Tax avoidance is the legitimate minimizing of taxes, using methods included in the tax code. Businesses avoid taxes by taking all legitimate deductions and by sheltering income from taxes by setting up employee retirement plans and other means, all legal and under the Internal Revenue Code or state tax codes.
Most taxpayers use some form of tax avoidance.
For example, individuals who contribute to employer-sponsored retirement plans with pre-tax funds are engaging in tax avoidance because the amount of taxes paid on the funds when they are withdrawn in retirement is usually less than the amount the individual would owe. Furthermore, retirement plans allow taxpayers to defer paying taxes until a much later date, which allows their savings to grow at a faster rate.
Some Examples of Tax Avoidance:
• Taking legitimate tax deductions to minimize business expenses and thus lower your business tax bill.
• Setting up a tax deferral plan such as an IRA, SEP-IRA plan to delay taxes until a later date.
• Taking tax credits for spending money for legitimate purposes, like taking a Work Opportunity Tax Credit for hiring workers in your business.
• Using tax deductions, changing one’s business structure through incorporation or establishing an offshore company in a tax haven.
In summary, Tax avoidance is generally the legal exploitation of the tax regime to one’s own advantage, to attempt to reduce the amount of tax that is payable by means that are within the law whilst making a full disclosure of the material information to the tax authorities.
Tax evasion, on the other hand, is the illegal practice of not paying taxes, by not reporting income, reporting expenses not legally allowed, or by not paying taxes owed. In this situation, the phrase “ignorance of the law is no excuse” comes to mind. Tax evasion is most commonly thought of in relation to income taxes, but tax evasion can be practiced by businesses on state sales taxes and on employment taxes. In fact, tax evasion can be practiced on all the taxes a business owes.
Examples of Practices Which Are Considered Tax Evasion:
- It’s considered tax evasion if you knowingly fail to report income.
- Under-reporting income (claiming less income than you received from a specific source.
- Providing false information to the IRS about business income or expenses
- Deliberately underpaying taxes owed
- Substantially understating your taxes (by stating a tax amount on your return which is less than the amount owed on the income you reported)
- Failing to declare assessable income
- Claiming deductions for expenses that were not incurred or are not legally deductible
- Claiming input credits for goods that Value Added Tax (VAT) has not been paid on
- Failing to lodge tax returns in an attempt to avoid payment.
- The following are some signs that a person or business may be evading tax:
- Not being registered for VAT despite clearly exceeding the threshold
- Not charging VAT at the correct rate
- Not wanting to issue a receipt
- Providing false invoices
- Using a false business name, address, or taxpayers identification number VAT registration number
- Not providing staff with payment summaries.