One isn’t good. One is illegal. And one has the potential to come with some stiff penalties, including jail time. Yet, too many people believe that both of the terms we're about to discuss are one in the same.
Do you know the difference between tax evasion and tax avoidance? While each of the terms appear similar in nature, they’re both very different — and it’s important to know and decipher between the two, especially when it comes to the law. Here’s a closer look at the key differences between tax evasion and tax avoidance.
Tax evasion is the act of illegally hiding income or other information from the Internal Revenue Service (IRS). Say, for instance, that you’re a self-employed contractor who accepts cash. If you made $75,000, but only report $30,000 to the IRS when it’s time to file your taxes, then you’re hiding $45,000 of taxable income. That’s tax evasion.
Other examples of tax evasion include underpaying taxes, claiming fake business expenses to reduce taxable income and claiming illegitimate dependents.
Sometimes, tax evasion occurs inadvertently. But other times, it’s carried out with the specific intent of avoiding paying taxes. Whether or not there’s evidence of intent can go a long way toward determining a punishment for the act. Some common instances of inadvertent tax evasion include paying someone (i.e., a nanny, contractor, etc.) cash under the table, not reporting overseas income and even failing to report income from illegal activities. There are some real estate technicalities that can also be considered evasion.
For those that did intend to deceive the IRS, punishments range from fines to prison time. Some notable cases of tax evasion include reality star Mike Sorrentino, who’s currently serving an 8-month prison sentence for not paying taxes on about $9 million in income from 2010-12. Talk about a situation.
Wesley Snipes, on the other hand, was sentenced to a three-year prison sentence in 2008 for failing to file tax returns. While these examples involve celebrities, many middle-class consumers are also found guilty for evasion each year as well.
What can you do if you’ve committed tax evasion? We suggest filing an amended tax return — Form 1040X — immediately. This form essentially allows you to make changes to previously filed returns so that you pay what you owe to the government. Typically, admitting to your mistakes can go a long way toward the severity of your punishment. But ignoring things — even when you realize you’ve made a mistake — will likely only come to haunt you long-term.
While tax evasion is essentially hiding taxable income, tax avoidance is a means of using legal methods to reduce either taxable income or taxes owed. The key word here is “legal.” Yes, while tax avoidance may seem like a criminal term, it actually consists of taxpayers taking advantage of various tax codes to reduce the taxes that they owe.
Some good examples of tax avoidance include:
- Placing money into a 401K retirement account, as this money is deducted pre-tax from your paycheck.
- Making a charitable contribution or donation and writing off the amount on your taxes.
- Deducting business-related expenses that you need for working out of the home.
- Deducting interest from mortgages or student loans.
- Deducting day care expenses.
- Deducting medical expenses (should you reach a certain amount of out-of-pocket medical expenses in a calendar year).
You’ve heard the old saying about how there’s nothing certain but death and taxes. And while nobody likes paying taxes, these funds are essential to funding many of the city, state and national benefits that we enjoy and take for granted today. So be sure to avoid, not evade. While tax avoidance is perfectly legal as long as you’re following doing it by the book, evasion is not — and the consequences could be significant.
By working with a professional accountant on your personal and business taxes, you can avoid facing the repercussions of tax evasion or improper tax avoidance. Want some help? Contact Scott Boyar today for your tax preparation and bookkeeping needs.