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February 14, 2023

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When Does Tax Avoidance Cross the Line to Tax Evasion?

Tax planning is crucial for high-income individuals. While the Internal Revenue Code imposes substantial tax liability for those who are in the one percent, it also provides opportunities for high-income taxpayers to lawfully reduce the amount they owe.

The Internal Revenue Service (IRS) refers to this as “tax avoidance,” and it is completely legal.

But, the line between what is legal and what isn’t is often very fine. Additionally, while the IRS has provided guidance on certain tax avoidance strategies, in many cases what the Internal Revenue Code allows (and what it doesn’t) is open to interpretation. As a result, it is not uncommon for high-income taxpayers who use tax avoidance strategies to face IRS scrutiny, and, in some cases, this scrutiny will lead to allegations of tax evasion.

Tax Avoidance vs. Tax Evasion

The IRS’ Definition of Tax Avoidance

The IRS defines tax avoidance as, “[a]n action taken to lessen tax liability and maximize after-tax income.” As we mentioned above, the Internal Revenue Code provides high-income taxpayers with several options for implementing lawful tax avoidance strategies. Some examples include:

  • Deferring recognition of income
  • Accelerating recognition of losses
  • Investing in tax-exempt and tax-efficient assets and accounts
  • Making charitable donations
  • Making gifts to trusts and foundations
  • Using conservation easements
  • Using offshore tax strategies

This is just a small sampling. There are numerous other ways that high-income individuals can lawfully reduce their federal tax liability below what they would pay if they simply reported their income on an annual basis. Tax planning professionals and wealth advisors routinely help their clients implement these strategies, and many high-income individuals use these strategies to lawfully avoid millions of dollars in potential tax liability each year.

The IRS’ Definition of Tax Evasion

In contrast to tax avoidance, tax evasion involves “failure to pay or . . . deliberate underpayment of taxes.” So, whereas tax avoidance involves lawfully minimizing a taxpayer’s liability to the IRS, tax evasion involves paying less than a taxpayer lawfully owes. Tax evasion is a serious crime under federal law. Specifically, Section 7201 of the Internal Revenue Code provides:

“Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title . . .  shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.”

As further explained in the IRS’ Tax Crimes Handbook, tax evasion can involve either: “(a) the willful attempt to evade or defeat the assessment of a tax, [or] (b) the willful attempt to evade or defeat the payment of a tax.”

  • Evading Assessment of Tax – Evading assessment of tax involves filing a federal income tax return that does not accurately reflect a taxpayer’s tax liability. This could be due to nondisclosure of income sources, improperly claiming credits or deductions, or otherwise improperly underreporting taxable income.
  • Evading Payment of Tax – Evading payment of tax involves attempting to avoid responsibility for taxes that a taxpayer acknowledges he or she owes. According to the IRS, this “almost always involves an affirmative act of concealment of money or assets from which the tax could be paid.”

Both forms of tax evasion are subject to the same legal standards and trigger the same penalties. Among other things, this means that establishing guilt requires proof of willfulness and proof of an affirmative attempt to “evade or defeat” the taxpayer’s federal income tax liability.

Examples of When Tax Avoidance Crosses the Line

So, when does tax avoidance cross the line to tax evasion? Simply put, tax avoidance becomes tax evasion when the strategies used no longer comply with the Internal Revenue Code. To be clear, while willfulness and evidence of an affirmative attempt to evade a taxpayer’s liability are required for criminal prosecution, even unintentional violations of the Internal Revenue Code can lead to substantial tax, interest and civil penalty liability for high-income taxpayers. As a result, when defending against allegations of tax evasion related to the use of tax avoidance strategies, high-income taxpayers must be very careful to ensure that their defense strategies address all pertinent risks.

Some relatively common examples of scenarios in which tax avoidance can lead to allegations of tax evasion include:

1. Abusive Use of Conservation Easements

The IRS has been paying particular attention to the use of conservation easements as a tax avoidance strategy in recent years. While charitable contributions of conservation easements can trigger substantial deductions, the IRS targets taxpayers in cases involving suspected excessive deductions and façade easements for properties that are already subject to local restrictions.

2. Fraudulent Itemized Deductions

Along with the contribution of conservation easements, various other types of itemized deductions can also significantly reduce high-income taxpayers’ liability to the IRS. However, taxpayers must be able to substantiate all itemized deductions, and they must be able to demonstrate that they qualify for all claimed deductions under the Internal Revenue Code. While taking advantage of legitimate deductions is a lawful form of tax avoidance, claiming deductions for which a taxpayer isn’t eligible constitutes tax evasion.

3. Offshore Tax Evasion

The IRS has also been paying particular attention to high-income taxpayers’ use of offshore tax planning strategies. While high-income taxpayers can mitigate their tax liability through strategic offshore planning, the default rule is that U.S. taxpayers must report their foreign financial assets and worldwide income from all sources. Failure to report foreign assets or income can trigger IRS scrutiny, and, in many cases, this scrutiny will lead to tax evasion allegations.

Contact Tax Defense Lawyer Lawrence Brown in Fort Worth, TX

Lawrence Brown is a tax defense lawyer in Fort Worth, TX who focuses on representing high-income clients in high-stakes federal tax controversies. If you are facing scrutiny from the IRS for suspected tax evasion, call 888-870-0025 or contact us online to arrange a confidential initial consultation.

Tax Evasion