What Is Tax Avoidance vs. Tax Evasion?

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Updated on Friday, October 23, 2020

While both tax avoidance and tax evasion may sound like something that could get you in trouble with the IRS, tax avoidance is legal, while tax evasion is not. Tax avoidance means taking steps to lower your tax bill. Tax evasion, on the other hand, is deliberately paying less than you legally owe.

You’ll learn more below about the difference between tax avoidance vs. tax evasion, and how to avoid having the IRS target you for not paying your fair share.

What is tax avoidance?

Tax avoidance involves taking deductions, credits and other tax breaks that you’re eligible to claim. So is tax avoidance legal? Yes: Many taxpayers use tax avoidance strategies to lower their taxable income and liability, and it’s perfectly legal. After all, lawmakers created the tax rules that help qualified taxpayers reduce their tax obligations. So if you’re wondering how to not pay taxes legally, tax avoidance is how you can do it.

Tax avoidance can take many forms: It might include minimizing your taxable income, maximizing tax credits and deductions or controlling the timing of income and deductions.

Some specific examples of legal tax avoidance strategies, otherwise known as tax loopholes, include:

  • Making tax-deductible or pre-tax contributions to retirement accounts, such as 401(k)s and IRAs
  • Investing in U.S. savings bonds or municipal bonds that earn tax-exempt interest income
  • Making charitable donations that qualify for a tax deduction
  • Claiming the Earned Income Tax Credit or the Child and Dependent Care Credit
  • Prepaying state and local taxes in December, even though they aren’t due until after year-end, so you can deduct them in the year paid
  • Postponing a year-end bonus until the following year because you expect to be in a lower tax bracket next year
  • Deducting business expenses, such as the business use of your home

What is tax evasion?

Tax evasion is a type of tax fraud that involves intentional, illegal attempts to not pay or underpay the taxes you owe.

Tax laws are complicated, and anyone can make a mistake on their tax return. If the IRS catches your error, it will send you a notice suggesting a correction. If that correction means you owe additional taxes, the IRS will charge penalties and interest on the amount you underpaid.

However, there’s a big difference between making an honest mistake and wilfully committing tax evasion.

Here are a few examples of what’s considered tax evasion:

  • Intentionally underreporting or omitting income: You own a business, and clients pay you via cash, check and credit card. You report the income you receive from checks and credit cards on your tax return because you know there’s a paper trail, but you leave out the income you receive in cash, assuming the IRS can’t trace it.
  • Claiming fake or improper deductions: You’re self-employed and claim personal expenses such as commuting costs, meals, concert tickets, clothing and home decor as business expenses.
  • Falsely allocating income: In addition to your full-time job, you have a side hustle selling handmade home décor. When you make a sale, you ask your customer to make the check payable to your elderly mother, who is in a lower tax bracket.
  • Improperly claiming tax credits: You take the Earned Income Tax Credit by claiming that your child lives with you more than six months out of the year, even though your child lives with your ex-spouse full time.
  • Concealing assets: You earn interest from a bank account in a foreign country, but you don’t report the account to the IRS or pay taxes on the interest income.
  • Not filing tax returns: You try to avoid paying taxes by simply not filing a tax return.

Tax evasion penalties

In addition to collecting the back taxes owed, tax evasion penalties can involve hefty fines and even jail time.

According to the IRS Code, if you’re convicted of felony tax evasion:

  • The IRS can fine you up to $100,000 ($500,000 in the case of a corporation)
  • You can be sentenced to up to five years in prison
  • You may be ordered to pay for the costs of your own prosecution

According to the United States Sentencing Commission, in the 2019 fiscal year, 65% of tax fraud offenders were sentenced to prison, and the average jail time for tax evasion was 16 months.

The difference between tax avoidance and tax evasion

Tax Avoidance vs. Tax Evasion

Tax Avoidance

Tax Evasion

  • Claiming deductions and credits for which you're eligible or finding other legitimate ways to minimize your tax liability.
  • Legal: If you make an honest mistake on your return resulting in a lower tax bill, you must pay the correct tax owed, plus penalties and interest.
  • Examples include common tax planning strategies, such as claiming tax deductions and credits, deferring income and accelerating deductible expenses.
  • Intentional attempts to not pay or underpay the amount of tax you owe.
  • Illegal: If convicted of tax fraud, you must pay the back taxes owed and can be sentenced to up to five years in prison, fined up to $100,000 ($500,000 for corporations) and ordered to pay prosecution costs.
  • Examples include hiding taxable income, over-reporting tax deductions and improperly claiming tax credits. 

How to avoid tax evasion

It costs the IRS time and money to investigate and prosecute tax evasion cases, so they usually reserve those resources for big-time tax cheats.

Tax evasion investigations can originate from several sources:

  • Computer screening: Something about your tax return sends up a red flag in the IRS system, and you receive a notice that the IRS intends to audit your tax returns for a recent number of years (per the IRS, it’s generally the last three years, but no more than six). During the audit, the auditor finds evidence that causes them to believe that you knowingly and willingly evaded your tax obligations.
  • Related examinations: The IRS audits one of your business partners or someone else you have a financial relationship with, and that audit leads them to you.
  • Tips from the public: The IRS accepts reports from individuals who believe another taxpayer isn’t complying with the tax laws.
  • Referrals from other agencies: The majority of tax fraud investigations start when the IRS receives information about possible tax evasion from other federal, state or local agencies or the U.S. Attorney as part of that agency’s investigation into another criminal matter.

Typically, the IRS isn’t going to try to prosecute you for tax evasion if you overestimated the value of your charitable donations by a couple hundred dollars one time. They’re usually looking for large amounts or a pattern of tax dodging that stretches over several years.

As long as you’re not willfully engaging in income tax evasion, your chances of facing tax evasion charges are pretty slim. In fact, in the 2019 fiscal year, the IRS initiated only 1,500 tax fraud investigations and recommended prosecution for 942 cases. Considering the IRS processed more than 253 million federal tax returns and supplemental documents that year, the percentage of taxpayers who face tax evasion charges is very small.

Still, if you’re worried about tax penalties or winding up on the wrong side of an IRS audit, be sure to familiarize yourself with federal and state tax laws, and consider turning the job of preparing your return over to a reputable professional — either online or in person. Professional tax preparers are required to keep up with changing tax laws, and their expertise can help you take advantage of tax avoidance strategies without committing income tax evasion. A financial advisor firm may have tax professionals available to help you lower your taxes while ensuring you are still adhering to all state and federal tax law.