“ Making a distinction between tax avoidance (which is legal) and tax evasion (illegal). ”
In September, the IRS announced that it intends to shift its focus from less-wealthy taxpayers to high-income earners. Audit rates will not increase for those earning less than $400,000 a year.
The announcement to hold “our wealthiest filers accountable to pay the full amount of what they owe” might leave some of us asking a delicate question: Does this mean I can fudge a bit on my taxes?
Surely you’re a law-abiding citizen who’d never try to cut corners on your taxes. But let’s just say you’re intrigued that the IRS is increasing its scrutiny of other folks (attention is shifting to partnerships, corporations and promoters who are abusing tax laws as well as the wealthy).
If you’re more than intrigued — and weighing whether to fudge, fib or downright lie on your federal tax return — consider the context of the IRS announcement.
“The IRS is not saying it will look away from tax evasion if you are a less-wealthy taxpayer,” said Kassi Fetters, a certified financial planner in Anchorage, Alaska. “What the IRS is saying is that with new funding from the Inflation Reduction Act, it will restore the decade-long drop in audits for wealthy taxpayers.”
While the IRS news doesn’t mean you’re free to cheat on your taxes, it does underscore the distinction between tax avoidance (which is legal) and tax evasion (illegal).
“When we talk about tax avoidance, we’re talking about permissible tax-return positions based upon legal gray areas,” said Colin Walsh, a principal at Baker Tilly, a Chicago-based tax and consulting firm. “Frequently as a tax attorney or CPA, we encounter situations where we’re reporting something on a tax return and the law doesn’t really give us a precise answer.”
By contrast, knowingly making a false statement on your tax return crosses the line. Examples of illegality include taking a deduction for which you clearly do not qualify or substantially underreporting your income by hiding a chunk of your earnings.
When her clients explore tax avoidance moves, Fetters responds by asking, “In an audit, do you think you’d win?” She adds that most taxpayers are not trying to commit fraud. They simply want to know if it’s okay to claim a specific deduction.
A common scenario involves rental properties. For example, a property owners buys a lawn mower for a rental property that is also used as a main residence. Normally, the proper deduction would reflect the percentage use for the rental property. But percentages can blur.
“You want to think about what happens if you’re audited,” Fetters said. “You’ll have to prove you used the lawn mower as you claimed. If you don’t win, you’ll pay the tax back plus penalties and interest. For something like this, you won’t go to jail.”
Bottom line: The IRS isn’t inviting anyone earning less than $400,000 to fib. But if there’s legal justification to avoid tax — and a reasonable legal judgment could be made to uphold your tax reporting rationale — than it may be worth doing.
Just make sure you know the risk. And consult with a tax professional if you’re concerned about potential penalties from the IRS.
“I would strongly encourage anyone giving tax advice to have conversations about risk with their clients on the front end,” Walsh said. “I lead our firm’s tax controversy group and all too often, clients operate under the misimpression that when a CPA signs your tax return, every line item is bulletproof.”
When accountants raise tax avoidance issues upfront, they enable taxpayers to make an informed decision on how much risk they’re willing to incur. They can weigh pros and cons and proceed with full awareness of what might happen if they’re audited and how much money is at stake. Said Walsh: “[So] if the IRS comes knocking, it doesn’t come as a shock.”
More: Do you live in one of these 13 states? The IRS could do your taxes next year — for free.
Also read: My wife and I bought a beautiful lakeside home for $700,000. It’s now worth $1.2 million. Do we sell now to avoid capital gains?
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