Voluntary Compliance: The Basis Behind Tax Laws
A good starting point to understand these terms is to go back to the fundamentals of the United States federal income tax system, notably the concept of voluntary compliance.
Our income tax system is rooted in voluntary compliance, which requires taxpayers to report all income honestly to tax authorities. It follows that when people fail to declare some of all of their reportable income, they’re breaking the law.
Why Is Tax Evasion Illegal?
If a taxpayer is hiding their income intentionally — by lying, concealing information or committing fraud (where they associate income or assets with someone else) — then this kind of willful act is known as tax evasion. It’s illegal and leads to serious consequences.
Common examples of tax evasion include non-reporting or underreporting of:
Cash-in-hand payments for jobs like babysitting, catering, cleaning or manual labor;
Income from online platforms such as Etsy;
Gains made on digital currencies like Bitcoins; and
Payments from a cash business like tutoring, pet sitting or childcare.
Tax evasion can also include things like overstating deductions and failing to file a tax return.
Of course, given the complexity of the Internal Revenue Code (IRC), innocent or careless mistakes can and do happen. In these instances, the IRS will attribute the error to negligence rather than tax fraud, though you can still be hit with a penalty 20 percent of the taxes associated with the understated income. .
Why is Tax Avoidance Legal and Encouraged?
While tax evasion is against the law, tax avoidance is perfectly legal — and often encouraged.
Tax avoidance is about managing and structuring your finances in a way that complies with the tax code, while at the same time, minimizes your total income tax.
Within the tax code, there are provisions that allow eligible taxpayers to limit the tax they pay by claiming certain deductions, credits, and adjustments to income. Essentially, these provisions have been built into the tax code to influence taxpayer behavior.
For instance, to encourage home ownership, an interest deduction is available for eligible homeowners with a mortgage. To make it easier for primary caregivers to get back to their job and career, working parents could potentially qualify for a credit for childcare expenses. To promote financial protection for families, death benefit from a life insurance policy is exempt from tax.
In reality, most taxpayers are already engaging in some form of tax avoidance. For example, if you pay money into an employer sponsored retirement plan with pre-tax funds, then that is a tax avoidance strategy because firstly, you’re deferring tax payment and secondly, you will likely pay less tax when the funds are withdrawn in retirement.
If you hold on to an investment for a longer period to qualify for the long-term capital gains rate, you’re also engaging in tax avoidance.
What About Tax Loopholes?
Since the tax code is complex and always changing, it’s unsurprising that some experts have found ways to take advantage of particular provisions to reduce tax liability without violating the law. But regardless of whether loopholes within tax legislations are deliberately built in, they are regarded as tax avoidance.
Why Does Taxpayer Intent Matter For Failing To Pay Taxes?
When assessing a failure to pay as tax avoidance vs tax evasion, tax authorities will often focus on the intention of the taxpayer. If the taxpayer is deemed to deliberately conceal assets or income, then the IRS will likely attribute the act as tax evasion.
What Are The Penalties for Tax Evasion?
A taxpayer charged with tax evasion could be convicted of felony, and be:
imprisoned for up to five years; or
fined up to $250,000 (or $500,000 for a corporation); or
both, and handed a bill for prosecution costs.
There are a number of penalties that authorities could apply, such as a failure to file penalty or an underpayment penalty. Interest can also be charged on penalties owed.
Tax evasion can have other undesirable consequences too. For example, you may have a higher audit risk and your accountant may refuse to work with you on ethical grounds.
Staying Compliant With Your Tax Payments
While you won’t need to figure out the entire tax code to avoid being charged with tax evasion, you should have a working knowledge of the provisions relevant to you. So, if you’re claiming the child and dependent care tax credit, be sure you understand the rules around eligibility, how to claim the credit, applicable limits and record keeping.
Remember, if you need any advice on your tax return, Jackson Hewitt’s Tax Services can help. With over 35 years of advisory experience, our trusted Tax Pros will get you every credit and deduction you deserve — legally of course! So book your appointment today!