What Is Tax Fraud?

Tax Fraud Explained in Less Than 4 Minutes

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Tax fraud is the act of intentionally and wrongfully trying to evade taxes, which can lead to both civil and criminal penalties.

Understanding what tax fraud is compared to legal strategies that reduce tax liability can help taxpayers stay on the right side of the law while minimizing their tax burden.

Definition and Examples of Tax Fraud

Tax fraud involves knowingly committing a wrongdoing to evade taxes that should be owed. For example, someone might report less income than they know they truly earned to deceive tax agencies and pay less income tax.

Importantly, tax fraud differs from tax avoidance. Tax avoidance involves legally minimizing taxes, such as by taking full advantage of provisions in the tax code that allow you to deduct legitimate expenses.

According to the Internal Revenue Service (IRS), “Taxpayers have the right to reduce, avoid, or minimize their taxes by legitimate means. One who avoids tax does not conceal or misrepresent, but shapes and preplans events to reduce or eliminate tax liability within the parameters of the law.”

Tax fraud involves intentional wrongdoing, such as a business owner claiming an expense for something they never purchased. The IRS might then discover this lie during an audit, for example.

Claiming an illegitimate expense and intentionally trying to trick the IRS or another tax agency into thinking that you have less taxable income than you really do is tax fraud.

How Tax Fraud Works

You commit tax fraud when you knowingly try to pay less in taxes than you legally owe. Making an honest mistake on your taxes (like miscalculating) or being negligent (like failing to keep records) could potentially just incur a penalty. Still, tax fraud differs, as it is intentionally done by the taxpayer to illegally pay less money than they actually owe.

Normally, you owe income taxes on the money you earn, aside from adjustments like credits and deductions. But someone committing tax fraud might knowingly try to hide some of their income or assets in an effort to pay less tax.

For example, someone committing tax fraud might keep a secret bank account and only report earnings that go into a known bank account. Or, to deceive tax agencies, a business owner might try to reduce their taxable income by claiming they paid $50,000 in advertising expenses when really they only paid $5,000.

When you commit tax fraud, you could be prosecuted. In civil fraud cases, the government might try to collect the correct amount of tax owed plus penalties. But those who commit tax fraud can also face criminal prosecution. That can mean fines and/or potentially even going to prison for tax fraud.

Tax agencies like the IRS can catch tax fraud through several means. An audit, for example, might reveal that a claimed deduction for a business expense was faked by the taxpayer. The IRS has access to certain records that might reveal tax fraud, such as a 1099 form that reports income from freelance or gig work that you chose not to report and tried to hide from the IRS.

What Tax Fraud Means for Individuals

Tax fraud is a serious issue, not only for moral reasons regarding paying your fair share of taxes but also because it is illegal. If you try to deceive the IRS or other tax agencies, you could face significant penalties or even go to prison.

Keep in mind that trying to pay less than what you legally owe is very different from making legal, strategic tax-reduction decisions, like maximizing retirement contributions to tax-deductible accounts.

So when it's time to do your taxes, you may want to work with a tax professional or use tax software that can help you find as many legal tax deductions and tax credits as possible. But avoid working with someone who encourages you to do something fraudulent, like underreporting your income.

Key Takeaways

  • Tax fraud involves knowingly committing a wrongdoing by trying to pay less tax than what’s legally owed according to the tax code.
  • Tax avoidance differs from tax fraud, as the former involves taking advantage of legal strategies, like maximizing legitimate tax deductions.
  • Committing tax fraud can potentially lead to civil and criminal penalties, including imprisonment.