To keep more money in your pocket and avoid any trouble with the taxman, it’s key to know the difference between tax evasion and tax avoidance.
What is Tax Avoidance?
Tax avoidance is a method of reducing tax liability within the legal boundaries by exploiting loopholes in the tax laws. This involves finding creative ways to minimize tax payment while still following the rules. It may involve adjusting financial records or taking advantage of tax credits, deductions, and exemptions offered by the government. While tax avoidance was once considered lawful, it can now be considered a criminal act in certain circumstances. The ultimate goal of tax avoidance is to defer, transfer, or eliminate tax obligations.
Examples of Tax Avoidance
- Retirement plans can reduce taxable income and lower taxes owed, making them a useful tool for tax avoidance. Contributing to an employer-sponsored plan or an IRA is considered tax avoidance.
- Maximize your deductions for work expenses by claiming unreimbursed expenses on your tax return, such as mileage and stationery, as allowed by the IRS.
- Any money you contribute to a Health Savings Account (HSA) is tax deductible.
- Capitalize on tax-advantage retirement accounts including 401(k)s and individual retirement accounts.
- Creating a tax-deferred plan, such as an IRA, SEP-IRA, or 401(k), to postpone taxes until a later date.
- Take the mortgage tax deduction
- Taking tax breaks for spending money for legitimate reasons, such as providing paid family leave to your employees.
- Home equity loans have tax-deductible interest.
- Creating offshore subsidiaries or bank accounts in tax-friendly countries helps entities reduce taxes by avoiding paying higher taxes in their home country
What is Tax Evasion?
Tax Evasion refers to the illegal act of avoiding paying taxes by means of deception or concealment. This can include hiding income, falsifying expenses, overstating tax credits or exemptions, and misrepresenting material facts. Such practices result in the reporting of an inaccurate amount of income earned. Tax Evasion is a criminal offense, and individuals found guilty may face legal penalties. It encompasses acts such as deliberate misstatement of facts, concealment of relevant documents, failure to keep complete records, and making false statements.
Examples of Tax Evasion
- Ignoring overseas income which often affects people with rental properties overseas.
- The IRS considers cryptocurrency taxable, and transactions involving cryptocurrencies are subject to its rules. Some taxpayers may overlook the fact that their cryptocurrency holdings have appreciated in value and thus, are taxable.
- Paying an employee in cash is not considered tax evasion, but failing to report and make payroll tax payments to the IRS is. Employers are required to report the wages paid on Schedule H and provide workers with a W-2 form each year
- Under reporting income. This can also include income from illegal activities that people do not report.
- Failing to file tax returns.
- Deliberately underpaying taxes.
- Not reporting an income source.
- Providing false information to the IRS about business income or expenses.
- Overstating the amount of deductions.
- Keeping two sets of books.
- Making false entries in books and records.
The difference between Tax Evasion and Tax Avoidance
- Tax avoidance is completely legal and tax evasion is a criminal activity.
- Tax avoidance is a strategy used to reduce one’s tax burden without violating the law. Tax evasion is an illegal act committed in order to avoid paying taxes.
- Tax avoidance implies hedging of tax, but tax evasion refers to the suppression of tax.
- Tax avoidance aims to reduce the tax burden by following the letter of the law. Tax evasion, on the other hand, reduces tax liability by using unfair means.
- Tax evasion entails taking advantage of legal loopholes. Tax evasion, on the other hand, includes the deliberate concealment of material facts.
- The arrangement for tax avoidance is made prior to the occurrence of tax liability. Unlike tax evasion, where the arrangements for it are made after the occurrence of the tax liability.
- Tax avoidance results in the postponement of the tax, whereas tax evasion results in either imprisonment, a penalty, or both if the assessee is found guilty.
Bottom line
To avoid being charged with tax evasion, it’s important to be aware of the tax laws for income and employment taxes, including legal deductions and recordkeeping requirements. A trustworthy tax professional can assist you and it is essential to keep accurate records of income and expenses, especially if you have a cash-based business. Keeping up with industry news and education can also help prevent tax evasion.