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Tax Strategies & Credits

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

by
Gordon W. McNamee
on
8/29/2021
Tax Avoidance vs. Tax Evasion - What's the Difference?

Paying taxes is an inescapable part of life. Most people can remember the shock and disappointment they felt when they looked at their first paycheck and saw the amount withheld. It feels unfair, but the amount that is taken out pays for valuable services, including the Social Security benefits that we will all eventually need.

Despite the positives that our taxes pay for, it is natural to wish you could hold on to more of your hard-earned money. There are two ways to do this – a right way and a wrong way. The right way is referred to as tax avoidance and the wrong way is referred to as tax evasion. The first is legal and strategic, while the second is illegal and short-sighted. Let’s take a look at both.

Tax Avoidance  

Tax avoidance is the legal process of using methods outlined in the tax code to minimize the amount of taxes that you owe. By using the tools available to you, you can hold on to more of your after-tax money. Examples of tax avoidance tools include deductions and tax credits to which you are entitled, and the establishment of employee retirement plans that shelter income. These strategies are written into local, state, and federal tax codes.

Here are a few tax avoidance strategies that businesses can take advantage of:

  • Tax deferral plans such as SEP-IRAs, 401(k) plans, and IRAs. All of these postpone tax liabilities.
  • Tax deductions and credits available for true business expenses

In addition to these tools, there are also clauses known as tax shields and tax loopholes that can legally lower the amount of tax owed. These exist as a result of laws that have provided savvy taxpayers with the ability to offset taxable income. One example of these types of deliberately created  tax-reduction strategies is accelerated depreciation.

Though the Tax Cuts and Jobs Act removed or limited many of these deductions, others continue to exist. The best way to ensure that you are making use of as many of these loopholes as you are entitled to, work with an experienced tax planner who can identify ways for you to minimize your liability.

Tax Evasion 

Where tax avoidance makes use of legal tricks and tools to lower tax liability, tax evasion is deliberate fraud that misrepresents or hides income from the tax authorities. It is illegal, and taxpayers who attempt these strategies put themselves at risk for significant penalties and fines.

Some examples of tax evasion include:

  • Inflating the amount of a deduction to which you are entitled or claiming credits or deductions to which you are not entitled
  • Underreporting income
  • Hiding money in offshore accounts
  • Failing to report cash transactions

Tax evasion is both illegal and intentional non-payment of taxes. It is tax fraud, and it is a felony. It is defined by the Internal Revenue Code as a willful attempt to “evade or defeat any tax” law. The repercussions can be significant, with fines up to $250,000 for individuals and up to $500,000 for corporations. Perpetrators also face the potential of up to five years in prison, plus court costs. Though they may argue that they were not aware of the law, ignorance is not excused.

Though a person who pursues tax evasion may feel that they aren’t doing anything wrong, deceiving or misrepresenting their income or expenses to the IRS is the definition of fraud, and as such will be prosecuted by the IRS Criminal Investigation unit.

Business Tax Evasion of Trust Fund Taxes 

One of the most common methods that businesses use to evade taxes is failure to pay taxes that have been withheld for payment to federal or state tax authorities. Known as “trust fund taxes” because they are entrusted to the business for payment, these may be employment taxes withheld from an employee’s paycheck or state sales taxes collected on transactions. Either, if detected, will result in the imposition of significant penalties and fines.

There are an unfortunate number of methods and strategies used by tax evaders in order to perpetrate tax fraud. Though all of them boil down to failing to report income, some specific examples include:

  • Failing to report an income source
  • Claiming less income than actually received from an income source
  • Providing false information about business expenses or income
  • Purposely paying less than is owed for taxes
  • Understating your taxes owed by a substantial amount
  • Overstating the deductions to which you are entitled or claiming false deductions
  • Keeping a real set of books and one with falsified numbers
  • Claiming tax credits that you are not entitled, both personal and business
  • Falsifying entries in income and expense records
  • Reporting personal expenses as business expenses
  • Hiding assets or income or transferring them illegally to evade taxes 

When a business owner has employees, they are required to withhold payroll taxes on their employees’ behalf and submit them to the appropriate federal and state agencies. Examples of fraud involving employment taxes include:

  • Withholding federal income tax or FICA taxes from employee paychecks and failing to report them or submit them
  • Failing to withhold federal income tax on behalf of employees
  • Hiring an outside payroll service that does not submit payroll taxes to the IRS (known as employment leasing)
  • Paying employees “under the table” in cash and not reporting the payments or withholding taxes
  • Preparing and submitting false payroll tax returns
  • Failing to file payroll tax returns

What if You Make an Honest Mistake?

There is a notable difference between making a mistake by not paying taxes and intentionally perpetrating tax fraud. The former is considered negligence, and will result in penalties and interest due (i.e. 20% of underpayment plus payment of the amount owed.) 

What You Need to Know to Avoid Being Charged with Tax Evasion 

Not every individual or business that is charged with tax evasion meant to practice fraud. Tax evasion is willful, and there are certainly examples of individuals using illegal strategies without having known that they were wrong. Though there is no way to avoid the fines and penalties that you owe, the best strategies for avoiding being charged with tax evasion include:

  • Make sure that you know the laws surrounding employment and income taxes. Information on legal deductions and recordkeeping requirements is readily available, and if you follow the rules you will be able to avoid an audit. If you are a business owner, adhere to the requirements regarding reporting payroll tax and withholding.
  • Find an experienced and thorough tax professional and hire them. They will help you to prepare your taxes in a way that is in full compliance with the laws, ensuring that you have and provide all documentation of income and expenses. 

To stay up-to-date on how to legally minimize your tax liability and avoid the risk of being charged with tax evasion, make sure you are working with a credible tax professional.

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Gordon W. McNamee

Gordon W. McNamee

Gordon W. McNamee is a Certified Public Accountant (CPA) based in Rancho Cucamonga, CA. Gordon W. McNamee can assist you with your tax return preparation, payroll, accounting and tax planning needs. <br /> <br /> 2021 is Gordon W. McNamee, CPAs 38th year in the profession. As as a former IRS agent (1984 through 1987), Gordon has been in public accounting since 1987. Gordon specializes in individual, corporate, HOA, trust, estate and payroll taxes. He also prepares financial statements and provides accounting & bookkeeping services. He enjoys making his clients feel at ease while providing a personalized professional service.

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