What Is Tax Avoidance?

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 quite a few breaks. You can avoid some taxation of your income by using them.

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. You can't claim both the standard and itemized deductions, but you can claim both tax credits and deductions.

Tax credits are considered better than deductions because credits are dollar-for-dollar reductions of what you owe the IRS. Deductions result in lowering the amount of your income that could be taxed. 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 because you can claim these and claim an itemized or standard deduction as well, just as you can with tax credits. Subtracting adjustments from your gross income produces your adjusted gross income (AGI), then 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.

An Example 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 you can prove your transactions if necessary.

Let's say you and your spouse have a 3-year-old child. You can claim the child tax credit that's worth $2,000 per qualifying child in tax year 2022, the tax return you'll file in 2023. You can claim the credit because your joint income falls below the phaseout limit of $400,000 per joint tax return.

The IRS will shave $2,000 off the amount you realize you owe in taxes when you complete your tax return. You've avoided taxation on a portion of your income to this extent.

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 2022. The standard deduction for married couples filing joint returns is $25,900 in tax year 2022, so you'd avoid paying taxes on $25,900 of your income if you claim it.

The IRS would then tax you on the remaining $45,100 remaining balance, assuming you don't claim any other tax breaks.

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. But it could be zero in capital gains if you pass it to an heir rather than sell it and its fair market value has appreciated to $50,000 by that time. Your heir has avoided a capital gains tax bill as a result.

The 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.

The Qualified Business Income Deduction

This provision lets you avoid taxation of 20% of your business income if you're self-employed or have earnings from a pass-through business entity, such as a partnership or an 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.

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.

Frequently Asked Questions (FAQs)