The difference between Tax Avoidance and Tax Evasion comes down to one word, Legality.
Starting with the “Tax Gap” we can use this to understand the impact of not paying your taxes. The tax gap is the gross difference between the tax liability for a given year and the amount of taxes paid on time. In other words, it compares the total amount of taxes owed by taxpayers and the number of timely payments that taxpayers make.
Why is this a problem?
The IRS periodically estimates the tax gap, which gives a broad view of the nation’s compliance with federal tax laws. The average annual tax gap is estimated at $441 billion (about 83.6%). This means that roughly 15% of Americans are not in compliance with the voluntary tax system. As a result, their failure to comply shifts their tax burden to taxpayers who consistently pay their fair share of taxes.
Tax avoidance is the use of legal methods to decrease the amount of income tax that an individual or business owes.
Individuals and businesses can take advantage of tax avoidance by claiming as many deductions and credits as allowable. Therefore, it is considered a legal method that is used by taxpayers to cut down how much taxes they owe to the IRS.
Unlike tax evasion, tax avoidance is a legitimate tax strategy that should be used by EVERY taxpayer. Additionally, the IRS incentivizes taxpayers to utilize tax avoidance strategies by making yearly adjustments to the dollar amount of allowable deductions and credits.
common tax avoidance strategies and the benefits that they provide:
- Standard Deduction – allows taxpayers to deduct a set dollar amount from their taxable income each year, according to their filing status.
- Individual Retirement Account (IRA) – allows taxpayers to plan for retirement by reducing their adjusted gross income (AGI), dollar-for-dollar, by the total amount of contributions made to the account. See table for 2021-2022 IRA contribution deduction limits.
- Business Expenses – ordinary and necessary business expenses, such as rent and utilities, are deductible either fully or partially based on the percentage of time spent on business operations.
While many taxpayers are aware of these tax avoidance strategies and much more, some still chose to improperly apply them to their unique tax situations, thus risking the possibility of tax evasion practices.
Tax Evasion is using illegal means to avoid paying taxes. As noted above, tax evasion can sometimes start as a tax avoidance strategy. However, the improper application and/or willful attempt to bypass the tax code is what eventually results in tax evasion.
Common tax evasion tactics used by businesses and individuals:
- Underreporting income or overstating expenses to the IRS.
- Claiming unallowable credits or deductions.
- Hiding away income in offshore accounts
- Operating the business in “all-cash” and failing to maintain proper receipts.
Not only is tax evasion illegal, but it could also lead to hefty fines, penalties, and/or jail time. According to Section 7201 of the Internal Revenue Code, tax evasion can lead to the following:
- A fine of not more than $100,000 ($500,000 in the case of a corporation)
- Imprisonment of up to 5 years
- or BOTH!
After examining the fines and penalties above, one may think it unfathomable that increasingly more taxpayers are convicted of tax evasion each year. While we’ll never know the definite answer, my goal is that this article will help YOU and your business to remain on the right side of tax compliance. By understanding the available tax avoidance strategies, you can ensure the protection of your business and personal assets from tax evasion claims.
