Best Practices

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

by Ana-Maria Sanders   Feb 22, 2021

Two terms that are used interchangeably but shouldn't be are "tax avoidance" and "tax evasion." Avoidance can be legal in the right circumstances. Evasion never is.

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Those who evade taxes face substantial penalties from the IRS. However, it is possible to avoid paying taxes legally.

What is Tax Avoidance?

Tax avoidance is the legal act of reducing taxes and increasing after-tax income. People "avoid" taxes by exercising lawful abatements and tax credits, as well as through employee retirement programs.

Avoiding taxes is a legitimate way to pay the lowest tax rate.

Some examples of how to avoid paying taxes legally include:

  • Tax deductions can be used to minimize dues.
  • Couples may file separately in order to receive a lower tax rate.
  • Consumers may use a tax deferral plan to postpone paying taxes.

How to Avoid Taxation

Filling out tax forms.

A tax loophole is a technicality in the tax code that helps someone avoid paying taxes. Before using a tax loophole, consider that tax laws are complicated. It's best to seek out professional help from a qualified tax expert.

Tax shields are another way to avoid taxes. A tax shield is a deduction that reduces one's income taxes. For example, debt interest is sometimes deductible. So, a consumer may be able to use debt interest as a tax shield by deducting it from taxable income.

Tax avoidance requires planning. These strategies help people find the lowest possible tax rate:

  • minimizing taxable income
  • maximizing tax deductions and tax credits
  • adjusting the timing of income and deductions
  • Efficient tax planning requires reliable estimates of your personal and business income. Several years of income and expense projections are necessary, and adjustments may be needed for those who reach new income brackets.

What is Tax Evasion?

Tax evasion is using illegal methods to skip paying taxes. In other terms, evading taxes involves:

  • withholding, hiding, concealing, or presenting misleading income
  • maximizing deductions without any credible proof
  • covering up or not including cash activities
  • storing or hiding money in offshore accounts

According to the Internal Revenue Code, any individual who has willfully engaged in an attempt or succeeded in evading taxes is guilty of a felony by law. When caught and convicted, the penalties are large — up to $250,000 for individuals or $500,000 for corporations, and possible jail time of up to five years.

Evasion is tax fraud, which is interpreted as unlawful and deliberate non-payment of taxes. Fraud is characterized as the explicit act of deceiving and misleading.

Some examples of tax evasion include:

  • Underreporting one's actual income
  • Leaving out an income source
  • Overstating the number or sum of deductions
  • Keeping two sets of books — one "actual" book with personal records and another book to provide misleading information to the IRS
  • Declaring personal expenses as business expenses
  • Concealing or transferring assets or income to offshore accounts

One of the Most Famous Tax Evasion Cases

Tax evasion cases.

Walter Anderson's case is one of the largest tax evasion lawsuits in U.S. history. The previous telecommunications executive was indicted for concealing his earnings by using aliases, offshore bank accounts, and shell companies.

In 2006, Anderson was arrested. He eventually confessed to hiding approximately $365 million worth of income. Walter Anderson was sentenced to nine years in prison and fined $400 million.

Anderson's plea agreement contained a clerical error in the amount, and he ended up paying less than he should have.

How Tax Evasion Penalties Work

It's not just the big fraudsters like Walter Anderson that face penalties. Even smaller instances of tax evasion can result in civil and criminal charges.

Civil

In civil cases, the government reports that the taxpayer made a mistake, calculation error, or was inattentive in preparing and filing the taxes. Civil cases may result in a fine, but they do not include prison time like in criminal cases.

A civil tax penalty usually occurs after a state or federal tax inspector notices an issue with a tax return. This can be anything from obvious mistakes to mild calculation inaccuracies or other predicaments. Civil tax cases may end in no penalty at all or may result in fines. For example, forgetting to register a return may result in a 5% penalty, based on the volume of taxes per month.

Criminal

In a criminal case, the government accuses the taxpayer of using deliberate methods to avoid paying the taxes owed. Criminal cases are more severe and can lead to fines and even imprisonment.

Ways to commit tax fraud include underreporting income, exaggerating expenses, and not filing a yearly tax return. Breaking state and federal state laws may result in the following penalties:

  •  Prison – Committing tax fraud can result in years of prison time.
  • Fines - A conviction for a tax evasion penalty or other tax crimes may result in a fine. Courts may enforce fines in addition to prison or probation time.
  •  Restitution - Most tax fraud cases require restitution, meaning the individual charged with tax fraud must pay back the taxes they neglected to pay to the state or federal government.
  • Costs of Prosecution - Federal law permits a court to command someone convicted of tax fraud to compensate for prosecution costs, alongside fines or restitution. The prosecution costs for tax fraud cases tend to vary, but they can easily reach up to thousands of dollars.
  • Probation - A court also holds the right to sentence an individual that committed tax fraud to probation. In these cases, probation sentences regularly last for about a year. However, certain instances warrant longer sentences. Those on probation are obliged to abide by the court's orders. If they fail to do so, they may risk having the probation extended. They may also need to pay additional fines, go to prison, or face other penalties.

