While both sound like something that the IRS would frown upon, tax evasion and tax avoidance are two different things. Tax avoidance refers to the use of legitimate methods to reduce your tax liability, while tax evasion involves the use of deception and other fraudulent activities to do the same. While some taxpayers knowingly perform tax evasion, others fall for the promise that a “third party” can reduce the amount of taxes they owe. The IRS often catches people involved in these schemes and will sometimes find their clients to be guilty of evading their taxes.
Tax Avoidance as a Legitimate Way to Reduce Tax Liability
The process of “tax avoidance” involves the use of tax deductions, credits, and adjustments for which you are legally eligible. Most taxpayers do it, and there’s nothing wrong with it. The government created these methods to help qualified taxpayers to lower their tax liability.
Tax deductions can be used to lower your taxable income. So when you take them, you can reduce the amount you will have to pay. Some of the common tax deductions can include but may not be limited to:
- Contributions to tax-advantaged retirement accounts (such as a 401(k) or IRA).
- Contributions to a health savings account (HSA)
- Some business expenses.
- Mortgage taxes.
You can also choose between an itemized deduction or taking the standard deduction.
Tax credits can help you to lower your tax bill “dollar-for-dollar.” Taking them will reduce the amount of tax you owe on your income. Some of them are also referred to as “refundable,” which means that they can increase your tax refund if the amount of the credit is greater than the amount of remaining taxes you owe. There are a number of tax credits related to children and dependents that are commonly used (such as the child tax credit). There are also tax credits related to education, student loan interest, and even green energy.
Tax Evasion is Illegal and is Considered a Form of Tax Fraud
When it comes to tax fraud, most people think of large corporations that cheat on their taxes or identity thieves who file fraudulent returns, but the same is true for tax evasion (which refers to the intentional and illegal attempt to not pay or underpay taxes). You may not even realize you’re evading your taxes. If you have a nanny, housekeeper, or yard maintenance person that you pay in cash, you may have to send them a W-2 every year for the purpose of tax reporting. Otherwise, it could be considered a form of tax evasion if their wages are considered to be payroll tax payments.
You can also get in trouble by ignoring overseas income. It doesn’t matter where you earned your money. If you’re a US citizen (or even a US person), the IRS always gets a cut. Any money you earned abroad (such as wages, tips, consultancy fees, alimony, capital gains, rental income, and gambling winning) can be taxed. Even if you have a foreign bank account that’s earning interest, you need to report it to the IRS. Not paying it can lead to your passport being revoked.
One of the most common forms of tax evasion is claiming deductions and credits for which you’re not legally eligible, but it can also involve the following:
- Establishing a fake religious organization to keep from paying taxes by claiming tax-deductible “donations.”
- Fraudulently filing a tax return that claims zero income for the year or under-reporting your income.
- Allocating income to a relative in a lower tax bracket.
- Claiming personal travel expenses (such as souvenirs, personal meals, or upgrades to first class) as business travel expenses.
- Omitting cryptocurrency gains from your tax return.
If you knowingly or mistakenly under-reported your taxable income, you can file an amended return for previous years. If you have already corrected the problem, the IRS is less likely to pursue you for tax fraud. Some taxpayers could end up being guilty by association if they worked with a tax preparer who got arrested for tax evasion.
Tax evasion is considered a criminal offense that can come with severe penalties, which can include time in jail. You never want to claim benefits for which you don’t qualify, and you want to make sure that anyone who prepares your taxes uses honest methods to reduce your taxable income. The IRS also knows the difference between a mistake and an act of fraud, so you don’t have to worry if you made an error. Before they can charge you with tax evasion, the IRS Criminal Investigation Division has to prove that you willfully committed the offense.