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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. How do you know when shrewd planning—tax avoidance—goes too far and crosses the line to become illegal tax evasion? Often the distinction turns upon whether actions were taken with fraudulent intent. Business owners often find themselves subject to more scrutiny than wage-earners with a similar level of income. Because a business owner has more options to avoid tax, both legally and illegals. Here are some of the most common criminal activities in violations of the tax law:. But, in addition to the rich and famous who make the news, there are hundreds of convictions of businessmen and businesswomen who attempted to evade payment of taxes. He received income in the form of wages, non-salary payments, and corporate payments for his personal expenses. The personal expenses included: The business owner willfully attempted to evade paying his federal income taxes by skimming gross receipts of his plumbing business and paying personal expenses from his business accounts and claiming them as business expenses. As part of his tax evasion scheme, he instructed several of his employees to solicit checks from clients payable in his name, rather than in the name of the business. He also deducted personal expenses as business expenses and similarly lowered the figures on his Schedule C profit, thereby substantially reducing his tax for tax years through Tax evasion can include federal and state employment taxes, state income taxes and state sales taxes as well. The following example illustrates this. In addition he either filed false federal income tax returns or failed to file federal income tax returns for the years at issue. He also filed false Illinois sales tax returns. He used the unreported income to fund a lavish lifestyle in Lebanon, where he spent considerable time and built a luxurious home, purchased a farm worth hundreds of thousands of dollars, and became a successful owner of a soccer club. Tax avoidance requires advance planning. Nearly all tax strategies use one or more of these strategies to structure transactions to obtain the lowest possible marginal tax rate:. Forecasting income and expenses is critically important. Effective tax planning requires solid estimates your personal and business income for the next few years. You will want to avoid having the 'right' tax plan made 'wrong' by erroneous income projections. You should already be projecting your sales revenues, income, and cash flow for general business planning purposes, so you should have much of this information available for tax planning While estimates by their nature are inexact, the more accurate you can be, the better your planning will be. 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. When you want to reduce the amount of tax that you owe, you will find that tax credits are nearly always better than tax deductions. A credit reduces your tax bill dollar-for-dollar, whereas the value of a deduction is affected by your marginal tax rate. This is an important principle to remember when evaluating whether it is better to claim a credit or a deduction when both are available for a given expense. You also need to know the special rules that apply to certain types of deductions, such as. In many cases, a business owner can deduct benefits that would be considered nondeductible personal expenses for an employee. Examples would be business use of a computer or business use of the family car. Know the rules regarding which expenses are deductible and make sure to document them properly. Over-exuberant payment of personal expenses from business funds is a red flag for audits and may be considered proof of tax fraud. Consider the big picture when claiming deductions. Claiming certain types of deductions can have a tax impact in later years. 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. Once you have claimed every tax deduction that you can, turn your attention to uncovering every possible tax credit that you can claim. As noted earlier, tax credits are generally better for you than deductions because credits are subtracted directly from your tax bill. Deductions, in contrast, are subtracted from the income on which your tax bill is based. In fact, the more you reduce your taxable income, the lower your bracket and the less valuable each additional deduction becomes. This means that you should definitely be aware of potential credits and what is required to claim them. In this case, the catch is that many tax credits are available only in certain, very limited situations. Most federal income tax credits currently available to 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. Other credits apply only to certain industries, such as restaurants and bars, or energy producers. There are also a few credits designed to prevent double taxation, and a few designed to encourage certain types of investments that are considered socially beneficial. In addition, the forms and procedures used to calculate and claim business tax credits often are quite complicated. While we do provide an outline of the basic rules, so you can decide whether to pursue a credit, we recommend that you leave the technical details to your tax professional. The federal income tax is a progressive system. It means that different levels of income are taxes at 'progressively' higher rates. One goal of tax planning to lower your taxable income, so you are taxed in a lower tax bracket with lower tax rates. The federal income tax is designed to tax higher levels of income at higher tax rates. A 'tax bracket' refers to the highest marginal tax rate that you pay on any part of your taxable income. This is the rate that will apply to each additional dollar that you earn, until you earn so much that you graduate to the next bracket. If you operate your business as a sole proprietorship, an LLC that has not elected to be taxed as a corporation, a general partnership, or an S corporation, your business income 'passes through' to your personal income tax form and is taxed at the individual tax rates. If you operate your business as a regular corporation, the corporation pays its own taxes at the corporate tax rates which may be lower than your individual rate and you are taxed only on income received from the corporation. The dollar amounts for each bracket depends upon your filing status e. The bracket amounts are based on taxable income, not gross income. You need to know your current tax bracket in order to make wise tax planning decisions, since many decisions will make sense for those in certain brackets, but not for those in others. You can find the current tax brackets on the IRS website or in your personal income tax form instructions. Although 'do it now' is excellent advice in nearly every situation, when it comes to taxes there can be a benefit to carefully considering the timing of various transactions. 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. While this might only net you a few dollars in extra interest, it might also provide you with the liquidity to make additional investment in your business. Delaying when your liability for tax occurs is not the same as delaying payment of tax! You very seldom have the option of actually delaying payment of the income tax you owe. 