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Why is it So Dangerous & How Not to Fall Into the Trap

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Whenever I read the words “tax evasion,” the tonal beats from Law and Order start to play in my head. The association is reflexive: in the United States, tax evasion is a felony. You should avoid evading taxes because the consequences can be steep. You’ll not only end up having to pay the tax you were trying to avoid in the first place, but you could get a penalty of up to $250,000 and possibly go to prison for up to five years. Not to mention the IRS could audit you and any business you become involved with for the rest of your life!

Tax evasion might seem tempting and appear easy, but it is a trap. The good news is that you need never fall into this trap. In this article, we will show you how to avoid evading taxes.

What Is Considered Tax Evasion?

Tax evasion is using illegal means to avoid paying taxes. The two most common forms are:

  1. Not reporting all taxable income.
  2. Taking unallowed deductions.

What is essential here is that these activities are done willfully; like fraud, it is the intent to deceive that makes the action a crime.

What’s the Difference Between Tax Avoidance, Mistakes, and Tax Evasion?

What if you make a mistake on your taxes or look for ways to avoid paying more taxes than necessary? Thankfully, that’s not the same as tax evasion. In fact, it’s common for people to look for ways to reduce their tax burden. And it’s totally fine to do, as long as you’re eligible for the dedications and are not lying on your tax forms.

Examples of Tax Avoidance

Let’s not confuse tax evasion with tax avoidance. It would be foolish not to take advantage of legal means to lower the amount of taxes you owe. There are a handful of perfectly legal tax avoidance strategies, including the following events:

  • Putting money into your IRA or 401(k) and deducting those amounts
  • Using the mortgage tax deduction for your residence
  • Taking tax credits for installing or investing in solar energy project
  • Deducting legitimate business expenses

Gig economy workers and other self-employed people can also take advantage of many legal tax avoidance strategies. If you want to find other ways to save money on your taxes, check out Cofield’s Concepts. In this educational tax course from advisor Carter Cofield, you’ll learn everything you need to know about how to take advantage of tax deductions.

What if You Just Make a Mistake?

The Internal Revenue Service makes an emphatic distinction between unintended errors and intentional evasion.

Mistakes can include calculation errors, transposition errors, writing down wrong information, and other common errors in filling out tax forms. Given the complexity of U.S. tax laws and the plethora of forms, schedules, and timelines involved, it is easy to make mistakes. The IRS understands this, which is why they allow you to amend your taxes and fix any mistakes.

Further Reading: Best Tax Preparation software

Common Types of Tax Evasion

Here are some of the most common activities that will land you in hot water:

  • Underreporting income (e.g. failure to report the sale of a business)
  • Falsifying income records (e.g. lying to your CPA or attributing your income to a spouse or child)
  • Willfully underpaying taxes (Tyco CEO Dennis Koslowski famously shipped empty crates to the company’s New Hampshire address to avoid paying sales taxes on the art purchases for his NYC home.)
  • Inflating your expenses and deductions
  • Hiding income from your side hustle
  • Hiding interest in an offshore account (like Texas financier Robert Allen Stanford’s hidden millions in Antigua)

Interestingly, the IRS may determine you evaded paying taxes even if you did not file a tax return. For example, if the IRS receives 1099 Forms from a person or company that hired you in 2019 and you did not file a tax return that year, the IRS may infer that you are attempting to evade paying taxes on your income.

Also, it is technically true that the IRS may hold employees “ultimately responsible” for tax owed on their wages by employers. However, the IRS slyly admits that it does not pursue such cases against employees. The IRS is emphatic about litigating against employers, so employees would likely suffer from lost social security and other benefits.

Why Is Tax Evasion Illegal and Can You Go to Jail?

Tax Evasion is illegal because it breaks the social contract. Because we live together in society, we share an implicit agreement to cooperate for social benefits. For example, we sacrifice some individual freedom (the draft and some education are compulsory) for state services (the military and public schooling). Taxes finance education, defense, infrastructure, and other services on which we are all dependent. Evading taxes threatens all of society; it also costs the government billions of dollars annually.

Not surprisingly, tax evasion is punished severely. Tax evasion cases usually start with an audit. An audit may uncover simple mistakes, resulting in further taxes, penalties, and even a payment plan. During an audit, there are two hot buttons that are most likely to result in criminal prosecution and jail time:

  1. If the IRS audit uncovers large amounts owed and have occurred for several years — demonstrating a pattern of willful evasion.
  2.  If, during the audit, the taxpayer makes false statements or purposely hides records (such as bank accounts or other assets).

The IRS calls these behaviors “badges of fraud” as they generally indicate tax evasion. The current audit of former president Donald Trump’s income taxes is investigating precisely these two allegations.

So while the IRS does not pursue criminal tax evasion cases for many people, the penalty for those who are caught is harsh.

How to Report Tax Evasion

Ordinarily, tax evasion is prohibitively expensive and dangerous but there is a way to make money from it: reporting and documenting tax evasion to the IRS. The service runs a Whistleblower Rewards Program which in FY 2020, which was interrupted for 2.5 months by Covid, made awards of $86.6 million to whistleblowers (and collected more than $472 million in taxes).

The IRS is required to award tax whistleblowers 15% to 30% of the proceeds collected from tax evasion if the whistleblower’s tip is one where:

  • The IRS decides to take action
  • The amount in dispute exceeds $2 million (including interest and penalties)
  • The IRS collects the tax underpayments (including related actions)

Whistleblowers are also protected by strong laws that safeguard their anonymity and impose draconian penalties on persons or corporations seeking retaliation.

To qualify for a reward, you will need to supply highly specific evidence about the extent of the tax evasion, such as a bank statement from an unreported account, or a document from an unreported business, or an asset sale. You must also sign and submit your report under penalties of perjury. We strongly recommend that an attorney review whistleblower’s submissions before sending it to the IRS (though anonymity in IRS proceedings is assured).

We can’t emphasize specificity enough — 46% of whistleblower claims are rejected as a result of allegations that aren’t specific, credible, or are speculative in nature. On the other hand, fewer than 1% of claims are rejected because the IRS already knew the information.

The Bottom Line

The risk to reward ratio of tax evasion is simply terrible — because if it weren’t, we would all consider it. And then there are large moral, ethical, and legal reasons why you might not want to be a tax cheat. Just don’t do it.

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