Tax Avoidance vs. Tax Evasion for American Expats
Tax Obligations: What is Expected? What is Right?
Judge Learned Hand once made the following statement: “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury...Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.” In other words, the IRS does not write complicated tax laws and then punish you for taking advantage of them. Actually, such diligence is greatly rewarded. Paying more than necessary will not earn you bonus points with the IRS. You are invited to take advantage of each “loophole,” write-off, and deduction that has been made available through the tax current tax code.
What is Tax Avoidance?
Some of us feel over-obligated when it comes to our tax burden, possibly even guilty over claiming high dollar deductions. For us, the term “tax avoidance” might bring to mind thoughts of illegal, or at the very least, unethical, behavior. But tax avoidance, in the mind of the IRS, is simply smart accounting and filing. Not every taxpayer will perform the due diligence required to claim the wealth of exclusions, deductions and credits offered within the intricate lines of the U.S. tax code. The IRS is aware of this and is able to offer larger benefits than would otherwise be available because of the complexities involved in the claiming. Following the tax code to the letter and reaping the benefits is both legal and wise. Obtaining these benefits is akin to winning a prize or, maybe more accurately, succeeding in a treasure hunt.
Other countries (including the UK and New Zealand) have also begun to use the phrase “tax avoidance” to imply a legal obtaining of tax credits and deductions. It should be noted that many of these countries apply two terms to legal avoidance, though: tax avoidance and tax mitigation. In such cases, tax avoidance does imply some level of unethical behavior, at least implying that the citizen is seeking to take advantage of his country’s tax code by using its loopholes in ways that were not originally intended. To imply completely ethical and wise avoidance of unnecessary taxes and claiming of intended deductions and credits, the phrase “tax mitigation” is used.
What is Tax Evasion?
British Chancellor, Denis Healey, simplified the difference between tax avoidance and tax evasion as “the thickness of a prison wall”. Tax avoidance, even in cases where the full intent of the tax code is not being honored, is not illegal. Tax evasion is illegal, pure and simple. And tax evasion can land you in jail. Expats and stateside citizens alike may be tempted to underreport their earnings as a way of avoiding taxes. Expatriates may be doubly tempted to do so to avoid double taxation. This is not wise tax preparation; this is lying. And lying to the IRS is a serious offense. Tax avoidance allows you to remain on the right side of the law, tax evasion puts you in direct conflict with it.
The Cost of Being Caught
When you sign your tax return before filing, you are swearing that every bit of knowledge included on that form is true. If you know that it is not true, the filing of that particular return is a lie.
Civil tax penalties are levied against those who evade taxes through fraudulent reporting. Tax fraud can also be prosecuted and result in possible jail time. Purposeful underreporting (tax evasion) seems to be especially tempting to expats. Big brother is farther away and more things would have to happen in order for the expat to get caught. An expat’s employer rarely reports his earnings to the IRS, so the expat may feel “safe” in altering the truth a bit. The IRS realizes its lesser control of expats, however, and is becoming increasingly strict in both its filing requirements and swift prosecuting of evading.
Nevertheless, underreporters are rarely caught except by audit. A large number of itemized deductions, self-employment income and other easily misrepresented amounts serve as red flags for the IRS and may result in an audit. Of course, returns are also audited at random, so one cannot be careful enough to avoid the prospect completely.
The IRS should really only be feared by those who would willfully seek to deceive it. Auditors do understand the difference between purposeful evasion and an ignorance of the law. Either way, penalties will result from underreporting. Whether fraudulent or negligent, the failure-to-pay penalty (in addition to interest) is .5% of your taxes for each month that the balance goes unpaid (capping at 25%). Fail to file altogether, and you will be assessed a 5% penalty (in addition to interest) for every month that your tax balance goes unpaid (also capping at 25%). However, underpaid taxes that are a result of fraud can be assessed a 75% penalty as well as Federal criminal charges.
Other penalties resulting from tax fraud are a $500 fine for insufficiently detailed returns that are deemed “frivolous,” and a 20% Accuracy-related Penalty for returns that reflect a blatant disinterest in understanding the tax code. These penalties might seem small and less than intimidating on their own, but for those who have sought to deceive the IRS, combined penalties can result in fines of $250,000, in addition to jail time.
What is the Best Way to Save Money on Taxes as an Expat?
The best way to save money on your taxes is through legal tax avoidance (tax mitigation to those from the UK). Not only can you save thousands upon thousands of dollars by following the tax code to the letter of the law, but you will also avoid the fines and penalties that go along with the evasive approach. If you are out to save the most tax dollars possible, the best thing to do is to hire a professional. If you are an American expat living overseas, you can save even more but with even more effort and painstakingly learned knowledge needed. It is imperative that you hire an international tax professional that understands the current tax code and the benefits it holds for expats. Do not simply trust your avoidance/evasion status to another person, though. Do educate yourself in the current tax code and the tax intricacies of your country of residence. Tax laws are complicated. Seeking to understand and follow them will determine your savings as well as your standing with the IRS and the law.
I.J. Zemelman, EA is the founder of Taxes for Expats