Tax Avoidance or Tax Evasion: Which One is Legal?
Understanding the Rhetoric
We often hear about people that 'don't pay taxes' or 'don't pay their fair share of taxes'. Very wealthy people are reported to pay lower taxes than their secretaries. Is real or rhetoric? Are both sides stretching, distorting, and embellishing the facts to suit their needs and agendas?
Is playing within the rules tax evasion and 'not paying your fair share'? Is everyone that lowers their tax bills evading taxes or just using effective tax planning? Is lowering your tax bill illegal or something even the IRS expects? Some taxpayers will do anything to avoid paying taxes. What is the difference between tax avoidance and tax evasion?
"Tax Avoidance" Versus "Tax Evasion"
One is legal, one is illegal. One can earn you a lower tax bill and larger tax refund, the other can cost you interest, penalties, fines, and even jail time. Which is which?
Tax avoidance is using the federal tax laws to your advantage. You are allowed to use the laws to LEGALLY reduce the amount of tax that you are obligated to pay. Even the U.S. Supreme Court has recognized "the legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means that the law permits, cannot be doubted".
Tax evasion involves a deliberate attempt to conceal or misrepresent income or other financial information with the sole purpose of decreasing or eliminating your tax liability. Tax evasion by under reporting or failing to report income or profit, and/or overstating deductions is ILLEGAL. Tax evasion can result in penalties and interest on the tax due. In some cases it can lead to fines and even incarceration.
The Rules of the Game
Just like in sports, there are rules with regard to federal income taxes. For federal income taxes, the basic rules of the game are in IRS Publication 17, "Your Federal Income Tax for Individuals". Affectionately known as Pub 17 to those in the tax business.
Like the NFL Rule Book for football, Pub 17 explains in detail what is allowed, expected, and not allowed when filing your individual federal income tax return. Although there are gray areas, in general, follow the rules and you should be fine. Good financial planning and tax strategy would arrange your financial affairs to legally minimize your tax bill.
In football, intentionally taking a penalty, declining a penalty, punting on third down, or stopping short of the goal line do not seem like good strategies if you want to win the game. But, all of these strategies have been used, some more often than others, with the intention of helping a team win the game. These strategies are not used because one team wants to be a 'nice guy' or feels sorry for the other team. The same can be said for taxes.
Compared to football, the tax rules are more complex. It is prudent to use the tax laws and rules to your advantage to minimize your tax liability. Taking a deduction, utilizing a credit, creating a tax strategy is not gaming the system, it IS the system. Even the IRS and Supreme Court agree.
Legal versus Illegal
So, what is legal and what is illegal?
- Not paying a high tax rate: For earned income, the more money you earn, the higher your marginal tax rate. Dividend income and capital gains are taxed at a lower tax rate than earned income. If most of your income comes from investments, your income tax liability will be smaller than if you earned the same amount of income working. That may or may not sound fair, but it is legal. It is the way the tax code is written.
- Reducing your taxes by taking a credit, exemption, or deduction: Taking an exemption, deducting real estate taxes, mortgage interest, or a charitable deduction is legal. Taking the Earned Income Credit, child tax credit, or a credit for college expenses is also legal. Taking advantages of any or all of these is not only legal, it is prudent. Creating deductions, claiming exemptions you are not entitled to, and falsifying information to get a tax credit are all illegal.
- Not reporting income: Decreasing your taxable income by not reporting some or all of your income for a cash business, not reporting all of your tip income, not reporting income when you are paid in cash for a service, or just failing to include a 1099 or W-2 on your income tax return are all illegal. Not reporting a W-2 or 1099 is just plain stupid. The government already knows about this income.
We All Play The Game
Rich, poor, or in the middle, we take advantage of the rules when we file our tax returns. We would be crazy not to.
Yes, certain wealthy individuals pay a low effective tax rate because the majority of their income is taxed at the lower rates for capital gains and dividends. That doesn't make it illegal. They are just following the rules.
Middle class tax payers often use itemized deductions and credits to lower their income tax or even their effective tax rate. This isn't wrong. They are just following the rules.
Lower income workers often qualify for child tax credits and Earned Income Credits. These credits can result in a refund that is larger than the total amount of federal income tax withheld. Nothing is wrong or illegal here. They are just following the rules.
All of these tax payers are filing their returns and following the rules. They are doing what is legal. They are allowed, even encouraged, by the current tax law.
The Bottom Line.
If there is a problem? How do we solve it? One thing is clear, the tax code is too complicated. Laws are passed to help a certain group, encourage a behavior, and even to reward political supporters. Every deduction, credit, and change in tax rates are passed into law for a purpose, but it doesn't seem the purpose is to raise revenue for the federal government.
If there is a problem with the rules, then they need to be changed. Until Congress changes the tax code, eliminates complicated deductions and credits, and otherwise simplifies the rate structure, tax payers will continue to take advantage of every resource available within the law to lower their tax liability. As they should.
Any federal tax or tax planning information provided above or linked to this article is not meant to be specific to any particular individual or situation. Anyone who wishes to apply this information should first discuss it with an accountant or tax professional to determine its appropriateness or how it specifically applies to their unique situation.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2012 Mark Shulkosky