Simple Breakdown of Tax Avoidance v Tax Evasion
So you may be asking yourself simply out of curiosity or perhaps even for personal reasons “what’s the difference between tax avoidance and tax evasion?” Either way…we don’t judge. But allow us to break it down for you.
The simple answer, courtesy of the IRS Fraud Handbook, is that tax “avoidance” involves legal means to reduce one’s tax liability, such as claiming a mortgage deduction or contributing to an approved charity, and tax “evasion” is an illegal method that does the same thing, such as an “intentional understatement or omission of income” and “improper deductions.”
If a taxpayer goes beyond the clear black-and-white distinction (contributing to a 401k and ommitting the ownership of buried treasure), the distinction between the two is almost entirely subjective, because what does it mean to “intentional[ly]” understate income or claim an “improper” deduction?
Consider the following example, which actually occurs rather frequently in one form or another. Assume Susan invests in a shaky startup not because she has a “gut feeling” that the analysts are wrong and that the company will turn a healthy profit, but because she wants to claim the $3,000 capital loss. Further assume that Susan is not very bright and she sends an email to her broker outlining her plan and the reasons behind said scheme.
If you cannot see the difference between tax avoidance and tax evasion in this example, you are not alone. 59 percent of UK voters said it was “unacceptable” to use “artificial but legal methods to minimise the tax they pay.” Many IRS auditors do not see a difference either. So, they often scrutinize these returns in the hopes that they can at least shame or threaten the taxpayer into paying some additional tax.
In these situations, there is no substitute for an experienced attorney who knows the letter of the law, because in many numbers-based tax prosecutions, that’s about all that matters.
Highlighting the Difference Between Tax Avoidance and Tax Evasion
To further illustrate this point, consider the following two examples. While each one is legal, each one nearly always draws unwanted attention from the IRS.
The deferred compensation avoidance/evasion is hard to follow. It’s quite common for employers to defer some payments to their highly-compensated workers. Many times, these workers have already hit the $127,000 annual FICA cap. Since the IRS considers deferred money the same as received money, such individuals may not have to pay the FICA tax.
Assume Susan started a new job on January 1 that pays $200,000 a year. She defers $73,000 of her 2017 compensation. Not coincidentally, that amount puts her right at the FICA cap for 2017. Since she’s already met the FICA maximum and the IRS considers the $73,000 as 2017 earned income, she will pay no FICA taxes on it when her employer eventually pays it.
A few years down the road, Susan’s W-2 will look a little funny and the IRS will want additional FICA tax money. But under current law, Susan probably will not have to pay it.
Another scenario involves the estate tax freeze. If an owner sells a radpidly-expanding family business, family members will not pay taxes on the increased value of the business when they acquire it after the owner dies.
Assume Susan’s father owned a restaurant. Right before he added another location, he sold the restaurant to Sam for $1 million. Sam gave Susan’s father a promissiory note for $1 million at 5 percent interest. When Susan’s father dies, she only pays taxes on the $1 million note, even if the restaurant has doubled or tripled in value.
The IRS suits despise the estate tax freeze even more than they dislike the deferred compensation workaround, but as Congress has passed no laws against the freeze, any such prosecutions are mostly sound and fury signifying nothing.
A final note is that an attorney must not only know what the law is, but what the law was at a certain point. Congress cannot pass an ex post facto law. So, even if lawmakers outlaw the estate tax freeze or deferred compensation workaround, Susan would not be liable for additional taxes because such plans were legal when Susan took advantage of them.