Tax avoidance is the use of legal methods to reduce the tax that you owe. This is accomplished by taking advantage of allowable credits and deductions, and through strategic tax planning that prioritizes favorable tax treatment. Tax evasion means illegally reducing your tax burden by omitting or falsifying information. While tax avoidance is perfectly legal and often built into the tax code, tax evasion is illegal and subject to civil and criminal prosecution.
Deductions and Credits
While tax avoidance may have a shady connotation, the IRS actually encourages certain behaviors by offering tax credits in exchange. Through incentivizing taxpayers with a lower tax liability, lawmakers are able to promote goals such as health insurance, education, and retirement savings, which are healthy for the overall economy and provide relief to individual taxpayers. There are many legitimate tax credits built into the tax code that allow taxpayers to legally reduce their tax liability. Some common examples include:
- Using pre-tax dollars to fund retirement savings plans such as an IRA or 401k
- Taking allowable deductions for items such as mortgage interest, property taxes, medical expenses, business expenses, and charitable contributions
- Claiming allowable credits such as the child tax credit
One of the reasons the tax code is so complicated is due to the many details and provisions surrounding some of these laws. So long as you are careful to follow the IRS guidelines set forth, reducing your taxes in this way is perfectly legal.
Tax Planning & Professionals
Strategic tax planning plays an important role in reducing tax liability, and this is where a tax professional such as a competent CPA or tax attorney can be particularly helpful. The tax code is complex to interpret, and you want to make sure that your efforts to minimize your taxes provide you with the maximum benefit while staying within IRS guidelines.
There is often more than one way to structure a taxable transaction, and careful tax planning considers and evaluates the tax impact of each option. By factoring in the tax impact of each option as well as the effect of the transaction itself, you may be able to reduce or eliminate the resulting tax liability. Here are some scenarios where strategic tax planning can be impactful in helping to avoid or reduce taxes:
- Investing in municipal bonds: Tax-exempt municipal bonds may yield a lower interest rate than other investments, but the effective yield rate when the tax benefit is factored in may make these bonds the more profitable investment.
- Capital gains treatment: Although it may be profitable to sell an investment now, it may be worth selling it in the future instead, even at a lower price, in order to be eligible for long-term capital gain tax treatment.
- Accelerated depreciation: While certain deductions allow larger write-offs for assets in the beginning of their useful life instead of depreciating the asset over time, it is important to look at projected future income and consider when depreciation will be most beneficial.
Tax evasion describes illegally and deliberately falsifying or concealing information to reduce or eliminate a tax liability. Typical examples of tax evasion include:
- Keeping two sets of financial records
- Purposely under-reporting income
- Claiming false deductions or over-stating deductions
- Claiming personal expenses as business expenses
Tax evasion is subject to fines of up $250,000 for individuals ($500,000 for corporations) and jail time of up to five years. Because the line between legal tax avoidance and illegal tax evasion is one that you don't want to cross, and because tax law can be extremely complex to interpret, a competent tax professional should be consulted to ensure that you stay on the right side of the law.