Is it Tax Planning, Avoidance, or Tax Fraud?
When a US Taxpayer wants to reduce their tax liability, the general terms that are used are phrases such as ‘Tax Planning,” ‘Tax Avoidance,” and/or ‘Tax Minimization.’ From a baseline perspective, the term tax avoidance does not mean a Taxpayer is conducting anything illegal or improper. For example, if a person wants to max out their 401(k) or other deferred income retirement plan in the current year — because they are currently in a high tax rate and they plan to be in a lower tax rate when they retire — that is a form of legal tax planning and tax avoidance.
Because the Taxpayer is planning on avoiding taxes now, to pay taxes later at a lower tax rate in the future (when their overall income will be less). In other words, the Taxpayer defers their current income by investing the 401(k), so that when the income is paid out to the Taxpayer in the future, instead of being taxed currently at a 37% tax rate, his tax rate retirement would instead be his retirement tax rate — which is closer to 20%. This is a form of tax planning.
Let’s look at three examples of tax planning, tax avoidance, and tax fraud.
Proper Tax Planning
Jim has a high net worth, and his kids are getting ready to graduate college. He is hoping to retire in the next 5 to 10 years. Jim also wants to plan to assist his children in the future, but he also has a wife from the first marriage and various assets that have increased significantly in value. This means when Jim passes away — hopefully very far in the future — there might be an estate tax implication. Therefore, Jim works with a tax and estate planning attorney to effectively create a QTIP trust and various irrevocable charitable trusts to minimize estate tax in the future. This is a form of effective tax planning and legal tax avoidance.
Gray Area Tax Planning
Michelle is a US person who has various sources of income. She is a permanent resident and resides outside of the United States. Michelle wants to claim treaty benefits to reduce her US source income. There are various provisions of the treaty which may assist her, but they are ambiguous — and there is recent court litigation on one of the key provisions she wants to utilize. While it is perfectly legal for Michelle to tax plan based on ambiguous and/or not an entirely ‘clear’ legal position, she must be aware that depending on what the outcome of the litigation is — it may cause her to have to go back and revise her tax planning strategies. This is an example of gray area tax planning in which nothing the Taxpayer is doing is illegal, but she may be relying on a tax position that is not necessarily stable — and may not have much longevity. This type of planning can be equated to gambling in that if it does not turn out in Michelle’s favor she may have a significant tax liability, in addition to fines, penalties, and interest.
Richard is a high-income earner with a majority of his income being generated from cash-paying clients. He has clients all over the world and he collects income from both domestic and foreign clients. Like most people, Jim does not want to pay a lot of taxes. Jim is relatively young and does not want to worry right now about future planning – – he just wants to lower his taxes now. Therefore, Jim starts to embellish his expenses for his business to artificially reduce his tax liability. While some of the expenses are legitimate, most of them are not, which has now artificially reduced his tax liability. This is a form of illegal tax fraud and improper tax avoidance.
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