Tax Avoidance: A Legal Way to Reduce Taxes

Tax Avoidance: What Is It?

The employment of legal strategies to reduce an individual’s or a company’s income tax liability is referred to as tax avoidance. Often, this is done by utilizing all permitted deductions and credits. It can also be done by giving tax-beneficial investments a higher priority, such as purchasing tax-free municipal bonds. Tax evasion, which relies on unethical practices like fabricating deductions and underreporting income, is not the same as tax avoidance.

Key Aspects

• Any legal strategy employed by a taxpayer to reduce the amount of income tax due is known as tax avoidance.
• Tax avoidance strategies can be used by both individual and corporate taxpayers to reduce their tax obligations.
• Tax avoidance techniques include using tax credits, deductions, income exclusions, and loopholes.
• These are legitimate tax benefits that are provided to promote specific actions, such property ownership or retirement savings.
• Tax evasion, as contrast to tax avoidance, relies on unethical practices such underreporting income.

Tax Avoidance: Overview

Many taxpayers might use tax avoidance as a legal technique to avoid paying taxes or at the very least reduce their tax obligations. In fact, millions of people and organizations employ some type of tax avoidance to reduce the amount they legally and properly owe to the Internal Revenue Service (IRS). Tax avoidance is also referred to as a tax shelter in this context.

Taxpayers may benefit from tax avoidance by utilizing a number of credits, deductions, exclusions, and loopholes, including:

• Making a child tax credit claim
• Investing in retirement accounts and contributing the maximum amount possible each year
• Claiming a tax deduction for a mortgage
• The act of funding a health savings account (HSA)

Before being included into the U.S. Tax Code, credits and deductions (and, thus, tax avoidance) must first be approved by the U.S. Congress and signed into law by the president. Once completed, these clauses may be used to some or all taxpayers’ benefit or relief.

Tax avoidance is built into the Internal Revenue Code (IRC). By providing tax credits, deductions, or exemptions, legislators use the Tax Code to influence the behavior of the public. By doing this, they inadvertently fund certain necessary services like higher education, retirement savings, and health insurance. Rather, they might use the Tax Code to promote national objectives like increased energy efficiency.

Factors To Consider

The U.S. Tax Code is one of the most complicated in the world due to the growing usage of tax avoidance. In fact, because of its complexity, many taxpayers fail to take advantage of important tax benefits. Each year, taxpayers spend billions of hours completing tax returns, most of which is spent trying to find ways to reduce their tax burden.

Because of the annual changes to the tax code, families frequently struggle to decide how much money to set aside for retirement, savings, and education. Companies particularly bear the effects of a tax code that is continuously changing since it can have an impact on employment choices and expansion plans.

Most proposals to alter the Tax Code center on eliminating or curtailing tax avoidance. By flattening tax rates and eliminating the majority of tax avoidance provisions, newer plans frequently aim to streamline the procedure. Establishing a flat tax rate, according to its supporters, would make it unnecessary to use tax avoidance techniques. Yet, opponents claim that the idea of a flat tax is regressive.

Nonetheless, there are some tax laws that unfairly favor people with higher earnings. For illustration:

• For estates worth less than $12.06 million in 2022 and $12.92 million in 2023, federal estate taxes are eliminated.
• Compared to most earned income, capital gains are taxed at a lower rate.
• Both a first and second home’s mortgage interest is tax deductible, but not a third one.

If you’re a business owner, independent contractor, or investor, make sure to keep every receipt that could be helpful for permissible tax avoidance.

There Are Various Types of Tax Avoidance

As mentioned above, taxpaying entities can avoid taxes in a number of ways. The U.S. Tax Code’s exclusions, loopholes, and various credits and deductions are included in this. The following are only a handful of the resources available to taxpayers to benefit from tax avoidance.

Standard Deduction

90% of households, according to the Urban-Brookings Tax Policy Center, will use the standard deduction rather than itemizing their deductions. For 2022, the standard deduction for solo filers is $12,950, and for married couples filing jointly, it is $25,900. In 2023, the amounts increase to $13,850 for individuals and $27,700 for married couples filing jointly.

The Tax Cuts and Jobs Act (TCJA), which was adopted in 2017 and doubled the standard deduction and capped deductions for state and local taxes at $10,000, has rendered the mortgage interest deduction useless for the majority of Americans.

Nonetheless, a lot of small business owners, independent contractors, investors, and other people keep each and every business expense receipt that might be deductable. Others jump at the chance to confront the IRS and try to get every tax deduction and credit they can.

Savings For Retirement

You’re most likely avoiding taxes if you’re saving money for retirement. And that’s advantageous. Every person who makes contributions to an employer-sponsored retirement plan or makes investments in an IRA is avoiding taxes.

If the account is a so-called traditional plan, the investor receives an instant tax deduction equivalent to the annual contribution they make, up to a cap that is adjusted annually. When the money is withdrawn when the saver retires, income taxes must be paid on it. Both the retiree’s taxable income and the taxes due will likely decrease. That is tax avoidance.

Roth plans let investors save after-tax funds, and the tax cut will come in the form of tax-free savings after retirement. In this instance, the full account balance is tax-free. With Roths, the investor can permanently avoid paying income tax on the earnings their contributions generate during the year.

Workplace Costs

To avoid paying taxes, you can use deductions from your place of employment. On your yearly tax return, you might be eligible to deduct some costs that you did not receive reimbursement for from your employer. These expenses are thought to be necessary for you to perform your duties. Workplace costs can include gas for a personal car, union dues, or other necessary tools.

Through Offshoring

Corporations and high-net-worth individuals (HNWIs) can transfer money to overseas tax havens through loopholes in the U.S. Tax Code. These are areas with laxer rules, more benevolent tax policies, lesser financial risks, and discretion.  Going offshore by setting up subsidiaries or bank accounts allows these taxpaying entities to avoid paying (higher) taxes in their home countries.

Tax Evasion Versus Tax Avoidance

Tax evasion and tax avoidance are frequently confused. Although both are techniques to avoid paying taxes, they are extremely different from one another. While tax evasion is entirely prohibited, tax avoidance is largely permitted.

When persons underreport or fail to report income or revenue earned to a taxing authority like the IRS, it is considered tax evasion. If you don’t record all of your income, including tips and bonuses from your company, you are engaging in tax evasion. Tax evasion also includes claiming credits to which you are not legally entitled. Even if they have filed returns, some taxpayers engage in tax evasion by failing to file their returns or by failing to pay their taxes.

Tax evasion is a serious crime. Liable parties may be subject to a fine, a jail sentence, or both.