Look, we can all agree that taxes are a pain. Doing them, paying them, not getting a return. You know the drill.
The reality is, we all want to enjoy maximum tax relief and pay as few taxes as possible. Nobody enjoys paying taxes but, as upstanding citizens, we have to do our part to maintain critical functions like schools and roads.
Some people want to evade this responsibility, though. Unfortunately, this leads to the problem of tax evasion.
After reading this article, you'll better understand what actions fall under tax evasion so you can avoid them.
Understanding tax evasion is essential, even though you’re not actively out there trying to evade your taxes. That’s because you can commit tax fraud unknowingly and incur immense losses when you get caught for it.
For instance, did you know that the IRS could demand you pay up if your employer deliberately evades employment taxes?
The IRS will first require payment from your employer. If your employer can’t pay, then YOU must pay the outstanding amount.
You also need to learn how to detect potential tax scams.
Last but not least, you'll also learn about the tax evasion whistleblowing program that offers enormous rewards for helping out the IRS.
Let’s start with understanding more about what exactly tax evasion is.
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What Is Tax Evasion?
Tax evasion is a criminal act where a person or an entity deliberately fails to pay their tax liability. People or entities that commit tax evasion face criminal charges and penalties.
Tax evasion is a federal offense under the IRS tax rules. Those found guilty of tax evasion may be punished with jail sentences, hefty fines or both.
As an example, IRS tax rules define the punishment for false and fraudulent statements as follows:
- The jail time can extend to a maximum of 3 years.
- The fine can go up to $250,000 for individual taxpayers and up to $500,000 for corporations.
- The expenses of the prosecution may also have to be paid by the guilty party.
The Tax Gap Problem
The reason tax evasion is considered a federal crime is due to the tremendous losses it creates for the government. Tax evasion is the leading cause of the tax gap, i.e., the difference between total tax liability and total tax paid.
It's estimated to stand at about $500 billion each year.
Tax evasion is a serious cause for concern since the U.S. government is suffering hundreds of billions of dollars in lost revenue each year.
What Counts as Tax Evasion?
Tax evasion includes both deliberate underpayment and deliberate nonpayment of tax. Generally, taxpayers are considered guilty of tax evasion if it's deemed that they committed the act knowingly.
Several aspects are investigated to determine their intent. The financial situation of accused taxpayers is investigated to uncover attempts aimed at concealing reportable income or acts of fraud.
For instance, when a taxpayer tries to hide assets by associating them with someone else, then the intention will be deemed deliberate, and such an act is considered fraudulent. Tax evaders commonly use the tactic of associating their assets with others so they can deliberately avoid paying the tax liability of their assets.
A somewhat similar case involves reporting taxable income using someone else’s Social Security Number. This is also a type of identity theft.
Examples of Tax Evasion
Certain transactions don't involve documentation, for instance, cash payment for goods and services. If a taxpayer doesn't report this kind of taxable income to the IRS while filing taxes, then it'll be considered as an attempt on the taxpayers part to conceal income.
Here are some of the most common tax evasion examples:
- Underreporting taxable income
- Intentionally underpaying taxes
- Falsifying documents related to taxable income
- Falsely claiming business expenses
- Claiming tax benefits on illegitimate dependents in tax returns
For example, claiming on your tax return that you earned $50,000 the previous tax year when, in fact, you made $80,000 during the same period is tax evasion. This is a rather blatant example.
Another typical example would be intentionally claiming more deductions than what you are legally entitled. For instance, claiming that you are eligible to $15,000 in deductions when you are allowed just $5,000. This is also a form of tax evasion.
Tax evasion and tax avoidance may appear to be the same thing. However, they are entirely different acts.
Tax evasion is a crime, whereas tax avoidance is legal.
Under tax avoidance, taxpayers use legal means to pay lower taxes. There are several ways this can be done.
For instance, paying charity to approved entities and certain investment holdings like contributing to your IRA can be considered tax avoidance. As you know, the latter is a type of tax-deferred investment.
The taxes arising on these investments are paid only after the invested amounts and interest earned are withdrawn. Tax credits are also a great way of reducing the tax owed by you.
Everyone wants to reduce their tax liability. Unfortunately, some taxpayers employ tax evasion to reduce the tax burden. Obviously, this isnt what we recommend.
Tax avoidance is a much better, safer, and legal way to reduce your tax liability. Under tax avoidance, you can use legitimate means to reduce taxes included under the IRS tax rules. To give you another example, tax shields can be used to avoid high tax amounts.
