There are two different ways to deal with your tax liability (the amount you owe in taxes): tax evasion and tax avoidance. Even though they look alike at first glance, they are not the same thing and have different moral and ethical consequences.
In this post, we’ll take a look at both terms, and use some examples to understand what differentiates them to help you make a more informed decision when handling your taxes.
What is tax evasion?
Tax evasion is a deliberate act of tax fraud which involves:
- underreporting income
- exaggerating deductions
- or participating in other fraudulent activities with the intent to lower one’s tax liability
It entails purposefully falsifying financial information on tax forms in order to pay less tax than what is required by law. As a criminal offence, tax evasion carries severe consequences that might include fines, jail time, or both.
Typical examples of tax evasion include:
- withholding income from tax authorities
- failing to report cash transactions
- fabricating invoices
- and maintaining offshore accounts to conceal money
An example of tax evasion
Emily Davis owns her own company and runs a modest clothes store. She routinely underreports her business income on her tax returns by falsifying business costs and failing to disclose cash sales. She takes this action to lower her tax bill and pay less in taxes.
Emily used tax evasion strategies for several years, which caused her to owe much less in taxes than she should have.
However, during a routine tax audit, the IRS becomes aware of her conduct. Emily is then accused of intentionally and deliberately filing false information on her tax returns, which is considered tax evasion.
If found guilty, she may face penalties, fines, and potential imprisonment.
This example shows how tax evasion entails knowingly providing false financial information in order to lower tax responsibilities. This is against the law and carries legal ramifications.
What is tax avoidance?
Tax avoidance is the deliberate attempt to lower one’s tax liability through the use of legal strategies and tactics to take advantage of tax incentives, deductions, and exemptions that are required by tax legislation.
Contrary to tax evasion, tax avoidance is a perfectly legal tactic that people and organizations frequently use to simplify the process of fulfilling their tax obligations. The objective of tax avoidance strategies is to minimize one’s tax obligation while remaining compliant with tax legislation.
The following are all prevalent methods of tax avoidance:
- investing in tax-advantaged accounts (e.g., retirement plans)
- deducting eligible expenses
- structuring businesses to minimize tax liability
- and utilizing tax credits
Taxpayers are encouraged to employ these strategies rationally, provided that they do not violate any tax regulations.
An example of tax avoidance
John Smith is a high-income individual who wants to reduce his tax liability legally.
As a small business owner, he takes advantage of legitimate business deductions allowed by tax laws to reduce his taxes. He keeps thorough records of business expenses, ensuring he claims all eligible deductions.
John regularly invests in tax-advantaged accounts like 401(k)s and IRAs to lower his taxable income. By contributing the maximum allowed amount to these accounts, he reduces his current-year taxable income.
When selling any of his investments, he strategically times the sale to benefit from lower long-term capital gains tax rates, reducing his overall tax liability on investment gains.
He also utilizes various tax credits, such as the Earned Income Tax Credit or the Child Tax Credit. These credits directly reduce the amount of taxes he owes.
Finally, John makes substantial donations to qualified charitable organizations. These donations are tax-deductible, allowing him to lower his taxable income and reduce his tax bill.
In this example, John engages in tax avoidance by using legal means to minimize his tax liability. He follows existing tax laws and regulations to optimize his financial situation while staying within the boundaries of the law.
5 Key Differences Between Tax Avoidance and Tax Evasion
1. Legality
Tax avoidance is legal. It entails minimizing the tax burden by utilizing legal tactics, deductions, and incentives offered by tax regulations.
On the other hand, tax evasion is illegal. It includes dishonest practices, including understating income, concealing assets, or fabricating documentation in order to avoid paying taxes.
2. Ethics
Taxpayers employ tax avoidance strategies in an effort to minimize their tax liability by means that are lawful and acceptable.
On the other hand, tax evasion involves a willful intent to deceive tax authorities by engaging in unlawful actions to pay less tax than owed.
3. Consequences
There are generally no legal consequences for engaging in tax avoidance, as it operates within the confines of the law.
On the other hand, tax evasion can lead to severe legal consequences, including fines, penalties, and potential imprisonment.
4. Disclosure
Taxpayers engaging in tax avoidance often disclose their financial activities on their tax returns, but they do so while making use of legal deductions and exemptions.
Tax evasion, on the other hand, is deliberately providing false or misleading information on their tax returns to conceal income or assets.
5. Public Perception
While tax avoidance can sometimes attract public scrutiny, it is generally viewed as a reasonable approach to managing tax liabilities within the bounds of the law.
However, tax evasion is widely condemned, both legally and ethically, and is considered a criminal act with negative public perception.
Can I be found guilty of tax evasion for a mistake?
Not really. The IRS can distinguish between honest tax evasion and mistakes in tax filings. The IRS Criminal Investigation Division is obligated to establish proof of your intentional commission of an offense in order to file charges of tax fraud.
An error in one’s tax return may lead to the imposition of penalties, but it ought not to encompass allegations of evasion.
You will be required to demonstrate that you were not cognizant of the strategies employed by your tax preparer in order to avoid liability for the evasive action.
Complicating matters further, this could be accomplished with the knowledge of your tax preparer that they were employing unlawful methods while concealing their true intentions.
Final Thoughts
Tax evasion is breaking the law to fraudulently lower your tax liability, and it is punishable by law.
Tax avoidance, on the other hand, is following the law to lower your tax liability, and it is common practice.
To make sure you are abiding by the tax rules, you need to know the difference between these two actions. Paying taxes in a way that avoids paying taxes is legal and normal.
Photo by Iryna Tysiak on Unsplash