Tax avoidance is the practice of using the provisions of the Internal Revenue Code (IRC) to your advantage, reducing the amount of your taxes owed. It involves taking advantage of available loopholes in the IRC, and it's perfectly legal.
The tax code is based on what the Internal Revenue Service (IRS) terms "voluntary compliance." You're supposed to willingly part with your dollars and turn them over to the federal government. You can incur penalties for not doing so. But the IRS also refrains from taxing every dollar you bring in by providing you with a few breaks. You can avoid some taxation of your income by using them.
Definition and Examples of Tax Avoidance
Tax avoidance means taking full advantage of the tax rules that provide for tax deductions and credits. Deductions and credits require knowledge of available tax breaks so you can make use of them, as well as meticulous record-keeping so that you can prove your transactions.
Let's say you and your spouse both hold down full-time jobs, so your 3-year-old child must go to daycare Monday through Friday. This service costs you $1,000 a month. You can potentially claim the child and dependent care tax credit for 50% of up to $8,000 per year of your child care expenses as of 2021. You'd spend $12,000 over the course of the year, but the IRS would effectively give you up to $4,000 (50% of $8,000) back when you file your tax return. You've avoided taxation on a portion of your income to this extent.
The American Rescue Plan increased limits for the child and dependent care credit for the 2021 tax year.
The IRC also provides for a standard deduction based on your filing status. This is a dollar amount that comes off your income as you begin preparing your return. Let's say you and your spouse earned $75,000 in 2021. The standard deduction for married couples filing joint returns is $25,100 in 2021, so you'd avoid paying taxes on $25,100 of your income if you claim it. The IRS would then tax you on the remaining $49,900 remaining balance, assuming you don't claim any other tax breaks.
How Does Tax Avoidance Work?
Tax avoidance works by reducing your taxable income and/or your tax bill to the IRS. The IRC provides three techniques for doing so: tax credits, tax deductions, and adjustments to income. Deductions and adjustments lower your taxable income. Credits subtract from what you owe the IRS. All three work to minimize what you end up owing the IRS in taxes.
You have a choice to make when it comes to deductions. You can claim the standard deduction for your filing status or you can itemize your deductions, but you're not permitted to do both. You should use the option that shaves the most off your taxable income. While you can't claim standard and itemized deductions, you can claim tax credits and deductions.
Familiarize yourself with the tax code, or consult with a tax professional to ensure you're claiming every deduction or credit you qualify for.
Tax credits are considered better than deductions because credits are dollar-for-dollar reductions of what you owe the IRS. In contrast, deductions result in lowering the amount of income that could be taxed. For example, a $20,000 deduction would reduce your tax bill by $4,400 if your effective tax rate was 22%, but a $20,000 credit would reduce your tax bill by $20,000.
As for adjustments to income, they're particularly advantageous. You can claim these and use an itemized or standard deduction, just as you can with tax credits. Subtracting adjustments from your gross income produces your adjusted gross income (AGI), and you can further claim other deductions and tax credits from there. Some available adjustments to income include money you spent on educator expenses if you're a teacher and on any student loan interest you paid during the year.
Other Methods of Tax Avoidance
A few other tax perks can help you avoid taxation, in addition to or in combination with those that reduce income taxes.
Capital Gains Tax
Capital gains result when you sell an asset or investment for more than you paid for it. That gain is taxed according to your regular tax bracket if you held the asset for one year or less. It's subject to special, more beneficial tax rates if you hold it for longer than a year. Waiting until the 366th day or longer to sell an asset for a gain will reduce your tax rate to 0%, 15%, or 20%, depending on your overall taxable income.
These rates can be considerably less than the ordinary income tax brackets, so again, you've avoided paying taxes on any more income than you have to.
The Step-Up in Basis
The IRC has a special capital-gains provision for inherited assets as well. Normally, a gain is the difference between your purchase price of an asset, plus your costs of maintaining it (your "basis"), and the amount for which you sell it. But the purchase price threshold "steps up" to the asset's fair market value as of the date of your death if you pass it on to a beneficiary rather than sell it.
You might have a $30,000 basis in an asset that you sell for $50,000 because you purchased it for $30,000. That's $20,000 subject to capital gains for you. But it could be zero in capital gains if you pass it to an heir rather than sell it—if its fair market value has appreciated to $50,000 by that time. Your heir has avoided a capital gains tax bill as a result.
Home Sale Exclusion
The home sale exclusion lets you avoid paying capital gains tax on the sale of your primary residence. You can exclude up to $250,000 in capital gains from taxation if you sell your home for more than you pay for it. This increases to $500,000 if you're married and file a joint tax return. Some qualifying rules for how long you owned the property and how long you lived there do apply, however.
Qualified Business Income Deduction
This provision lets you avoid taxation on 20% of your business income if you're self-employed or have earnings from a pass-through business entity, such as a partnership or S corporation. These entities are set up so that their incomes and losses trickle down to be reported on their owners' tax returns. You would pay taxes on only $80,000 of your income, rather than $100,000, if you qualify for and claim this deduction and your income derives from a pass-through business entity.
Tax Evasion vs. Tax Avoidance
Tax avoidance is a gift from the IRS. Tax evasion is illegal. Tax avoidance involves not paying taxes according to legitimate, legal rules. Tax evasion involves taking an "affirmative act" or deliberate step to "make things seem other than what they are," according to the IRS.
|Examples of Tax Avoidance||Examples of Tax Evasion|
|Claiming tax credits, deductions, or adjustments to income that are provided for by law.||Failing to report income, such as not including cash tips you earned, on your tax return.|
|Claiming tax exclusions allowed by the Internal Revenue Code.||Claiming tax deductions, credits, or adjustments that you don't qualify for.|
Tax evasion can result in penalties, and the IRS will certainly pursue the taxpayer for any back taxes. Tax avoidance options should be fully substantiated with any necessary documentation to prove that you qualify should the IRS request evidence of your deductions, credits, or adjustments.
- Tax avoidance is the legal practice of taking advantage of tax provisions that allow you to claim deductions, adjustments, or credits from your total gross income to avoid paying any more in taxes than is necessary or required.
- Tax avoidance provisions are available not only to reduce income taxes but the capital gains tax and some types of business income taxation as well.
- Tax avoidance is distinctly different from tax evasion, which involves a willful effort to cheat the IRS out of tax dollars owed.
Frequently Asked Questions (FAQs)
Is it illegal not to pay taxes?
If you deliberately choose not to report taxable income, also known as underreporting, that is a violation of the IRS tax code. It is considered tax evasion and is illegal. You can be fined or even imprisoned if caught and convicted. However, if your taxable income is low enough, you may owe no taxes. In this case, it is legal not to pay them.
What are the penalties for tax evasion?
Tax evasion is a felony. If convicted, you face fines of up to $100,000, five years in prison, and the cost of prosecution. The fine for corporations can be as high as $500,000.
IRS. "Topic No. 701 Sale of Your Home."
IRS. "Part 25 Special Topics."
Cornell Law School Legal information institute. "Tax Evasion."