What Is the Difference Between Tax Avoidance and Tax Evasion?
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 is the legitimate minimizing of taxes and maximize after-tax income, using methods included in the tax code. Businesses avoid taxes by taking all legitimate deductions and tax credits 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.
Some Examples of Tax Avoidance Strategies
- Taking legitimate tax deductions to minimize business expenses and 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 tax credit for giving your employees paid family leaves.
Tax Loopholes and Tax Shields
A tax loophole is tax avoidance. it's a clause in the tax laws that people creates a hole people can go through to reduce their taxes. It's a way to avoid paying taxes, but since it's in the tax code it's not evasion.
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. If you are tempted to use a tax loophole, be aware that the tax laws are complex and difficult to interpret. Getting a competent, honest tax expert can save you from going over the line to tax evasion.
Tax shields are another strategy for avoiding taxes. A tax shield is a deliberate use of tax expenses to offset taxable income. The number of tax shields has been reduced since 2018, with the Tax Cuts and Jobs Act removing or limiting many Schedule A deductions.
Some tax loopholes are deliberate on the part of lawmakers; accelerated depreciation is one example.
Tax evasion, on the other hand, is using illegal means to avoid paying taxes. Usually, tax evasion involves hiding or misrepresenting income. This might be underreporting income, inflating deductions without proof, hiding or not reporting cash transactions, or hiding money in offshore accounts.
The Internal Revenue Code says that the willful attempt to "evade or defeat any tax" law is guilty of a felony. If convicted, tax evasion can result in fines of up to $250,000 for individuals ($500,000 for corporations) or imprisonment of up to five years, or both, plus court the cost of prosecution.
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."
In this situation, the phrase "ignorance of the law is no excuse" comes to mind.
Tax Evasion and Trust Fund Taxes
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.
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, particularly cash income.
- 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).
- 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 without having documents to support them
- 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.
- 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.
- Filing false payroll tax returns or failing to file these returns.
Intentional Tax Evasion vs. Mistakes
Sometimes taxpayers make mistakes; this is considered negligence, not intentional tax fraud. But the IRS will probably send you a notice of penalties and interest due. In the case of a mistake that results in an underpayment of taxes, for example, the IRS can still impose a penalty of 20% 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.
To avoid being charged with tax evasion:
- 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, especially if you have a cash-based business. And keep reading articles from this site and others, to learn more about what constitutes tax evasion.