How Underreporting Income Backfires
Taxpayers shouldn't think the IRS won't discover their income if they don't report it. There are several ways in which the IRS can determine how much tax is owed by taxpayers even if they fail to submit required tax documents.
The IRS can assess tax liability from information sent by third parties such as 1099 forms or W-2 forms sent by employers.
Underreporting taxable income can create severe problems for taxpayers because third parties--to comply with tax laws--will report all transactions they executed with the taxpayer. So, tax avoidance may eventually be uncovered by the IRS.
Common Types of Tax Evasion
Tax Fraud Committed by Tax Preparers
In this type of tax evasion, tax preparers may act fraudulently and falsely report financial information. These scams typically peak at tax filing season.
This tax fraud is significant because around half of all taxpaying individuals and entities rely on tax preparers. According to the IRS, this is the fourth leading type of tax fraud.
Some unethical tax preparers typically deceive nave clients by telling them, for instance, they may have more credits than what they are eligible for.
For example, a client may be eligible for tax credits of $5,000, but a dishonest tax preparer may claim they are eligible for $15,000 in tax credits. By claiming they can give big tax refunds, tax preparers try to negotiate higher fees in return.
If a tax preparer takes fees as a percentage of your tax refund, then you must be very careful. This is typically the most blatant warning sign.
Other common-sense steps can be taken to avoid falling prey to these scammers:
- Always hire a qualified tax agent, attorney or CPA
- Check their credentials
- For Enrolled Agents, you can visit the IRS website to check for their enrollment status
- Visit professional body websites of attorneys and accountants to check for their status
The IRS has put together their Dirty Dozen list, so you can learn more ways of protecting yourself.
Abusive Tax Schemes
Abusive tax schemes involve the creation of domestic and foreign trusts to capitalize on financial secrecy laws of certain overseas jurisdictions. This way, tax evaders hide their financial activities to avoid taxes illegally.
These schemes often involve overly-elaborate and complicated financial transactions. By taking advantage of secrecy laws and intricate financial arrangements, they aim to hide assets and identities of investors so tax payments can be illegally avoided.
As the saying goes, if it's too good to be true, it probably is.
Beware of all trusts that promise to eliminate your tax liability. You also need to be careful if a trust promises to reduce your taxes substantially. If the trust offers greater tax benefits compared to others, then it may not be legitimate.
Overly-complex financial schemes and financial instruments may also be a cause for concern. They may not all be fraudulent, however, investigating something you don't understand is always recommended.
Never commit yourself to a financial arrangement you don't understand and certainly be careful with any type of overseas scheme.
Employment Tax Fraud
Employers must withhold Social Security, Federal, Medicare, and Unemployment taxes from their employee’s salaries. Failure to withhold these amounts can be regarded as tax evasion.
Deliberate concealment of salaries and benefits by the employer through cash payments is one obvious trick (i.e., getting paid under the table). But there are other more dishonest examples:
- Misclassification: Some businesses classify their employees as independent contractors. This is a common form of employee tax evasion. That’s because employee withholding taxes don’t apply to independent contractors. The primary criterion is that a worker is an employee if the hiring firm has the right to order what work must be done and how it must be performed.
- Pyramiding: The employer will withhold taxes owed by the employee but will deliberately fail to remit the amount to the IRS. The employer will then file for bankruptcy so the liability accrued can be discharged. The employer will then launch a new business and repeat this procedure.
- Third-party fraud: A business may hire a professional employment firm to lease workers. Under such a contract, the firm will handle all matters of the leased employees related to payroll and employment taxes. Some firms deliberately avoid paying employment taxes.
Under bankruptcy laws, financially distressed organizations can reduce and manage debt to survive. The idea here is to allow bankruptcy filers to restructure or reduce certain debts so they can retain a certain level of assets required for the survival of their business.
If done legitimately, bankruptcy can lawfully protect businesses from tax liabilities.
Once the business has filed for bankruptcy, an automatic stay is issued for preventing creditors from collecting the debt. This includes tax liabilities.
The IRS cannot demand payment of tax liabilities, although it can demand you file returns and perform tax audits.
Since this is a powerful legal tool, certain businesses abuse bankruptcy filings to avoid paying taxes despite being capable of discharging their tax liability. Doing so is illegal and considered as tax fraud.
