The short answer is that the difference between tax avoidance and tax evasion is legality. Many people like to use these two terms interchangeably, but they are two different issues. Many times you’ll find celebrities and convicted or alleged felons in court proceedings regarding tax evasion, Alternatively, you’ll find shrewd businesspeople in the news for avoiding their taxes and having to only pay pennies on the dollar in taxes much to the chagrin of the wider public. It can leave you scratching your head wondering why some people are able to shirk taxes legally while others are criminalized and punished for what looks like the same thing. The truth is that they are both very deliberate actions, but one group is attempting to owe as little as possible, while the other group is attempting to pay little to none through questionable means.
Tax Avoidance
Both individuals and businesses can leverage tax avoidance strategies. Tax avoidance in business often involves corporate tax planning that can help minimize a tax bill using legal strategies. It is perfectly legal to employ tax avoidance strategies like income exclusion. Some of the more common ways people avoid taxes include retirement planning, owning a business, investing, and real estate. Taking advantage of these tax loopholes can make a big difference in the amount of taxes you owe each year. The way most people avoid taxes is by claiming as many deductions and credits as legally possible to reduce their tax liability as much as possible. Another common way involves prioritizing investments with tax advantages. These are often referred to as tax shelters. Credits and deductions like the Child Tax Credit and Health Savings Account are other ways to take advantage of tax avoidance. The difference between tax credits and tax deductions is that tax credits are subtracted from what you owe, and tax deductions are subtracted from your gross income.
When it comes to the Internal Revenue Code (IRC), tax avoidance comes built-in. The government has allowed these avoidances to manipulate citizens to help advance a variety of national goals. Goals like increasing energy efficiency, producing more educated talent through college degrees, and improving health outcomes are national priorities. That’s why these essential services are indirectly subsidized by the American government through these tax avoidances. The IRC is one of the most complicated tax codes in the world because of its many tax avoidances and annual changes. Many people fail to take advantage of many tax avoidances they’re eligible for simply because they either don’t know they exist or they don’t understand them.
Tax Evasion
The definition of tax evasion on the other hand is a deliberate failure to comply with tax laws. When most people think about tax evasion, they think about gamblers, drug dealers, and unscrupulous businessmen making money through illegal means. Although these are reasons people evade taxes, this isn’t as common as regular citizens cheating on their taxes. Ways to evade taxes include underreporting or hiding income, inflating expenses, falsifying tax records and documents, and offshoring income in places that don’t adhere to American tax laws. These less obvious tax evasion methods include not filing tax returns and filing tax returns and not paying the taxes due. Likewise, not reporting tips or bonuses paid to you by your employer and claiming credits you’re ineligible for is also tax evasion. It’s important to consult a tax professional, tax attorney, or certified public accountant if you are unsure of whether or not you’re engaging in tax avoidance or tax evasion.
The Main Differences
There are some subtle differences between tax evasion and tax avoidance, and then there are some pretty glaring differences. While achieving the lowest possible tax liability is the goal of both strategies, they have very different consequences. Here are some of the differences.
- Tax avoidance is legal and tax evasion is illegal.
- Tax avoidances are built into the IRC, to give people legal options for reducing their tax liability.
- Tax evasion can result in prosecution, fines, penalties, levies, and even jail time, while tax avoidance gets you gets you a lower tax bill.
- Tax avoidance is transparent and easy to identify.
- Most people see tax avoidance as smart money handling, and tax evasion as fraudulent and unscrupulous.
- While both tax avoidance and tax evasion can negatively impact the health of the economy, by decreasing how much public funds are available, the ethics are clearly defined.
Real World Examples
Here are a few real-world examples to help you better understand the ins and outs of tax evasion and tax avoidance. Legal ways to avoid taxes include retirement savings, offshoring income, and claiming deductions and tax credits. Illegal ways to evade taxes include claiming credits you’re ineligible for and underreporting income.
- Savvy citizens will maximize their tax contributions as a tax avoidance strategy. Tax-advantaged retirement accounts like an IRA and a 401k reduce your taxable income.
- Claiming tax deductions like charitable donations, mortgage interest, and student loan interest can be used to reduce your taxable income.
- Taking advantage of tax credits like those designed for buying an electric vehicle or paying for daycare or college tuition are also legal ways to reduce your taxes.
- If you employ someone in your household like a nanny or housecleaner and pay them under the table with no 1099 or W-2, you are evading taxes.
- Reporting personal expenses as business expenses is tax evasion.
- Not reporting business income from international sources is tax evasion.
It should be stated that the IRS is aware that mistakes happen sometimes. These instances are viewed as negligence rather than tax evasion. Instead of prosecution and fines, the taxpayer typically pays smaller fines and interest charges. These smaller penalties can still be pretty steep, however. When errors are made, it’s in your best interest to address them right away by amending your tax return. Consulting a tax professional is the best way to avoid mistakes and the 20% of the underpaid amount penalty assessed on accuracy-related mistakes. You don’t need to be an expert, but familiarizing yourself with tax law can go a long way when it comes to avoiding mistakes.
