Tax Evasion vs. Tax Avoidance
There's nothing wrong with wanting to lower your tax bill. Where you can run into trouble is how you go about doing that. You can take legitimate steps to avoid paying taxes and maximize your after-tax income. But failing to pay or deliberately underpaying taxes you owe is tax evasion and illegal.
Understanding the difference between tax evasion and tax avoidance often isn't complicated. The following information and examples will explain what activities cross the line. These could result in you facing an Internal Revenue Service (IRS) audit, tax penalties, or even jail time for tax crimes.
What Is Tax Avoidance?
While tax evasion is illegal, there are steps every taxpayer can take to reduce their tax liability. In fact, there are provisions in the federal tax code and state law that encourage these actions to boost behaviors like saving for retirement, buying a home, or donating to charity. Reducing your tax liability while complying with tax laws is tax avoidance. Tax avoidance can also include taking advantage of legal loopholes in the tax system to save money.
Many people pay more state and federal income tax than necessary because they misunderstand tax laws, don't save for retirement, or fail to keep good records. The most common means of tax avoidance is claiming all your allowed deductions and credits. For example, contributing to a pre-tax retirement fund reduces your taxable income.
Modern technology also makes it easy to take advantage of tax avoidance strategies. That's because most tax preparation software products, like TurboTax, include a tax calculator that will analyze your finances and help you find ways to reduce your tax bill legally.
Examples of Tax Avoidance
Federal and state tax laws provide for deductions, credits, and adjustments to your income that will lower your tax burden. High-income taxpayers often use tax professionals, such as tax attorneys or CPAs, to help them take full advantage of the legal ways to reduce future tax bills. Tax planning can reduce your taxable income in a given year. It also might lower the tax rate on that income by moving you to a lower tax bracket.
Here are some common tax avoidance strategies:
- Increasing Retirement Savings: Putting aside money for your retirement is an effective tax avoidance tool. Employer-sponsored retirement plans often take money from your pre-tax earnings. If your employer has no plan, you can set up a Roth individual retirement account (IRA) that will allow your retirement savings to grow tax-free.
- Maximize Work Deductions: Pay attention to your unreimbursed business expenses. The IRS lets you deduct expenses that are "ordinary and necessary" to do your job if your employer does not repay you. That would include things like union dues, unreimbursed mileage, and tools.
- Invest in Your Home: If you use a mortgage to buy your house or a home equity loan to finance improvements, you often can claim a deduction on the interest you pay. Another advantage of investing in your home is that, when you sell it, you will enjoy an exemption from the capital gains tax for the first $250,000 ($500,000 for married couples) in profits.
- Fund a Health Savings Account: If you have a high deductible health care plan, consider funding your health savings account (HSA). For 2023, up to $3,850 in contributions for an individual ($7,750 for a family) are deductible and can be used to pay for qualified medical expenses. What you don't use rolls over to later years.
What Is Tax Evasion?
Tax evasion is the use of illegal means to avoid paying your taxes. Tax evasion occurs when the taxpayer either evades assessment or evades payment. This differs from tax fraud, which generally refers to a taxpayer's attempts to lower their tax bill by falsifying information.
An example of evading assessment would be transferring assets to prevent the IRS from determining your actual tax liability. If a taxpayer hides the assets after a tax liability has become due and owing, it is an attempt to evade payment.
An honest mistake on your tax return doesn't qualify as tax evasion. A conviction requires proof that you willfully acted to evade the assessment or payment of your taxes. This crime comes with serious penalties, including:
- Fines: Tax evaders must pay their original tax liability plus interest, and hefty fines also accompany any conviction. For individuals, a fine of up to $100,000 can be assessed.
- Prison: A conviction for tax evasion could result in being sentenced to up to five years in prison.
Examples of Tax Evasion
Courts generally find that taxpayers who participate in one or more of the following have committed tax evasion:
- Underreporting Income: Taxpayers are always coming up with new ways to hide income from the IRS. But if you intentionally acted to keep the IRS from learning how much you earned, it's tax evasion. When you file your return, you must provide honest and true earnings statements or face criminal charges.
- Taking Unearned Deductions: This usually occurs when individuals list deductible expenses on their tax forms that they did not incur.
- Not Filing Tax Returns: You can't hide from the IRS by not filing a return. The IRS receives tax statements from employers and interest statements from financial institutions. If you made money, the IRS likely knows and expects you to file a return.
- Deliberately Underpaying Taxes: Filing your return is only half of your responsibility. You are also required to pay your taxes. Failing to pay can be punished as harshly as if you never filed. If you're having trouble paying, contact the IRS or state agency to arrange a payment plan.
- Claiming Business Deductions for Personal Expenses: The IRS is on the lookout for small-business owners and self-employed individuals who write off their personal spending as business-related by making the payments from their business bank accounts.
Questions on Tax Avoidance vs. Tax Evasion? A Tax Lawyer Can Help
The line between tax avoidance and tax evasion can be narrow. Therefore, it's always best to seek the legal advice of a local tax attorney if you are concerned that your efforts at tax avoidance could be considered illegal by the IRS. Likewise, suppose state or federal tax authorities have already contacted you about an issue with your taxes. In that case, it's important to have a skilled advocate who understands the laws to protect you.
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