Tax Avoidance is Legal; Tax Evasion is a Crime
As an individual taxpayer and as a business owner, you often have more than one way to complete a taxable transaction. Tax planning evaluates various tax options to determine how to conduct business and personal transactions in order to reduce or eliminate your tax liability.
Although they sound similar “tax avoidance” and “tax evasion” are radically different. Tax Avoidance lowers your tax bill by structuring your transactions so that you reap the largest tax benefits. Tax avoidance is completely legal and extremely wise. Tax evasion, on the other hand, is an attempt to reduce your tax liability by deceit, subterfuge, or concealment. Tax evasion is a crime. Often the distinction turns upon whether actions were taken with fraudulent intent.
The IRS notes that the following are some of the most common criminal activities in violations of the tax law:
1. Deliberately under reporting or omitting income.
Omitting your income deliberately is not desire.
2. Keeping two sets of books and making false entries in books and records.
Engaging in accounting irregularities, such as a business’s failure to keep adequate records.
3. Claiming false or overstated deductions on a return.
This can include claiming a large charitable deduction without substantiation. The IRS is always vigilant when it comes to inflated deductions from pass-through entities.
4. Claiming personal expenses as business expenses.
This is an easy trap for a sole practitioner to fall into because often assets, such as a car or a computer, will have both business and personal use.
5. Engaging in a sham transaction.
For example, if payments by a corporation to its stockholders are in fact dividends, calling them “interest” or otherwise attempting to disguise the payments as interest will not entitle the corporation to an interest deduction.
6. Hiding or transferring assets or income.
From simple concealment of funds in a bank account to improper allocations between taxpayers. For example, improperly allocating income to a related taxpayer who is in a lower tax bracket, such as where a corporation makes distributions to the controlling shareholder’s children, is likely to be considered tax fraud.
Note: Keep in mind that tax evasion isn’t limited to federal income tax. Tax evasion can include federal and state employment taxes, state income taxes, and state sales taxes as well.
Minimizing Taxes Requires Skillful Tax Planning:
Tax avoidance requires advance planning. Nearly all tax strategies are based on structuring the transaction to obtain the lowest possible marginal tax rate by using one or more of these strategies:
- Minimizing taxable income
- Maximizing tax deductions and tax credits
- Controlling the timing of income and deductions
Forecasting income and expenses are critically important.
To make use of any of these strategies, it is essential that you estimate your personal and business income for the next few years. The effort to come up with crystal-ball estimates may be difficult and by its very nature will be inexact. The better your estimates, the better the odds that your tax planning efforts will succeed.
Deductions and Credits Reduce Your Taxes
Your tax planning goal is to pay the least amount of tax that is legally possible. You can reduce your ultimate tax bill by attacking on two fronts.
- First, take full advantage of every available deduction—both business and personal—to reduce your taxable income.
- Then, once determine the tentative tax due; claim every tax credit that is available to you.
Claiming Deductions Minimizes Taxable Income
To reduce your taxable income, you must be aware of what is deductible and what isn’t. In many cases, a business owner can deduct benefits that would be considered non-deductible personal expenses for an employee. Don’t overlook the possibility of purchasing health insurance, investing for your retirement, or providing perks like a company car through your business.
Consider the big picture when claiming deductions.
One example is electing to expense (deduct) the entire cost of a business asset in the year of purchase. While this will lower your tax liability for the current year, you will not be able to claim depreciation deductions in the future. If you anticipate your business income increasing in the future, you may want to scale back the current deduction so that you can claim depreciation deductions in future years.
Tax Credits Shave Dollars off Your Tax Bill
Once you have claimed every tax deduction that you can, turn your attention to uncovering every possible tax credit that you can claim.
Most federal income tax credits currently available to small business owners are very narrowly targeted to encourage you to take certain actions that lawmakers have deemed desirable. Examples include credits designed to motivate you to make your company more accessible to disabled individuals or to provide health insurance to your workers.
Although you can’t literally lower your tax rate (the rates are established by Congress), there are certain actions you can take that will have a similar result.
- Choosing the optimal form of organization for your business (such as corporate, sole proprietorship or partnership).
- Structuring a transaction so that payments that you receive, are classified as capital gains rather than ordinary income. Long-term capital gains earned by non-corporate taxpayers are subject to lower tax rates than other income.
- Shifting income from a high-tax-bracket taxpayer (such as yourself) to a lower-bracket taxpayer (such as your child). One fairly simple way is to do, by hiring your children. The tax laws limit the usefulness of this strategy for shifting unearned income to children under age 18, but some tax-saving opportunities still exist.
Control the Tax Year for Income and Deductions
By choosing an appropriate method of tax accounting and by thinking ahead to accelerate (or delay) when you receive income or incur expenses, you can exert some degree of control over your taxable income in any given year.
Careful planning can delay the timing of an event or transaction that gives rise to tax liability. Delaying recognition of income can be valuable.
Control Tax Liability by Postponing Income, Accelerating Deductions
By taking actions that delay the time when particular income items must be reported on your return, you can shift liability on that income to a different tax year. In general, you will be better off if you can postpone the receipt of income until the next year and accelerate payment of expenses into the current tax year. In this way, you can delay your tax liability on the deferred income to the next tax year
Consider These Simple Ideas to Delay Income and Accelerate Deductions
Of course, you should check with a tax professional before taking action in order to ensure that you haven’t overlooked critical factors.
- Delay collections
- Delay dividends
- Delay capital gains
- Accelerate payments
- Accelerate large purchases
- Accelerate operating expenses
- Don’t try to camouflage the substance of a transaction by the form the transaction takes.
- Don’t try to disguise the tax impact of a single transaction by breaking it into multiple steps.
- Don’t expect the IRS to treat your relatives as if they were strangers.
Be Alert! Avoid Common Tax Planning Traps
IRS Focuses on Substance, Not Form
Choosing to use one form of transaction, rather than another, to minimize your tax liability will not (in-and-of-itself) invalidate a transaction for income tax purposes. For example, you can elect to give your child a gift of $10,000 or put the child on the payroll where she can earn $10,000. Doing the tax calculations and picking the method that results in the lowest overall tax liability for the family is a wise course of action.
However, you cannot avoid tax liability simply by the label that you give a transaction. The IRS is going to look at the real purpose—the substance—of the transaction and tax it according. For example, you can give your son a car, or you can sell your son your car. However, you can’t sell your car and claim it was a gift.
Business owners often run afoul of the “substance over form” rule when they attempt to disguise compensation as “dividends” or “return of capital.” The IRS will not be amused; nor will you be when you receive an increased tax bill, plus interest and (most likely) penalties.
Related Taxpayers Face Closer Scrutiny
The IRS pays close attention to transactions that involve taxpayers who have close business or family relationships. In fact, the tax laws have given the IRS special powers to deal with specific areas where related taxpayers have historically used their relationships to unfairly reduce their taxes.
You can expect that IRS agents will closely scrutinize business dealings that you have with family members or other related parties. Often, the IRS will combine its audit of returns for a closely held corporation with an audit of returns of the corporation’s owners or principal officers, in order to discover any attempts to shift personal expenses to the corporation.