What's the difference between tax fraud and negligence?

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What's the difference between tax fraud and negligence?

When it comes to filing taxes, one of the biggest concerns is that we’re going to mess something up. Even though we can make changes with an amended return, that worry is still there: am I going to get audited? Get a fine? Worse, go to jail somehow?

The good news is that you’re probably not going to do hard time for a mistake on your taxes. Just .0022% of taxpayers of are convicted of tax crimes in the average year even though 17% of taxpayers aren’t following at least one tax law.

So what gives? How can there be so many people breaking the law yet so few people paying the price for it?

The difference comes down to tax fraud versus negligence, and whether the mistake you made is intentional.

Tax fraud

The easiest way to define tax fraud is to let the IRS do it for us: it’s "an intentional wrongdoing, on the part of a taxpayer, with the specific purpose of evading a tax known or believed to be owing."

Some of the things that constitute fraud are not filing your taxes at all, not paying your tax bill once you do file, underreporting income, or claiming deductions or credits that you shouldn’t. The fine folks at the IRS are trained to flag suspicious activity; some are obvious, like if they discover that a false Social Security number is being used or that a corporation has multiple financial ledgers (almost a sure sign that something fishy is going on).

Others signs more nuanced, such as reported income not matching up with what it should be, which could just be the result of a typo. But underreported income is the most common type of tax fraud, and it usually happens with freelancers, whose income is more difficult to track than salaried workers, and people who have cash-heavy income reports, like those in service industries.

But remember the IRS’ definition – it has to be an intentional wrongdoing. The IRS places a high emphasis on willfulness, which it calls a "common element of tax crimes." Including an error on your taxes isn’t a crime, but doing it on purpose is.

Penalties for tax fraud depend on the extent of the crime. The minimum penalty is typically an additional fee of up to 75% of whatever you didn’t pay (on top of paying the original tax bill in full) but this can go as high as $250,000 and even jail time.

Negligence

The tax code is long and confusing. I know this. You know this. And, importantly, the IRS knows this. That’s why they’re willing to cut people slack if something’s wrong on their taxes. More often than not, you misreport something on a tax form because it’s an obscure detail that you weren’t aware of and not because you’re an evil mastermind.

Negligence includes failure to make a "reasonable attempt" to comply with tax laws (for example, you don’t know if you qualify for a deduction, and instead of checking you just claim it); being careless when filing your return; or failing to keep adequate records that would be needed to, for instance, verify deductions you’re making.

Going back to the issue of willfulness, the IRS notes that "a good faith misunderstanding of the law or good faith belief that one is not violating the law negates willfulness." If it’s all an honest mistake, you’ll usually be in the clear – to an extent.

Negligence means that you won’t get hit with as hard of a penalty as in fraud cases (and no jail time, which is always nice) but there still might be a fine involved. This is a fee of 20% of the tax you should have paid. It’s a lot less than the 75% you can pay in a fraud case, but enough that we should all double check our returns before we file them.

Avoidance versus evasion

A subplot in the fraud vs negligence debate is the idea of whether or not someone is avoiding taxes or evading them. It sounds like those are indistinguishable, but they’re not quite the same.

Avoidance of taxes is trying to lower your tax bill – and it’s completely legal. We accept credits and make deductions and contribute to pre-tax retirement funds like 401(k)s and basically do whatever we can to not pay as much as we normally would have to. It’s all on the up-and-up; you’re not making any attempt to hide what you’re doing.

Evasion, on the other hand, is taking deliberate action to evade paying taxes, and involves some sort of deceit or concealment. This is where tax fraud comes in: you’re doing something like hiding income streams or fraudulently claiming deductions.

A good way to not be brought up on charges of tax fraud is to simply not be shady when filing your tax return. There are a lot of ways you can lower your tax bill that are legal: donate to charity, use a 401(k) or an IRA, look for deductions everywhere you can, whether it’s with your home, your car, or your business.

So remember, practice avoidance and not evasion, and always double check your return before you send it off.

Image: GotCredit