What is Tax Avoidance?
Tax avoidance is a legal method by which an individual, enterprise or business organization reduce their taxable income under existing law and therefore, while filing their returns, the tax payers may modify their earnings and deductions as per guidelines are given by IRS/Income Tax authorities to lower their tax burdens.
Tax avoidance is completely legal and approved by law. The governments allow tax benefits on the amount deposited towards retirement benefits, healthcare expenses, interest paid on the mortgage, etc.
Components of Tax Avoidance
- Contribution Towards Retirement Benefits – In most of the countries, the contribution made towards retirement benefits are deducted from Gross IncomeGross IncomeThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity. before arriving at taxable income. For example – In the United States, one can contribute up to $19,000 to a 401(k) if you’re under 50. If you’re 50 or older, this limit increases to $25,000.
- Healthcare Expenses – Almost everywhere, the amount paid for health, medical and dental insurance, and also for dependants are deductible from gross total income, and the taxpayer should make use of it.
- Investments – The governments allow deductions for investment in certain funds specified by them. Also, the interest portion is deductible on mortgage payments. So a taxpayer should take into consideration if he/she has made a deductible investment.
- Business Expenses – For businesses, all the expenses incidental to business are allowed for the deduction. However, personal expenses should not be included in that. Only the expenses which can be proved to be incidental to the business if asked should be considered for deduction.
Tax Avoidance for Individuals
In the above example, we see that despite getting the same salaries, Mr. X, Y & Z end up paying different amounts of tax, and their take-home salaries also differ. The reason being a contribution to retirement fund social security. Now one can argue that Mr. Y’s take-home salary has reduced by $(40700-36020) = $4680 as compared to Mr. X. We must note here that a healthy contribution to retirement funds ensures that the person also gets a healthy amount after retirement.
In this case, though the take-home salary for Mr. Y has reduced by $4680, his contribution has increased by $6000 in retirement funds as compared to Mr. X. A similar comparison can be made between Mr. Y and Mr. Z, and the conclusion can be made. So we here that tax avoidance many a time is personal choices and investment considerations a person makes from various options made available by authorities.
Tax Avoidance for Businesses
While calculating the Taxable Income of a business or profession the following receipts must be added to Gross Total Income –
- Profit and gains from any business or profession carried on at any time during the previous year
- Any compensation or receipt from any specified person
- Any other receipt incidental to the business
Following expenses should be deducted while calculating the Taxable Income of a business or profession –
- Salaries and other benefits paid to employees
- Insurance charges incidental to the business
- County and other local taxes
- Marketing and other office expenses
- All product-related cost and other costs incidental to the business
We know that tax on businesses in most countries is between 25-35%, and if a business fails to consider, let’s say $1000 for the deduction, it misses on $250 ($1000*25%) benefits and that is the extra cash outflow. Also, any expenses of personal nature must not include in business expenses for the deduction; else, the business will be liable for fines and penalties. Also, if there is any previous loss that should also be considered if set-off is allowed as per the Tax laws of that country.
- Increase in the income of the individual or business entity
- Increase in the working capital of individual and business
- Increases the savings tendency in individuals
- Improves business opportunities by providing tax shelters
- Ethical way of fulfilling obligations
- Motivates a person or enterprise to take up new opportunity if a lot of tax benefits are given initially
- Individual and business entity can invest the saved tax amount in grabbing new opportunities
- The decrease in the revenue of the government;
- Decrease in the growth rate on the nation if tax collection is too low
- Increased government intervention and more strict tax policy
- The tax avoidance policies are more of government-friendly than individual.
- An individual can only save a certain percentage; they still have to pay taxes.
- Tax avoidance just means the final decision remains with individuals.
- Governments decide mostly where the investment should be diverted.
- It does not contribute a lot to the economy; most revenue comes from indirect taxes in the economy.
- It is not sufficient; there must be other resources and benefits to motivate people to start or take up a new business or profession.
So now we understand that Tax avoidance is a legal and ethical way of saving taxes. It must not be confused with tax evasion. Tax evasion is allowed by the government and authorities, whereas Tax evasionTax EvasionTax Evasion is an illegal act in which the taxpayers deliberately misreport their financial affairs to reduce or evade the actual tax liability. This includes using multiple financial ledgers, hiding or representing lesser income, gains, or profits than actually earned, overstating deductions, & failing to file returns. attracts fines, penalties, and unethical ways of saving taxes. So when a person or business is planning for taxPlanning For TaxTax planning is the process of minimizing the tax liability by making the best use of all available deductions, allowances, rebates, thresholds, and so on as permitted by income tax laws and rules imposed by a country's government. It contributes to better cash flow and liquidity management for taxpayers, as well as better retirement plans and investment opportunities. avoidance, it should always consult with an expert for advice in case of any ambiguity. Also, organizations once caught in Tax fraudTax FraudTax fraud is the deliberate use of wrong information in filing tax returns. or scandals; their goodwill is hampered for a long time. It is a great tool for personal financesPersonal FinancesPersonal Financing is a way of saving, investing, and growing an individual's money. It can be for an individual or a family as a whole and requires some level of financial literacy such as tax laws, investment opportunities, etc. and business planning, and it should be used cautiously.
This article has been a guide to what is Tax Avoidance and its definition. Here we discuss components of tax avoidance and its examples in individuals/business, advantages & disadvantages. You can learn more about accounting from the following articles –