Tax Evasion vs. Tax Avoidance: What's the Difference?

Understanding this distinction is crucial for every taxpayer. The following information and examples will explain what activities cross the line and could result in an Internal Revenue Service (IRS) audit, tax penalties, or even jail time.

What Is Tax Avoidance?

Many people pay more in state and federal income tax than necessary because they misunderstand tax laws or fail to keep good records.

Tax avoidance is the legal practice of reducing your tax liability by taking advantage of deductions, credits, and other provisions in the tax code. In fact, there are provisions in the federal tax code and state law that encourage things like:

• Saving for retirement
• Buying a home
• Donating to charity

Tax avoidance can also include taking advantage of legal loopholes in the tax system to save money while remaining in full compliance with tax laws.

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.

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 other common tax avoidance strategies:

• Increasing retirement savings: Putting money aside for 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 reimburse 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). HSA contributions that your employer deducts from your paycheck are taken out pre-tax, so they just reduce your taxable income. If you make contributions on your own, those payments are deductible when you do your tax return.

What Is Tax Evasion?

Unlike tax avoidance, tax evasion is the use of illegal means to avoid paying your taxes. Tax evasion, often used interchangeably with the term tax fraud, occurs when a taxpayer willfully attempts to evade assessment or evade payment of a tax.

An honest mistake on your tax return doesn’t qualify as tax evasion. A conviction requires proof that you willfully acted to evade your taxes.

What Does “Willful” Mean?

For an action to be considered tax evasion, the IRS must prove it was “willful.” This is a key legal standard that separates a criminal act from an honest mistake. In the context of tax law, willfulness means a voluntary and intentional violation of a known legal duty.

This means you can’t be convicted of tax evasion for simple negligence or a misunderstanding of the law. Prosecutors must show that you:

1. Knew what the law required
2. Intentionally chose to disobey the law

For example, forgetting to report a small amount of income is likely a mistake. Creating a complex scheme to hide income offshore demonstrates a willful intent to evade 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.

Key Differences: Tax Avoidance vs. Tax Evasion

While both tax avoidance and tax evasion aim to reduce tax liability, their approaches and consequences are fundamentally different.

Questions on Tax Avoidance vs. Tax Evasion? A Tax Lawyer Can Help

The line between legal tax avoidance and illegal 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, if state or federal tax authorities have already contacted you about an issue with your taxes, it’s important to have a skilled advocate who understands the laws to protect you and ensure you’re pursuing only legal tax reduction strategies.