The penalties don't stop here. Those who receive probation, for instance, may need to maintain employment and comply with a variety of other requirements. That’s why it is best to compare tax avoidance vs evasion before committing a crime.

Tax Avoidance vs. Tax Evasion

Filing for taxes.

As mentioned above, the principal difference lies between what's legal and illegal.

According to Beverly Hills, California-based tax attorney Mitch Miller "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,"

For instance, placing money in a 401(k) or subtracting a beneficent donation is absolutely legitimate to decrease a tax band. On the other hand, hiding assets, income, or data to evade accountability for taxes is an illegal practice known as evasion.

What is Tax Planning?

Similar to avoidance, tax planning is a legal way to decrease the amount of taxes owed. Planning helps reduce taxes through deductions, credits, discounts, and exemptions.

One benefit of tax planning is saving through a retirement plan such as Individual Retirement Accounts (IRA). For example, suppose an individual's IRA is invested in a company stock paying dividends of $1,000. In that case, this person does not have to pay the dividend tax.

A fundamental characteristic of tax planning is preparing for an individual's future. An experienced tax planner may promote tax reduction plans for the short-term and long-term.

The Four Components

There are tax avoidance strategies possible for many Americans. Below are the key reasons why one should — or should not — employ them:

Purpose

The purpose should be to reduce one's taxes legally. Evasion is considered as the act of not paying taxes that should be paid.

Legality

Tax planning and avoidance tactics need to be legal, or else it's evasion.

Timing

Proper tax planning requires the avoidance to occur before the taxes are due. In contrast, evasion starts after liability.

Consequences

Using deductions and other tax tools correctly results in owing less money. On the other hand, a tax evader may receive penalties and even jail time.

Choosing the Right Method

While tax planning is anything but straightforward, the line between avoidance and evasion is clear to tax professionals.

Those with any doubts about their tax planning should get help from a licensed tax specialist or firm. A professional will know about tax law changes.

How to Avoid Paying Taxes Legally

Getting your taxes out of the way.

The IRS provides a range of tax credits and deductions that can lawfully decrease the taxes you owe. Tax deductions help reduce the volume of taxable income. Tax credits lower the tax due, and in some instances, can produce a sizable refund.

It is your right to use legal deductions and credits. Here are the steps to make that happen.

See if You Qualify for Tax Credits

Many people don't know that tax credits mean free money. The IRS offers 17 tax credits combined in five categories for individuals to benefit from:

  • Education credits
  • Family tax credits
  • Healthcare credits
  • Homeownership and real estate credits
  • Income and savings credits

You can also read more on the IRS credits and deductions page for a more in-depth analysis of all the credits.

Wait for Long-Term Capital Gains

Investing is an essential tool when you are shooting for long term wealth growth. Moreover, one of the most appealing benefits of investing in stocks, mutual funds, bonds, and real estate is the tax benefits.

An investor with a capital asset for more than one year is eligible to hold a preferred tax rate of 0%, 15%, or 20% on the capital gain, depending on the income. However, if the asset is kept for less than a year prior to selling, then the capital gain is taxed at regular income rates.

Recognizing the difference between long-term and short-term capital gains is crucial for growing wealth.

Start a Business

Aside from generating supplementary income, a side business gives many tax benefits. Business owners can subtract certain business expenses from their taxes. An example of a deductible expense is health insurance premiums.

If the business owner runs a home office, they can apply to deduct part of their home expenses. For example, the share of utilities around the house and the internet consumed while conducting business may be deducted.

What is a Tax Refund Cash Advance?

A tax refund cash advance emergency loan is more commonly known as a refund anticipation loan (RAL). This loan is made based on the amount you will receive from the federal income tax refund.

Many different types of companies offer this product. Everyone from tax preparers like H&R Block to small financial institutions may have a tax refund loan available. It is important to do a little research to make sure that you are working with a reputable company.

Tax refund loans are generally given for a couple of weeks, which is the usual amount of time it takes for the IRS to process the tax refund.

The loan received is equal to the value of the anticipated refund minus the fees or interest charges. Borrowers may receive the loan through a prepaid card, a check, or as an electronic deposit to your bank account. When the IRS processes your refund, it may be directly issued to the lender.

Ana-Maria Sanders, author at OpenLoans
Financial Analyst
Ana-Maria Sanders writes about consumer and business finance. She has been featured on Business.com, CreditCards.com, FOX News, and FOX 29.
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