When taxes take a chunk out of your business earnings, you might consider ways to lessen that burden. Tax evasion and tax avoidance both allow you to lower your tax bill, but there’s a big difference between the two. One method is legal (tax avoidance), while the other is not—and could even land you in jail. Here’s what to know about these tax-tapering strategies and how to stay above board.
Tax evasion is illegal
Tax evasion is a crime that involves concealing income or important information from tax authorities to lower your tax bill. It’s a serious form of tax fraud that can land you in hot water. Once the authorities catch on, it could result in fines, prison time, or both.
This isn’t an exhaustive list, but here are examples of how some business owners commit tax evasion:
- Paying a worker in cash to avoid payroll taxes and other workplace requirements
- Failing to report income earned overseas
- Hiding sources of revenue
- Running a side gig and not reporting any of the income
- Exaggerating or lying to claim tax deductions
- Claiming tax credits illegitimately
- Hiding assets to reduce a tax bill
- Destroying tax records
- Lying on a tax return
- Lying to a federal tax agent
- Keeping two sets of books for a business
The IRS usually discovers these cases through routine tax audits, which involve combing through a taxpayer’s income tax returns and financial records. If the tax agent notices suspicious behavior or finds errors that the taxpayer knowingly and willingly made over time, they’ll dig deeper. Tax fraud often occurs over several years and involves a large amount of money. In 2023, the median loss for tax fraud was $358,827, though some cases went into the millions.
Tax avoidance is legitimate
Tax avoidance refers to using legitimate methods to reduce, avoid, minimize, or otherwise alleviate your tax bill. According to the Internal Revenue Service, tax avoidance is perfectly legal—and even encouraged.
As a business owner, you have plenty of ways to lower your taxes. Some of these strategies include:
Claiming legit tax deductions and tax credits
Deductions and credits both help you pay less at tax time, but they work in different ways. A quick refresher: Tax deductions reduce the amount of your income that’s subject to taxes, while tax credits directly lower your tax bill dollar for dollar.
Depending on the type of business you run, there are plenty of tax deductions and tax credits that can help you save money. There’s even a sweet tax break when you have a home office.
Of course, you’ll need to prove you qualify for any tax breaks you claim. That’s why keeping records is so important. If the IRS audits your business, you can prove you qualify by providing those documents.
Maximizing your retirement savings
Offering a retirement plan at work can help you attract and retain top talent while allowing you to save for your own future. There are even tax benefits to be had.
For instance, you may claim a tax credit of up to $500 a year for the first three years you offer a 401(k) plan. You may also deduct some of your administrative fees as a business expense, and your employer contributions are exempt from federal, state, and payroll taxes in some cases.
Solo business owners may also qualify for a tax break by contributing to a SEP-IRA or a one-participant 401(k) plan.
Changing your business structure
When opening a business, you can choose a business structure that best fits your needs. It’s also possible to change that structure in order to save money in taxes. Partnerships, limited liability companies (LLCs), S corporations, and C corporations each have tax advantages and disadvantages from both a federal and state perspective.
Switching from a sole prop to an S corp, for example, allows you to minimize self-employment taxes and potentially save hundreds or thousands of dollars a year.
Or, establishing a partnership could reduce your tax liability when you divide income among multiple owners. This is a perfectly acceptable form of tax avoidance—but it’s one example of where things can go wrong. Let’s say you and your partner hatch a plan where he secretly returns his share of the profits to you, and you don’t report the income to the IRS. Then you and your partner have committed tax evasion.
Consequences of tax evasion
Here are some of the most common penalties you might face if the IRS finds out you used illegal means to evade taxes:
- Up to five years in federal prison or jail.
- A fine of up to $250,000 ($500,000 for a corporation).
- A felony on your record.
- A bill for the costs of prosecuting you.
Federal prison is the harshest punishment available, but very few people actually wind up serving jail time for tax fraud. In 2023, for example, 363 individuals were sentenced to jail or prison for this type of offense. The average sentence length was 16 months.
Civil penalties are much more likely. On top of any fines you pay for tax evasion, you’ll probably also have to pay the taxes you owe plus penalties for underpaying and/or failing to file a tax return. The IRS will also levy interest on the unpaid balance. With seriously delinquent tax debt, the federal government could revoke your passport, collect your Social Security benefits, or put a lien on your property.
Work with a tax pro to keep things above board
The key difference between tax evasion and tax avoidance is whether you use legal methods to lower your tax liability. Generally, you can avoid taxes and a criminal offense by being honest on your tax return and when speaking with tax authorities. If you’re unsure about a particular tax break or tax-minimizing strategy, it’s worth talking with a CPA or tax professional.
