Tax evasion and tax avoidance sound very similar, but the consequences could not be more different. One is a way of legally reducing your overall tax liability, resulting in you paying less money to Uncle Sam and keeping more to yourself. The other is illegally hiding your earnings or refusing to pay taxes you owe, resulting in fines or even jail time.
We have a tax system of voluntary compliance. That means that as citizens or business owners, we are responsible for reporting our own earnings, filing, and paying the appropriate taxes on time. But, just because it is a voluntary system does not mean it is optional. There are significant consequences for not paying the taxes that you owe.
However, there are various legal ways of reducing your tax liability. By taking advantage of the IRS tax code and applicable deductions, credits, adjustments, and loopholes, you can ensure you hang onto as much of your money as possible. Many people pay more taxes than required because they misunderstand tax law.
Tax Evasion
Tax evasion is failing to pay or underpaying taxes you owe to the government. It is illegal. Some forms of tax evasion are obvious, such as not reporting income earned through illegal activities such as gambling or selling stolen goods. However, other forms of tax evasion are more subtle. These are some common examples of tax evasion:
- Not reporting all income sources, such as tips or money earned under the table for things like tutoring, babysitting, yard work, or home repairs
- Overstating deductions or claiming deductions you don’t qualify for
- Underreporting your income
- Filing false payroll tax reports
- Claiming personal expenses as business expenses so that you can deduct them
- Reducing payroll expenses by paying employees under the table or failing to withhold payroll taxes
- Hiding income or assets, such as in concealed offshore bank accounts
Punishments for Tax Evasion
The consequences of tax evasion depend on whether the IRS determines it was an accidental or intentional failure to pay. The IRS will also look for patterns to see if your failure to pay constitutes a “willful evasion” over several years. If they determine that you willfully attempted to deceive the government to avoid paying taxes, it is considered a federal crime, and the maximum penalties include heavy fines and jail time.
If you are convicted of tax fraud, the law dictates that you can be fined up to $100,000 ($500,000 for businesses) and be sentenced to five years of jail time. This is why it is so important that you keep good records and work with a tax attorney or trustee, especially if you have significant assets.
Tax Avoidance
In contrast with tax evasion, tax avoidance is a way that individuals, businesses, or organizations can use legal methods to reduce their tax liability. Even if you are utilizing specific deductions or tax loopholes, it is crucial that you make sure that you do so legally and that you qualify for the deductions. Otherwise, you may still be committing tax fraud.
There are many ways to legally reduce the amount of money you must pay in taxes. Here are a few common examples:
- Deducting qualified business expenses
- Claiming tax credits for dependent children
- Investing in a tax-beneficial retirement plan
- Putting money into a tax-favored educational savings account
- Deducting charitable contributions
- Gifting assets to your children to avoid inheritance taxes
- Using a 1031 exchange or installment sale when selling significant assets
Ways of Legally Avoiding Capital Gains Taxes
If you have highly appreciated assets, your capital gains taxes might be your biggest tax burden. The money you earn when you sell an asset is called a capital gain. For example, if you bought Bitcoin for $100,000 and sold it ten years later for $1.5 million, your capital gains would be $1.4 million.
The government wants a piece of that profit. Depending on your income bracket and your state, you can owe up to 30% of your profit in capital gains taxes. That means you could owe $420,000 in capital gains taxes when you sell your Bitcoin.
If you want to know how to avoid capital gains taxes on cryptocurrency, rental property, inherited property, or when selling a business, here are a few options:
Offset Capital Losses
If you have highly appreciated assets such as crypto or stocks, you likely also have some underperforming assets. If you sell them in the same year, you can offset up to $3,000 worth of capital gains with losses. Selling an asset at a loss to reduce the tax burden on your gains is called tax loss harvesting and is an example of legal tax avoidance.
Donate to Charity
If you donate an appreciated asset to charity before selling it, not only will you not owe any taxes on that asset, but you can deduct the current fair market value of the asset from your income taxes.
Defer Capital Gains Taxes with a Deferred Sales Trust
A Deferred Sales Trust is a legal method of delaying your capital gains taxes and/or distributing the payment of your taxes over time. By controlling the timing of your capital gains taxes, you can take advantage of other deductions or a more favorable tax bracket, thus reducing your overall tax liability.
The Deferred Sales Trust falls under the IRS rules regarding installment sales. Instead of selling your appreciated asset directly to a buyer, you sell to an independent third-party trust and receive a promissory note in return. The trust sells your asset to the buyer and takes receipt of your profits. Your profits are then invested and distributed back to you over time, as outlined in the promissory note. You only pay taxes on the portion of the profits you receive each year.
You can also choose to structure your promissory note to make interest-only payments, allowing you to defer 100% of the capital gains tax. In this case, only ordinary income tax will be due on the interest payments.
Using a tax-deferred trust is a tested and proven legal strategy for delaying and even reducing capital gains taxes. However, it is essential that you have the help of a knowledgeable deferred sales trust attorney to ensure that your trust follows all the appropriate regulations and you aren’t inadvertently committing tax fraud.
Bottom Line
Nobody wants to pay more taxes than they have to. While tax evasion is illegal and can result in fines and jail time, tax avoidance is using all the available legal resources to ensure you don’t overpay on your taxes.
A financial advisor, tax attorney, or deferred sales trust trustee can help you explore all your options for legally reducing your taxes.
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Capital gains taxes can be a significant burden if you have appreciated assets. These taxes apply to the profit you earn when selling an asset. To learn how to minimize capital gains taxes, check out the infographic for options.
