Tax evasion vs. tax avoidance: How to tell the difference

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• Tax evasion and tax avoidance both seek to lessen taxes.
• If you break federal, state, or local laws to avoid taxes, it's tax evasion.
• Tax avoidance is when you use legal means, such as credits and deductions, to reduce the tax you owe.

Tax evasion is a costly problem for the US government. The Internal Revenue Service estimates that the gap between the amount of tax revenue it collects and what taxpayers actually owe is more than $400 billion a year. The advent of cryptocurrency has exacerbated the problem.

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Americans are entitled to avoid taxes, as long as they do it in compliance with federal, state, and local laws. That means keeping honest records, reporting all earned income, and following eligibility requirements for tax deductions and credits.

Otherwise, your efforts to lower your taxes could tip toward tax evasion. Here's what you should know.

Tax evasion vs. tax avoidance: At a glance

Tax evasion and tax avoidance are methods of paying less tax or no tax. But they are concepts you do not want to confuse. 

"The big difference is that tax evasion is illegal while tax avoidance is legal and even celebrated," says Adam Brewer, a tax attorney in California and Hawaii who specializes in helping individuals and businesses resolve tax controversies. "The end goal is the same, but how you get there is different."

• Tax evasion: Avoiding payment of taxes by deliberately failing to report all or some of your income to the IRS or misrepresenting your financial situation to the IRS.
• Tax avoidance: Minimizing the amount of taxes you owe by claiming credits, deductions, or adjustments to income for which you're eligible.

What is tax evasion?

Willfully breaking the law to avoid paying taxes is tax evasion. This can mean failing to report both honest money that you earn from a legitimate business or job or money you earn from an illegal activity, such as social gambling. 

Whether you attempt to "hide" money, falsify income records, or withhold information from your tax preparer, it's considered tax evasion.

"Tax evasion is a criminal offense, so prison is a potential consequence," Brewer says. However, a more common punishment for the average taxpayer is paying fines, interest, and the unpaid tax, he says.

What are examples of tax evasion?

Most people think of tax evasion in grandiose terms, such as hiding millions of dollars in offshore accounts. Though this type of tax evasion often makes headlines, it's not the only way people skirt the rules to underpay taxes. 

Failing to report income to the IRS that you've earned in seemingly innocuous ways can also be considered tax evasion. For example, cash that you earn "under the table" from a garage sale, babysitting job, or side gig should generally be reported to the IRS.

What is tax avoidance?

There are several ways to lessen or eliminate your tax liability without breaking any rules. According to the IRS, "tax avoidance is perfectly legal."

"Tax avoidance is reporting your income, but then strategically claiming deductions you are allowed by law so that you pay less or no tax," Brewer says. There's a paper trail that the IRS can use to prove your income and eligibility for certain tax breaks.

What are examples of tax avoidance?

There are several ways to legitimately reduce your taxes if you own a rental property, Brewer says. You may be able to claim deductions for depreciation, repairs, property taxes, and other expenses related to operations and upkeep, which would reduce the amount of rental income you have to pay taxes on.

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Saving for retirement in a 401(k) or other pre-tax account is another savvy tax-avoidance strategy.

"It's easy, it reduces your tax burden today, and it helps you set aside money for later in life," Brewer says.

Tax evasion vs. tax avoidance frequently asked questions

What's the difference between tax avoidance and tax evasion?

Tax evasion is lessening your tax liability through illegal methods, such as deliberately failing to report all or some of your income from a business or side gig. Tax avoidance is using deductions, credits, and other legal means to lower your tax bill.

Can you get in trouble for tax avoidance?

You can't get in trouble for tax avoidance if you claim deductions and credits that you're eligible for. A professional who knows the ins and outs of federal, state, and local tax laws can help you employ smart tax-avoidance strategies.

How does the IRS catch tax evaders?

The IRS catches tax evaders by performing audits of suspicious tax returns. Eventually it may lead to investigating the taxpayer's claims by working with other government agencies and financial institutions. 

What are some examples of tax evasion?

Common examples of tax evasion include underreporting income by hiding money in unidentifiable accounts, lying about the amount or sources of income, falsely claiming dependents, and overstating business expenses.