Certain corporate professionals commit fraudulent acts to avoid tax payments. For instance, they may underreport income, claim excessive credits, overstate their deductions or employ complicated financial arrangement to obscure their transactions.
A prime example of corporate tax evasion is Enron, which collapsed in a high-profile scandal. In the investigative report presented to Congress, it was found that the elaborate fraud was carried out with the help of leading accountants, lawyers, and investment bankers.
Because of this fraud, Enron illegally evaded paying taxes from 1996 to 1999 and paid only nominal amounts in taxes until the scam was uncovered.
Other categories of tax fraud are closely related to one or more of the above types of fraud.
Example of Tax Avoidance
It's much better to aim for tax avoidance. Here are a few examples of legal ways tax liability can be brought down:
- Saving for college
- Contributing to a flexible spending account
- Adding to a health savings account, our recommended choice is Lively
- Using tax credits for which you are eligible because of marriage, offspring, and/or income level
- Making charitable contributions
There are many more ways of bringing down your tax liability. You'll need to know about tax rules to understand how you can reduce your taxes.
Self-employed people can enjoy several tax benefits that lower their tax liability, too. Looking into these benefits is worthwhile.
Reporting Tax Evasion
Now we’re going to get a little weird and take this in a different direction. There’s actually a way to make money by reporting tax evasion.
As I said before, hardly anyone seems to enjoy paying taxes. Taxes may be thought of as just bad news. However, there is one way you can GAIN because of cooperating with the IRS.
Nobody ever seems to talk about it, and yet it could surpass every other tax benefit combined.
Admittedly, it's not exactly a piece of cake, but if you get it right, you'll strike pure gold.
The answer is whistleblowing.
Honest taxpayers have even more reason to be thrilled this year because whistleblower director of the IRS Lee Martin has announced terrific awards for whistleblowers. Thanks to tip-offs from whistleblowers, the IRS successfully collected $1.44 billion worth of taxes, interest, and penalties from tax dodgers in 2018.
The IRS awarded a generous share of the amount recovered to whistleblowers: an astounding 27%. Whistleblowers earned a spectacular $312 million which is almost TEN times the amount awarded in 2017 ($33.9 million).
You can stand to gain a lot if you report tax cheats to the authorities. And you shouldn't hesitate to report them since they are the principal reason you and your loved ones suffer a more significant tax burden.
The best part is there are whistleblower protection laws in place that will keep you anonymous. So report with confidence with no fear of reprisal. Your identity and the information you provide are confidential.
If the IRS uses information provided by you, you can gain up to 30% of the tax, penalties, and interest collected because of your tip-off.
You must gather evidence about the extent of tax underpayment first. This is important because if your information is deemed to be a substantial contribution towards the recovery of tax liability, then you can earn a maximum of 30% from the amount recovered.
You’ll want to try to gather documentation and point towards areas that could provide evidence for successful prosecution. You must also provide a roadmap that’ll help the IRS to prove tax evasion.
Although the IRS has suffered budget cuts and is pursuing fewer cases compared to the previous year, it’s still instrumental in its investigation. The IRS revealed that its Criminal Investigation Division achieved a conviction rate of 91.7% during the fiscal year 2018.
As a whistleblower, you can be almost sure that accurately reporting tax evaders can lead to successful prosecution.
Remember that poor quality information or lack of details can lead to substantially reduced reward or even no reward. It’d be best to seek the advice of an attorney that specializes in whistleblowing cases.
Don’t Forget to File On Time
By not filing your taxes on time, you can get slapped with an evasion accusation. To avoid dealing with this, make sure you file your taxes on time by April 15th, 2020.
If you need additional time and you qualify for a tax filing extension, you can have as late as October 15, 2020 to submit your tax return. Make sure you do meet the qualifications and are approved for an extension, though.
As you know by now, tax evasion is indeed not advisable. It’s illegal, even if you don’t know you’re doing it. Our best recommendation is to use a reputable tax preparer that comes with assurances and protections, so you don’t end up in a hot mess.
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Outside of that, you can have your taxes reduced by following legitimate tax avoidance techniques. Yes, it sounds bad, but doing things like maxing out a 401(k), contributing to a 529 college plan, and other strategies are legitimate ways of tax avoidance.
And finally, if you’re resourceful enough, you can even become a tax evasion whistleblower to gain rewards. Just don’t make it your day job (otherwise I’d start to reconsider the companies you’re working for).