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 your 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. Controlling the timing of income recognition and deductions is generally possible only if you use the cash method of accounting. Although delaying the receipt of income does mean that have to wait longer to receive payment, you will have the amount you save on taxes available for your use for over a year. You should not use this strategy when you will be in a higher tax bracket in the coming year—either because your income will increase or because the tax rates will increase. You want to realize income in the year in which you will be in the lower tax bracket. You should not accelerate deductions when doing so may mean that you would lose some of the value of the deduction. For example, if you are in the 33 percent bracket this year, but anticipate being in the Similarly, if you foresee that your business profits will rise substantially over the next few years, you need to balance claiming a large deduction in one year versus spreading that deduction over several years. This applies most clearly in the case of electing to claim a large depreciation deduction in the first year the property is in service, but can apply to losses from sales of capital assets as well. Remember, only a few of these suggestions will work if you use the accrual method of accounting. In most cases, you accelerate income or defer deductions by simply doing the opposite of the suggestions outlined earlier in this article. If you plan to sell a capital asset, make sure to sell that asset in the current tax year. Delay the purchase of supplies until next year, if possible. Again, any strategies aimed at changing the tax year of income and deductions are much easier to implement if you use the cash method of accounting. Although strategies aimed at changing the year in which income and deductions are reflected on your tax return are usually more difficult to accomplish using the accrual method, this does not mean that they cannot be done. Although you want to explore all avenues to reduce your taxes, you need to be aware that certain tax strategies are likely to fail. Taking advantage of the complexity of the tax laws to reduce your legal tax debt makes good sense. Getting tripped up in the complexity and having the IRS disregard your planning strategies does not. And, deliberately disregarding the tax law to shield income is foolhardy. In addition to the obvious: 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. 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 can not 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. Business owners often run afoul of the 'substance over form' rule when they attempt to disguise compensation as 'dividends' or 'return of capital. Mike Appleton, the manager and principal stockholder of a Plasti-Cast, Inc , a regular corporation, lands a lucrative contract to supply components to a multi-national corporation. The IRS sees things differently. While the IRS can step in and reclassify a transaction based upon its substance, rather than its form, taxpayers often find that they have to live with the consequences of their initial choices. This means that if you choose a particular form for a transaction, you may have a difficult time trying to convince the IRS that the substance of the transaction differs from the form you chose. The IRS sometimes uses what is known as the 'step transaction' doctrine to argue that the substance of a particular transaction is different from its form. When it relies on this doctrine, the IRS will treat a multi-stage transaction as a single, unified transaction. It will not break up a single transaction into two or more steps for income tax purposes. So, the intermediate steps in an integrated transaction will not be assigned separate tax consequences. Many sales and exchanges of property have multiple steps and, if the rules are followed, these are perfectly valid. 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. Examples of this include the denial of interest-paid deductions to businesses that borrow money to purchase life insurance contracts benefiting their officers and employees, and the special accounting rules that apply to interest and expense payments between related parties. You can expect that IRS agents will closely scrutinize business dealings that you have with family members or other related parties. Among the items that IRS agents are likely to scrutinize carefully are vacation trips disguised as business trips, purchases of household furnishings or payments for household expenses such as repairs and mortgage payments charged off as corporate expenses, and excessive salaries paid to stockholders and relatives. Federal Taxes Learn more about keeping your business compliant with federal tax requirements. Individuals and business owners 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. Here are some of the most common criminal activities in violations of the tax law: Deliberately under-reporting or omitting income. Keeping two sets of books and making false entries in books and records. Claiming false or overstated deductions on a return. These range from claiming unsubstantiated charitable deductions to overstating travel expenses. It can also include paying your children or spouse for work that they did not perform. The IRS is always vigilant when it comes to inflated deductions from pass-through entities. Claiming personal expenses as business expenses. This is an easy trap to fall into because often assets, such as a car or a computer, will have both business and personal use. Proper record-keeping will go a long way in preventing a finding of tax fraud. Hiding or transferring assets or income. This type of fraud can take a variety of forms, from simple concealment of funds in a bank account to improper allocations between taxpayers. 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. As discussed below, it is the substance, not the form, of the transaction that determines its taxability. Think Ahead When you want to reduce the amount of tax that you owe, you will find that tax credits are nearly always better than tax deductions. Warning Know the rules regarding which expenses are deductible and make sure to document them properly. Warning Delaying when your liability for tax occurs is not the same as delaying payment of tax! Warning Controlling the timing of income recognition and deductions is generally possible only if you use the cash method of accounting. Example Mike Appleton, the manager and principal stockholder of a Plasti-Cast, Inc , a regular corporation, lands a lucrative contract to supply components to a multi-national corporation. Federal Tax Tax Planning. Newest on top Oldest on top. Our experts are always available M-F 8: BizFilings is not a law firm and does not provide legal advice. If legal advice is required, please seek the services of an attorney.
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