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?
A taxpayer who intentionally hides income— by lying, concealing information, or committing fraud (where they associate income or assets with someone else) — has committed a willful act known as tax evasion. It’s illegal and carries serious consequences.
Common examples of tax evasion include non-reporting or underreporting of:
- Overseas income;
- Cash-in-hand payments for jobs like babysitting, catering, cleaning, or manual labor;
- Income from side gigs;
- Income from illegal activities
- Gains made on digital currencies like Bitcoins; and
- Payments received from a cash business like tutoring, pet sitting, or childcare.
Tax evasion can also include things like overstating deductions or 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 intentional tax fraud, though you can still be subject to a 20 percent penalty on the taxes associated with the understated income.
Why is Minimizing Your Taxes Legal and Encouraged?
While tax evasion is against the law, minimizing your taxes is perfectly legal — and often encouraged.
Minimizing your taxes is about managing and structuring your finances in a way that complies with the tax code, while at the same time, lowering your total income tax.
Within the tax code, there are provisions that allow eligible taxpayers to limit the amount of 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 benefits from a life insurance policy is exempt from taxes.
In reality, most taxpayers are already engaging in some form of tax minimization. For example, if you contribute to an employer-sponsored retirement plan with pre-tax funds, that is a tax-minimization strategy because (1) you’re deferring a tax payment, and (2) 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 minimizing your taxes.
What About Tax Loopholes?
Since the tax code is complex and always changing, it’s not surprising 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 the tax code are deliberately built in, they are regarded as ways to minimize your taxes.
Why Does Taxpayer Intent Matter For Failing To Pay Taxes?
When assessing a failure to pay, tax authorities will often focus on the intention of the taxpayer. If the taxpayer is deemed to have deliberately concealed assets or income, the IRS will likely consider the act as tax evasion.
What Are The Penalties for Tax Evasion?
A taxpayer charged with tax evasion could be convicted of a felony, and be:
- imprisoned for up to five years; or
- fined up to $100,000 (or $500,000 for a corporation);
- or both, and be responsible 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 is also 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 help to get you every credit and deduction you deserve — legally of course! So book your appointment today!