Tax Evasion vs Tax Avoidance: Everything Expats Need To Know

Taxpayers often get confused between the terms tax avoidance and tax evasion. While they both involve reducing your tax burden, they have different meanings and consequences. Not understanding the difference and choosing the wrong path can result in hefty fines and legal troubles with the tax authorities.

Here’s the major difference: Tax evasion is illegal and involves using deceitful practices to avoid paying taxes, while tax avoidance is legal and involves strategic planning to minimize taxes. 

Tax Evasion: Use of Illegal Means to Lower Your Tax Bill

The IRS considers tax evasion a serious offense and can result in criminal charges. It occurs when you intentionally avoid paying taxes through fraudulent actions. This includes underreporting your income,  hiding your assets, falsifying your documents, and overstating your deductions. 

Think of a buffet where everyone pays for the food they eat. Tax evasion would be like trying to fill your plate and sneak out without paying. You’re enjoying the benefits of the buffet without contributing your fair share. It’s not just illegal but also unethical. 

Tax authorities can impose a large penalty and place you in jail if they find you guilty of tax evasion. You could serve up to 5 years in prison or pay up to $250,000 in fines. The amount of time for jail time depends on how serious your violation is, how much money is involved, and how many times you’ve done it. 

The IRS considers filing a false return as a more serious offense, which can lead to imprisonment, compared to simply failing to file. However, simply omitting information or unintentionally forgetting to include income on your tax return, especially if it’s your first offense, doesn’t automatically classify you as a tax evader. The IRS recognizes that taxpayers can make mistakes in their filings and generally gives them the benefit of the doubt.

Before the agency can charge you with tax evasion, they must first prove that there was willful conduct to evade taxes. This means that you intentionally falsify information or misreport your income to avoid paying taxes.

Besides facing significant fines and possible imprisonment, tax evasion can lead to the seizure of your assets, loss of pension benefits, and even the revocation of your passport.

Examples of Tax Evasion

Deliberately failing to report your income constitutes tax evasion. Here are some other instances wherein tax evasion can happen:

1. Not reporting to the IRS your payroll tax payments.

Failing to report or pay employment taxes on wages paid to employees or household workers (e.g., via Forms 941, 940, Schedule H, and issuing W-2s).

2. Failing to report income from rental properties outside of the country.

This often affects people who own rental properties outside of the country.

3. Failing to disclose foreign assets, including foreign bank accounts and foreign entities.

The Foreign Account Tax Compliance Act (FATCA) requires owners to disclose annually to the IRS foreign assets, including bank accounts and foreign entities. In reporting your foreign assets and accounts, you may need to file the FBAR and IRS Form 8938 together with your federal income tax return each year to comply with IRS requirements.

4. Not paying Bitcoin taxes

While cryptocurrencies are a relatively new form of money, the IRS already has a rule about them: they are taxable. In filing your tax return, keep in mind that Bitcoin transactions are subject to tax.

5. Not reporting income from illegal activities

Tax evasion also happens when you don’t report income from illegal activities, such as drug dealing or prostitution. The income from these should be reported to the IRS through your tax return.

Other instances that constitute tax evasion include:

• Not reporting income to the IRS or other tax authority
• Overclaiming expenses
• Understating your tax amount owed
• Declaring bankruptcy and restarting the company under a different name

Tax Avoidance: Use of Legal Means to Lower Your Tax Bill

Many people and businesses use legal ways to lower their tax bills. This strategy is called tax avoidance. While the goal is to pay fewer taxes, tax avoidance is permitted by the IRS. It involves using available credits, deductions, and other adjustments to income that you qualify for under the law.

Think of tax avoidance like using coupons at the grocery store. When you use coupons, you’re still paying for the items, but you’re saving money by paying less than the full price without violating any law.

There are several ways you can legally reduce the amount of taxes you owe. One common strategy is to put generous contributions into retirement accounts like 401(k)s or IRAs. This not only helps your savings grow, but it also lowers how much of your income is taxed. Another way is to take advantage of tax credits, such as the Earned Income Tax Credit or Child Tax Credit. These credits can directly lower the amount of taxes you have to pay, dollar for dollar. You can also reduce your taxable income by maximizing deductions for expenses like mortgage interest or charitable donations. Additionally, investing in tax-deferred accounts like Health Savings Accounts can help lower your overall tax bill even further.

Unlike tax evasion, which can result in harsh penalties and imprisonment, tax avoidance typically does not carry the same level of risk. As long as you follow the tax rules, you can legally minimize your tax liability and keep more of the money you worked hard for.

However, you have to understand that while tax avoidance is legal and common, there’s a distinction between using lawful tax-reducing methods and engaging in abusive tax avoidance schemes. Abusive schemes exploit legal loopholes in ways that go against the law’s purpose. Involvement in such schemes can draw attention from tax authorities and lead to severe consequences.

Examples of Tax Avoidance

Tax avoidance uses lawful ways to reduce tax. Here are some examples:

1. Tax Deduction

Reducing the amount of your taxable income will also decrease your tax liability logically. Here, you subtract the amount of the tax deduction from your income, making your taxable income lower. The lower your taxable income is, the lesser your tax obligation will be.

2. Tax Credit

This is a dollar-for-dollar reduction in your actual tax bill. A tax credit provides a dollar-for-dollar reduction in your tax bill. For refundable credits, any excess may generate a refund. For example, if you owe $250 but qualify for a $1,000 refundable credit, you may receive a refund of $750 (results depend on the specific credit).

3. Charitable Donations

Tax-deductible donations are contributions of money or goods to a tax-exempt organization such as a charity. These donations reduce taxable income. Itemize your deductions when filing tax returns annually so that you can claim tax-deductible donations to charity.

4. Individual Retirement Accounts

An individual retirement account (IRA) offers valuable tax benefits to retirement savers. This is because contributions to some IRAs can be tax-deductible. Likewise, withdrawals can be tax-free.

Other forms of tax avoidance are:

• Setting up residence in a country with low-income tax rates
• Putting assets in your partner’s name so that they can pay a lower rate of income tax
• Setting up a company and paying dividends instead of income to avoid national insurance payments
• Handing down your assets to your children before dying to avoid inheritance tax
• Income shifting

Why Consult A Tax Expert?

Now that you know which is which, you may feel that you can safely go about planning on your own to minimize your tax liability. 

However, that’s dangerous because tax laws are complex and always changing.  One mistake can put you in trouble with the IRS. 

Your best bet is to first consult with a tax professional.

Hiring an expert can help you in three ways:

1. They’re tax law experts. They know the ins and outs of tax laws, saving you the time and frustration of learning everything yourself. They can develop effective and legal strategies to minimize your taxes. 
2. They can deal with the IRS for you. You won’t have to worry about receiving intimidating letters or calls from tax authorities because the expert will handle all communication on your behalf.
3. They can give you the highest level of peace of mind. With a tax expert by your side, you can be confident that your taxes are handled accurately, allowing you to sleep better at night.

If you need help with tax planning or other tax needs, call Tax Samaritan at 775-305-1040 for a free 15-minute, no-obligation consultation with our tax experts. 

To request a personalized tax quote, please click on the link below to answer a few basic questions that will help us better understand your tax situation and filing requirements: https://www.taxsamaritan.com/expat-tax-return-getting-started/expat-tax-quote/.