What it is:
Tax evasion is the act of illegally avoiding tax liability.
How it works (Example):
Tax evasion is a felony. Section 7201 of the Internal Revenue Code states, "Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution."
For example, let's say that John wants to lower his tax bill. On his Form 1040, he claims a $500 deduction for charitable donation of goods that he did not actually donate, he neglects to report $6,000 of income he made in cash from giving piano lessons and he does not report income he received from an offshore bank account. John is committing tax evasion.
Why it Matters:
Taxes reduce the amount of cash an investor has left over to spend or reinvest. Accordingly, most people try to minimize their tax bills by making their portfolios (among other things) as tax efficient as possible, and this strategy in itself is not illegal nor is it unethical.
But there can be a fine line between tax efficiency and tax evasion. Notably, in order to prove tax evasion, there must be proof of intent to evade an unpaid tax liability. In our example above, the prosecution would have to prove that John willfully attempted to hide information in order to avoid paying taxes. If intent does not exist, the IRS may (or may not) resort to imposing fines, penalties, and interest.