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Tax Avoidance: Definition & Overview

Updated: November 25, 2022

There are some murky waters to navigate when it comes to tax avoidance. 

Legality makes the significant distinction between tax avoidance and tax evasion. Currently, it is entirely lawful to just avoid paying taxes, but doing so might result in heavy fines and legal action, and it is quite simple for the former to transform into the latter.

Read on as we learn more about tax avoidance.

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    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, which is where taxpayers use 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. 

    As 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.

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    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. Or, it’s 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 have to get approved by the U.S. Congress. Then, they must get signed by the president in order for the law to get added to the U.S. Tax Code. Once this happens, taxpayers can benefit from the new relief. 

    There are specific details and requirements surrounding tax avoidance written directly into the Internal Revenue Code (IRC). In essence, lawmakers can implement parts of the Tax code to help direct consumer behavior through exemptions, deductions, or credits. 

    When this happens, they then try to reduce or subsidize some essential services. For example, this could be 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. 

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    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 either avoid paying taxes or reduce their income tax owed. This includes various types of exclusions, credits, and deductions and it’s a form of legal tax avoidance. 

    Let’s take a closer look at some of the different types of tax avoidance and how they work. 

    Retirement Savings 

    If you’re part of a retirement savings program, it can be common that you’re taking part in tax avoidance. But don’t worry, that’s not a negative thing. 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. This amount can only equal the amount that was contributed and up to a certain limit. 

    Once you retire and decide to withdraw your retirement savings or a portion of it, you are required to pay income tax. In this case, however, 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 2021, the standard deduction for individuals was $12,550 and $25,100 for married couples who file their taxes jointly. 

    These amounts have risen for 2022, with the individual amount increasing to $12,950 and the married couples’ amount increasing to $25,900. 

    Workplace 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 personal vehicle mileage. 

    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 

    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 any revenue earned. These details are meant to be submitted 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. 

    And it doesn’t matter how big or small the income amount is. For example, income includes things like bonuses or tips paid to you by your employer. As well, if you claim tax credits that you aren’t eligible for then this is 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.

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    FAQs About Tax Avoidance

    Can You Avoid Taxes Legally?

    Yes, you can as long as you use legal tax avoidance strategies. Tax avoidance is a completely legal way to help reduce the total amount of tax you need to pay. This can come through different tax credits, deductions, or income exclusion.

    What Happens If You Don’t Pay Taxes?

    If you don’t pay taxes on income earned it’s considered to be tax evasion. If you get caught by the Internal Revenue Service for tax evasion, you can be faced with significant fines, prison time, or both.

    How Does Tax Avoidance Affect the Economy?

    The economy relies on taxes. When they’re not paid, it can reduce the revenue that a government can generate. This ultimately affects the level of public expenditures, meaning tax avoidance will affect the economy.

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