Tax Avoidance vs. Tax Evasion

By: Pamela Martinez, JBS Corp. 

In a typical year, tax season runs from January 1^st to April 15^th; however, due to the COVID-19 pandemic, the 2020 Tax season was extended to July 15^th.  Now that Tax Day has come and gone, we want to discuss the differences between tax avoidance and tax evasion. The two strive for the same goal—paying little to no income tax, but one can easily land you with a lengthy prison sentence.

Tax Avoidance

Tax avoidance is the method in which an individual or corporation uses the Internal Revenue Service’s (IRS) own playbook against them to avoid paying taxes or reduce their taxable income legally.

Tax Evasion 

Tax evasion is the illegal approach employed by an individual or corporation to conceal their income in efforts to avoid/minimize paying taxes. This act is considered a federal offense and is punishable by law. Penalties for tax evasion are dependent on the severity of the case.

Here are a few examples of the penalties an individual might face when prosecuted for tax evasion: 

• A $250,000 fine (can reach up $500,000 for corporations)
• Up to five years in prison 
• Subject to the payment of income tax on the concealed income PLUS penalty and interest calculated monthly!
• At a higher risk of being audited by the IRS for the rest of the individual/corporation’s life 

Tax avoidance isn’t the only legal route in minimizing the amount of taxes an individual has to pay. There is a third realm in the mix—tax deferral. Tax deferral is an option that not many people are familiar with, but it enables individuals to defer to pay their taxes later into the future. The most common method is contributions to a retirement account like a 401(k). 

The Difference Between Tax Avoidance and Tax Evasion 

The key difference between tax avoidance and tax evasion is the legality of the two actions. With tax avoidance, individuals essentially claim deductions and adjust their income to reduce their tax liability, all legal per the federal tax laws. On the other hand, tax evasion is when an individual owes money to the IRS and opts to pay their dues.

What Each Income Class Does

Unfortunately, the middle class is more susceptible to tax evasion, while the rich typically function under tax avoidance. The reason for this is simple; wealthier individuals have ample resources at their disposal to aid them in handling their finances, including taxes. They hire specialized accountants and attorneys to work around the clock. In contrast, those in the middle class generally do not have access to resources, which would enable them to avoid and defer their taxes legally.

This does not exclude the wealthy from tax evasion, but it is not as prominent as it is in other socioeconomic classes. For example, in the early 2000s actor, Wesley Snipes was sentenced to three years in prison for failing to file his taxes for nearly five years.

Examples of Tax Avoidance 

• Investing in a retirement account, such as a 401(k): The money placed in a retirement account is essentially tax-exempt until that money is removed from the account, at which point you’ll have to pay taxes on it.
• Mortgage interest deduction: Enables homeowners to deduce the interest paid on their homes from their taxable income. 
• Child tax credit: This credit is given to those taxpayers who claim dependents under the age of 17. The credit is given per-child and ultimately reduces the tax liability of the parent.
• Work deductions: The IRS permits non-reimbursed work expenses that are “ordinary and necessary” to carry out your responsibilities. 

Examples of Tax Evasion

• Underreporting income: Failing to report all or some income to the IRS.  
• Not filing a tax return: Willfully failing to file taxes. 
• Under-the-table transactions: Paying staff such as babysitters and gardeners, or employees in a business, cash instead of direct deposits is considered a failure to report wages. 
• False deduction claims: Lying about any deductions such as business expenses and dependents.
• Falsifying income: Lying about annual income. 
• Underpaying taxes: tax responsibilities don’t stop at filing, if an individual files their taxes but fails to pay the money owed, they are illegal evading their tax liability. 

What You Should be Doing

Employees: 

• Keep organized records of your spending, especially receipts of business expenses, which were not reimbursed.
• Claim all deductions your eligible for. 
• Contribute to a retirement account, college savings plan, health savings account, flexible spending account (to pay for childcare expenses)
• Donate to charity (if your itemized deductions surpass the standard deduction)

Self-Employed/ Small Businesses:

• Employ a family member 
• Meet with your accountant to create a tax plan that can readjust your current spending strategy to ensure maximum qualified deductions
• Offer tax-exempt employee benefits such as healthcare, transportation benefits, etc. 
• Set up a small business retirement plan 

The general consensus is that taxes are awful, but our legal obligation is to file and pay what is owed. Instead of playing Russian roulette with the law in the coming tax seasons, take advantage of tax manipulation practices. Remember, of the crimes committed by Chicago gangster Al Capone, the only crime the federal government could pin on him was tax evasion.