From the time taxes were first imposed on American citizens, people have been trying to find ways to escape paying them. While some taxpayers continue to find legal ways to avoid paying a portion of their taxes, others simply choose to evade taxes or not pay them at all. Avoiding taxes and evading taxes may sound like similar actions, but the two terms have very different meanings. Avoiding taxes can be accomplished though various legal means, whereas evading taxes is highly illegal and can result in severe penalties. In order to effectively reduce taxes without suffering serious consequences, it is critical that all taxpayers fully understand the differences between avoiding taxes and evading taxes.
Clearly understanding what separates tax avoidance from tax evasion is a vital step for any taxpayer who wishes to save money on taxes without breaking the law. The most important difference between these two situations is that avoiding taxes can be done legally, while evading taxes cannot. In fact, tax avoidance is defined as "the minimization of tax liability by lawful methods" (freedictionary.com). Anytime methods outside of the legal boundaries are used to avoid taxes, it is considered to be tax evasion. There is a fine line which separates these two actions and as one tax professor explained "you can legally avoid paying taxes through smart business planning", but the minute you step over the line, you are evading taxes (esbinlaw.com).
Many different methods can be used to legally avoid taxes. It is up to the taxpayers to understand these methods so that they can benefit from the tax savings without breaking the law. The two most commonly used methods to avoid taxes include income deferral and income tax deductions. Income deferral, the first method mentioned, involves postponing the receipt of income until a succeeding tax year. This legal method of avoiding taxes is based on the "wherewithal-to-pay" concept and it is allowed by the government only under certain specific conditions. The idea behind this concept is that taxpayers should not be obligated to pay taxes until they have the ability to pay, which occurs only when income is recognized. This method is often beneficial to taxpayers due to the progressive tax rates. If gross income is lower in a subsequent year, then the deferred income will be taxed at a lower rate, rather then the current tax rate. Income deferral is also used frequently by businesses which use accrual basis accounting. These businesses are often able to defer income that is received from advanced payments for good or services. The IRS specifies this rule in Revenue Proceeding 2004-34, where it states that "qualifying taxpayers generally may defer to the next succeeding taxable year the inclusion in gross income for federal income tax purposes of advance payments (as defined in section 4 of this revenue procedure) to the extent the advance payments are not recognized in revenues (or, in certain cases, are not earned) in the taxable year of receipt" (irs.gov). This method of deferring taxes is again based on the "wherewithal-to-pay" concept.
Another widely used method to defer taxes is through employer-sponsored retirement plans such as Roth IRA's or 401K plans. Individuals who are enrolled in these plans are able to defer paying income taxes until the funds are withdrawn, typically after retirement. The amount of taxes paid on the funds when they are withdrawn is often much less then the amount the individual would owe at his or her current tax rate (investopedia.com). Deferring taxes can prove to be a great way for taxpayers to avoid paying taxes, but it is important that it is done carefully and within the restraints of the law.
A second and very popular way in which taxes can legally be avoided is through the use of tax deductions. Taxpayer's are able to use tax deductions to reduce their total income, which...