Most Americans have only heard the term "tax evasion" in relationship to high-profile cases of celebrities (one would hope). And while "tax avoidance" may sound similar, the differences are important. Tax evasion and tax avoidance aren't quite the same thing. What's the difference between tax avoidance and tax evasion?
If you hear the terms "tax avoidance" and "tax evasion," you might easily confuse the two. One of these, however, could land you in a lot of trouble with the law.
Below we'll explore the difference between tax avoidance and tax evasion so that you have a better understanding of the terms independently.
What is tax evasion?
Tax evasion is what you might hear of celebrities like professional soccer player Lionel Messi falling into. Although evasion literally means "avoiding," the IRS views tax evasion as an illegal act. The IRS definition of tax evasion is either the failure to pay taxes or the intentional underpayment of taxes.
Tax evasion can happen when someone fails to report all of their income. People who collect tips or other harder-to-track money may commit tax evasion if they don't report that as income to the IRS.
Tax evasion examples often include failure to report in full these types of income:
- Income from illegal activities like gambling or selling stolen goods
- Money from babysitting or tutoring work
- Tips or bonuses
- Any other type of payment received in cash or "under the table"
Can you go to jail for tax evasion?
If you don't report your income and pay the federal taxes due, you're committing tax evasion. The consequences of tax evasion, if you're caught, can be quite dire. Some include:
- Requirement to pay taxes owed ("back" taxes)
- Monetary penalties depending on the severity of tax evasion (up to $100,000)
- Prison time
The most extreme cases of tax evasion can lead to the individual serving time in prison. These severe consequences are why some people are so careful to file their taxes correctly and on time, to avoid making a mistake on taxes that would trigger an IRS audit.
Is it very common to go to jail for tax evasion? No, in fact, H&R Block shared that in 2015, only 1,330 taxpayers out of a total of 150 million were indicted for tax evasion. This figure only accounts for legal income sources, not money acquired through illegal activities.
What is tax avoidance?
Tax avoidance, on the other hand, is when individuals use legal steps provided by the IRS in order to lower their tax burden. These are strategies that taxpayers employ to ensure they pay only the amount of taxes required and no more.
What are some common examples of tax avoidance?
Tax avoidance may consist of a number of tactics:
- Tax credits
- Tax deductions
- Income exclusion
The key difference between tax avoidance and tax evasion is legality. Tax avoidance is perfectly legal, while tax evasion isn't.
Some specific types of tax avoidance include claiming the child tax credit, claiming a mortgage tax deduction, and maxing out your contributions to an employer-sponsored retirement account like a 401(k).
Of course, some may disagree about the morality of some forms of tax avoidance (especially in regard to corporations and their tax loopholes). But it's important to monitor the tax code for any changes in tax credits or deductions.
How do you avoid tax evasion?
The goal is to accurately file your tax returns (if you're required to file) each year on time and pay any taxes owed. By following a few simple steps, you can make sure that you pay the required taxes, but don't pay more than necessary.
- Keep accurate records of all forms of income, including from side hustles, tips, or bonuses
- Include all income on your tax forms
- Take advantage of tax credits and deductions and other benefits that can lower your tax bill
- Pay any taxes owed promptly
- If unsure, hire a tax professional to prepare your tax returns