What Is Tax Avoidance?
The term tax avoidance refers to the use of legal methods to minimize the amount of income tax owed by an individual or a business. This is 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 avoidance is not the same as tax evasion, which relies on illegal methods such as underreporting income and falsifying deductions.
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, income exclusion, and loopholes are forms of tax avoidance.
- These are legal tax breaks offered to encourage certain behaviors, such as saving for retirement or buying a home.
- Tax avoidance differs from tax evasion, which relies on illegal methods such as underreporting income.
Understanding Tax Avoidance
Tax avoidance is a legal strategy that many taxpayers can use to avoid paying taxes or at least lower their tax bills. Millions of individuals and businesses engage in tax avoidance to reduce how much they owe to the Internal Revenue Service (IRS) legally and legitimately. When used in this context, tax avoidance is also referred to as a tax shelter.
Taxpayers can take advantage of tax avoidance through various credits, deductions, exclusions, and loopholes, such as:
- Claiming the child tax credit
- Investing in a retirement account and maxing out your annual contributions
- Taking the mortgage tax deduction
- Putting money into a health savings account (HSA)
Credits and deductions must first be approved by the U.S. Congress and signed into law by the president before they become part of the U.S. Tax Code. Once done, these provisions can be used for the benefit or relief of some or all taxpayers.
Tax avoidance is built into the Internal Revenue Code (IRC). Lawmakers use the Tax Code to manipulate citizen behavior by offering tax credits, deductions, or exemptions. By doing so, they indirectly subsidize certain essential services such as health insurance, retirement saving, and higher education. Or, they may use the Tax Code to advance national goals, such as greater energy efficiency.
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. In fact, its sheer complexity causes many taxpayers to miss out on certain tax breaks. Taxpayers end up spending billions of hours each year filing tax returns, with much of that time used looking for ways to avoid paying higher taxes.
Families often have a difficult time making decisions about retirement, savings, and education because the tax code changes every year. Businesses especially suffer the consequences of a tax code that constantly evolves, which can affect hiring decisions and growth strategies.
Eliminating or reducing tax avoidance is at the core of most proposals seeking to change the Tax Code. Newer proposals often seek to simplify the process by flattening tax rates and removing most tax avoidance provisions. Proponents of establishing a flat tax rate argue that it would eliminate the need to pursue tax avoidance strategies. Opponents, however, call the flat tax concept regressive.
There are some tax policies, though, that disproportionately advantage citizens with higher incomes. For instance:
- Federal estate taxes are not levied on estates valued at less than $12.92 million in 2023, increasing to $13.61 million in 2024
- Long-term capital gains are taxed at a lower rate than most earned income
- Mortgage interest is deductible on both a first home and a second (but not a third) home
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
As noted above, there are several ways that taxpaying entities can avoid paying taxes. This includes certain credits and deductions, exclusions, and loopholes that make up the U.S. Tax Code. The following are just a few of the tools taxpayers have at their disposal.
The Standard Deduction
The IRS reported that 87.3% of taxpayers used the standard deduction rather than itemizing their deductions in 2020. The standard deduction is $13,850 for single filers in 2023, increasing to $14,600 in 2024, and $27,700 for married couples filing jointly in 2023, increasing to $29,200 in 2024.
For most Americans, that negates the usefulness even of the mortgage interest deduction—especially now that the Tax Cuts and Jobs Act (TCJA), which was signed in 2017, increased the standard deduction and capped deductions for state and local taxes at $10,000.
But there are plenty of small business owners, freelancers, investors, and others who save every business expense receipt that may be eligible for a deduction. Others leap to the IRS challenge and angle for every tax deduction and credit they can get.
Retirement Savings
Saving money for your retirement means you’re probably engaging in tax avoidance and that’s a beneficial strategy. Every individual who contributes to an employer-sponsored retirement plan or invests in an individual retirement account (IRA) is engaging in tax avoidance.
If the account is a traditional plan, the investor gets an immediate tax break equal to the amount they contribute each year, up to an annually revised limit. Income taxes on the money are owed when it is withdrawn after retirement. The retiree’s taxable income will likely be lower as well as the taxes owed.
