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

Tax avoidance means legally reducing your taxable income. Tax evasion means concealing income or information from the IRS — and it's illegal.
November 21, 2017
Income Taxes, Personal Taxes, Taxes
Tax Evasion vs. Tax Avoidance
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Tax avoidance and tax evasion are two very different things. Avoidance is legal, while evasion is not. What’s the difference? It largely boils down to two elements: lying and hiding.

What are tax evasion and avoidance?

“Tax avoidance is structuring your affairs so that you pay the least amount of tax due. Tax evasion is lying on your income tax form or any other form,” says Beverly Hills, California-based tax attorney Mitch Miller. Putting money in a 401(k) or deducting a charitable donation are perfectly legal methods of lowering a tax bill, so long as you follow the rules; but concealing assets, income or information to dodge liability typically constitutes evasion.

Ways evasion can accidentally happen

Evading taxes doesn’t require elaborate schemes or dark-alley meetings. Here are a few ways it can happen more easily than you’d think:

Paying the nanny under the table

Paying someone who works for you in cash doesn’t constitute tax evasion, says Greg Freyman, a CPA in St. Johns, Florida. What does, however, is a lack of communication with the IRS and payroll tax payments. You should report the wages you pay on Schedule H and give the worker a W-2 each year, he says. Not sure if that household helper counts as an employee? IRS Publication 926 will help you decide.

“Income is income,” Freyman says.

An innocent mistake on your tax return doesn’t automatically turn you into a tax evader — intent is a factor.

Ignoring overseas income

This often affects people who work or own rental properties outside of the country, Freyman says.

“We’ve heard a lot of times: ‘But my property is not in the U.S. Why in the world should I report any income on it if it’s a rental?’” he says. “That’s one that always gets people. They think just because it’s out of the country, they don’t have to report it.”

Banking on bitcoin

Using bitcoin won’t get you through any secret loopholes. So-called cryptocurrencies are a new phenomenon, but the IRS already has rules about them: Their transactions are taxable. And sometimes taxpayers overlook bitcoin holdings that have increased in value.

“They might get rid of it and not realize that that’s still income,” Freyman warns.

Not reporting income from an all-cash business or illegal activities

Some of the most common tax evasion cases involve people running cash businesses who pocket money from the cash register without reporting the income, Miller says.

“That’s tax evasion,” he says. “That is very, very common — and the IRS knows that’s very common.”

Tax evasion also happens when people don’t report income from illegal activities, such as drug dealing or prostitution. (Yes, you have to report that on your tax return.) Evading taxes on income from prostitution and bootlegging is what brought down the notorious gangster Al Capone.

Penalties for tax evasion

An innocent mistake on your tax return doesn’t automatically turn you into a tax evader — intent is a factor.

But if you did intend to evade taxes, here’s a taste of the penalties you’ll face, according to the IRS:

  • A felony on your record
  • Five years in jail, and/or
  • A fine of up to $250,000 ($500,000 for corporations)
  • A bill for the cost of prosecuting you

Jail time is a real possibility for willful evaders, but civil penalties may be more likely, according to Miller. Still, civil penalties add up — they can easily double the tax originally owed, he says. Some examples include:

  • Failure-to-file penalties
  • Underpayment penalties
  • Accuracy-related penalties
  • Interest on penalties owed

Another consequence of tax evasion is higher audit risk. Typically, only the last three years of your tax returns are eligible for audit. “If you omit 25% or more of your gross income [from a tax return], that extends the statute of limitations to six years,” Miller says.

Your tax preparer might dump you, too.

“We can only advise and guide and say, ‘OK, in this kind of case, you should really change this. This is not good,’” Freyman says. “And if the client refuses or doesn’t want to do it, then it’s up to us.… Do we want to work with this client, is this client ethical?”

Think you won’t be caught? Don’t be so sure. The IRS pays whistleblowers.

Don’t evade — avoid

There are plenty of ways to reduce your tax bill legally. Capitalizing on tax-advantaged retirement accounts such as 401(k)s and individual retirement accounts is one way.

But there are also hundreds of tax deductions and credits. You might qualify if you paid for tuition, day caremoving expenseslegal fees or tax advice. Having a home office or making charitable donations can also qualify you. Your tax prep software or tax advisor can help you find the options that apply.

What to do if you want to come clean

File an amended return using IRS Form 1040X, which lets you make changes to tax returns you’ve filed in the past.

“In general, the IRS is sort of like religion,” Miller says. “If you’re contrite, they generally won’t nail you.”

But, he adds, “There are certain areas that they do not compromise on.”

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