Updated July 14, 2023
Definition of Tax Avoidance
Tax avoidance is a method by which a taxable person (i.e., an entity or an individual, or any other business organization) can reduce his / its taxable income by playing within the legal parameters allowed by the taxation law of the country and paying tax to the government on the reduced income income-slab.
Explanation
- In a rational world, every earning person wants to pay lower taxes. The only question is whether you want to reduce your tax bill legally or illegally.
- There are three methods of reducing the tax bill: tax avoidance, tax deferral & tax evasion.
- Tax avoidance is a legal method to reduce your tax liability to comply with the provisions of tax laws. Tax deferral is how you can shift your taxable income in future years. Tax evasion is an illegal method to reduce the taxable income.
- The word “tax avoidance” is treated illegally in a few countries. Avoidance means you want to avoid it irrationally. However, tax avoidance is treated as tax minimization or tax planning in the US.
- So, this means using every legal weapon to reduce the cash outflow for taxes.
Features of Tax Avoidance
Features mean those things which describe the matter as it is & it may have some good points or bad points. So, features may also include bad parameters as well.
- Tax Avoidance is a legal method to avoid taxes or reduce tax bills.
- The provisions are made from the advantage point of view of the taxpayer.
- Some taxpayers may exploit the provisions even if they do not fit into the provisions.
- Such provisions for tax avoidance are generally made for the middle-income group of earners in the country.
- Some of the tax minimization provisions are made for corporates. We will understand this in the heading “Strategies of Tax Avoidance.”
Example of Tax Avoidance
Mr. Y has the following information for the year 2019
|
Particulars |
Amount ($) |
| Earnings received from personal & business | 4,15,800 |
| Mortgage Interest paid | 21,900 |
| Property Taxes paid | 8,400 |
| Medical expenses paid | 2,250 |
| Contributions made to charitable institutions | 15,600 |
| Expenses incurred for Investments | 2800 |
| Rental Income | 35,400 |
Solution:
| Particulars | Amount ($) |
| Incomes | |
| Earnings received from business | 4,15,800 |
| Rental Income | 35,400 |
| Total Income (A) | 4,51,200 |
| Tax avoidance strategies allowed: | |
| Mortgage Interest paid | 21,900 |
| Property Taxes paid | 8,400 |
| Medical expenses paid | 2,250 |
| Contributions made to charitable institutions | 15,600 |
| Expenses incurred for Investments | 2,800 |
| Total allowances (B) | 50,950 |
| Taxable Income (A-B) | 4,00,250 |
Explanation:
- The person has reduced the taxable income from $ 451200 to $ 400250 using all sorts of tax avoidance measures.
- Thus his disposal income has increased by $ 50950.
Methods of Tax Avoidance
Some of the well-known methods to avoid the tax or legally reduce the tax include the following:
- Contributing to IRA is one of the easiest ways to reduce the tax bill. You have two options: park your money as a contribution or pay for your taxable income. A wise person would choose investment over expenditure.
- The second is to deduct the expenses which are incurred in making investments.
- The tax rate on short-term capital gain is always higher than long-term-held assets. Hence, if you plan to sell the assets, sell the old ones first.
- If your property value can be reduced with logical reasons with the help of local valuers, you can reduce the tax arising on real estate taxes.
- To the extent possible, install energy-efficient components in your home and offices. These installations help you gain tax credits. These tax credits can be used to reduce your tax bill. Further, energy-efficient components save on your energy bill in the long term.
- If you can get home finance quickly, we suggest you take a home loan to reduce your tax liability by allowing the interest paid part as your expense.
Strategies of Tax Avoidance
|
Strategies |
Explanation |
| Long-term Capital Gains | An investment advisor can easily suggest when you should sell the stocks, bonds, real estate, etc., to reduce the taxable again & to increase the tax losses. So, tax planning comes into the picture here. A jointly married taxpayer filing the return can benefit from a zero tax rate if their taxable income is under the prescribed limit. |
| Tax Harvesting | It is a simple strategy when you can reduce your tax bill by selling securities at a loss. |
| Contribution to retirement accounts | You can quickly reduce the tax bills by $ 19000 by investing in retirement accounts under 401(k). |
| Utilizing the IRS Credits | There are many methods to earn IRS Credits. Some of these include a tax credit for having no children, American Opportunity Tax Credit, Saver’s credit, Child & dependent care credit, etc. |
Advantages
Some of the advantages are given below:
- Tax avoidance helps in reducing tax bills.
- Reduction in tax bills means an increase in the taxpayer’s disposable income.
- This further leads to an increase in household consumption or investments.
- Such provisions further strengthen the economy in the long term.
- This is a legal method of reducing tax liability by availing everything within the four corners of tax laws.
- An increase in disposal income means the working capital of the sole proprietor business is increased.
- Due to the habit of investments, taxpayers can develop the habit of savings. Such savings are helpful in today’s scenario of COVID-19.
Disadvantages
Some of the disadvantages are given below:
Every coin has two sides. Despite the advantages of tax avoidance, there are a few disadvantages that warrant our attention:
- A reduction in your tax liability means a reduction in the government’s revenue.
- This leads to lower benefits for the poor income group of the country.
- Lower tax collection entails lower growth prospects for the country.
- You cannot reduce your tax liability to absolute zero. Even after the tax avoidance strategies, you will be bound to pay taxes on some of the income.
- The reason is that few tax policies are made from the good point of view of the government.
Conclusion
People usually consider the word tax avoidance negatively. So, one should clearly understand the difference between tax avoidance & tax evasion. The theft of taxes is called tax evasion. If you do not pay tax, even if you know the tax is payable, in that scenario, we say, “Someone has evaded the tax liability.” If any entity has mistakenly done tax evasion instead of tax avoidance, it can disrupt the company’s image in public. Tax frauds are now considered criminal offenses leading to arrests. So, one should have a clear picture of tax avoidance without ambiguity.
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