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 organisation) 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 that arises is whether you want to reduce your tax bill in a legal manner or in an illegal manner.
- There are basically three methods of reducing the tax bill viz., 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 a method by which you can shift your taxable income in future years. Tax evasion is an illegal method to reduce the taxable income.
- In few countries, this word “tax avoidance” is treated in an illegal manner. Avoidance means you want to avoid it irrationally. However, in the US, tax avoidance is treated as tax minimization or tax planning.
- 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 & it may have some good points or bad points. So, features may also include the bad parameters as well. Features of tax avoidance are as follows:
- Tax Avoidance is a legal method to avoid to taxes or reduce the tax bills.
- The provisions are made from the advantage point of view of the tax payer.
- Some tax payers 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 minimisation 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:
- Using all sorts of tax avoidance measures, the person has reduced the taxable income from $ 451200 to $ 400250.
- Thus his disposal income has increased by $ 50950.
Methods of Tax Avoidance
Some of the famous methods to avoid the tax or reduce the tax in a legal manner include the following:
- One of the easiest ways to reduce the tax bill is by making a contribution to IRA. You have two options: either you park your money as a contribution or pay for your taxable income. A wise person would obviously 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 are planning to sell the assets, make sure you 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 the energy-efficient components in your home as well as offices. These installations help you gain on the 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 easily, we would suggest you to 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 to the picture here. A married tax payer filing the return jointly can avail the benefit of zero tax rate if their taxable income is under the limit prescribed. |
| Tax Harvesting | It is a simple strategy when you can reduce your tax bill by selling securities at a loss. |
| Contribution in retirement accounts | You can easily reduce the tax bills by $ 19000 by investing in retirement accounts under 401(k). |
| Utilising the IRS Credits | There are many methods to earn the IRS Credits. Some of these include a tax credit for having no children, American Opportunity Tax Credit, Saver’s credit, Child &dependant care credit, etc. |
Advantages
Some of the advantages are given below:
- Tax avoidance obviously helps in reducing the tax bills.
- Reduction in tax bills means an increase in disposable income of the tax payer.
- This further leads to an increase in household consumption or an increase in investments.
- Such provisions further strengthen the economy in the long term.
- This is a legal method of reducing the 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, tax payers can develop the habit of savings. Such savings are useful in today’s scenario of COVID-19.
Disadvantages
Some of the disadvantages are given below:
Every coin has two sides. In spite of the advantages of tax avoidances, there are a few disadvantages which warrant our attention:
- A reduction in your tax liability means a reduction in the revenue of the government.
- This leads to lower benefits to 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 part of the income.
- The reason is that few tax policies are made from the advantage point of view of the government.
Conclusion
People usually consider the word tax avoidance in a negative manner. So, one should clearly understand the difference between tax avoidance & tax evasion. The theft of taxes is called as 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 as criminal offences leading to arrests. So, one should have a clear picture of tax avoidance without any ambiguity.
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