Roth plans allow investors to save after-tax money and the tax break will come after retirement in the form of tax-free savings. In this case, the entire balance of the account is tax-free. Roths allow the saver to permanently avoid income taxes on the money their contributions earn over the years.
Workplace Expenses
Before 2018, you could use deductions through your workplace to avoid federal taxes. In some states, you still may be able to claim certain expenses that are not reimbursed through your employer on your annual tax return. These workplace expenses should be considered necessary to do your job. Some examples include mileage on a personal vehicle, union dues, or tools you may need.
Offshoring
There are loopholes in the U.S. Tax Code that allow 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 these taxpaying entities to avoid paying higher taxes in their home countries.
Tax Avoidance vs. Tax Evasion
People often confuse tax avoidance with tax evasion. While both are ways to avoid having to pay taxes, they are very different. Tax avoidance is very legal while tax evasion is completely illegal.
Tax evasion happens when individuals underreport or fail to report income or revenue earned to a taxing authority like the IRS. You are guilty of tax evasion if you don’t report all of your income, such as 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 taxes or not paying their taxes 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?
The simple answer to this question is yes. Tax avoidance can be a legal way to avoid paying taxes. For instance, you can avoid paying taxes by using tax credits, deductions, exclusions, and loopholes to your advantage. Many businesses use different legal strategies to avoid paying taxes, such as offshoring profits, using accelerated depreciation, and taking deductions for employee stock options.
Tax avoidance can become illegal when taxpayers deliberately make a point to ignore tax laws. 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 generally a legal way that taxpayers can avoid paying taxes. They can do so by using tax credits, deductions, exclusions, and loopholes 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. However, tax avoidance becomes illegal if taxpayers abuse these strategies and don’t follow tax laws.
Tax evasion, on the other hand, is the deliberate failure to comply with tax laws. By doing this, taxpayers evade tax assessment and the 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?
There are many strategies that taxpayers can use to avoid paying taxes. These are very legal and legitimate options. They include taking the standard deduction, contributing to a qualified retirement account, claiming work-related expenses, and offshoring profits.
The Bottom Line
Contrary to what most people think, tax avoidance is a legal way to avoid paying too much in taxes. There are different strategies in place that you can use to completely avoid paying or lower your tax liability. For instance, you can use the standard deduction to avoid paying excess taxes on your annual income. And if you save for retirement in an IRA, the amount is also considered a tax avoidance strategy. However, make sure you don’t confuse this with tax evasion, which is illegal and has serious consequences. When in doubt, consult a tax or financial professional to ensure you are compliant with the tax laws.
Related Terms: Tax Evasion, Tax Deduction, Tax Credit, Income Tax, Internal Revenue Service (IRS), Tax Code.
References
- Intuit Turbo Tax. “Tax Avoidance, Tax Evasion and Tax Sheltering: How They Differ”.
- U.S Department of the Treasury. “Writing and Enacting Tax Legislation”.
- Internal Revenue Service. “Credits and Deductions for Individuals”.
- Internal Revenue Service. “2022 Annual Report to Congress (ARC) - Publication 2104”. Page 31.
- Internal Revenue Service. “Estate Tax”.
- Internal Revenue Service. “Topic No. 409, Capital Gains and Losses”.
- Internal Revenue Service. “Publication 936, Home Mortgage Interest Deduction”. Page 2.
- Internal Revenue Service. “Publication 1304, Statistics of Income: Individual Income Tax Returns Complete Report 2020”. Page 21.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2024”.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2023”.
- Internal Revenue Service. “Topic No. 503 Deductible Taxes”.
- Congressional Research Service. “Reference Table: Expiring Provisions in the ‘Tax Cuts and Jobs Act’ (TCJA, P.L. 115-97)”. Pages 1-2, and 5.
- Internal Revenue Service. “Traditional and Roth IRAs”.
- Internal Revenue Service. “Publication 5307, Tax Reform Basics for Individuals and Families”. Page 7.
- Congressional Research Service. “Tax Havens: International Tax Avoidance and Evasion”. Pages 1 and 12.
- Internal Revenue Service. “The Difference Between Tax Avoidance and Tax Evasion”. Page 1.
- United States Code. “26 USC 7201: Attempt To Evade or Defeat Tax”.
