Tax Avoidance: Definition & Overview

KEY TAKEAWAYS

• Tax avoidance is a term to describe legal methods a taxpayer can use to help minimize the total amount of income tax they owe.
• Various types of income expulsions, deductions, and tax credits are types of tax avoidance.
• Tax avoidance refers to legal tax breaks that get offered to taxpayers to help encourage certain behaviors.
• Both individual taxpayers and corporations can use tax avoidance to help reduce the amount of their tax bills.
• Tax avoidance does not work the same as tax evasion. Tax evasion involves a taxpayer using illegal methods to reduce their income tax.

What Is Tax Avoidance? 

Tax avoidance is a term that’s used to describe various legal methods that individuals and corporations can use to limit the income tax owed. More often than not, this happens through claiming as many allowable credits and deductions as possible. 

TAs well, tax avoidance can occur when you prioritize various investments with tax advantages. For example, an investment with a tax advantage could be buying a tax-free municipal bond. It’s important to recognize that tax avoidance is not the same as tax evasion. Tax evasion has to do with illegal tax reporting methods, such as falsifying deductions or underreporting income.

How Does Tax Avoidance Work? 

There are certain things that a taxpayer can do to help reduce the total amount of income tax owed. Tax avoidance is a strategy that’s commonly used by many taxpayers to avoid paying certain taxes. It is used to help lower their tax bills. 

It’s completely legal to do, and millions of individuals and businesses around the country take advantage of tax avoidance to reduce the amount they have to pay the Internal Revenue Service (IRS). Tax avoidance is also commonly referred to as a tax shelter. 

Tax avoidance works by allowing taxpayers to take advantage of certain deductions, credits, loopholes, and exclusions. There are various forms of tax avoidance and methods of tax avoidance. Some of these include: 

• Maxing out your annual contributions that incur from investing in a retirement account
• Take the mortgage tax deduction 
• Claiming the child tax credit 
• Setting money aside and putting it into a health savings account (HSA)

The deductions and credits that are available first had to be approved by the U.S. Congress. Then, they were signed by the president in order for the law to get added to the U.S. Tax Code. Once it’s a new tax law, taxpayers can take advantage of it.

There are specific details and requirements surrounding tax avoidance written directly into the Internal Revenue Code (IRC). In essence, lawmakers can implement new rules into the tax code to help direct consumer behavior through exemptions, deductions, or credits. By directing a specific behavior, the government is subsidizing the economy. For example, by allowing the higher education credit or allowing pre-tax deductions, the government is indirectly subsidizing the likes of higher education, retirement savings, or health insurance. There are lots of options for tax avoidance and tools taxpayers can utilize.

Types of Tax Avoidance 

There are some popular methods an individual taxpayer or corporation could use to take advantage of tax avoidance. It can help them to reduce their income tax owed. This includes various types of exclusions, credits, and deductions If you’re unsure about ‘What happens if I don’t file taxes?’ and are looking for legal ways to reduce your tax bill, tax avoidance methods such as retirement savings, standard deductions, job-related expenses, and offshoring can be explored.

Retirement Savings 

If you’re part of a retirement savings program, it can be common that you’re taking part in tax avoidance. For example, if you contribute to your employer-sponsored retirement plan, it’s a type of tax avoidance. This can also be the case if you make regular contributions to an individual retirement account (IRA). The plans that are on the more traditional side, if you will, are eligible for an immediate tax break. For tax purposes, the money is taken out of your income when you contribute to the retirement plan, which lowers your taxable income.

You will be required to pay income tax once you retire and decide to withdraw your retirement savings or a portion of it, however, the assumption is that your taxable income and taxes owed will be lower.

Standard Deduction 

The standard deduction is one of the most common ways an individual taxpayer can take advantage of tax avoidance. In 2022, the standard deduction for individuals was $12,950 and $25,900 for married couples who file their taxes jointly. 

These amounts will rise for the tax year 2023, with the individual amount increasing to $13,850 and the married couples’ amount increasing to $27,700.

Job-Related Expenses

There are certain expenses that you are eligible to deduct to help avoid paying taxes. Most employers have a list of allowable expenses you can deduct. But, there are some expenses that your employer might not deduct but you can deduct on your annual tax return. 

These would be costs that are directly related to and necessary for you to complete your job. Some of the most common examples of this include tools you might need to purchase, union dues, or vehicle mileage that’s incurred for employment purposes. Job-related expenses have to be itemized on your tax return.

Offshoring 

Offshoring is most common for high-net-worth individuals and corporations. The U.S. Tax Code has several loopholes in it that allow them to move amounts of money offshore, which is also referred to as a tax haven. 

For instance, going offshore can provide more options for locations with more favorable tax laws and looser regulations. As well, they might offer reduced financial risks and strict confidentiality. Essentially, moving money into a tax haven helps avoid paying higher taxes compared to their home country. 

Examples of Tax Avoidance 

Offshoring is most common for high-net-worth individuals and corporations. The U.S. Tax Code has several loopholes in it that allow them to move amounts of money offshore, which is also referred to as a tax haven. 

For instance, going offshore can provide more options for locations with more favorable tax laws and looser regulations. Other countries might also offer reduced financial risks and strict confidentiality. Essentially, moving money into a tax haven helps avoid paying higher taxes compared to their home country.

Investing

Investing in tax efficient financial instruments or in real estate is another great way to avoid paying taxes right now. The tax burden gets pushed to a later point in time making it possible for you to use the money to invest or spend to curb the economy.

Examples of Tax Avoidance 

Depending on if you’re an individual taxpayer or a corporation, there can be many ways to reduce your tax bill legally using tax avoidance. For example, certain retirement accounts such as a 401(k) or an individual retirement account would fall under the criteria of tax avoidance. 

Other examples of tax avoidance can include certain medical expenses, daycare costs, tuition costs, and charitable donations. However, there can be different criteria depending on where you’re located and if you’re an individual or corporation.

Tax Avoidance vs Tax Evasion: What’s the Difference? 

While they might sound similar and often get confused, tax avoidance and tax evasion are two entirely separate things. To keep things simple, tax avoidance is legal and tax evasion is illegal. 

Tax evasion occurs when taxpayers don’t report their income or revenue earned. The U.S. bases its income tax system on voluntary compliance, so all income should be reported to the IRS when you file your tax return. Essentially, if you fail to report all of your income then you’re guilty of tax evasion. 

It doesn’t matter how big or small the amount is. For example, income includes things like bonuses or tips paid to you by your employer. Income also includes the crypto currency you mine. Furthermore, if you claim tax credits that you aren’t eligible for, it’s also considered tax evasion. 

You can be either fined, jailed, or both if you conduct illegal practices and take part in tax evasion.

Summary

The term tax avoidance refers to a legal strategy that individual taxpayers or corporations can use to help reduce their income tax owed. More often than not, tax avoidance occurs through various credits and deductions that are allowable as well as income exclusion and loopholes in the Internal Revenue Code. 

The primary purpose of tax avoidance is to help encourage taxpayers to make smarter decisions and change their behaviors. For example, different types of retirement savings plans are a form of tax avoidance. It helps you avoid paying taxes on income until you’re ready to use it.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.