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  • Tax Evasion vs Tax Avoidance

    Posted on August 26th, 2010 William No comments

    As the old joke goes, what's the difference between tax avoidance and tax evasion? About twenty years.

    Tax avoidance is (legally) reducing the amount you owe in taxes. Tax evasion is (illegally) paying less than you owe in taxes. Someone avoiding taxes might use a tax shelter such as a retirement account. Someone evading taxes might need a swiss bank account. Clear enough?

    The government distinguishes between legitimate tax shelters, which are intended to generate income in a tax-preferred way, and abusive tax shelters, which exist only to keep money from being taxed. Some common tax shelters include IRAs, 401(k) and 403(b) retirement plans, municipal bonds, and even employer-sponsored health benefits and real estate. This is why retirement plans have contribution limits; those limits keep them from being used to shield an excessive amount of income from taxation.

    Abusive tax shelters, according to the IRS, include foreign trusts, where money is hidden in other countries, artificial inflation of business losses, Lease-in/Lease-out schemes, and abusive IRA contributions (where people create businesses for the sole purpose of making additional IRA contributions). On the IRS website, they provide an example of an abusive tax shelter, where someone attempts to deduct a child's non-deductible education expenses by assigning income to a trust.

    There are a number of legal principles that allow the courts to fight attempted tax fraud. Courts may invalidate a transaction when it appears to have been done for no purpose other than to avoid taxes; in some cases, this means determining whether the transaction would have occurred if not for the tax benefits. Since a complex series of transactions is often performed to obscure the true purpose of moving the money around, the court may consider all transactions in the series to be a single transaction, looking at the substance rather than the individual steps.

    Tax shelters are the reason that many large businesses, some with billions of dollars in profit, pay no federal taxes. Granted, they have armies of lawyers to help, but what works for them can work for you as well.

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