Paying taxes is a necessary obligation for all who earn an income, but if you know what you’re doing, you could legally save yourself a lot of money and stress when it comes to taxes. Tax planning and tax evasion represent ways of saving money on taxes, but one is legal and one is not. 

Paying taxes is based on the idea of voluntary compliance–which means it is left up to the taxpayer to report and pay taxes on all income earned. Some taxpayers take it upon themselves to limit the taxes they pay, which can be done legally or illegally. Legally limiting the amount of taxes you pay is smart, illegally limiting the amount of taxes you pay could mean big trouble for you. 

What is Tax Planning? 

The Internal Revenue Service (IRS) defines tax planning as “An action to lessen tax liability and maximize after-tax income”. Basically tax planning is structuring your assets in order to pay as little tax as possible. Tax planning uses legal methods found in the tax code to decrease your total tax liability. 

Here are some examples of tax planning strategies:

• Maximizing your retirement contributions. Tax-advantaged retirement accounts, including IRAs and 401(k)s, allow you to reduce your taxable income as you put aside money for your later years.
• Claiming as many tax deductions as you can. Tax deductions allow you to use qualified expenses to reduce your taxable income. Some popular deductions allow taxpayers to write off gifts to charity, medical expenses, mortgage interest and some student loan interest.
• Taking tax credits to the max. Tax credits are dollar-for-dollar reductions in the amount of tax you owe, provided you meet specified qualifications. Some of the most common credits shrink your tax bill if you have children, pay for daycare, buy an electric car or pay college tuition.
• Working with a tax professional. A tax pro can help ensure you legally lower your tax liability as much as possible.

What is Tax Evasion? 

Tax evasion is the failure to pay or the deliberate underpayment of taxes. Tax evasion is illegal and can include misrepresenting your income, purposefully inflating your deductions, not reporting all applicable business transactions or hiding money in untraceable accounts. 

Tax evasion is a felony. According to the IRS Tax Crimes Handbook, any attempt to “evade or defeat” a tax is punishable by up to $250,000 in fines ($500,000 for corporations), five years in prison, or a combination of the two. In addition, you’ll also be responsible for covering the costs of the prosecution. 

Some examples of tax evasion include: 

Some common examples of tax evasion include:

• Paying household employees under the table. If you’re going to pay a household employee, like a nanny or a cleaner, that money needs to be reported on a W-2 form.
• Reporting personal expenses as business expenses. While certain business expenses are tax-deductible, personal expenses are not.
• Underreporting cash transactions. If you run a cash-based business, all transactions need to be reported to the appropriate tax authorities.
• Ignoring income from international sources. If you do business internationally, you still need to report that income.
• Overstating your deductions. You need to have proof, such as receipts, for all of your eligible deductions. It’s not a good idea to estimate them.

Unintentional Tax Mistakes vs. Tax Evasion 

Sometimes mistakes happen, and the IRS does understand this. Unintentional mistakes when filling out tax forms can happen and this is usually referred to as tax negligence. Tax negligence can be corrected by paying a smaller penalty and any associated interest penalties. In cases of negligence, the Accuracy-Related Penalty is 20% of the portion of the underpayment of tax that happened because of negligence or disregard.

So why is Tax Evasion a Crime and Tax Planning is not? 

The answer simply lies in the intent of the taxpayer. Tax evasion involves intentionally breaking the law by not paying taxes that are owed. In contrast, tax planning is simply taking legal advantage of the tax code to reduce tax liability. 

It is important to note that the tax code in the United States is very complex and the line between tax evasion and tax planning can sometimes be fine. Make sure you contact a tax professional if there is any question about the legality of how your taxes are paid. 

Let the experts at the Law Offices of Robert J DeGroot answer your questions about tax evasion and tax planning. We’re here to help!