What Is the Difference Between Tax Avoidance and Tax Evasion?

© The Balance, 2018

No one likes to pay taxes. But taxes are the law. The terms "tax avoidance" and "tax evasion" are often used interchangeably, but they are very different concepts. Basically, tax avoidance is legal, while tax evasion is not. 

Businesses get into trouble with the IRS when they intentionally evade taxes. But your business can avoid paying taxes, and your tax preparer can help you do that. 

Tax Avoidance

Tax avoidance is the legitimate minimizing of taxes, using methods included in the tax code. Businesses avoid taxes by taking all legitimate deductions and by sheltering income from taxes by setting up employee retirement plans and other means, all legal and under the Internal Revenue Code or state tax codes.

You may have heard of "tax shields" These shields are for protection against higher taxes, and they are the strategies of tax avoidance.

Some Examples of Tax Avoidance Strategies 

  • Taking legitimate tax deductions to minimize business expenses and thus lower your business tax bill. 
  • Setting up a tax deferral plan such as an IRA, SEP-IRA, or 401(k) plan to delay taxes until a later date. 
  • Taking tax credits for spending money for legitimate purposes, like taking a Work Opportunity Tax Credit for hiring workers in your business. 

Tax Loophole

A tax loophole is tax avoidance. According to Investopedia, a loophole is a

"technicality that allows a person or business to avoid the scope of a law or restriction without directly violating the law."

Since the tax code is so complex, savvy tax experts have found ways to lower taxes for their clients without breaking the law, taking advantage of parts of the law.

Some tax loopholes are deliberate on the part of lawmakers; accelerated depreciation is one example.

Note the word "avoid" in the definition; finding a way to avoid paying taxes by finding a hole in the tax code is tax avoidance, not evasion. Just be aware that there are some gray areas in the law. Getting a competent, honest tax expert can save you from going over the line to tax evasion. 

Tax Evasion

Tax evasion, on the other hand, is the illegal practice of not paying taxes, by not reporting income, reporting expenses not legally allowed, or by not paying taxes owed. In this situation, the phrase "ignorance of the law is no excuse" comes to mind. 

Tax evasion is part of an overall definition of tax fraud, which is illegal intentional non-payment of taxes. Fraud can be defined as "an act of deceiving or misrepresenting," and that's what someone evading taxes does — deceiving the IRS about income or expenses. The IRS Criminal Investigation unit prosecutes cases under the broad designation of "tax fraud."

Tax evasion is most commonly thought of in relation to income taxes, but tax evasion can be practiced by businesses on state sales taxes and on employment taxes. One common tax evasion strategy is failing to pay turn over taxes you have collected from others to the proper federal or state agency.

These taxes are called trust fund taxes, because they are given in trust to a business, with the expectation that they will be turned over to the appropriate state or federal agency. Failing to pay employment taxes to the IRS and sales taxes to a state taxing authority and other federal, state, and local taxes can mean high fines and penalties.

In fact, tax evasion can be practiced on all the taxes a business owes.

Examples of Tax Evasion/Tax Fraud Practices

In general, it's considered tax evasion if you knowingly fail to report income or you don't file an income tax return. Some practices considered tax evasion/tax fraud:

  • Under-reporting income (claiming less income than you actually received from a specific source
  • Not reporting an income source
  • Providing false information to the IRS about business income or expenses
  • Deliberately underpaying taxes owed
  • Substantially understating your taxes (by stating a tax amount on your return which is less than the amount owed on the income you reported).
  • Filing false payroll tax reports or failing to file these returns. 
  • Deliberately underreporting or omitting income,
  • Overstating the amount of deductions
  • Keeping two sets of books
  • Making false entries in books and records
  • Claiming personal expenses as business expenses
  • Claiming false deductions
  • Hiding or transferring assets or income

Employment Tax Fraud Examples

Tax evasion isn't limited to income tax returns. Businesses that have employees may be committing tax evasion in several ways: 

  • Failure to withhold/pyramiding: An employer fails to withhold federal income tax or FICA taxes from employee paychecks, or withholds but fails to report and pay these payroll taxes, as described above. 
  • Employment leasing, which the IRS explains is hiring an outside payroll service that doesn't turn over funds to the IRS.
  • Paying employees in cash and failing to report some or all of these cash payments.

Here are some other tax mistakes business owners make that are considered tax evasion. 

Intentional Tax Evasion vs. Mistakes

Sometimes taxpayers make mistakes; this is considered negligence, not intentional tax fraud. In the case of a mistake that results in underpayment or nonpayment of taxes, the IRS can still impose a penalty of 20 percent of the amount of underpayment, in addition to requiring repayment.

How to Avoid Tax Evasion Charges

While tax evasion might seem willful, you may be subject to fines and penalties from the IRS for tax strategies they consider to be illegal and which you were unaware you were practicing.

The best way to avoid being charged with tax evasion is to know the tax laws for income taxes and employment taxes. For example, knowing what deductions are legal and the recordkeeping requirements for deductions is a big factor in avoiding an audit. For employers, knowing the payroll tax reporting and payment requirements will help keep you out of trouble. 

Get an honest, careful tax professional to help you with your taxes. Listen to your tax preparer and keep excellent records of all income and expenses, even if you have a cash-based business. And keep reading articles from this site and others, to learn more about what constitutes tax evasion. 

The Cost of Tax Evasion/Tax Fraud

Some tax evasion cases may be reviewed in tax court, but others are turned over to the IRS criminal division or to a state or local taxing authority for prosecution.

Even if the taxpayer is eventually found not guilty, the costs in time and money are enormous. 

Tax Fraud is a crime. Since tax evasion is considered intentional and "willful," the IRS can bring criminal charges against those convicted of tax evasion. The penalties can include jail time as well as substantial fines and other actions. 

Just to be clear, the tax law says that anyone who willfully attempts to "evade or defeat any tax..." is guilty of a felony. On conviction, in addition to paying the cost of the trial, the fine may be up to $100,000 ($500,000 in the case of a corporation) and prison time of up to 5 years can be imposed.