Every taxpayer can take advantage of strategic tax planning to avoid overpaying on taxes. But as these methods become more aggressive, the line between legal tax avoidance and illegal tax evasion can become a blurry one.
The true total cost of tax evasion cannot be known, but the IRS reported an average annual gross tax gap of $441 billion in 2019, with the IRS recovering $60 billion through voluntary late payments and enforcement activities.
“The tax gap is how much people should have paid versus how much they actually paid,” says Janet Holtzblatt, a senior fellow at the Urban-Brookings Tax Policy Center. “That translates into a noncompliance rate of about 14% — about 14% of total taxes are not paid even after accounting for enforcement.”
But tax law enforcement has been weakening in recent years as the IRS struggles to maintain the resources to fight evasion, potentially allowing more individuals and corporations to illegally avoid paying taxes. The audit rate among individual taxpayers in 2010 was 1.1%, declining to 0.4% in 2019, according to the IRS. Among large corporations, the same trend holds: In 2010, the audit rate was 16.6%; in 2019, the percent of audits was more than cut in half to 6.2%.
And ultimately, “the honest taxpayer is paying for that evasion and avoidance,” says Steven Balsam, accounting professor at Temple University’s Fox School of Business in Pennsylvania.
Most tax evasion involves high-net-worth individuals and businesses rather than individuals receiving a W-2, but certain behaviors among typical individual filers can trigger audits and penalties.
[See: Red Flags That Could Trigger a Tax Audit.]
What Is Tax Evasion?
Tax evasion is the use of illegal means to avoid paying taxes. Examples of tax evasion might include claiming illegitimate deductions, misreporting or underreporting income and setting up shell corporations overseas.
“People who take cash payments or work under the table, that is tax evasion and that is illegal — even if they did not get a 1099, they are required to report it” says Charlene Wehring, a financial advisor and founder of Wehring Wealth Management in Texas. “The IRS is not dumb. They look at your lifestyle. If you report a little bit of income but you pay your mortgage every year, buy new stuff, drive 16 cars a year, that money is coming from somewhere.”
[READ: How to Choose Your Tax Filing Status.]
What Is Tax Evasion vs. Tax Avoidance?
While tax evasion is illegal, tax avoidance — also known as strategic tax planning — is taking legal steps to pay less in taxes. Tax avoidance is a common practice among individuals and businesses. In fact, anyone who has utilized a company 401(k) or personal IRA has engaged in tax planning to limit taxes owed.
For the typical taxpayer who is not self-employed, options for tax avoidance are limited. Examples include using tax-advantaged savings accounts, such as retirement or educational savings plans, taking steps to avoid realizing capital gains over the years or engaging in charitable giving.
Experts say corporations, self-employed individuals and individuals with the means to hire accountants and tax attorneys to manage their wealth may have more options at their disposal.
Whether a business or an individual, deciding when tax avoidance becomes tax evasion can be a gray area depending on who you consult.
“For the most part, you are going to engage in tax planning strategies with an accountant or consult with someone in the tax planning profession. And you want to get multiple opinions, not just one,” says Carlos Dias Jr., financial advisor and owner of Dias Wealth LLC in Florida. “Opinions will vary from one person to another. Some accountants are more aggressive on one item — they might have more experience in one area so they’re more aggressive in that area, but others might play it ultraconservative.”
[Read: What Happens if You Don’t Pay Your Taxes?]
Penalties for Tax Evasion
Tax evasion is a criminal activity and can result in jail time. However, the penalties for underpaying taxes can vary widely. Taxpayers who realize their income was underreported or that they otherwise made a mistake on their return can file a 1040-X, which can correct an already-filed form 1040, make certain elections after the deadline and change amounts adjusted by the IRS, among other things.
In more severe cases, taxpayers and corporations may be able to negotiate what they owe with the IRS or may need to go through proceedings in a formal tax court setting. But for the typical taxpayer, experts say a worst-case scenario would involve paying a penalty.
“Some of our clients do get letters from the IRS stationary and they panic,” Balsam says. “Take a deep breath. Don’t panic. Consult with someone like me or the CPA who prepared the return. Most of the time it’s fairly innocent and easy to rectify, and no one’s going to send you to jail.”
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Everything to Know About Tax Evasion and Avoidance originally appeared on usnews.com
