What Is Tax Avoidance?
Tax avoidance refers to the use of legal methods to minimize the amount of income tax owed by an individual or a business. It's generally accomplished by claiming as many deductions and credits as are allowable. It may also be achieved by prioritizing investments that have tax advantages, such as buying tax-free municipal bonds.
Tax evasion relies on illegal methods such as underreporting income and falsifying deductions. They're quite different practices.
Key Takeaways
- Tax avoidance is any legal method used by a taxpayer to minimize the amount of income tax owed.
- Individual taxpayers and corporations can use forms of tax avoidance to lower their tax bills.
- Tax credits, deductions, and income exclusion are forms of tax avoidance.
- The Internal Revenue Code (IRC) offers legal tax breaks to encourage certain behaviors such as saving for retirement or buying a home.
- Tax evasion relies on illegal methods to reduce taxes such as underreporting income.
Understanding Tax Avoidance
Tax avoidance is a legal strategy that many taxpayers use to lower their tax bills. Millions of individuals and businesses use some form of tax avoidance to legally and legitimately cut down how much they owe the Internal Revenue Service (IRS). Methods of tax avoidance are also referred to as tax shelters when used in this context.
Taxpayers can take advantage of tax avoidance through various credits, deductions, and exclusions including:
- Claiming the Child Tax Credit and numerous other available tax credits
- Investing in a retirement account and maxing out annual contributions
- Claiming the mortgage tax deduction
- Putting money into a Health Savings Account (HSA)
Tax credits and deductions must first be approved by the U.S. Congress and signed into law by the president before they can become part of the U.S. Tax Code. These provisions can then be used for the benefit and relief of taxpayers.
Tax avoidance is built into the Internal Revenue Code (IRC). Lawmakers use this Tax Code to manipulate citizen behavior by offering tax credits, deductions, or exemptions. They indirectly subsidize certain essential services such as health insurance, retirement savings, and higher education or they may use the Tax Code to advance national goals such as greater energy efficiency.
Tax credits work somewhat differently than tax deductions. They're subtracted from what you owe the IRS or other tax authorities after you prepare your tax return and figure out what you owe. Tax deductions are subtracted from your gross income to arrive at your taxable income.
Special Considerations
The expanding use of tax avoidance in the U.S. Tax Code has made it one of the most complex tax codes in the world. Its complexity causes many taxpayers to miss out on certain tax breaks because they simply don't understand them. Taxpayers end up spending billions of hours each year filing tax returns and much of that time is spent looking for ways to avoid paying higher taxes.
Families often have a difficult time making decisions about retirement, savings, and education issues because the tax code can change annually. Businesses especially suffer the consequences of a tax code that frequently evolves and this can affect hiring decisions and growth strategies.
Proposals to the Tax Code often attempt to simplify the process by flattening tax rates and removing many tax avoidance provisions. Proponents of establishing a flat tax rate argue that it would eliminate the need to pursue tax avoidance strategies but opponents call the flat tax concept regressive.
Make sure you save every receipt that may be useful for legal tax avoidance if you're a business owner, freelancer, or investor.
Types of Tax Avoidance
Taxpaying entities can avoid paying taxes in several ways with the help of the credits, deductions, and exclusions that make up the U.S. Tax Code. These are just a few of the tools that taxpayers have at their disposal to take advantage of tax avoidance.
The Standard Deduction
The IRS has reported that87.3% of taxpayers used the standard deduction rather than itemize their deductions in 2020. The standard deduction is $14,600 for single filers in 2024 and $29,200 for married couples filing jointly.
The alternative to claiming the standard deduction is to tally up every itemized, tax-deductible expense you paid during the tax year and enter them all on Schedule A of your tax return. You can then claim the total of these deductions instead. But this is only advantageous if the total amount is more than the standard deduction you qualify for. You'd be subtracting less from your taxable income otherwise.
The Tax Code doesn't allow you to claim both the standard deduction and to itemize deductions as well. You must do one or the other.
Retirement Savings
Saving money for retirement means that you're probably engaging in tax avoidance. Every individual who contributes to an employer-sponsored retirement plan or invests in an individual retirement account (IRA) is engaging in tax avoidance.
The investor gets an immediate tax break equaling the amount they contribute to a traditional plan each year up to a limit that's updated annually. Income tax on the money isn't owed until it's withdrawn after the saver retires. The retiree's taxable income will be less in the years the contributions, reducing taxes owed. Growth on the money is typically taxed after retirement when withdrawals are made.
Roth plans work differently. There's no immediate tax break for making contributions. They allow investors to save after-tax money so the tax break comes after retirement in the form of tax-free savings. Roth accounts allow the saver to permanently avoid paying income tax on the money their contributions earn over the years, subject to some qualifying rules.
Offshoring
The U.S. Tax Code allows corporations and high-net-worth individuals (HNWIs) to move their money to offshore tax havens. These are locations that have looser regulations, more favorable tax laws, lower financial risks, and confidentiality. Going offshore by setting up subsidiaries or bank accounts allows taxpaying entities to avoid paying higher taxes in their home countries.
Tax Avoidance vs. Tax Evasion
People often confuse tax avoidance with tax evasion. Both are ways to avoid paying taxes but tax avoidance is legal and tax evasion is not.
Tax evasion occurs when people underreport or fail to report income or revenue they've earned to ataxing authority such as the IRS. You're guilty of tax evasion if you don't report all your income, such as if you omit tips or bonuses paid by your employer. Claiming credits to which you aren't entitled is also considered tax evasion. Some taxpayers are guilty of tax evasion by not filing their tax returns or not paying their taxes due even if they've filed returns.
Tax evasion is a serious offense. Entities that are found liable can be fined, jailed, or both.
Is Tax Avoidance Legal?
Tax avoidance can be a legal way to avoid paying taxes. You can accomplish it by claiming tax credits, deductions, and exclusions to your advantage. Corporations often use different legal strategies to avoid paying taxes. They include offshoring their profits, using accelerated depreciation, and taking deductions for employee stock options.
Tax avoidance can be illegal, however, when taxpayers deliberately make it a point to ignore tax laws as they apply to them. Doing so can result in fines, penalties, levies, and even legal action.
What's the Difference Between Tax Avoidance and Tax Evasion?
Tax avoidance is a legal way for taxpayers to avoid paying taxes. They can do so by using the tax credits, deductions, and exclusions that are part of the tax code to their advantage. Using these strategies can help them either avoid paying taxes altogether or lower their tax liability. Tax avoidance can be illegal if a taxpayer abuses these strategies and doesn't follow tax laws.
Tax evasion is the deliberate failure to comply with tax laws. Taxpayers evade tax assessment and payment of their taxes. Tax evasion can entail hiding income, offshoring income in areas that don't comply with a taxpayer's home country, falsifying tax records, and inflating expenses. Tax evasion can result in fines, penalties, levies, and even prosecution.
What Are the Types of Tax Avoidance?
Taxpayers can use many strategies to avoid paying taxes and they're legal and legitimate options. They include taking the standard deduction or itemized deductions, contributing to a qualified retirement account, claiming tax credits, and offshoring profits.
The Bottom Line
Tax avoidance is a very legal way to avoid paying too much in taxes. There are strategies in place that you can use to lower your tax liability. You can use the standard or itemized deductions to avoid paying excess taxes on your annual income. The amount is also considered a tax avoidance strategy if you save for retirement in an IRA or 401(k).
Don't confuse tax avoidance with tax evasion which is illegal. Consult a tax or financial professional about how to ensure that you're following the letter of the law if you're in doubt.
