By Jamie Johnson, WCI Contributor
Nobody likes giving their hard-earned money to the government, but taxes are a part of life. Fortunately, the IRS provides legal ways for individuals and companies to lower their tax burden through deductions and credits. This behavior is known as tax avoidance, and it’s a legitimate way to reduce your taxable income. In comparison, tax evasion involves illegally concealing or misrepresenting your income to avoid paying taxes.
If you’re reading this article, you’re probably not trying to actively engage in tax evasion. By understanding the difference between the two concepts, you can avoid unknowingly committing fraud and getting in trouble with the IRS. After all, if there's one government entity you don't want to mess with, it's the IRS.
What Is Tax Avoidance?
Tax avoidance is a legal way taxpayers can minimize the amount of income tax they owe. You can do this by claiming as many deductions and credits as possible or by prioritizing investments with certain tax advantages.
Examples of Tax Avoidance
Here are some examples of tax avoidance that will help lower your tax burden.
- Contributing to a retirement account with pre-tax dollars, including a 401(k) or 403(b)
- Taking advantage of the child tax credit
- Taking the mortgage tax deduction
- Contributing to a Health Savings Account (HSA)
- Contributing to a college savings fund, like a 529
- Investing in municipal bonds
- Deducting business expenses
- Giving to charity
- Tax-loss harvesting
Is Tax Avoidance Legal?
The term “tax avoidance” can invoke some negative connotations, but it’s completely legal. Tax deductions and credits are approved by Congress and signed into law before they become part of the US Tax Code.
The tax code actually supports taxpayers finding ways to cut down on their tax burden. However, you have to follow the rules—you can’t lie or misrepresent the number of deductions you’re taking.
What Is Tax Evasion?
According to the IRS, tax evasion is deliberately underpaying or failing to pay your taxes. Individuals or corporations may misrepresent their income to the IRS by underreporting their income, exaggerating their deductions, or hiding money in an offshore account.
Even if you don’t report your income or turn in certain tax forms, the IRS has other means of verifying your income. IRS officials can look at third-party information on your W-2 or check 1099 forms. So, it’s hard for the average person to get away with tax evasion.
Examples of Tax Evasion
Here are some examples of tax evasion that could very well get you in trouble.
- Underreporting your income
- Exaggerating business tax deductions
- Deliberately underpaying on your taxes
- Hiding money and the interest earned in an offshore account
Is Tax Evasion Illegal?
Tax evasion is illegal, and there are severe consequences for engaging in this practice, including fines and possible jail time. Tax evasion is a federal crime because it creates enormous losses for the federal government.
It creates a “tax gap,” which is the difference between the taxes owed and what’s actually collected. One report found that the tax gap costs the government around $600 billion annually.
Other Types of Tax Evasion
When people think of tax evasion, they might imagine someone hiding income in a bank in the Cayman Islands. But the truth is, tax evasion is more nuanced than that, and it can take many different forms. Let’s look at a few other types of tax evasion.
Employment Tax Fraud
Some employers choose to evade their employment tax responsibilities by withholding employment taxes from their employee’s paychecks. Then, they either “borrow” this money or just take it with no plans to repay that money.
Some businesses also engage in employment tax fraud by misclassifying employees as independent contractors. Others will pay employees in cash to avoid their full tax responsibility.
Bankruptcy Fraud
When you file for bankruptcy, you reduce and manage your debt to achieve financial relief from your creditors. Businesses can use bankruptcy to restructure their debt so the company can survive.
But some businesses use bankruptcy as a way to avoid paying the taxes they owe. This practice is illegal and considered a form of tax fraud.
Corporate Fraud
Corporate fraud involves:
- Under-reporting income
- Claiming excessive credits or deductions
- Setting up complex financial arrangements to avoid their full tax responsibility
Enron is probably the best-known example of corporate tax fraud—the company avoided paying taxes for years before the scam finally collapsed.
Tax Avoidance vs. Evasion—What’s the Difference?
Tax avoidance is a legal strategy to lower your taxes, while tax evasion is an illegal strategy used to avoid paying what you owe. When used correctly, tax avoidance helps you reduce the amount you owe during tax season.
But if you’re caught and convicted of tax evasion, you could face a fine of $250,000 and up to five years in prison. Even if you’re not convicted, you’ll still have to pay the amount you originally owed, and you could get hit with civil penalties.
How to Avoid Tax Evasion Charges
The U.S. Tax Code is complex, and it’s a fine line between tax avoidance and tax evasion. If you aren’t careful, it’s easy to fall into that gray area where your tax-avoidant strategies border on tax evasion.
But the IRS understands that mistakes happen, and it typically only pursues willful and blatant cases of tax evasion. Here are some strategies to avoid tax evasion charges:
- Don't lie: Honest people rarely have to deal with tax evasion issues.
- Work with an accountant: Hire an accountant to manage your taxes every year. An accountant understands tax laws and can ensure that you report your income, deductions, and tax credits correctly. Here's a list of WCI-vetted tax strategists to help you.
- Understand tax laws: It’s a good idea to have a basic understanding of tax laws, especially when it comes to reporting deductions. Understanding what you can and cannot legally deduct can help you stay out of trouble.
- Keep careful records: You want to keep meticulous financial records in case you ever get audited. It’s a good idea to keep your tax records for at least seven years.
- Make sure you file on time: Make sure you file your taxes on time every year, and if you’re self-employed, pay your quarterly taxes on time. If you perpetually pay late or forget to file, you could get hit with tax evasion charges. If you’re unable to file your taxes on time for some reason, make sure you file an extension by the due date.
Reporting Tax Evasion
If you suspect tax fraud, you should report this activity to the IRS. Ironically, you can actually earn money for doing so—the Whistleblower Office administers rewards for turning in tax evaders. If you suspect another individual or company is engaging in tax evasion, you can report this to the IRS.
If you need help with tax preparation or you’re looking for tips on the best tax strategies, hire a WCI-vetted professional to help you figure it out.
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