Tax Evasion: Meaning, Definition, and Penalties

Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

Timothy Li is a consultant, accountant, and finance manager with an MBA from USC and over 15 years of corporate finance experience. Timothy has helped provide CEOs and CFOs with deep-dive analytics, providing beautiful stories behind the numbers, graphs, and financial models.

What Is Tax Evasion?

Tax evasion is an illegal activity in which a person or entity deliberately avoids paying a true tax liability. Those caught evading taxes are generally subject to criminal charges and substantial penalties. To willfully fail to pay taxes is a federal offense under the Internal Revenue Service (IRS) tax code.

Key Takeaways

• Tax evasion can be either the illegal non-payment or the illegal underpayment of actual tax liabilities due.
• Tax evasion can be determined by the IRS regardless of whether or not tax forms were filed with the agency.
• To determine tax evasion, the agency must be able to show that the avoidance of taxes was willful on the part of the taxpayer.
• While tax evasion is illegal, tax avoidance includes finding legal ways (within the law) to reduce taxpayer obligations.

Understanding Tax Evasion

Tax evasion applies to both the illegal nonpayment as well as the illegal underpayment of taxes. Even if a taxpayer fails to submit appropriate tax forms, the IRS can still determine if taxes were owed based on the information required to be sent in by third parties, such as W-2 information from a person’s employer or 1099s. Generally, someone is not considered to be guilty of tax evasion unless the failure to pay is deemed intentional.

Tax evasion occurs when a person or business illegally avoids paying their tax liability, which is a criminal charge that’s subject to penalties and fines.

Failure to pay proper taxes can lead to criminal charges. In order for charges to be levied, it must be determined that the avoidance of taxes was a willful act on the part of the taxpayer. Not only can a person be liable for payment of any taxes that have been left unpaid, but they can also be found guilty of official charges and may be required to serve jail time. According to the IRS, the penalties include jail time of no more than five years, a fine of no more than $250,000 for individuals or $500,000 for corporations, or both—along with the costs of prosecution.

What Qualifies As Tax Evasion?

A variety of factors are considered when determining if the act of failure to pay was intentional. Most commonly, a taxpayer’s financial situation will be examined in an effort to confirm if the nonpayment was the result of committing fraud or of the concealment of reportable income.

A failure to pay may be judged fraudulent in cases where a taxpayer made efforts to conceal assets by associating them with a person other than themselves. This can include reporting income under a false name and Social Security Number (SSN), which can also constitute identity theft. A person may be judged as concealing income for failure to report work that did not follow traditional payment recording methods. This can include acceptance of a cash payment for goods or services rendered without reporting it properly to the IRS during a tax filing.

Tax Evasion vs. Tax Avoidance

While tax evasion requires the use of illegal methods to avoid paying proper taxes, tax avoidance uses legal means to lower the obligations of a taxpayer. This can include efforts such as charitable giving to an approved entity or the investment of income into a tax deferred mechanism, such as an individual retirement account (IRA). In the case of an IRA, taxes on the invested funds are not paid until the funds, and any applicable interest payments, have been withdrawn.

What Are Examples of Tax Evasion?

There are numerous ways that individuals or businesses can evade paying taxes they owe. Here are a few examples:

• Underreporting income
• Claiming credits you're not legally entitled to
• Concealing financial or personal assets
• Claiming residency in another state
  
• Using cash extensively
• Claiming more dependents than you have
• Maintaining a double set of books for your business

How Does the IRS Catch Tax Evaders?

The IRS Criminal Investigation Division conducts criminal investigations of alleged violations of the Internal Revenue Code. These investigations follow strict guidelines and can be initiated from information from within the IRS when a revenue agent, for example, detects possible fraud. A preliminary investigation is conducted and determines whether there's sufficient evidence to open a criminal investigation.

If an investigation is opened, a special agent uses investigative techniques to obtain evidence, including interviewing third part witnesses, conducting surveillance, executing search warrants, subpoenaing bank records, and more. If the evidence and its analysis substantiate criminal activity, the case can be referred for prosecution. But, according to the IRS, "each level of review may determine that the evidence does not substantiate criminal charges and the investigation should not be prosecuted."

Can You Go to Jail for Tax Evasion in the U.S.?

Yes, you can. Tax evasion is a felony that is punishable by up to five years in prions or a fine of up to $250,000 (or $500,000 for corporations) or both.

The Bottom Line

Tax evasion is the illegal intentional nonpayment or underpayment of taxes due, and those who engage in it can be subject to criminal prosecution, penalties, and jail time. Tax evasion is not the same as tax avoidance, which is the practice of lowering your tax obligation by legal means such as investing in retirement accounts or taking applicable tax credits when submitting your tax return.