MLR

Tax avoidance vs. tax evasion: Know the difference

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Two tax advisers meet for drinks after work. The first one says, “What’s the difference between tax avoidance and tax evasion?” The second one answers, “Ten years in jail.”

handcuffs on tax form

This old joke demonstrates the importance of understanding the difference between taking advantage of legal tax savings opportunities and breaking the law.

Members of certain professions tend to be targeted to an inordinate extent for questionable tax schemes. These professions include entertainers, professional athletes, and, surprisingly, doctors, dentists and other medical professionals.

What common characteristics do members of these groups share?

They are highly motivated individuals dedicated to their profession or craft and tending to focus almost exclusively on their jobs and families. They earn higher-than-average income. And they have limited direct contact with professional advisers, often relying on intermediaries like business managers or agents.

It is only natural for higher-income people who pay a lot of taxes to perceive that they’re missing out on the many so-called loopholes criticized by politicians and television news
commentators.

As a dedicated, hard-working medical professional, you probably focus limited attention on your own financial affairs. So, if a colleague tells you, “I met a guy who cut my tax bill by 25 percent,” it is understandable for you to be a little interested.

Certainly, not every tax planning opportunity is against the law. However, unscrupulous promoters of tax scams thrive in the close-knit communities of professionals, where they can be
introduced to potential new clients by word of mouth without the need to promote their programs publicly.

When a trusted colleague introduces you to a promoter, you have a tendency to assume, perhaps unreasonably, that someone else has vetted and reviewed the veracity of the promoter’s tax savings claims.

What could be better than a chance to save significant taxes without the need to spend a lot of time reviewing the program or doing a background check on the promoter? If many of your associates are doing it, you may be inclined to think that it must be OK.

There are perfectly legal ways to reduce your taxes. Tax professionals call this process tax avoidance.

Tax evasion is against the law. In a civil case, the IRS can assess financial penalties and collect interest on back taxes. When criminal tax fraud is involved, jail time can result.

Most people identify tax fraud with failing to file tax returns or filing a return without reporting all of the income. Tax fraud can also result from other activities, such as:

  • Hiding income in offshore bank accounts or trusts, disguising its true ownership
  • Claiming false or inflated deductions based, for example, on setting up a “management company” to receive unreasonable “management fees” from your medical practice and then having the management company contribute its income to a retirement plan for your benefit
  • Making frivolous arguments, such as:
    • Filing a tax return is voluntary.
    • Compensation for personal services is not income.
    • The federal income tax violates the Fifth Amendment “due process” requirement.

So how do you determine whether the tax planning being promoted is a legal tax avoidance opportunity or an illegal tax evasion scheme?

Here are three steps you should take:

1. Apply the too-good-to-be-true test. As with so many things in life, if the opportunity sounds too good to be true, it probably is. This test is alternatively known as the smell test.

2. Consult your own tax adviser. Your adviser should be a CPA or an attorney, and you should actually pay for this professional’s advice. Acceptable tax advisers for this purpose exclude casual friends, in-laws, other
medical professionals, business managers and any adviser – even a CPA or an attorney – introduced to you by the promoter.

3. Apply the front-page-of-the-newspaper test. This test should be applied even though the tax planning opportunity is supported by your tax adviser. If your proposed
activities were detailed on the front page of a widely read newspaper where it would be seen by your friends, relatives, colleagues and patients, how would you feel – even if it were ultimately determined that your tax savings actions were perfectly legal?

Do not let an overly aggressive tax planning scheme tarnish the reputation you have worked so hard to build. You aren’t required to pay more than your fair share of taxes. Moreover, you should be taking advantage of every legal tax reduction opportunity available to you.

To make sure you do not inadvertently get yourself involved in a questionable tax scheme, engage the services of a reputable tax adviser, and spend a reasonable amount of your time with the adviser. If you find yourself communicating with your tax adviser only through intermediaries, you aren’t spending an appropriate amount of time on your personal financial affairs.