Tax Avoidance vs. Tax Evasion
Table of Contents
The definitions, differences, examples, whistle-blowing, and penalties.
What is tax avoidance?
Unlike tax evasion, which relies on illegal methods, tax avoidance is a legal method of reducing taxable income or tax owed by an individual or business. It is a legal strategy that taxpayers can use to legitimately lower their IRS tax bills. Most commonly, tax avoidance is done through claiming as many deductions and credits as possible. For example, contributing to a pre-tax retirement fund lower’s your taxable income. In addition to claiming tax deductions and tax credits, investing in tax-advantaged accounts such as IRAs and 401(k)s helps to reduce your tax liability. Likewise, you can achieve tax avoidance by prioritising investments that have tax-advantages, such as buying tax-free municipal bonds.
Examples of tax avoidance
Taxpayers can take advantage of tax avoidance through various deductions, exclusions and credits. You may qualify for tax deductions and credits if you paid for day care, medical expenses, tuition, or even sales taxes.
Here are some other frequently used tax avoidance strategies, to reduce your tax burden legally:
1.) Increase Retirement Savings
Retirement plans take away from your pre-tax earnings, making putting aside money for your retirement an effective tax avoidance tool. The taxable income will be reduced, as well as the taxes owed. Every person who is contributing to an employer-sponsored retirement plan or invests in an individual retirement account (IRA) is engaging in tax avoidance.
2.) Maximise your work expenses deductions
The IRS allows you to deduct work-related expenses that are not reimbursed by your employer on your annual tax return, including mileage and stationery.
3.) Put money into a Health Savings Account (HSA)
Any money you contribute to a health savings plan is tax deductible.
4.) Capitalise on tax-advantage retirement accounts
Tax-advantaged retirement accounts include 401(k)s and individual retirement accounts, and are popular methods of tax avoidance.
5.) Claim the Child Tax Credit (CTC)
6.) Take the mortgage tax deduction
7.) Use the Standard Deduction
The Standard Deduction is $12,550 for individuals and $25,100 for married couples filing jointly for 2021. For 2022, this increases to $12,950 for single filers and $25,900 for married couples filing jointly.
8.) Use home equity loans
Unlike other methods of borrowing, home equity loans have tax-deductible interest.
9.) Tax-smart college savings
Some college plans work the same way 401(k)s or IRAs work, in that your investment grows tax deferred. Payments for college costs effectively come out federal tax-free.
10.) Offshoring
Setting up offshore subsidiaries or bank accounts in ‘tax havens’ with more favourable tax laws, allows taxpaying entities to avoid paying higher taxes at home.
I want to know more about US Taxes abroad
What is tax evasion?
Tax evasion is when a person or entity deliberately avoids paying their true tax liability, through illegal methods. Wilfully failing to pay taxes (illegal non-payment) or falsifying how much tax is owed (illegal underpayment) is a federal offence under the IRS tax code. Intent is a big factor here – generally, you are considered guilty if this was intentional.
Examples of tax evasion:
Here are some examples of tax evasion:
1.) Ignoring overseas income
This often affects people with rental properties overseas.
2.) Banking on Bitcoin
The IRS has rules about cryptocurrencies, and their transactions are taxable. Often, taxpayers can overlook their cryptocurrency holdings that have increased in value.
3.) Paying someone ‘under the table’
While paying someone who works for you in cash is not tax evasion, not communicating with the IRS to make payroll tax payments does. You need to report the wages you pay on Schedule H and give workers a W-2 annually.
4.) Under reporting income
Income can be earnt from things such as tips, bonuses, or casual jobs such as dog walking. If you do not report all income, you can be found guilty of tax evasion. This can also include income from illegal activities that people do not report. Such as drug dealing or prostitution.
It is common for people who run cash businesses and pocket money from the cash register to not report this income.
5.) Taking unearned deductions
This happens when taxpayers claim expenses that they did not incur.
6.) Failing to file tax returns
If you made any money, the IRS will know from monitoring tax statements from employers and interest statements from financial institutions.
7.) Deliberately underpaying taxes
Failing to pay your taxes is punished just as harshly as failing to file your return or report your income.
What is the main difference between tax evasion and tax avoidance?
While tax avoidance and tax evasion are both centred around avoiding paying taxes, they are very different. To summarise, tax avoidance is a legal and legitimate strategy, while tax evasion is illegal and results in harsh punishments. Tax evasion is a serious offense, and those found guilty can be fined and/or jailed.
What are the requirements for tax evasion?
In order to be considered as tax evasion, the act of failing to pay must be intentional and deliberate. When
determining whether it was intentional, various factors are considered. The taxpayer’s financial situation will be examined to see whether the non-payment was a result of fraudulent activity, or the concealment of reportable income.
Failure to pay may be judges as fraudulent when a taxpayer made efforts to conceal assets by associating them with someone other than themselves. This also includes reporting income under a false name and SSN (Social Security Number), also constituting identity theft.
Someone might be judged as concealing income when failing to report work for which the payment was not recorded traditionally. For example, accepting cash payment and not reporting it to the IRS.
Penalties for tax evasion
The IRS can easily determine the non-payment or underpayment of taxes. This is because information is sent by third parties, such as W-2 information from a person’s employer, or 1099s. Making mistakes on your tax returns does not automatically render you a tax evader – intention is a big factor.
If you intend to evade taxes, the penalties include the following:
Criminal record
5 years in jail, and/or A fine of up to $250,000 ($500,000 for corporations)
Legal bill for the cost of your prosecution
Civil penalties that can double the tax originally owed, such as failure-to-file penalties, underpayment penalties, accuracy-related penalties, and interest on penalties owed.
Higher audit risk. Typically, the last three years of your tax return are eligible for audit.
Does the IRS pay whistle-blowers?
Yes, so don’t think the chances of being caught are low. The IRS may pay awards in exchange for valuable information regarding tax evaders. The IRS focuses its efforts on these claims, as it is typically the higher income individuals that cheat taxes for higher sums of money.
If you receive a whistle-blower award, you will need to report it when you file your taxes.
What to do if you want to come clean about tax evasion?
File an amended return using IRS Form 1040X, which lets you make changes to tax returns you’ve filed in the past.
How do I report a tax cheat?
No one likes paying more than their fair share of taxes to compensate for those who are evading theirs.
The Internal Revenue Service (IRS) estimates that Americans underpay their taxes by about $441 billion every year. Despite IRS effort, there is still a gap between the tax evader and the IRS, and the IRS misses out on revenue. When reporting a tax cheat, the IRS will need specific information. This information includes the type of violation and availability of records. You will need to gather the supporting evidence (not through illegal methods), as the IRS is not likely to invest the time and resources unless it will likely pay off.
The tax evasion must be financially significant enough to warrant the IRS opening an investigation, and it can take several years to complete an investigation into tax evasion.
If you decide to report someone you suspect is cheating their taxes, use IRS Form 3949-A. This form asks for basic information on the tax evader you are reporting, the violation committed and details surrounding it, and how you learned about the violation. If you don’t want to fill out this form you can simply write a letter to the IRS, along with Form 211 (an application for the award).
