Tax Fraud: What It Is And How To Avoid It

Tax fraud comes in a variety of forms, from falsifying documents and orchestrating elaborate tax schemes, to misrepresenting your financial situation and evading taxes. Tax fraud is a serious offense, punishable by fines and even jail time.

Actor Wesley Snipes and musician Willie Nelson are just two examples of celebrities who got into hot water with the IRS for tax evasion, which is a type of tax fraud. For Snipes, his multi-million-dollar tax debt landed him in jail for three years, while Nelson’s more than $16 million in back taxes and penalties caused the IRS to seize most of his property, including his tour buses and bank accounts.

What is tax fraud?

How does the IRS determine what is fraud? “You’ve got to look at facts and circumstances. You’ve got to look at the taxpayer intent, or the tax advisor intent,” says Larry Gray, government liaison for the National Association of Tax Professionals.

Fraud is not when a taxpayer makes a mistake; it’s an intentional effort to cheat the government out of money.

Take this tax scam that periodically circulates on social media: Scammers suggest people fill out a phony W-2 form, using a fake employer and fabricating large amounts of income, with a hefty portion of that (fake) income showing as being withheld for taxes. The next step? File a tax return for a five-figure tax refund.

The scam puts people at risk for both financial and criminal penalties, the IRS says.

Another recent scheme involved conservation easements, with scammers abusing a provision in the tax code that allows a break for preserving property instead of developing it, says Mark Luscombe, principal tax analyst with Wolters Kluwer Tax & Accounting.

The scheme involved inflated land appraisals and inappropriately large deductions, according to the IRS.

All of which is to say that tax fraud can take many forms. Tax evasion, which is a type of tax fraud, involves the use of deceit, subterfuge, camouflage or concealment to get out of paying what you owe, according to the IRS. But tax avoidance is perfectly legal, and is essentially financial planning to reduce your tax bill.

What are the penalties for tax fraud?

Deliberately misleading the IRS for your financial benefit can have major consequences, depending on the severity of the case.

In civil fraud cases, the government must prove fraud by clear and convincing evidence, according to the IRS. The punishment is payment of the tax owed as well as any penalties and interest added to that amount.

Criminal cases require sufficient evidence to prove guilt beyond a reasonable doubt. Punishment can reach levels of $100,000 and beyond, as well as multiple years of imprisonment.

When the IRS gets wind of potential fraud, an investigation can be opened to obtain facts and evidence for the case. If it finds you “willfully and intentionally” chose not to comply with the law, you’re at risk for penalties.

That said, making a mistake or being careless on your taxes doesn’t amount to tax fraud, according to the IRS. The IRS will work with you to repair your record, although you can expect to pay fines to get into good standing.

“The IRS tends to try to avoid going into the criminal side of things. They just want their money,” Luscombe says. “If they can get their money through things like deferred payment plans, an installment agreement or an offer in compromise, they will tend to do that. But if they’ve got a really abusive situation, sometimes they want to make an example of someone.”

Tax fraud vs. tax avoidance

Tax fraud is illegal; tax avoidance is not.

In fact, tax avoidance is often equated with good tax planning. Tax avoidance involves shaping or planning your finances to reduce or eliminate tax liability by legitimate means, according to the IRS.

Maxing out your 401(k) contributions could be considered tax avoidance. So could making IRA contributions to lower your tax bill. It’s also fair to carefully consider when and how to make charitable contributions, timing them so that they have the most beneficial effect on your tax bill.

But some tax avoidance strategies cross the line into evasion and fraud.

“You might use a tax advisor who has a reading of the code that helps you lower your taxes from what you anticipated because of his interpretation,” Luscombe says.

“That can start out as tax avoidance, but if the IRS decides that’s an abusive reading of the code, then they might label it as what they call a transaction of interest,” he says. “There’s an area in which avoidance can become evasion.”

Remember, if a tax avoidance strategy seems too good to be true, it probably is, Luscombe says. And if you’re unsure, it’s worth it to contact a reputable tax advisor to weigh in before you file.