these Americans, income is independently verified and taxes are withheld before people get paid.The IRS knows how much you made because Congress requires your employer, pension agency or stock broker to report your income to  IRS computers.

Under this reporting regime, cheating is nearly impossible.

America’s other income tax system applies to wealthy people who own their business, including Bill Koch and Donald Trump.

No Income Verification

Congress trusts such people to faithfully report their revenues, profits and losses and to pay 100 percent of their income taxes voluntarily. Unlike workers, there is little or no independent verification of business income.

It makes no sense to regard them as models of integrity, given decades of experience showing that tax cheating is rampant. One man pocketed $450 million tax-free with the IRS in the dark until a jilted lover turned him in. The IRS admitted in 2005 that it has no idea about the extent of high-end tax cheating.

Audits are the only way to have any assurance that rich business owners are paying the taxes that Congress requires.

But the number of audits has been shriveling along with time spent per audit. In addition, the IRS adopted rules two decades ago, at the behest of Congress, requiring auditors to warn companies in advance what issues would be examined and to not look more broadly unless the evidence they found rose to indications of criminality. The IRS long ago abandoned quality in corporate audits in favor of closing them quickly. And it has told Congress that the tax code is so complex that it cannot untangle many of the tax shelters sold by Wall Street.

Corporations have learned that withholding documents is a good way to avoid getting caught not paying all the taxes they owe. That is one of the many accusations against Bill Koch and his company leveled in whistleblower complaints by Charles Middleton, Koch’s former top tax executive.  Koch and his company, Carbon Oxbow LLC, simply say the IRS closed its audit with no changes.

Playing 'Audit Roulette'

Middleton gave the IRS documents that he says show Koch and his company knowingly engaged in “audit roulette,” which is cheating in the expectation that it was unlikely to be caught by IRS auditors and, if is, by withholding documents.

Last year, the risk that millionaires and billionaires would have their tax returns audited was 1-in-31. Every tax expert I know says the willingness to play audit roulette has been rising as audits of the rich and their companies have shrunk over the last three decades.

Tax audit roulette, not incidentally, is a much safer bet than spinning the wheel in Atlantic City where the odds are 19-to-1.

Audit rules for partnerships, which do not pay taxes directly, are dramatically more in favor of tax cheats. Over the last two decades, audit rates have ranged between 400-to-1 at the turn of the century to 224-to-1 in recently.

The falling audit risk is measured by the Transactional Records Access Clearinghouse (TRAC) at Syracuse University, which has a federal court order requiring the IRS to turn over data monthly.

TRAC’s latest report documents “an alarming and continued downward spiral in government audits of the wealthiest taxpayers and America's corporate giants. Despite growing income inequality—­where the top 1% of Americans control much of the wealth in the United States—less and less attention is being given by federal agents and investigators to determine whether these same individuals and businesses properly report their true incomes and pay taxes on these dollars. Billions of dollars are arguably at stake, as is American faith in the fairness of our federal tax system.”

The way to make the system fair is to require withholding on all income. Business owners who take money out of their companies should be required to rely on a trustee whose legal duty is to withhold taxes and report the income, risking prison or failure to do so. That is how the system operates for workers, pensioners and investors.

Along with this Congress needs to enact rules requiring the reporting of loans to and from companies by their owners that are consolidated with individual income reports. That will enable IRS computers to flag what appear to be loans being used to disguise income, though in most cases follow up would be needed by humans.

In our complex 21^st Century economy we are beset with mind-numbing problems, many of which seem to defy sensible solutions. But requiring that all income be verified and treating business owners the same as their workers, that’s a simple problem that will get fixed if we demand our Congress act in our best interests regardless of how much it offends tax cheats among the political donor class.