What is tax evasion?
Tax evasion occurs when a person or an organization illegally takes purposeful steps to avoid paying a tax liability. A criminal offense under federal and state statutes, tax evasion is considered fraud. Violators can be charged with a felony for tax evasion.
There is some ambiguity as to what is considered tax evasion, but certain actions clearly fall under this umbrella. These include:
- Falsifying Internal Revenue Service (IRS) financial forms
- Underreporting income
- Compensating employees in cash
- Using a fake social security number
- Falsifying business income and/or expenses
- Claiming a nonexistent dependent (e.g., a child)
- Using multiple financial ledgers
- Underreporting cash tips (typically done by waiters and waitresses)
- Failing to file returns
There is a distinction between tax evasion and tax avoidance; only the latter is legal. Tax avoidance, or using tax law to pay the least amount of taxes possible, is encouraged. In many cases, the tax code offers various tax credits, exemptions and deductions that may be used to reduce or offset taxable income.
Though the IRS may be displeased with the routes people take to lower their taxes, in the context of tax avoidance, these methods are fair game until Congress decides to close these loopholes. Some of these include selling your business to a family member, resulting in an exemption or deduction in estate or gift tax; establishing a company’s tax residence in a different country; and making charitable donations.
There is also a distinction made between tax evasion and negligence. Both are defined as a failure to reasonably attempt to follow tax codes, and both are illegal. The IRS takes into consideration honest mistakes, sparing someone who may have simply misinterpreted instructions. There are certain measures that expose taxpayers to being accused of negligence, such as taking deductions they are not eligible for or keeping inaccurate financial records.
There are stiff penalties for tax evasion. A conviction carries a maximum fine of $250,000 for individuals or $500,000 for corporations. Violations can also incur up to a five-year prison sentence. The punishment for tax negligence is less harsh. People found to have disregarded tax rules are hit with a negligence penalty amounting to 20 percent of underpaid taxes.
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Tax evasion example
The most famous example of tax evasion in history may be the case of Al Capone. The famous gangster was once quoted as saying “… the government can’t collect legal taxes on illegal money.” However, the Supreme Court ruled in 1927 that illegally earned income was subject to income tax. In 1931, Capone was convicted on five counts of tax evasion from the years 1925 to 1927, and willful failure to file for the years 1928 and 1929. After this case, conviction for tax evasion became a major tool for taking down underworld crime figures.